Introduction

Digitalization has posed a huge threat to the global financial systems. From the growing use of electronic ‘cash’ including crypto currencies and e-commerce to the internationalization of supply chains, the explosion of peer-to-peer (P2P) networks, the disclosure of massive amounts of personal information through social networks, the increasing use of ‘deep learning’ methods in the analysis of ‘big data’, and the domination of major economic sectors by large almost monopolistic conglomerates, there has been a big shift in how business is carried out internationally and subsequently, in how these businesses are taxed.

Due to digitalization and the growing globalization of financial markets, the economic and political significance of Illicit Financial Flows(IFF) has grown markedly with significant effects on both industrialized and developing countries. IFF refer to undeclared funds that are illegally acquired, transferred or used as the product of illegal activities and tax evasion. They are financial gains acquired and transferred by taking advantage of the loopholes in the law or using technology aimed at circumventing the spirit of the law.

Capital Flight

Capital flight refers to the movement of funds overseas with the aim of obtaining better returns, often as a response to unfavorable business climate in the country of origin. However capital flight doesn’t always occur for morally sober reasons such as response to insufficient local investment opportunities. On the contrary, there are a myriad of investment opportunities in Africa for example, and the risks of such investments are more often than not negligible. This then sets the motive for the continuous instances of capital flight as evasion and corruption cover up, which in retrospect triggers unfavorable investment conditions.

Capital flight often deprives the concerned country of urgently needed resources for private and public investment, thereby hindering economic and infrastructure growth. It also goes hand in hand with political motives that weaken state parastatals and encourages the rise in corruption. With the recent Pandora papers leak that caused global uproar these past couple of weeks, it is clear that efforts such as the global minimum tax currently being rolled out in assenting jurisdictions, aimed at tackling IFF, must come not only from the countries where illicit financial flows originate but also from the recipient countries mostly offshore financial centres (OFC) with a high level of financial secrecy and low rates of taxation.

The leaks have shed more light on a niche industry devoted to tax avoidance and tax evasion schemes and the development of tax shelters. Tax shelters, narrowly defined in this case, are structures developed internally by a firm’s legal and accounting departments or by investment banks and large accounting firms. Most of these structures have international implications that traverse jurisdictions

1.Tax Avoidance and Tax Evasion

Tax avoidance refers to the use of legal methods to modify an individual’s tax position in order to minimize taxes owed. Tax avoidance can be exogenous or endogenous. Exogenous avoidance involves participation in tax shelters that generate losses that are subsequently set off against taxable income. Endogenous avoidance involves the adjusting of transactions or structures, mostly business or estate planning structure. Firms with higher pre-tax income levels and more extensive foreign operations are able to reduce their worldwide tax burdens through tax planning activities

Tax evasion refers to the use of illegal means to reduce one’s effective tax position. It often involves misrepresentation of income to Revenue authorities or overstating of deductions. The distinction between legal tax avoidance and illegal tax evasion may be clear in theory, but in practice the difference is more nuanced. “Aggressive tax planning” (ATP) is an example of such nuance.

2. Aggressive Tax Planning

Aggressive tax planning (ATP) refers to a scheme to reduce the effective tax position of an entity to a level below the one sought by the presiding fiscal policy. ATP is often seen as tax avoidance activity that complies with the letter but not the spirit of the law. This is because it exploits the shortcomings, weaknesses, or ambiguities in tax laws through the movements of funds, the construction of fictitious or shell companies, and/or the use of financial instruments or entities that are treated differently in different jurisdictions. Therefore ATP can be considered a transaction that blends elements both of legal tax avoidance and illegal tax evasion.

The economics of tax avoidance is one of differential avoidance. Whereas shareholders may be interested in maximizing post-tax profits, management may be motivated by a different interest. In a competitive market, the post-tax figure for tax avoidance may be less important than differential avoidance within the sector. In other words, Player A would be at a disadvantage if Player B or C, operating within the same industry, were able to mitigate tax more efficiently than they are able to.

However this often has a negative effect on the evolutionary process in the market and regulation. For example, when a new tax avoidance technique is invented, the first to use it is at an advantage compared to the rest in the market. Over time, the technique is emulated and spreads across the industry. Eventually, just as the regulators begin to pay attention to the new technique, the advantage of differential avoidance is eroded.

