Putting an end to the destructive illicit global flows of money

The illicit extracting, hiding and channeling of capital from poor countries to havens abroad destroys societies and must be curtailed. How do we go about achieving this?

Today we conclude the series, not because we have exhausted the issues but because we must stop somewhere in the hope that your interest on the subject of dirty money flows is kindled sufficiently for you to do further reading and ask questions. We shall point to sources for further reading at the end. We promised that today's installment will address the cost that illicit capital outflows impose on Africa/Kenya's efforts to reduce poverty and build accountable democracies. We also said we will point at ways to curtail the phenomenon, and so we will. But before we do so, let's recount the drivers and mechanisms of dirty money flows to remind us and to set the context for how to address the problem.

1. Corruption and unethical and unproductive rent-seeking business practices. The series was after all inspired by the on-going case in which Samuel Gichuru, the former Managing Director of Kenya Power and Chris Okemo a sitting MP and former Minister of Finance and Minsiter of Energy are faced with extradition to Jersey, a British Crown Dependency Territory, to stand trial for allegedly receiving bribes, among others, from a French Company Alcatel, arranged by a joint Venture of another French Company, Vivende and a Kenyan company, the Sameer Group of companies, the proceeds of which were deposited in several places, including Jersey. The extradition request is the result of pressure exerted by the United States following a plea-bargain in which a subsidiary of Alcatel registered in the US admitted to bribing government officials in several developing countries including Kenya. In exploring this case we pointed out that a key driver of dirty money flows is clearly bribery, kickbacks and corrupt procurement systems. However we also noted that politicians hardly act on their own for after all it takes 2 to tango – corrupt businesses and public officials. Okemo and Gichuru may have received kickback and bribes (if they are found guilty) but they could not have taken the monies out but for complicity, collusion or assistance of banks, lawyers, accountants and secrecy services provided by the Island of Jersey and many others. Corruption hurts the most when the money is taken out of the country.

2. Regulatory failure and lack of transparency: The story as told by the Nairobi law Magazine, which inspired the series, included active efforts by politicians including allegedly Mr Okemo as Finance Minister to weaken the regulatory framework in relation to banking supervision, banking secrecy and identification of beneficiary ownership of bank accounts and of companies. This regulatory failure and the lack of transparency helped to facilitate the receipt and movement of the alleged kick-backs through the banking system and outside the country.

3. The banking sector: Banks big and small facilitate the concealment and transfer of dirty money abroad through several means: Multiple accounts where a banker opens multiple accounts in multiple names in multiple jurisdictions for clients. This Impedes monitoring and tracing client activity and assets and allows quick, confidential movement of funds.; Special name or numbered accounts where a banker opens account in code names, thereby impeding the monitoring and tracing of client activity and assets creating conditions for illicit activities; Concentration accounts where a banker conducts client business through one single account that facilitates the processing and settlement of multiple individual customer transactions. The account that commingles the funds is used for internal purposes of the bank, but it can also be a method of hiding the origin of funds thereby impeding monitoring and tracing of client activity and assets;; Offshore account, "Shell" corporations or trusts formed to hold client assets offshore. Banker opens accounts in name of offshore entities; Offshore recordkeeping when bank maintains client records offshore and minimizes or eliminates information in the country of residence; Offshore jurisdictions where bank conducts business in a jurisdiction which criminalizes disclosure of bank information and bars bank regulators from some other countries. All these impede the monitoring and tracing of client activities and assets, impede bank, regulatory and law enforcement oversight and open the doors, hide or facilitate illicit activities. These services are services are used by legitimate companies as well criminal king pins such as drug barons, sex trade pimps, smugglers and illegal arms dealers alike.

4. Offshore secrecy jurisdictions, tax havens and the secrecy services industry: We explained how the 60+ most egregious offshore financial centres (secrecy jurisdictions and tax havens) 30 of which British territories (including the City of London) but also Switzerland, Luxemburg and Mauritius among others deliberately facilitate a secrecy industry and low-tax havens meant largely to encourage capital to flee from high tax paying jurisdictions. The secrecy laws are exploited by rich individuals and companies, including banks, to conceal and channel profits and wealth out of poor and rich countries alike into these havens. This secrecy industry is the product of the tax planning "innovations" of accounting firms, especially the Big 4 designed to help their clients aggressively avoid taxes. Along with their clients, they organise networks of offshore subsidiaries to avoid paying tax. The collapse of Enron provided a rare insight into precisely how this works. The US senate report into the Enron case shows how accountants Anderson facilitated Enron's massive tax avoidance. The company paid no tax at all between 1996 and 1999. Tax planning by the accountants made this possible and involved setting up a global network of 3,500 companies, more than 440 of which were registered in the Cayman Islands. The law firms kick in by specializing in the creation of empty companies which are in turn owned by empty companies scattered across several secrecy jurisdictions all designed to conceal the real beneficiaries of wealth.

