Illicit Financial Flows - Part I: A Primer

Lost funds, lost opportunities

Given South Africa’s alarming levels of inequality[i], every cent is needed to further its developmental objectives and deliver on the promises embodied in the Constitution. And yet, every day, sorely-needed funds haemorrhage out of government coffers and private savings in the form of illicit financial flows (IFFs). When the lifeblood of a country’s economy in drained by IFFs, it is the poor and marginalised who invariably suffer most.

This was made starkly clear by the conclusion reached by the High Level Panel on Illicit Financial Flows from Africa (High Level Panel) that Africa loses more than $50 billion per year through IFFs[ii]. When this figure is considered against money received in official development assistance from international sources, Africa is in effect a net creditor to the rest of the world.

The proliferation of IFFs needs to be addressed urgently and decisively. What is being done to deal with the problem? And, more importantly, what should be done but isn’t? The brief series will explore the answers to these questions in two parts by examining South Africa’s legislative framework and assessing the efficacy of the institutions mandated to fight IFFs. But, firstly, it will attempt to clarify what is meant by IFFs – a concept that is, unsurprisingly, nebulous.

Defining IFFs: not a straightforward exercise

One can sympathise with the inclination to ascribe a meaning to IFFs that is simple in its formulation or broad in its scope. However, care must be taken - the choice of definition used ultimately determines what conduct is regarded as furthering IFFs, and which, in turn, forms the basis by which statistics are compiled. These data, in mapping the extent of the problem, helps to inform the appropriate policy response.

A leading watchdog of IFFs, Global Finance Integrity, characterises the movement of money across national borders as “illicit” when such funds are “illegally earned, transferred, and/or utilized”. This definition was favoured by the High Level Panel in its report, which elaborated as follows:

“These funds typically originate from three sources: commercial tax evasion, trade misinvoicing and abusive transfer pricing; criminal activities, including the drug trade, human trafficking, illegal arms dealing, and smuggling of contraband; and bribery and theft by corrupt government officials.”

Maya Forstater of the Centre for Global Development points out a number of issues that arise from this and similar definitions of IFFs[iii]. These include:

• A “narrow” approach takes “illicit” as referring to conduct that contravenes a law. However, is this confined to illegality of the source of funds, or does it include illegality of transfer as well?
• Should IFFs apply to money only or could it include other forms of financial capital (which would include loans, equity, financial instruments, and the like)?
• What becomes of conduct that is not illegal per se, but is still undesirable or morally objectionable, such as tax avoidance?

Forstater highlights a number of arguments advanced in favour of using a broad approach that goes beyond illegality to include transfers that are improper. One such argument is that there is a large legal grey area regarding tax avoidance, and so any distinction is arbitrary. Further, whether or not a transfer of funds is considered an IFF should not depend on the capacity of enforcement agencies (or political will to pursue enforcement). Lastly, there is already global political agreement that the broader meaning of IFFs is preferred.

Despite these arguments, her view is that:

“using a conceptual definition of illicit financial flows which combines what is illegal with what is uncertain, or what is judged to be undesirable by some unelected group, undermines and confuses accountability and understanding.”

Therefore, under a “narrow” conception of IFFs, legal tax avoidance should be distinguished from IFFs. The High Level Panel accepted a definition that referred to illegality as a qualifying trait of an IFF, but then went on to state:

“We also felt that the term “illicit” is a fair description of activities that, while not strictly illegal in all cases, go against established rules and norms, including avoiding legal obligations to pay tax.”

While the definition chosen by the High Level Panel is narrow, its actual conception of IFFs favours a broad approach. No wonder, then, that there is ambiguity on this issue. Forstater’s concerns are justified.

Then there is the question of capital flight[iv], which can have a deleterious impact on a country’s economy. The World Bank records that IFFs and capital flight have been associated with each other since the 1990s[v] but the concepts are distinct. The High Level Panel also maintained that distinction, noting that “capital flight, which is sometimes driven by macroeconomic and governance factors, could be entirely licit.”

Ultimately, the definitional question will be settled by how the term is used by the various stakeholders. At this stage it is important to be mindful – particularly when considering facts and figures – of the definition used by bodies reporting on IFFs. Further, while it appears that even where the all-encompassing “broad” approach is favoured, responses to IFFs need to be tailored to account for the distinction between the “illegal” and the “undesirable”. This is because the implications for laws, enforcement mechanisms, and international cooperation are vastly different.

What conduct gives rise to IFFs?

