13 Nov 2007: ISS Today: Smart Business or Money Laundering?

13 November 2007: Smart Business or Money Laundering?

 

One of the issues that we predicted would rise in its importance to financial regulation around the world during 2007 is the use of offshore investment centres. Recent developments indicate that the prediction was well founded. The double-edged utility of the offshore investment of income, in countries where tax is either very low or non-existent, continued to be demonstrated during the year. Offshore investment remains one of the best ways of building up and securing income, by taking advantage of differences in rates of tax, estate duties and exchange controls around the world.

 

However, because it draws in income derived from activities carried out in a foreign environment, offshore investment is open to the infiltration of income earned unlawfully. Determining whether income from a foreign country has been legitimately earned is an extremely difficult task.

 

Proceeds of criminal activities in sub-sectors referred to variously as ‘the underground’ or the ‘shadow’ or ‘parallel’ economy,’ have been infiltrated into certain countries from offshore sources. As 2007 draws to an end, it is clear that clarity is sorely required on the principles, guidelines, and perhaps even laws by which to make such determinations.

 

The use of offshore investment centres to evade applicable taxes have been evaded has led to all of them being perceived as ‘tax havens’ – a term that should really be used only to describe countries that charge no tax. In its edition of the 6th November 2007, The Guardian newspaper reported the results of an investigation that should be quite interesting to resource-producing countries, offshore investment centres and resource consuming countries. The investigation revolved around a commodity well known to many of us, but very rarely associated with shady dealings – the banana. The investigation’s conclusion is emphatically stated at the beginning of the article:

 

Global banana companies supplying the UK are using tax havens to avoid paying tax on their profits here and in developing countries …

 

The investigation found that large corporations, three of which it named, had created structures ‘to move profits through subsidiaries to offshore centres such as the Cayman Islands, Bermuda and the British Virgin Islands, to avoid handing money over to tax collectors in the countries where their goods are produced, and in those where they are consumed.’ The significance of the case stems from that fact that the companies concerned account for more than two-thirds of the global banana trade – generating more than $50 billion in sales in the last five years. In each case, the corporate head office was in the United States, where the tax rate is a relatively high 35%. In contrast, both the Cayman Islands and Bermuda do not levy corporate tax. The banana-producing countries generally charge tax at 30% of profit. The global companies have resorted to unbundling themselves into service-providing subsidiary companies which are located offshore, away from the producing and consuming countries.

 

The scheme is anchored in the banana producing country. Each transaction starts off with the shipment of a consignment of bananas directly to the consuming country. As a plane or ship-load of bananas makes its way to the UK, the value of the bananas accumulates through a more circuitous route. Documents are sent through to the Cayman Islands, where a subsidiary, responsible for purchasing, adds a charge for the use of its ‘purchasing network’. They are then sent further on to the office of the holding company, situated in Luxembourg, where a further charge – for financial services – is added. From there, the documents may be sent to the Isle of Man, where an offshore insurance subsidiary levies a charge for its insurance services. Another subsidiary, in a different country, may also weigh in, to charge for the use of the brand name. The length of the chain inevitably impacts on the landing price of the bananas in the consuming country. The on-shore subsidiary, which supplies the retailer, eventually charges the ultimate price. According to the Guardian, the supplying subsidiary may even sell the bananas at a loss, resulting in no tax being due to the authorities in the consuming country. While a loss is reported from the ultimate transaction on shore, a cumulative profit has been made offshore.

 

Globalisation has produced a situation where a large proportion of world trade is made up of transfers between related companies. As a result, trade-related money-laundering is becoming a significant issue. Southern Africa predominantly comprises resource-producing countries. The region has long been a playground of resource-thirsty multinational corporations, some of which could engage in profit-siphoning activities of the kind described above.

 

One lesson from this case study is that the existence of tax practices that widely vary is an important factor in the corporate unbundling that precipitates and facilitates the tax evasion practices found by the Guardian. While countries generally find it easy to sign international conventions on law enforcement co-operation, they find it more difficult to do so when it comes to harmonising taxation practices. In developing measures against money laundering and trans-national crime, this is where the real test of political will lies. In the banana case, even if one of the tax havens in which one of the subsidiaries was located were to establish how funds accruing to the company were made, it would be unlikely to take any action, partly because it had suffered no harm.   

 

As 2008 approaches, it will be interesting to observe how the furore caused by the offshore investments by clients of First Rand Private Bank in South Africa is resolved. Even though no commodities were involved, offshore tax evasion appears to have been committed.

 

Charles Goredema, Programme Head: Organised Crime and Money Laundering Programme, ISS Cape Town