I concluded the second part of this story with the claim that the dominant way in which multinationals move capital abroad is to conceal it through the seemingly benign process of international trade, with the help of secrecy jurisdictions and accountants and lawyers. I also mentioned the inflation of financial obligations between subsidiaries of companies as a means of stripping off the capital of a subsidiary located in a high tax jurisdiction and transferring the capital through inflated interest payment to a low tax jurisdiction. In this instalment I shall try to explain how this works. I will also explain how it was calculated that US$1.8 trillion dollars illicitly left Africa between 2000-2008.

So what role does international trade play in moving dirty money around? What is well known is the way in which trading entities such as supermarkets and small banks are used to clean up criminal money such as monies earned from narcotics trade. Monies earned from criminal activities such as the sale of narcotics and illegal weapons or pimping in the sex trade, for example, are typically paid in cash.

That is why homes of criminal kingpins tend to be awash with cash. To deposit such large sums of cash in a bank can raise eyebrows unless you own the bank and can compromise the Central Bank’s banking supervision department. If you co-own a supermarket and are a narcotics dealer, how much easier to clean your dirty money than to hide it in the buying and selling of goods and in this process slowly release the dirty money to mix up with the clean bit? This practice is well known and although widespread contributes only to the 30-35 per cent share of dirty money as alluded to in Part 2.

The predominant way in which capital is hidden in trade and moved abroad is through the pricing of imports and exports. This strategy is employed not only by multinational companies but also by unethical local/national companies, traders and wealthy individuals seeking ways to minimise their tax obligations or find ways to stash their wealth abroad.

But the practice is most effectively exploited by multinational companies – here’s why: Firstly, multinational companies by the nature operate through subsidiaries scattered across the globe. This enables them to exploit transfer pricing.

Secondly, having multiple subsidiaries that can front shell companies provides opportunity for the registration of unlimited number of shell companies in multiple tax havens and secrecy jurisdictions in order to conceal their operations. This may explain why as much as 50 per cent of international trade takes place through tax havens.

Thirdly, trading between and among subsidiaries of multinational companies comprises as much as 60 per cent of global trade. This gives significant scope for the abuse of transfer pricing, unparalleled among any other players. The impact of such abuse is fundamental to the global economy.

So how does the manipulation of imports and exports lead to the transfer of resources abroad illegally? The essence is to make the transactions disappear from the books and thus the official statistics. One mechanism is through what is known as ‘falsified invoicing’.

This is when buyers and sellers collude and agree verbally to falsify their invoices, either by under or overstating import and export values; this helps minimise their obligations to the state and in moving capital abroad.

This practice is widespread; although difficult to verify accurately it is estimated that 45 to 50 per cent of trade transactions in Latin America are falsely priced by an average of more than 10 per cent. Meanwhile 60 per cent of trade transactions in Africa are mispriced by an average of more than 11 per cent (see Christian Aid’s ‘Death and Taxes’. This practice is used not only by multinational companies but also by individual traders.

The second mechanism is transfer mispricing. A transfer price is the price paid for an exchange of goods and services between related affiliates of the same transnational company (TNC). In most instances this involves either the parent firm trading with a subsidiary, or two subsidiaries of the same TNC trading with each other.

As deals between related TNC affiliates account for 60 per cent of global trade, there is ample scope for mispricing. This involves inflating or deflating imports and export prices between subsidiaries. Tax authorities say for a transaction to be legitimate, an ‘arm’s length principle’ should be followed by paying the open-market price. This requirement is often flouted, however, with transactions mispriced to enable the parent company to move money around to minimise tax.

Poor countries are particularly vulnerable to transfer mispricing since they typically will have little access to the necessary financial information from both the local and the parent company to be able to detect it. Most transnational companies typically aggregate their accounts across countries rather than publish them on a country-by-country basis. Moreover as most of the trading transactions would have taken place through the secrecy jurisdiction and via multiple other subsidiaries, verifying import-export price manipulation becomes even more difficult.

Mispricing of imports and exports of goods and services can also take place outside subsidiaries of TNCs by importers and exporters deliberately mis-invoicing on customs documents. This phenomenon has been analysed in detail in relation to Africa’s trade in commodities especially by Simon Pak, associate professor of Finance at Penn State University on his own and in collaboration with Maria de Boyrie and James Nelson at New Mexico State University. (See 'Capital movement through trade misinvoicing: the case of Africa’ and Christian Aid’s 'False Profits: robbing the poor to keep the rich tax-free' .