5. Multinational Companies: Corporate vehicles and secrecy services are used by wealthy individuals and companies big and small as well as by legitimate businesses and criminals alike. But far their biggest users are banks and companies. Banks use them to register and conceal the assets and activities of their clients; to conceal their own assets and liabilities including sub-prime loan assets, a phenomenon which contributed to the global financial crisis in 2008. But by far the greatest users of secrecy services and complex corporate vehicles are transnational companies. We explained how TNCs register multiple subsidiaries in several offshore financial centres (secrecy service providers and low tax centres) to conduct transfer mis-pricing and thereby conceal and shift profits into tax havens and reduce their tax liabilities.

6. Trade misinvoicing/mispricing: The previous article concentrated in explaining this phenomenon and noted that most of the US$1.8 trillion or so shifted out of Africa illicitly between 1970-2008 utilised the mechanisms of trade misinvoicing, which is inflating or deflating imports and exports in customs invoices as the case may in order to shift profits into zero or low tax jurisdictions. We noted that of the 3 ways by which dirty money moves around the world: bribery and corruption, criminal activities, commercial activities, the latter, in particular trade misinvoicing, constitute over 60% of the flows.

7. Underlying conditions: A recent UNDP report on illicit capital flows from the Least Developed Countries (LDC) outlines 3 main drivers of illicit capital flight: corruption and bad governance including regulating weaknesses; structural factors and macroeconomic factors. On structural factors the report notes that high income inequality can facilitate illicit capital flight when wealthy people feel the need to conceal their wealth including moving it abroad to avoid taxes. Another structural factor is the extent of trade and capital account openness, the view being that the more open trade regime and the rules government of capital the easier it is move capital out illicitly. On macroeconomic factors, the UNDP report suggests that large external debts, large and growing fiscal deficits and over-valued exchange rates create conducive conditions for illicit capital flight.

Putting an end to the destructive illicit global flows of money - 2 - Effects

If these are what drive the illegal exit of capital and the illegal accumulation of wealth how does it affect our countries and our societies?

1. Loss of badly needed investible capital: The UNDP report referred to above quoted the Prof. Njuguna Ndung'u, Governor, Central Bank of Kenya as saying during a keynote lecture at the South African Reserve Bank in 2007 that:

"Paradoxically, the accumulation of external liabilities in the region is mirrored by massive outflows of resources in the form of capital flight—the voluntary exit of private residents' own capital for safe haven away from the continent. The latest estimates published by UNCTAD suggest that capital flight from Sub-Saharan Africa is fast approaching half a trillion dollars, more than twice the size of its aggregate external liabilities".

Indeed as noted earlier, the Global Financial Integrity's conservative estimate of the scale of capital loss from Africa through illicit means alone to be in the neighborhood of $1.8 trillion of 39 years. This works out to an average of $11bn over the 39 years. The average over the last decade is in the hundreds of billions. A similar study conducted by Professor Simon Pak estimated the cumulative capital flight from Africa to the EU, the US and the UK and Ireland due only to commodity trade between the period 2005-2007 to be $620bn, or an average of over $200bn a year, which is more than 10 times the aid received by Africa over the same period. This steady estimated the capital loss to Kenya over the 3-year period (2005-2007) cumulatively around $200million. The scale of this loss is several times average foreign direct investment. In a strange twist, whist African countries are bending backwards to attract aid and foreign investment it is sleep walking into a major hemorrhage.

2. Loss of Tax Revenues: We have all woken up lately to the realization that the most reliable and dependable source of resources to invest in schools, roads, hospitals, energy sources and keep our democratic institutions running and maintain the peace is in fact taxation. When public officials steal or divert tax revenues to enrich themselves, our society suffers, the poor cannot get social protection and the market cannot be regulated adequately to create the enabling environment for innovations and competition. More so when we lose faith in the tax system it is hard to see how else public services and public infrastructure can be built. The market may provide some of that but the market is typically suited to supplying to those who can afford or otherwise can only provide tiered services thereby making inequality worse over generations. When the rich and companies do not pay their fair share of taxes the burden either falls disproportionately on low income people and workers or alternatively, the state's ability to provide public services and adequate regulation shrinks.

