South Africa’s trade misinvoicing gap averaged $19.9 billion (R309 billion) per year from 2008 to 2017, according to a report by Global Financial Integrity (GFI).

Released on March 3, the report – Trade-related illicit financial flows in 135 developing countries 2008-2017 – focuses on trade-related misinvoicing, one of the largest components of illicit financial flows (IFFs) between the 135 developing countries and 36 advanced economies.

The average size of the value gap between sub-Saharan Africa and the 36 advanced economies is $27.2 billion.

Trade misinvoicing

Trade misinvoicing refers to one party (the importer or exporter) deliberately falsifying the price, quantity or quality of goods being imported or exported, and in this way, illicitly transferring the difference, which may involve money laundering, customs duty evasion, and tax evasion.

Less than 2% of shipping containers are searched every year, raising a question mark over the veracity of customs invoices.

Import overinvoicing can be used to:

Shift money abroad (a seller can, for example, agree to pay the difference to another entity on behalf of the importer);

Overstate the cost of the imported product to reduce the income tax liability; and/or

Avoid anti-dumping duties.

Export underinvoicing can also be used to shift money abroad, evade income taxes and export taxes.

Illicit financial flows

Illicit financial flows pertain to illicit activity, and do not include tax avoidance. However, this is a moot point as there is increasing pressure by some (namely tax authorities and non-profit organisations) to include tax avoidance in the scope of illicit financial flows.

Presumably ‘trade-related’ illicit financial flows include the illegal drug trade, illicit arms deals, and the laundering of dirty money. After all, these illicit activities comprise the buying and selling of goods and services, and thus fall within the definition of trade. For example, transferring money from a mine rehabilitation fund offshore to be looted would be a trade-related illicit activity.

What about transfer pricing?

A transfer pricing transaction has two essential facets: it must be a transaction between persons who are connected persons or associated enterprises in relation to one and another; and the term(s) of that transaction must differ from a contract between two independent person’s dealing at an arm’s length.

An arm’s length transaction rests on the supposition that a transaction between two independent parties must be arm’s length (the terms and conditions including that the price has been fairly negotiated).

Transfer pricing rests on the assumption that the arm’s length price is the ‘real’ price, and that if the price of a transaction between two related parties differs from the arm’s length price, it has been ‘transfer priced’, and must be adjusted. Obviously, the calculation of the real price and the adjustment to be made results in a fairly high standard of living for the consultants who make their bread and butter this way.

In my view it is a far stretch to include transfer pricing under trade misinvoicing.

However, it is tempting for a tax authority to use the trade misinvoicing gap produced by the GFI as a target. Unfortunately, this could result in the tax authority using incorrect resources to chase this down.

Needless to say, transfer pricing can morph into tax evasion where there is an artificial break in the related-party link by, for example, inserting a non-related entity.

Resource-exporting countries

The GFI places emphasis on Africa’s resource-exporting countries losing illicit outflows of money and the tax thereon.

The exports of, say, gold, would have to be compared with the imports. There could be inconsistencies – for example, gold bars can have different gold content. Are apples being compared with pears?

Another example is that of diamonds. The value of a diamond is determined by its colour, clarity and size. There are many grades, and many shades. Certain ‘fancy’ colours demand a high value. Customs officials would have to be diamond experts to verify the value of diamond exports. Assuming of course that the diamonds are exported via official channels.

Companies could be tempted to falsify the price of their exports in order to maximise the benefits of rebates or take advantage of export subsidies.

A multinational may indulge in illicit activities and disguise them as legitimate business activities. This may include the payment of bribes, the incorrect labelling of goods (or services) imported or exported, illicit trade in and the smuggling of tobacco, and complex agreements to ensure that valuable intellectual property is housed in tax havens.

Many of these illicit activities are protected by first world countries in the race to entice direct foreign investment and encourage the international trading expansion of ‘their’ companies.

Developing countries

The GFI is of the view that much of the trade invoicing occurs in developing countries for the primary purposes of capital flight and tax evasion, as well as moving money from weak into hard currencies.

Political uncertainty acts as a major incentive to move funds offshore.

“Large profits generated from IFFs are often recycled through complex patron-client networks related to the particular features of the domestic political economy of a country, in which various interest groups develop a vested interest in perpetuating trade misinvoicing,” states the report.

Limitations of the analysis

Adjustments are made for direct import-export comparisons, such as converting all values to a ‘free on board’ (FOB) basis. This can lead to errors. Further, the value gap analysis cannot detect the overinvoicing of services, which would include management fees, interest payments, licence fees, royalty fees on intellectual property, and consulting services.

However, the GFI is of the optimistic view that the estimated value gaps are likely to be understated rather than overstated.

In addition, while the analysis can indicate that there is trade invoicing on the macroeconomic level, it is impossible to identify the trading partners that may have engaged in under- or overinvoicing. It is also impossible to determine the true price that should have been paid.

While this report cannot be used by the South African Revenue Service to pinpoint the companies to audit, nor by the National Prosecuting Authority to target IFFs, it is an indication that there is a lot of work ahead.

The ultimate success of any effort to curb illicit financial flows, whether trade-related or not, would be evidenced by the return of those funds and the successful prosecution of the enablers, such as the accountants, lawyers, bankers and estate agents.