Using a mix of regulatory and soft law tax measures to combat illicit financial flows

Illicit financial flows (IFFs) are often associated with illegal activities, such as money laundering, tax evasion, corruption, smuggling, human trafficking, and terrorism financing. Combatting IFFs is high on the agenda of international policy makers, and it is one of the targets of the United Nations (UN) Sustainable Development Goals (SDGs).¹ Developing countries are most vulnerable to IFFs, making it a particularly urgent matter for development finance and multilateral development banks such as the International Finance Corporation (IFC).

IFFs can deprive developing countries of the financial resources needed for structural transformation and sustainable growth and, in doing so, undermine investment and business confidence. Africa alone is estimated to have lost over $1 trillion to IFFs over the past 50 years—a sum equivalent to the total official development assistance received by Africa over the same time frame.² The continent continues to grapple with an estimated annual loss of $50 billion due to IFFs, hindering its development and making it imperative for local and global stakeholders to take action.

The fight against IFFs demands a comprehensive and multifaceted strategy that embraces a combination of government-led approaches and private sector–led voluntary initiatives. For the greatest impact, these should employ a mix of regulatory and “soft law” measures.³ Tax due diligence conducted by the IFC on its investee companies and their international group structures is among the relevant soft law measures available in the international community’s toolbox to stem IFFs.

What are IFFs?

There is no uniform global definition of IFFs. For the purposes of measuring IFFs in the context of the SDG targets, the UN defines IFFs as “[f]inancial flows that are illicit in origin, transfer or use, that reflect an exchange of value and that cross country borders.”⁴ The World Bank Group (WBG), which includes the IFC as its private sector arm, defines IFFs as cross-border flows “associated with activities that are deemed illegal in the local jurisdiction.”⁵ Correspondingly, the WBG’s Intermediate Jurisdictions Policy defines IFFs as “funds illegally earned, transferred, or used that cross border.”⁶

The categories of illegal activities that give rise to IFFs include illegal tax and commercial practices, illegal markets (trade in illegal goods and services), and other exploitation-type of activities and financing of crime and terrorism. Some IFF definitions also extend to cross-border flows generated by tax and commercial activities that are not illegal per se but illicit (see figure 1). One example of this cited by the UN is “aggressive tax avoidance” activities, such as manipulation of transfer pricing, treaty shopping, reliance on hybrid instruments and entities, as well as strategic location of debt and intellectual property, which aim to exploit weaknesses of the international tax framework to lower the tax burden of cross-border businesses in an artificial manner.⁷ The WBG Intermediate Jurisdictions Policy acknowledges the interrelationship between taxes and IFFs, through its purpose to “mitigate the risks of IFFs, tax evasion, and abusive tax planning in WBG Private Sector Operations.”⁸
 

Figure 1: Categories of Activities That May Generate IFFs

How can tax measures help to address IFFs?

Tackling the illegal act of tax evasion is, by itself, a way of combatting IFFs as funds that move offshore to evade taxes ultimately meet the definition of IFFs discussed above. Similarly, under the broader definition of IFFs posited by the UN, to the extent that IFFs encompass funds originating from abusive tax planning, anti-abuse tax measures should equally assist in curbing IFFs.

Beyond this, tax measures that tackle tax evasion and other tax abuses can also have an “indirect” effect on curbing a broader spectrum of IFFs that are not necessarily driven by tax considerations. In particular, the techniques that facilitate tax evasion are often employed to facilitate other IFFs, such as payments associated with money laundering, corruption, bribery, and fraud.⁹ For instance, a recent IMF working paper draws on the close synergies between tax evasion and money laundering, which rely on similar obfuscation techniques, and advocates a whole-of-government approach to tackling both crimes. The overlapping techniques mentioned include complex cross-border structures and transactions utilizing offshore and noncooperative secrecy jurisdictions to obscure the financial trail of funds, as well as shell companies and other multi-layered legal structures to hide the true beneficial owners.¹⁰

However, such regulated tax measures form only part of the solution for addressing IFFs, and “soft law” measures focusing on voluntary compliance and private sector–led initiatives have an important role to play. At the IFC, tax due diligence is an example of soft measures that scrutinize the tax behaviors of private sector investee companies and, in doing so, help to prevent and mitigate IFF risks through: (i) applying the Global Forum on Transparency and Exchange of Information for Tax Purposes international tax transparency standards and outcomes of its peer reviews to determine an offshore jurisdiction’s eligibility in an investee group structure; (ii) reviewing investee companies’ tax strategies and encouraging adoption of responsible tax practices, such as The B Team’s Responsible Tax Principles; and (iii) examining particular tax risk flags that overlap with IFF risk. This multipronged approach allows the IFC to build a holistic picture of investee groups and, in doing so, better assess and mitigate integrity concerns, whether stemming from tax abuse, money laundering, or IFFs more generally.

Source: blogs.worldbank.org