African Regional Integration and the Fight Against Illicit Financial Flows

This blog was orginally posted on afdb.org.

The African Development Bank estimates that illicit financial flows have drained in excess of a trillion dollars from Africa since 1980. These flows undermine the tax base, damage political institutions and exacerbate inequality. With major momentum behind global counter-measures, there are clear opportunities for progress at the regional level – including through stronger information exchange and cooperation, tax base harmonization and innovative uses of trade data.

Illicit flows are, by definition, hidden. Typically they involve the hidden movement of profits, hidden transfers of ownership, or hidden income streams. The main motivations are tax evasion (corporate and individual); laundering the proceeds of crime (largely human trafficking and drug trafficking); and corruption (including the theft of state assets and the bribery of public officials).

These will often rely on the manipulation of trade prices (including transfer prices, the name given to the prices established for trade between companies in the same multinational group); and the use of anonymous companies in relatively secretive ‘tax haven’ jurisdictions. Because illicit flows rely on being hidden, the main counter-measures are improvements in specific elements of financial transparency.

Growing civil society demands for ‘tax justice’ in many countries, coupled with the sharp rise in fiscal pressures on politicians in many OECD economies since the financial crisis that began in 2008, culminated last year in a series of substantive steps in the fight against illicit financial flows:

First, the G8 countries took a lead on the importance of knowing the beneficial owners of companies (read: identifying parties profiting from companies even if their names are not associated with those companies), recognizing that this is critically important to well-functioning markets and to combatting corruption, and – importantly – that their own lack of transparency has global ramifications;

Second, there was agreement at the G8 and G20 meetings on the need forautomatic, multilateral exchange of tax-relevant information between jurisdictions, and the OECD was mandated to produce a standard. This includes information about ownership of assets and income streams, and beneficial ownership information is necessary to make it function and to tackle not only tax abuse, but also other areas of illicit flows; and

Third, the same groups acknowledged that some country-by-country reporting by multinational groups is valuable to limit the extent of abusive or unfair profit-shifting (that is, commercial tax abuse), and the OECD was again mandated to produce an international standard.

While there remains much to do, these are important commitments – perhaps, this represents the end of the beginning for systematic financial secrecy.

Last year also saw a spate of high-profile reports, including those from theAfrican Development Bank and the African Progress Panel, on the scale of illicit financial flows out of Africa. In addition, the UN Economic Commission for Africa’s High Level Panel, chaired by Thabo Mbeki, continued its work and will publish a major report later this year. Drawing on two years of technical analysis, case studies and multiple country visits to engage with governments and civil society, the Mbeki panel report’s policy recommendations are likely to prove influential – both within Africa and in providing clear African leadership in the ongoing global processes. In addition, the Tana High-Level Forum on Security in Africa this year takes illicit flows as its theme.

There is no question then that the African policymakers are focused on the issues. They now face three major questions:

• What national or regional countermeasures are likely to yield benefits by reducing IFF?
• What national or regional countermeasures are needed to meet international responsibilities?
• What scope is there for greater benefits from the ongoing international processes?

The answers to all three are linked, because the opportunity to benefit from international processes will depend on regional and national actions.

Consider first the opportunity of engaging in automatic, multilateral exchange of tax information. To meet international responsibilities, national policymakers should ensure the collation of, and consider publishing, registers of the beneficial ownership of their own companies (and other vehicles such as trusts and foundations). Failure to do so means that countries risk providing the secrecy that can promote illicit financial flows elsewhere.

This same step is also necessary to be able to provide reciprocity in information exchange, which the new OECD standard makes a general requirement – so if Ghana, for example, wishes to receive information about Ghanaian residents’ assets in Jersey, Ghana would need to be in a position to reciprocate. This means Ghana would need systems in place to identify domestically all overseas beneficial owners and the specific residence jurisdictions thereof.

In addition, such a step would also offer clear value to Ghana independent of international information exchange, since this is a requirement for any effective anti-money laundering and related anti-corruption efforts. As a major World Bank study showed, for example, every single one of 150 large corruption cases explored involved an anonymous shell company.

Overall then, establishing effective systems to identify beneficial ownership in the financial system and of companies (and trusts and foundations where applicable) will have direct domestic benefits; will ensure countries meet their international responsibilities; and will provide the basis to participate in the new standard of automatic exchange of tax information, when reciprocity is required.

The area of automatic exchange of tax information also provides a powerful example of the benefits of regional cooperation. While unilateral US demands for information under the Foreign Account Tax Compliance Act (FATCA) have forced new openness from some of the most secretive jurisdictions such asSwitzerland, the principle of multilateral exchange was pioneered, and the precedent set, by the European Union through its Savings Tax Directive. The Directive has required automatic exchange of information (or in some cases a withholding tax) on savings income only, delivering more than €10 billion a year of interest payments into member states’ tax net, and now looks likely to beexpanded substantially in scope and effectiveness.

This regional initiative has also led to the strengthening of member systems domestically in order to facilitate cooperation, and has managed to include those member states (or in the UK’s case, their territories) that are most opposed to transparency. The equivalent within, for example, the East African Community, could yield similar benefits. In addition, it would also provide a powerful antidote to some sceptical OECD members and others, who have claimed that lower-income countries would not be able to establish the required systems, nor deal effectively or confidentially with the resulting information.

The EU has also pioneered an initiative to harmonize the corporate tax base, theCommon Consolidated Corporate Tax Base (CCCTB). This has the potential to reduce tax complexity for multinational groups operating across the region, while at the same time reducing the potential for avoidance through arbitrage of the differences between national tax systems. In addition, the CCCTB offers the potential for groups to file a single, consolidated tax return for the region – and allocate the taxable profits between member states according to a simple formula based on the location of sales, assets and employment.

This system of unitary taxation (taxing at the level of the multinational group, rather than separate accounting for each group company), and other variations which are in operation among the states of the US, provinces of Canada and the cantons of Switzerland, can allow the alignment of taxable profits with real economic activity. A major research project underway at the International Centre for Tax and Development is dedicated to exploring the potential for unitary taxation in developing countries, rather than persist with the OECD system of transfer pricing which has been increasingly criticized as unfit for purpose. A smaller regional group might nimbly take a lead in pursuing such a system.  

One further area in which regional groupings could take a lead in cooperating is in the use of customs data. First, by sharing trade price data, countries automatically expand the dataset against which they can judge and identify abnormal pricing – and this can be done in real time. Second, in the Open Government Guide, I propose ‘follow the money’ partnerships, working with major trading partners to identify abusive pricing happening at each end of the same transactions. Starting such a process on a regional basis could be powerful in its own right, and also provide a demonstration to other trade partners of the value of cooperation.

Finally, greater regional integration to curtail illicit financial flows has the potential to support a clearer and more credible African position in the international processes which otherwise risk responding to OECD and – at best – G20 member priorities, rather than reflecting the diversity of African countries’ situations. If African policymakers continue to focus in these important areas,2014 could be an important year for policy progress in the region and beyond.