Tax fraud amidst COVID-19

Analysis by Donasius Pathera

The COVID-19 pandemic has affected the global economy and Africa is currently bleeding profusely. So many companies are registering revenue losses and job losses have now become the order of the day.

Some governments have decided to partially own companies that are crucial to their economies. Such partial ownership can be in a form of injecting money into the firms or the hiring of experts to rescue the firms from downfall.

However, what African governments must not be blindsided and learn fast, is that this pandemic can also be a fertile platform for multinational companies to evade tax.

Having analysed data from the International Monetary Fund (IMF) from 30 countries in Africa and coordinating the results of research from data collected from the same IMF by Petr Janský and colleague, it comes to my mind that the continent is sleeping on the job.

Much time is being wasted on feeling sorry for companies for making losses, while some are stealing revenue from Africa. My analysis will look into several avenues with an emphasis of transfer pricing abuse by some multinational companies plying their trade in Africa.

From the IMF data, by the end of 2020, about 30 countries in Africa are going to lose about US$290 billion in corporate profits shifted to tax havens outside the continent. In terms of tax, these 30 African countries are going to lose approximately US$80 billion in tax revenue.

This means denying these African countries crucial funding for their social services. In short, the social services in these countries will be funded by lower income taxpayers leading to an increase in inequality.

To understand the analysis, I used IMF’s data on foreign direct investment (FDI) Fund to examine whether companies owned from tax havens report lower profits in high-tax countries compared to other companies.

Data for the following countries were analysed — Angola, Benin, Botswana, Burkina Faso, Cameroon, Cape Verde, Chad, Djibouti, Egypt, Eswatini, Gabon, Guinea Bissau, Ghana, Côte d’Ivoire, Kenya, Lesotho, Liberia, Madagascar, Malawi, Mali, Mauritania, Mauritius, Namibia, Niger, Nigeria, Rwanda, Senegal, Seychelles, South Africa and Tanzania.

 

The results which were also collaborated by Janský,  show  that countries with a higher share of FDI from tax havens report profits that are systematically and significantly lower, suggesting these profits have been shifted to tax havens before being reported in high-tax countries.

The strength of this relationship enables us to estimate how much more profit would be reported in each country if companies owned from tax havens reported similar profits to other companies.

The results showed that Rwanda is the country that is highly respected by investors in terms of business investment and is highly preferred by honest multinational companies.

All multinational companies that have been labelled to evade tax, are hesitant to invest in Rwanda because of their strict laws despite having a fertile environment for business growth.

Nigeria is considered to be a country that has been losing a lot of revenue from transfer pricing by multinational companies, the year 2020, it will also be the worst country in revenue loss.

The good news is that Nigeria is one of the few countries in Africa that receives Foreign Direct Investment with Egypt topping the list.

It was also found that lower-income countries on average lose at least as much as developed countries (relative to the size of their economies). At the same time, they are less able to implement effective tools to reduce the amount of profit shifted out of their countries.

But the biggest question is how this profit shifting takes place? There are three major ways in which multinationals can use in price shifting.

Debt shifting is one of the ways in which multinational companies register intangible assets such as copyright or trademarks in tax havens, and a technique known as “strategic transfer pricing”.

To see how these channels work, imagine that a multinational is composed of two companies, one located in a high-tax jurisdiction like Australia (company A) and one located in a low-tax jurisdiction like Bermuda (company B). Company B is a holding company and fully owns company A.

While both companies should pay tax on the profit they make in their respective countries, one of the three channels is used to shift profits from the high-tax country (Australia in our case, with a corporate income tax rate of 30%) to the low-tax country (Bermuda, with a corporate income tax rate of 0%). For every dollar shifted in this way, the multinational avoids paying 30 cents of tax.

Debt-shifting is when company A borrows money (although it does not need to) from company B and pays interest on this loan to company B. The interest payments are a cost to company A and are tax-deductible in Australia.

So they effectively reduce the profit that company A reports in Australia, while increasing the profit reported in Bermuda.

In the second channel, the multinational transfers its intangible assets (such as trademarks or copyright) to company B, and company A then pays royalties to company B to use these assets.

Royalties are a cost to company A and artificially lower its profit, increasing the less-taxed profit of company B.

Strategic transfer pricing, the third channel, can be used when company A trades with company B. To set prices for their trade, most countries currently use what’s called the arm’s length principle.

This means that prices should be set the same as they would be if two non-associated entities traded with each other.

But, in practice, it is often difficult to determine the arm’s length price and there is considerable space for multinationals to set the price in a way that minimises their overall tax liabilities.

Imagine company A manufactures jeans and sells them to company B, which then sells them in shops. If the cost of manufacturing a pair of jeans is US$80 and company A would be willing to sell them to unrelated company C for US$100, they would make US$20 in profit and pay US$6 in tax (at 30%) in Australia.

But if company A sells the jeans to its subsidiary company B for just US$81, it only makes US$1 in profit and so pays US$0.3 in tax in Australia.

Company B then sells the jeans to unrelated company C for US$100, making US$19 in profit, but not paying any tax, since there is no corporate income tax in Bermuda.

Using this scheme, the multinational evades paying US$5.7 in tax in Australia for every pair of jeans sold.

The biggest question is how this malparctise can be stopped. The root of the problem is the way international corporate income is taxed. The current system is based on an approach devised almost a century ago, when large multinationals as we know them today did not exist.

Today, individual entities that make up a multinational run separate accounts as if they were independent companies. But the multinational optimises its tax liabilities as a whole.

According to Janský, there is a need to switch to what’s called a unitary model of taxation. The idea is to tax the profit where the economic activity which generates it actually takes place — not where profits are reported.

The multinational would report on its overall global profit and also on its activity in each country in which it operates. The governments of these countries would then be allowed to tax the multinational according to the activity in their country.

In practice, defining what exactly constitutes “economic activity which generates profit” is the tricky bit. For a multinational that manufactures phones, for example, it is not clear what part of its profit is generated by, say, the managers in California, designers in Texas, programmers in Munich, an assembly factory in China, a Singapore-based logistics company that ships the phone to Paris, the retail store in Paris that sells the phone, or the French consumer.

Different proposals for unitary taxation schemes define this tax base in various ways. The five factors most often taken into account are: location of headquarters, sales, payroll, employee headcount and assets. Different proposals give different weight to these factors.

Ultimately, introducing unitary taxation would require a global consensus on the formula used to apportion profits. And, admittedly, this would be difficult to do. 

As the Organisation for Economic Co-operation and Development (OECD) says: It present[s] enormous political and administrative complexity and require[s] a level of international cooperation that is unrealistic to expect in the field of international taxation.

With COVID-19 amongst us and tax offices are working on shifts, there are high risks of limiting enforcement policies against those perceived as evading tax.

Even after noting some grey areas, most tax administrations in Africa are unable to pursue cases related to transfer pricing as they lack capacity.