Backgrounder: Illicit financial flows

Specific issues

Illicit financial flows and natural resources

7. In the area of natural resources, illicit financial flows occur mainly through corruption, illegal resource exploitation and tax evasion. Acts of corruption include bribes paid by companies and money embezzled from tax collection and budgetary allocations. Illegal resource exploitation has to do with undeclared corporate revenues from illegal resource exploitation and tax evasion (including smuggling and transfer pricing). These forms of illicit financial flows have dire consequences for the revenue streams of the extractive industry. Payment of bonuses, for instance, is hindered by bribes and payments outside central budget accounts. Royalties are affected by volume underreporting, value underestimation, price discount benchmarking or indexation, extortion and avoidance of fee payment. Also, corporate income taxes are declining because of transfer mispricing or over-invoicing, undue tax exemptions or rebates and company misreporting on volume or quality, inflating of operational costs and embezzlement. This situation affects development, as most countries are unable to maximize their gains from natural resource wealth, with corrupt Government officials and companies benefiting at the expense of the wider population (Le Billon, 2011).

Illicit financial flows and governance

8. Illicit financial flows and governance are strongly interrelated, with linkages at the domestic and international levels. For instance, governance challenges caused by kleptocratic regimes, political instability, weak tax administration, unfavourable exchange rates and the absence of the rule of law are opportunities for illicit financial flows to thrive (Abugre and Ndomo, 2014). These outflows are facilitated by the establishment of shadow financial systems such as tax havens, secrecy jurisdictions, disguised corporations, anonymous trust accounts, fake foundations, trade mispricing and money laundering techniques, which enrich developed countries and other developing regions. At the national level, illicit financial flows are undermining the dynamics of macroeconomic components such as domestic savings, hard currency reserves and tax collection in African countries. This has crippled their economies and reduced them to a cycle of external borrowing and debt service payments. It has also perpetuated their dependence on external aid. In 2011, for instance, total official development assistance inflows to Africa amounted to $50 billion, compared to $17.4 billion in 2002. Indeed, illicit financial flows are a catalyst for increased external borrowing, creating more scope for further debt, thereby limiting public expenditure (NEPAD, 2013). They also threaten stability and security, as criminal activities such as trafficking of people, weapons and drugs take place within and across borders (ECA, 2014).

Illicit financial flows and the private sector

9. Illicit financial flows affect the private sector in two ways. First, 60 per cent of such flows occur through mispricing or invoice manipulation by multinational and private companies to channel money abroad or launder money by bribing regulators or inspectors. These companies have a strong global presence and influence and are therefore able to do transfer pricing and evade tax through corrupt practices such as buying off national authorities. They even go as far as lobbying for the introduction of low taxes or laxer regulations during contract negotiations. The inability of African Governments to check and control such illicit acts has given free rein to multinationals to engage in mispricing of exports and imports, under-declaration of the quantities of natural. Illicit financial flows resources extracted and generous tax holidays, sold out just before the expiry period of the concessions, which actually re-emerge as an entirely different company. Secondly, illicit financial flows undermine the private sector by stifling business and entrepreneurship, and significantly reducing structural transformation and economic diversification (ECA, 2012).

Redirecting illicit financial flows to increase domestic resource mobilization

10. Increasing domestic revenue mobilization is a challenge for many Governments, particularly in low-income countries.

11. According to several studies, illicit financial flows are a potential source of domestic resource mobilization for the continent.

12. They undermine Africa’s fiscal policy space and deny its financial systems and Governments the opportunity to use domestic resource mobilization schemes. Tax evasion is a significant component of illicit financial flows. For example, double taxation treaties usually reduce or eliminate tax avoidance (tax payable where the business takes place) and withholding taxes (tax payable as the money crosses borders), allowing the financial transaction to go ahead unchecked. Multinational companies take advantage of different double taxation treaties to shift profits from country to country, exploiting the treaties with the lowest withholding tax rates.

13. Such staggering sums of illicit outflows have a significant economic impact on the ability of African countries to mobilize domestic resources. The proceeds of such flows undermine the continent’s potential for economic transformation as they drain tax revenues and scarce foreign exchange resources, stifle growth and socioeconomic development and weaken governance. As a result, African countries become trapped in a cycle of external borrowing and debt repayment, thus limiting them to external aid dependency (NEPAD, 2013).