The loss of tax revenues due to illegal concealment and transfer of capital abroad is enormous. A study commissioned by Christian Aid in 2009 entitled "False Profits". PDF estimated the loss of tax revenues to developing countries due to trade misinvoicing alone in the area of commodities to be over $160bn between 2005-2007.Kenya is among the top 10 developing countries in terms of size of revenue lost to the EU the US and the UK and Ireland, estimated to be over $54 million in lost revenue. The size of the loss will be even bigger if the study covered Kenya's trade relations with India, China, Pakistan and the Middle East.

3. Damages democracy and integrity of public and private institutions: The tax system plays a critical role in bridging the relationship between citizens and state. Besides the Constitution it is one of the most empowering tools for citizens to demand accountability from the state. To undermine it is to break this critical relationship which is at the heart of democratic governance. Wealthy individuals and companies that actively undermine the tax system through aggressive tax planning, tax avoidance and tax evasion indirect undermine the system of democracy. Similarly, when wealth individuals, public servants , banks and companies manipulate secrecy and bribe public servants in order to maximize, conceal and move personal wealth and profits abroad, they undermine the very integrity code which underpins any form of public association. This is costly to genuine business people as well as public service. Loss of faith in public institutions can have a dangerous effect on peace and stability.

4. Exacerbates Inequalities: Taxation is a potent instrument for reducing inequalities in a society in 2 ways; progressive taxation requires taxing the rich more as a proportion of their wealth compared to the poor. Secondly, increased revenue derived from the greater contribution of the rich when spent on the poor helps to enable the poor take advantage of opportunities in the future. The generation and concealment of dirty money to avoid taxes undermine the ability of governments to address inequalities. Inequalities matter to the rich and the poor alike because growing inequalities of certain types can be a source of future conflict. Some people say that one of the underlying drivers of the violence in 2008 in Kenya is the high levels of income inequalities measured both vertically and horizontally (i.e. in relation to social groupings defined by ethnicity religion and geographic space). Also we know that it is harder to reduce poverty in highly unequal societies compared to more egalitarian ones.

5. Undermines transparency, regulation and financial stability. The lack of transparency in banking operations and lax regulations were at the heart of global financial crisis when banks succeeded in concealing their sub-prime assets through what the Basel-based Bank for International Settlements (the 'bank for central banks') has referred to as the 'shadow banking system'. This is the setting-up of banks, bank-like institutions and funds, including hedge funds, private equity operations and structured investment vehicles – conduits used by mainstream investment banks and others – in jurisdictions (tax havens) outside the main financial centres and outside their regulatory reach.

The aims are to escape the type of regulation that banking activities usually face and to reduce the tax bill – even if most actual activity remains in the financial centres and not in the havens. One result is greater opacity, keeping the detail of arrangements largely out of sight (and out of mind) of more stringent regulators. This enabled banks and insurance companies to continue to market, and therefore make profit from, worthless derivatives, a practice which finally imploded into the banking crisis.

Banking secrecy compounds the transparency problem. Previous large-scale corporate bankruptcies – such as those of Enron and WorldCom –exposed nests of hidden transactions and liabilities, primarily located in tax havens. These structures misled investors about the true value of the companies' assets and liabilities. The current wave of bankruptcies is no different. A Christian Aid report, "The Morning after the night Before", published to explain the financial crisis, noted a situation where during a discussion in parliament in relation to the nationalization of Northern Rock bank it became clear that the British government – the new owner – did not know either who owned the Rock's Jersey-based offshore vehicle, Granite, or what, if anything, it was worth.

If this level of secrecy pertains to our banking sector, it dies not merit pointing out the potential danger in terms of banking stability and contingent liabilities that the people of Kenya carry.

Putting an end to the destructive illicit global flows of money - 3 - What can be done

What can be done?

Addressing these complex problems entails acting at both national and international levels.

National

The UNDP LDCs report mentioned contains a list of reform measures that governments can take ranging from tax policy reforms, trade policy reforms , customs reforms, inclusive growth, legal reforms etc. as a caveat the report emphasizes, and I concur that ultimately it is about the integrity of politics and politicians – what is sometimes called political will. But as political will doesn't always come voluntarily, active citizenship exercising pressure, surveillance, watch dog rolls and whistle blowing, providing evidence through research and dialogue etc. is often necessary to raise the opportunity cost of the absence of political will. But it is also true that even the best intended public will fail when the institutions they work for o not have the best skilled personnel and the tools including legal backing to detect and punish money laundering practices. In terms of domestic reforms I will hazard the following suggestions, taking Kenya as reference

i. Reforming the Companies and Banking Codes/Laws. The Constitution helpfully outlaws public servants from holding bank accounts abroad. However public servants can front special purpose vehicles and shell companies owned by shell companies all registered in secrecy jurisdictions to conceal their identities and circumvent the Constitution. To minimize this, the Law must insist on the following: the revelation beneficiary ownership by natural persons behind companies and ever corporate account. They should reveal the natural persons behind offshore entities that may be partners to the venture or the account and list all subsidiaries associated with the company wherever they may be registered. Banks should be discouraged from opening anonymous accounts, multiple accounts, special name or numbered accounts, concentration accounts and similar accounts that make it difficult to trace activities and the assets of their holders. Banking secrecy must be streamlined to address third party confidentiality issues but with full disclosure to tax and relevant national authorities.