3.Tax Arbitrage

Most tax mitigation techniques are legal in the sense that they employ techniques known as tax arbitrage. Such techniques are designed to exploit gaps, loopholes, or blind spots in national rules and regulations to affect a transfer of taxable events from high to low, or no tax jurisdictions. Most jurisdictions treat each corporate subsidiary of a group as an independent legal person. This implies that a corporation registered in one jurisdiction cannot be called a multinational.

A multinational therefore refers to a group of separate legal entities operating in several jurisdictions to the extent that they are recognised as legal entities in those jurisdictions. This is known as entity law and is often abused to effect transfer taxable events from high to low tax jurisdictions. This is a recipe for intra firm tax arbitrage techniques which exploits the mixture of corporate entities registered in Offshore Financial Centres (OFC) jurisdictions.

3.1 Intra firm Tax Arbitrage

The parent entity may establish two or more subsidiaries (adding up to the thousands) in two or more jurisdictions that enable tax arbitraging and will embed them in a complex corporate ecology. The tax arbitrage becomes effective when such a structure is seen as a whole in addition to factors such as jurisdictional locations and extensive knowledge of the intricacies of different laws and regulations as well as the financial statements of all the entities in the structure.

These structures are difficult to assess because more often than not, authorities do not have access to the organizational structures of these MNEs and if they do, it is difficult to assess which of the subsidiaries in the group often made up of hundred if not thousands of subsidiaries is set up for purposes of tax arbitrage.

While offshore registered entities are implicated in all known cases of tax arbitrating structures, not all OFC entities are necessarily used for arbitrating purposes. There are two major types of holding techniques, the first is where an offshore subsidiary is controlled by a parent but doesn’t subsequently control another company. These kind of subsidiaries are common and are often seen in hedging and currency trading. The second type however is the common one where offshore subsidiaries control other subsidiaries and are common with tax arbitraging techniques

3.2 Balance sheet arbitrage

Another form of arbitrage is balance sheet arbitrage. Income statements work on the principle of operating revenue minus costs incurred in generating such revenue. Taxes are subsequently determined based on net revenue. Financial derivatives can be used to move income away from the income statement through balance sheet arbitrage.

Financial gains from derivative trading over-the-counter (OTC) transactions can be used to boost a firm’s balance sheet. These gains are treated not as an income stream, but as assets.  As a result, while the firm is benefiting financially from trading, as long as the operations are entered into the balance sheet but not as an income stream, the tax on these operations is not paid. The incentive to book as many operations as derivatives then becomes obvious, particularly especially through subsidiaries in tax havens

4. Tax Mitigation

Business transaction can be carried out in different ways and therefore taxed differently, a common example is the nominal rate of corporate tax on corporate profits and the different taxation rates for capital gains tax or personal income imposed by most jurisdictions. Most taxpayers tend to shift their transactions to suit favourable categories of taxation and this is often known as the cubbyhole system. Most derivative enabled tax schemes focus on post hoc manipulation of taxable events. The practice , like any other arbitrage technique is an industry  response to inconsistent tax laws that focus more on form over economic substance in the tax treatment of derivatives

A typical use of post hoc manipulation as a tax mitigation technique is disassociation between ownership of an asset and ownership of value related to an asset. A buyer can decide to buy an option on a bond or share instead of buying a share itself, that way the buyer obtains gains from the changing value of an asset but in this case doesn’t pay capital gains tax because they don’t own the asset itself but rather the financial derivative of an asset. This even becomes more challenging to tax when a derivatives are constructed out of other derivatives. These kind of structures add an extra layer of opacity when trying to determine the tax approach needed.

5. Money Laundering

Tax evasion is often characterized by failure to report all of one’ income and offshore bank accounts all which often carry a money laundering undertone. Money laundering can be defined as an activity that disguises the nature, source, location, disposition or movement of proceeds from unlawful activities and presented as legitimate. When money is being laundered, the transactions are filled with tax evasion activities. Even though some of the tax evasion activities might be legal before law, the retention of money that should be paid as actual tax is a criminal conduct.

One of the main motives tied to money laundering is the legalization of illegally acquired money in order to avoid prosecution. Individuals are supposed to pay taxes on their earnings and in other jurisdictions it is irrespective where this income comes from. However declaration of illegally acquired funds possess a huge risk of prosecution. Bank secrecy and confidentiality has made it very hard or domestic authorities to track capital income due to the limited exchange of information with the country of residence.

Sabare Brian

Chantel Addero