In one of the studies. Pak, de Boyrie and Nelson looked at trade in commodities between 30 African countries and the United States over the period 2000-2005, using a price filter approach. This filter picks up sharp price differences quoted in the customs data compared to US/world median prices for the category of goods in question. The difference between the import export prices quoted in the customs invoices and the median prices are then aggregated to show losses due to misinvoicing. Africa lost over US$13 billion to the US alone through these practices between 2000-2005. Extend this to trade with the EU, Japan, India and China and the loss of capital through trade misinvoicing is astronomical.

Their studies demonstrate just how extreme the mispricing can be. For example, in November 2005, a set of golf clubs were imported into Nigeria for US$4,976, while the US/World median price for the same set of clubs was only US$82. During the same month, a gasoline generator was imported into Ghana from the US at a price of US$60,000 that could be purchased at the U.S./World median price of US$63.03. During June of 2005, an electric hair dryer was imported into Nigeria at a price of US$3,800 when the US/World median price of the item was estimated to be US$25. In February 2002, US customs data showed that Ghana exported diamonds to the US through New York via air cargo a total of 37 times, undervalued by US$311 million. In 2000, Ghana lost up to US$328 million of capital outflow through low priced exports. The amount of capital outflows from Ghana to the US through trade misinvoicing increased dramatically between 2003 and 2005. This type of invoicing is prevalent across the African continent.

Trade misinvoicing may be done to evade custom duties and restrictions, avoid paying taxes and fees, or to avoid quotas. It can also be used for smuggling, to launder illegally obtained money, or for other unknown reasons. Misinvoicing of imports by overpricing can be used to conceal illegal commissions and to transfer monies that are hidden in the inflated prices. Under-invoiced imports use misinvoicing to avoid or reduce import duties and restrictions; dump foreign produced goods at below market prices in order to drive out domestic competition; and to smuggle goods into a country to avoid paying taxes and fees.

Companies may over-invoice their exports as a response to their governments’ attempts to reward those companies or industries that increase their export revenues, or simply to hide illegal commissions that can be concealed within the inflated prices. In either case, over-invoicing of exports causes the amount of export subsidies offered by some developing countries to increase. On the other hand, under-invoiced export transactions may be used to avoid or reduce export surcharges in countries where these exist, or as a way to evade income taxes, launder money and/or facilitate capital flight.

Pak et al’s work is no doubt revealing but it severely understates the scale of capital losses through the manipulation of import/export prices. Their model captures mainly trade in goods/commodities. Trade in services and technology are increasing in importance. In addition, the model requires the use of customs data, which tends to be unreliable in many developing countries.

More comprehensive estimates come from the work of Global Financial Integrity, utilising published and verified data from the World Bank, the IMF and others. Their model builds on the World Bank’s Residual model, which compares a country’s source of funds with its recorded use of funds. According to the model, whenever a country’s source of funds exceeds its recorded use of funds, the residual amount comprises unaccounted for, and hence illicit, capital outflows. The World Bank model, however, also fails to capture trade in services or re-invoicing between subsidiaries.

A second approach compares a developing country’s exports to the world with what the world reports as having imported from that country, after adjusting for insurance and freight. Additionally, a country’s imports from the world are compared to what the world reports as having exported to that country. Discrepancies in partner-country trade data, after adjusting for insurance and freight, indicate misinvoicing. However, note that this method only captures illicit transfer of fund abroad through customs re-invoicing; IMF Direction of Trade Statistics cannot capture mispricing that is conducted on the same customs invoice.

The GFI model utilises these two but adjusts them for services and misinvoicing that is conducted in same customs invoices. It is this model that generated the figure of US$1.8 trillion lost to Africa between 1970-2008. See the GFI website for more details.

In the fourth and final part of this series,I shall examine the cost of these practices to Africa/Kenya’s development and suggest ways to minimise these leakages.

* Read Part 1
* Read Part 2
* Read Part 4
* Charles Abugre is the regional director for Africa, United Nations Millennium Campaign.
* Please send comments to editor[at]pambazuka[dot]org or comment online at Pambazuka News.