ii. Customs: The price filter model of Prof Simon Pak which I understand is used by the United States Customs to monitor trade misinvoicing or its adapted versions can be useful to minimize misinvoicing in imports and exports and may even be adopted to track domestic procurements of the public sector to minimize leakage through inflated pricing.

iii. Study of the nature and scope of transfer pricing: Kenya is a centre of many multinational companies. It will help immensely to have a better understanding of the nature and scope of transfer pricing involving companies operating in Kenya.

iv. Multiple bilateral information exchange: This is a second best solution. A preferred solution will be an international agreement for automatic exchange of tax information globally. In the mean time, Kenya should sign bilateral information exchange agreements with the major tax havens and secrecy jurisdictions including Jersey, Guernsey, the United Kingdom, Cayman Island, Hong Kong, Switzerland, Mauritius, Luxemburg etc. they should be aggressive in demanding total transparency especially in terms of beneficiary ownership of accounts and companies registered in these jurisdictions whom/which trades and does business with Kenya. The Germans have after all filed claims against Switzerland claiming $10bn from tax losses as a result of their nationals shielding their loot utilizing the Secrecy service of Swiss Banks. The British and the Americans have done the same.

v. Publish the profits you make campaign/rule: The Kenyan government should require all transnational companies to publish every year Kenya specific accounts showing the profits or losses they make. These profits and loss accounts should be verifiable, including procurements that taken place via tax havens and secrecy jurisdiction.

vi. Prosecute the Island state of Jersey. Kenya should counter-sue Jersey in the international court and the banks holding the alleged corrupt money from Okemo and Gichuru for complicity in corruption and for compensation for hoarding Kenyan tax payer's money adjusted for inflation. Kenya can take a leaf from Nigeria who have sued major companies like the German giant Siemens for corruption and have been compensated through out of court settlement.

International

I am fully aware that some of the suggestions I have above can be difficult to implement by small poor countries on their own. Indeed, stemming the floor of dirty money can only be successfully addressed through global agreements and global collaborative actions. These actions are particularly urgent in the following areas

Accounting reporting standards: At the moment, the global standards for financial reporting set by the biggest accounting firms, do not require transnational companies to disaggregate their accounts and report their profits on a country by country basis. Developing countries, and Africa in particular, need to pull together and push the international community to require the International accountancy Standards Board to include country by country reporting. Without this, it is impossible for individual countries to verify whether companies have paid them their right taxes. Such country by- country reporting would show if a company was declaring unexpectedly high or low profits in different jurisdictions, including recognised tax havens. This would enable developing country tax authorities to prioritise which financial flows need further investigation.

Automatic exchange of tax information: There should be strong global rules to enable developing countries to determine whether they have been paid the right amount of tax, in the right place, at the right time. The rules would require all states to exchange automatically the information they hold from companies and individuals. Compliance would be evaluated objectively, with sanctions against states that refuse to part with the information. The current OECD arrangements encouraging countries to enter into bilateral tax information exchange agreements (TIEA) does not suit all countries equally. Big countries like the United States can seek to haul Okemo and Gichuru to Jersey for trial because they have successfully prevailed upon Jersey to supply the relevant information. Kenya is unlikely, on its own with the weight of others, to receive the same treatment from Jersey.

Such an agreement should include a requirement that all banks and other financial institutions collect information, which should be available to the appropriate supervisors or regulators (including tax authorities), on the beneficial owners of all payments made, whether to residents or non-residents, individual and companies.

Going forward

A momentum is growing in this area. The African Union, has in collaboration with the Economic Commission for Africa has taken up this issue high up the political ladder. A high level commission on illicit capital flight will be announced shortly, I understand. The UNDP is also slowly building interest and capacity in this area aiming to support governments to address this problem. There is a growing civil society movement for tax justice and to fight illicit capital. Kenya is the seat of the tax Justice Network Africa. An East African coalition on tax is also on the way and the National Tax Payers Association of Kenya is an active member. There is enough basis of a collation of government, civil society and ethical businesses to pull together to address this dangerous cancer

This article is one of a part series on global dirty money, you can read other parts at Global Finance, articles 2013.