Before considering the laws and enforcement mechanisms against IFFs, it is useful to delve into the types of conduct that can give rise to IFFs to set the scene for what actions regulatory authorities are required to address. Some of these are familiar to the public – it will surprise no one that moving money that is used in the drug trade or to fund terrorist activity across borders is categorised as an illicit flow. Other IFFs are less well-known, such as the ones discussed below.

Trade misinvoicing involves deliberately misstating the value or quantity of goods transferred in cross-border transactions. This can be done for various reasons – to evade paying taxes and customs duties, claiming undue tax benefits, dodging regulatory controls on capital flows out of or into a country, or money laundering. This fraudulent activity falls clearly outside the bounds of legality.

Global Finance Integrity defines money laundering as “the process of disguising the proceeds of crime and integrating it into the legitimate financial system”, thus enabling the purchase of goods and services or its onward transfer without it being traced back to the crime or the perpetrator. One way criminal organisations do this is by mixing proceeds of crime with legitimate funds, with trade misinvoicing further obscuring the true nature of the funds. Another means by which money is laundered is by moving it through “secrecy jurisdictions” - providers of “facilities that enable people or entities to escape or undermine the laws, rules and regulations of other jurisdictions elsewhere, using secrecy as a prime tool”.[vi] Banks and other financial institutions in these countries accept money without requiring key identifying information from their clients and without reporting the transfer to authorities, including the authorities of the country from which the funds were transferred.

Secrecy jurisdictions are sometimes referred to as “tax havens” as they can be used to facilitate tax evasion.[vii] They are an enabling tool for IFFs arising from the commercial sector, which the High Level Panel lists as including:

• abusive transfer pricing;
• trade mispricing,
• misinvoicing of services and intangibles and using unequal contracts;
• aggressive tax avoidance; and
• illegal export of foreign exchange.

These countries also facilitate tax avoidance. Money is funnelled into the haven’s jurisdiction where legal loopholes are used as a basis to assert that such funds are not taxable in that country. Tax havens are often – but not exclusively – used for this type of tax avoidance, which is known as base erosion and profit shifting (BEPS). This shifting of profits from higher tax jurisdictions to ones with lower rates of taxation “erodes” the taxable income of the jurisdiction with the more onerous taxation requirements.

Transfer pricing involves the setting of the price of companies within the same group of companies. This often takes place in the context of multinational companies. In this regard, the High Level Panel notes that:

“Governments set rules to determine how transfer pricing should be undertaken for tax purposes (since, for example, the level of transfer pricing affects the taxable profits of the different branches or subsidiaries of the firm), predominantly based on the arm’s-length principle.”

The arm’s length principle

“compares the transfer prices charged between related entities with the price in similar transactions carried out between independent entities at arm’s length”.

Abusive transfer pricing is the manipulation of a transfer price to shift profits between jurisdictions and is a form of BEPS.

The scope of what actions can give rise to IFFs is broad and complex. There is a high degree of interrelatedness between them – after all, those seeking to illicitly transfer funds will use every means at their disposal to do so. Even companies conducting legitimate business can skate on the edge between the licit and illicit such as using teams of lawyers, accountants, and others to create extensive tax avoidance schemes.[viii] What is clear is that regulatory and enforcement bodies have their work in monitoring IFFs and then following up by taking action against the offender and – wishful thinking! – recovering funds lost pursuant to the illicit flow.

What next?

There is no single piece of legislation dedicated to fighting IFFs in South Africa. Rather, reliance is placed on a number of laws that involve cooperation and collaboration between a number of institutions, each bearing varying degrees of responsibility. These include the Financial Intelligence Centre Act[ix], various tax laws, the Companies Act[x], and general criminal laws such as those against fraud. The question that needs to be asked is whether these laws are achieving their objectives in curtailing IFFs from South Africa.

It seems that the answer to the question is no. The chair of the standing committee on finance in Parliament, Mr YunisCarrim, stated in May this year that South Africa is failing in its efforts to stem IFFs. He noted that:

“There needs to be far greater cooperation between the South African Revenue Service, the Financial Intelligence Centre, the Hawks and the National Prosecuting Authority to tackle the problem.”[xi]

He singled out the Hawks as the “weak link” in the chain and noted that while South Africa has sophisticated legislation in place, the challenge is in implementing that legislation, particularly as institutions lack capacity, adequate staffing, and other crucial resources. All in all, there was very little cause for comfort in Mr Carrim’s comments.

Part II of this series will take a closer look at some of the institutions tasked with fighting IFFs by considering their founding legislation and how well they have fared in meeting challenges they face.

Cherese Thakur
Legal Researcher
cherese@hsf.org.za

[i] The World Bank reports that: