How do multinationals and unethical companies conceal and move capital abroad? It is mostly through manipulating import and export prices. We concluded the previous section of this story with the claim that the dominant way in which multinationals move capital abroad is to conceal it through the seemingly benign process of international trade with the help of secrecy jurisdictions and accountants and lawyers.
We also mentioned the inflation of financial obligations between subsidiaries of companies as a means of stripping off the capital of a subsidiary located in a high tax jurisdiction and transferring the capital through inflated interest payment to a low tax jusridiction. In this installment we shall try to explain how this works. We also promised to explain how the $1.8 trillion dollars that illicitly left Africa between 2000-2008 was arrived at.
So what role does international trade play in moving dirty money around? What is well known is the way in which trading entities, say supermarkets, and small banks are used to clean up criminal money such as monies earned from narcotics trade. Monies earned from criminal activities such as narcotics and the sale of illegal weapons or pimping in the sex trade for example are typically paid in cash. That is why homes of criminal kingpins tend to be awash with cash. To deposit such large sums of cash in a bank can raise eye brows unless you own the bank and can compromise the Central Bank's banking supervision department. If you co-own a supermarket and are a narcotics dealer, how much easier to clean your dirty money than to hide it in the buying and selling of goods and in this process slowly release the dirty money to mix up with the clean bit? This practice is well known and although widespread contributes only to the 30-35% share of dirty money as alluded to in the previous article.
The predominant way in which capital is hidden in trade and moved abroad is through the pricing of imports and exports. This strategy is employed not only by multinational companies but also by unethical local/national companies, traders and wealthy individuals seeking ways to minimize their tax obligations or ways to stash their wealth abroad.
But the practice is most effectively exploited by multinational companies for the following reasons. In the first instance multinational companies by the nature operate through subsidiaries scattered across the globe. This enables them to exploit transfer pricing as we shall explain. Secondly, having multiple subsidiaries that can front shell companies provides opportunity for the registration of unlimited number of shell companies in multiple tax havens and secrecy jurisdictions in order to conceal their operations. This may explain why as much as 50% of international trade takes place through tax havens. Thirdly, trading between and among subsidiaries of multinational companies comprise as much as 60% of global trade. This gives significant scope for the abuse of transfer pricing unparalleled by any other players and the impact of such abuse is fundamental to the global economy.
The transfer of capital from developing countries - 2 - Falsified Invoicing and Transfer Mispricing
So how does the manipulation of imports and exports lead to the transfer of resources abroad illegally? The essence is to make the transactions disappear from the books and thus the official statistics. One mechanism is through what is known as "falsified invoicing". This is when buyers and sellers collude and agree verbally to falsify the invoices either by under or over stating import and export values as will assist in minimizing their obligations to the state or help in moving capital abroad. This practice is widespread and although difficult to verify accurately it is estimated that 45 to 50 per cent of trade transactions in Latin America are falsely priced by an average of more than 10 per cent; while 60 per cent of trade transactions in Africa are mispriced by an average of more than 11 per cent ("Death and Taxes" in www.christian-aid.org). This practice is used not only by multinational companies but also by individual traders/
The second mechanism is transfer mispricing. A transfer price is the price paid for an exchange of goods and services between related affiliates of the same transnational company (TNC). In most instances this involves either the parent firm trading with a subsidiary, or two subsidiaries of the same TNC trading with each other.
As deals between related TNC affiliates account for 60 per cent of global trade, there is ample scope for mispricing. This involves inflating or deflating imports and export prices between subsidiaries.. Tax authorities say for a transaction to be legitimate, an 'arm's length principle' should be followed by paying the open-market price. This requirement is often flouted, however, with transactions mispriced to enable the parent company to move money around to minimise tax.
Poor countries are particularly vulnerable to transfer mispricing since they typically will have little access to the necessary financial information from both the local and the parent company to be able to detect mispricing. Most transnational companies typically aggregate their accounts across countries rather than publish them on a country by country basis. Moreover as most of the trading transactions would have taken place through the secrecy jurisdiction and via multiple other subsidiaries, verifying import export price manipulation becomes even more difficult.
Mispricing of imports and exports of goods and services can also take place outside subsidiaries of TNCs by importers and exporters deliberately mis-invoicing on customs documents. This phenomenon has been analysed in detail in relation to Africa's trade in commodities especially by Simon Pak. Associate Professor of Finance, Penn State University singularly, and in collaboration with Maria de Boyrie of New Mexico State University and James Nelson, Associate Professor, also of New Mexico State University. This is expressed in the paper, "Capital Movement through Trade Misinvoicing. The Case of Africa". See also "False Profits" at Christian Aid.
In one of the studies. Pak, de Boyrie and Nelson looked at trade in commodities between 30 African countries and the United states covering the period 2000-2005. They use a price filter approach . This filter picks up sharp price differences quoted in the customs data compared to US/world median prices for the category of goods in question. The difference between the import export prices quoted in the customs invoices and the median prices are then aggregated to show losses due to misinvoicing. Africa lost over $13bllions to the US alone through these practices between 2000-2005. Extend this to trade with the EU, Japan, India and China and the loss of capital through trade misinvoicing is astronomical.
The transfer of capital from developing countries - 3 - A Price List
Their studies demonstrate just how extreme the mispricing can be. For example, in November 2005, a set of golf clubs were imported into Nigeria for $4,976, while the U.S./World median price for the same set of clubs was only $82. During the same month, a gasoline generator was imported into Ghana from the U.S. at a price of $60,000 that could be purchased at the U.S./World median price of $63.03. During June of 2005, an electric hair dryer was imported into Nigeria at a price of $3,800 when the U.S./World median price was estimated to be $25.In February of 2002, U.S. customs data showed that Ghana exported diamonds to the U.S. through New York via air cargo a total of 37 times with a total undervalued amount of $311 million. In 2000 Ghana that year lost up to $328 million of capital outflow through low priced exports. The amount of capital outflows from Ghana to the U.S. through trade misinvoicing increased dramatically between 2003 and 2005.
Trade misinvoicing may be done for the purposes of evading custom duties and restrictions, avoiding paying taxes and fees, avoiding quotas, smuggling, to launder illegally obtained money, or for other unknown reasons. Misinvoicing of imports by overpricing can be used to conceal illegal commissions and to transfer monies that are hidden in the inflated prices. Under invoiced imports use misinvoicing to: (1) avoid or reduce import duties and restrictions, (2) dump foreign produced goods at below market prices in order to drive out domestic competition and, (3) smuggle goods into a country in order to avoid paying taxes and fees
Companies could over invoice their exports as a response to their governments' attempts to reward those companies or industries that increase their export revenues, or simply to hide illegal commissions that can be concealed within the inflated prices. In either case, over invoicing of exports causes the amount of export subsidies offered by some developing countries to increase. On the other hand, under invoiced export transactions may be used to avoid or reduce export surcharges in countries where these exist or as a technique of evading income taxes, launder money and/or facilitating capital flight.
Pak et al's work is no doubt revealing but severely understates the scale of capital losses through the manipulation of import/export prices. Their model captures mainly trade in goods/commodities. Trade in services and in technology are increasing in importance. Besides, the model requires the use of customs data which often tend to be unreliable in many developing countries.
The more comprehensive estimates come from the work of Global Financial Integrity utilizing published and verified data from the World Bank, the IMF and others. Their model builds on the World Bank's Residual model which compares a country's source of funds with its recorded use of funds. According to the model, whenever a country's source of funds exceeds its recorded use of funds, the residual comprises unaccounted-for, and hence illicit, capital outflows. This model also does not capture trade in services or re-invoicing between subsidiaries.
A second approach compares a developing country's exports to the world with what the world reports as having imported from that country, after adjusting for insurance and freight. Additionally, a country's imports from the world are compared to what the world reports as having exported to that country. Discrepancies in partner-country trade data, after adjusting for insurance and freight, indicate misinvoicing. However, note that this method only captures illicit transfer of fund abroad through customs re-invoicing; IMF Direction of Trade Statistics cannot capture mispricing that is conducted on the same customs invoice
The GFI model utilizes these 2 but adjust them for services and misinvoicing that is conducted in same customs invoices. It is this model that generated the figure of US$1.8 trillion lost to Africa between 1970-2008.
In the final installment we shall examine the cost of these practices to Africa/Kenya's development and suggest ways to minimize these leakages.
I am a Ghanaian development economist, who has been active in international development for over 20 years; as a researcher and lecturer, as an NGO activist and development professional in several parts of the world. Working with others, I co-founded several development organisations around the world, including the Third World Network, ISODEC and the Centre for Public Interest Law in Ghana. Heading the United Nations Millennium Campaign in Africa, till December 2014. I currently head Savannah Accelerated Development Authority (SADA), Ghana.