Capital Flight and its impact on Africa

According to estimates, every year US$ 1.26 trillion - 1.44 trillion disappears without a trace from developing countries, ending up in tax havens or rich countries[1]. The main part of this is driven by multinational companies seeking to evade tax where they operate. The sum that leaves developing countries each year as unreported financial outflows, referred to as illicit capital flight, amounts to ten times the annual global aid flows and twice the amount of debt developing countries repay each year. Estimations of illicit capital flight from Africa over a 39 year period show that it has grown at an average rate of around 12 percent per year.

 

By far the vast majority of unrecorded transnational financial flows are illicit because they are violating the national criminal and civil codes, tax laws, customs regulations, VAT assessments, exchange control requirements and banking regulations of the countries from which unrecorded/illicit flows occur.

 

Forms of Capital Flight

 

Multinational groups of companies are often complex structures with many subsidiaries[2], a substantial number of which may be located in tax havens. Tax havens are jurisdictions that use secrecy and low tax rates as a selling point to attract businesses for their financial services industries. The banking secrecy that they apply makes it almost impossible to find out who owns an account there, how much money it is worth, and where the money came from. As a consequence, tax havens also hide criminal activities and illicit flows of money.

Profits of multinationals are allocated between subsidiaries through internal trading, a complicated process which is hard for tax authorities to police. It is estimated that 60% of international trade is now intra-firm trade between subsidiaries of the same multinational. Transfer pricing involves determining the sales prices between different entities within the same multinational. For this intra-firm trade, the price that creates the best overall result for the multinational corporation to which they both belong is often used. The companies may therefore allocate the profit between the two subsidiary companies in such a way that a minimal amount of tax has to be paid. When a multinational company deliberately manipulates the prices they charge for goods or services to artificially high or low prices to shift profits to low tax jurisdictions, this is called transfer mispricing.

Transfer mispricing allows even more tax evasion when it is applied to intangibles like logos, brands, consultancies or property rights. The company assigns ownership of its brand to a subsidiary created in a tax haven. All the productive parts of the company in other parts of the world then pay royalties and other fees to this subsidiary. This guarantees a continuous shift of money to tax havens. In 2007, more than half of global trade occurred via tax havens, although these accounted for merely 3% of global GDP.

International financial reporting standards (IFRS) only require multinational groups of companies to report on a consolidated basis - that means one set of accounts showing the overall financial activities and results for that group, without breaking them down for each country. This makes it very hard for tax authorities in developing countries to know what profit is made by a multinational company from activities in their country and how much tax should be paid; it is also difficult for them to uncover evidence of transfer mispricing.

 

Falsified invoicing can be performed in several ways, in all of which the import or export of goods is not reported truthfully or is even completely falsified. A company in a developing country that is importing goods could inflate the price it declares it has to pay to the foreign supplier so that it can report lower profits and therefore pay less tax. The reverse can also happen. A person exporting goods from a developing country could deliberately undervalue what is being sold, at least in official documents, so that profits are once again hidden. Since it is often based on verbal agreements between buyers and sellers, falsified invoicing is difficult to detect and is widespread.

 

Christian Aid has estimated that these two forms of illicit capital flight alone cause developing countries

to lose US$160 billion per year in tax revenue[3].

 

Some of the money made from, for example, transfer mispricing, returns to the country of origin through what is called ‘round tripping’. This means that a company that has shifted profits from a developing country towards a tax haven reinvests part of the profits in the same developing country. This time it is being considered as foreign direct investment and thus it can benefit from favourable fiscal conditions like tax holidays offered by the host country. Round tripping allows not only tax evasion but also takes advantage of the tax exemptions that many developing countries grant to incoming investment.

 

Consequences of Capital Flight

 

Forum Syd has calculated that the 15 of the countries with the highest cumulative illicit outflows are in Africa. They are Angola, Cameroon, Republic of Congo, Côte d’Ivoire, Ethiopia, Gabon, Ghana, Madagascar, Mozambique, Nigeria, South Africa, Sudan, Tanzania, Zambia, and Zimbabwe[4].

According to a report from Global Financial Integrity (GFI), the average of illicit outflows per year from Kenya during 2002-2006 can be estimated at US$ 686 million[5].This could be compared with the Net Official Development Assistance received, which for year 2000 was US$509 million and, by 2005, had risen to US$ 752 billion. In Tanzania again according to estimates from Global Financial Integrity, illicit capital flight from was on average US$ 660 million per year in the same period. The total illicit capital flight for 1970-2008 is estimated at US$7.356 billion. In 2007 alone, Nigeria lost £501m in the mineral fuel and oil sector. The country is an exporter of these products which means that this sum was lost through the artificial lowering of the final sale price by the companies in order to minimise the taxes to be paid in Nigeria[6].

 

This money, if properly registered and taxed in the country of origin, could of course contribute to considerable development and make a major difference in the fight to combat poverty. Illicit capital flight cancels investment, reduces tax collection, worsens income gaps, hurts competition, undermines trade and drains currency reserves.

On top of tax revenues there are other gains to be made if illicit capital flight is stopped. If it were not possible to evade taxes and make big profits on illicit capital flight without getting caught, some of the money would stay in the countries of origin. If reinvested, it would contribute to jobs and growth in those countries.

Capital flight represents a higher burden in Africa than in other regions. At the same time, actions to stop illicit capital flight must be taken by decision makers in both Africa and in the West if they are to succeed. The capital outflow from Africa and the absorption into western economies deserve equal attention and require concerted effort. Through greater transparency in the global financial system illicit outflows could be curtailed. To end the secrecy that facilitates it, an automatic and multilateral exchange of information between tax authorities and sanctions on tax havens that do not cooperate are necessary. Another critical measure would be to require multinational companies to report the profit they make and taxes they pay in each country where they operate. This could become mandatory if it were made part of international financial reporting standards.

 

There is also a need for specific measures at country level. Such measures include the building of legal frameworks better suited to address the problem, awareness-raising about the links between tax evasion, tax revenue and social services, as well as capacity building of tax authorities. Tax administrations in developing countries are often poorly resourced and lacking in staff capacity. Lack of technology and capacity to collect taxes, as well as the inefficiency and lack of expertise of tax authorities, create loopholes that otherwise could be plugged.

 

Thomas Lazzeri