March 24, 2020

Trade-based money laundering (TBML) and tax evasion contributed to a nearly $9-trillion loss for developing countries between 2008 and 2017, according to a recent report published by Global Financial Integrity (GFI)[1].

GFI analysed inconsistencies in import and export values between 135 developing economies and their developed economic partners and arrived at a staggering $8.8-trillion gap. In 2017 alone, the latest year for which GFI has data, the aggregate value gap amounted to $817.6 billion.

In an earlier study GFI calculated that $1.1 trillion flowed illicitly out of developing countries in 2013, while those countries received $99.3 billion in Official Development Assistance (ODA). In other words, for every development-targeted dollar entering the developing world in 2013, over $10 exited illicitly. This observation starkly highlights that illicit financial outflows critically impede these countries’ economic development goals.

In its recent report GFI attributes the gap to trade mis invoicing, which is the deliberate misstating of the price, quantity or other details of a transaction. Although the report noted that it is not possible to determine why invoices do not accurately reflect real values, why the gaps arose or who is to blame, it stressed that hiding (illicit) wealth from national authorities is likely to be the main driver that makes individuals engage in trade mis invoicing.

GFI believes the greater ability to store wealth, secure assets and hide illicit finances offered by the advanced economies and secrecy jurisdictions, such as tax havens and offshore centres, are the overriding ‘pull factors’ driving much of the world’s trade mis invoicing activity. The organisation concludes that trade mis invoicing is an enormous problem with a huge impact across the developing world.

One reason for magnitude of the problem is that it is very difficult to detect fraudulent trading activity. There is no such thing as a ‘Trade Police’ to determine whether the price agreed between buyer and seller is fair. If buyer and seller are driven by other motives than economic self interest, for example because they both belong to the same criminal organisation, Adam Smith’s ‘invisible hand’ supply and demand theory to set a price becomes irrelevant.

And what about tracking trade related financial flows? Unfortunately, as 80% of the financial settlements of international trade is done over ‘open account’, banks have very limited information to investigate possible mis invoicing and TBML red flags. It is a different story if the transaction makes use of trade financing facilities, where banks can request more documents as a condition for facilitating the trade. The bank will have more information and so a better opportunity to detect money laundering.

Another significant contributor to the erosion of developing countries’ tax base that GFI unfortunately does not address in its report is ‘transfer pricing’, a legitimate practice many large multi-national companies avail of to optimise their global tax position. These are tax avoidance structures that cleverly use existing tax loopholes between jurisdictions. Despite their legitimate status, these fiscally aggressive practices have an equally detrimental impact on resource-rich developing countries reasonable financial interests.

For example, flowers grown in East Africa for consumption in Europe are purchased for very low prices by a group company registered in a Free Trade Zone (FTZ) to be sold on to the parent company in The Netherlands with a ten-fold mark-up. The profit crystallised in the FTZ company is taxed at 0% and transferred to the holding in The Netherlands. As a result of the participation exemption rules, no further Dutch taxes are due. Meanwhile, the country where the flowers are produced is deprived of a fair share of the value appreciation to support its domestic tax base.

The OECD has recognised the detrimental effects of these practices on developing countries and is actively pursuing its Base Erosion & Profit Shifting (BEPS) programme to curb these legal but unfair practices that frustrate the UN Sustainable Development Goals (SDG) initiative.

[1] Global Financial Integrity, Trade-related Illicit Financial Flows in 135 Developing Countries: 2008-2017, March 2020. (