Two weeks ago, the Global Financial Integrity, a US-based watchdog released the ‘Illicit Financial Flows From Developing Countries Over The Decade Ending 2009’ study where it estimates that developing countries around the world lost a massive US$8.44 trillion.
On a local context, Malaysia was placed fifth in the world on cumulative total illicit financial flows (IFF) since 2000.
For 2009 alone, IFF (non-normalised) amounted to approximately US$46.86 billion (about RM145billion at an exchange rate of RM3.1 = US$1) and over the cumulative nine years, total IFF amounted to a massive US$350.47 (about RM1,086.46 billion).
Even on a more conservative estimate, Malaysia lost US$337.87 billion over the same period (about RM1,047.4 billion).
Two methods of estimations were used in the study, one being the World Bank Residual model (using the change in external debt, or CED), and secondly, trade mispricing (using the Gross Excluding Reversals method, or GER).
Through the balance of payments (a component of CED), it captures unrecorded capital leakages, i.e. illicit transfers of the proceeds of bribery, theft, kickbacks, and tax evasion. Meanwhile, outflow of unrecorded transfers due to trade mispricing was captured under the GER method.
Based on the study, Malaysia’s nine-year average normalised, i.e. conservative IFF amounted to US$14.17 billion (42 percent; RM43.9 billion) due to CED, while GER accounted for US$19.62 billion (58 percent; RM60.8 billion).
Meanwhile, average non-normalised IFF was US$15.43 billion (44 percent; RM47.5 billion) due to CED and US$19.62 billion (56 percent; RM 60.8billion) due to GER.
Malaysia is the only country where both channels of IFF, CED and GER, are roughly in comparable portions.
Definition of Illicit Financial Flows
Under the notes on methodology of the IFF, the Global Financial Integrity has detailed out the following:
“Hence, illicit flows may involve capital earned through legitimate means such as the profits of a legitimate business.
“It is the transfer abroad of that profit in violation of applicable laws (such as non-payment of applicable corporate taxes or breaking of exchange control regulations) that makes the outflows illicit.”
A more layman interpretation is IFF involves cross-border movement of money that is illegally earned, transferred, or utilised.
IFF generally involves the transfer of money earned through illegal activities such as corruption, transactions involving contraband goods, criminal activities, and efforts to shelter wealth from a country’s tax authorities.
What’s in the law?
The Malaysian Transfer Pricing Guidelines (TP Guidelines) was introduced in July 2003 by the Inland Revenue Board (IRB).
The TP Guidelines provide guidance to taxpayers on the application of arm’s length principle, which is espoused through the anti-avoidance provisions of the Income Tax Act 1967.
With the introduction of the TP Guidelines, a specialist group was set up within IRB to deal with transfer pricing issues. Desk audit and field audits were rigorously carried out since its set-up.
The statutory law that governs transfer pricing is provided under the anti-avoidance provision in Section 140 of the Income Tax Act; where it provides the power to the IRB director-general to disregard transactions that are deemed not arm’s length and make necessary adjustments to revise or impose additional tax liabilities.
Section 140 has been used widely by the IRB for local and cross-border transactions, adjusting any transfer pricing abuses.
The arm’s length definition was not defined in the Income Tax Act; however the concept and its application were provided under the TP Guidelines.
Under self-assessment system, the burden of proof lies with taxpayers to justify such transactions.
The IRB further introduced a new section, Section 140A, which came into effect on Jan 1, 2009, that empowers the IRB director-general to make adjustments on transactions of goods, services or financial assistance between related companies based on the arm’s length principle.
Additionally, all related parties’ transactions are required to be submitted, under Section N of the Form C, where the categories of related party’s transactions consist of:
- Total sales to related companies in/outside Malaysia;
- Total purchases from related companies in/outside Malaysia;
- Other payments to related companies in/outside Malaysia;
- Other payments to related companies in/outside Malaysia;
- Loans to related companies in/outside Malaysia;
- Borrowings from related companies in/outside Malaysia; and
- Receipts from related companies in/outside Malaysia.
There is no specific provision for non-compliance or not having transfer pricing documentation in place under the TP Guidelines.
However, where transfer pricing adjustments are made, any additional taxes resulting from such adjustments will be subjected to additional penalties of as high as 45 percent.
MNC’s transfer pricing
As detailed above, Malaysia has in effect the necessary laws and guidelines in place to deal with transfer pricing and money laundering activities.
So it was rather surprising when our learned Kota Belud MP Abdul Rahman Dahlan suggested that multinational companies (MNCs) are largely the cause of such massive amount of IFF, basing on Global Financial Integrity director Raymond Baker’s speech and certain parts of the study.
Perhaps, the question to ask is why despite having such laws in place; there is still a massive amount of IFF out of the country.
Instead, our learned MP has suggested that MNCs’ under/over transfer pricing under Western global financial system is to be blamed and chose to downplay the effect of corruption.
So what is the MP trying to imply? Is he suggesting that the likes of Intel, Agilent, Western Digital, and a whole host of Japanese and other MNCs, are involved in transferring IFF? Let’s just not be too quick to point fingers.
Having been in the transfer pricing environment for close to a decade, I must say that transfer pricing has been the one of the most scrutinised subject by the IRB since the TP Guidelines were introduced, where transfer pricing desk audits and field audits were conducted.
Even during routine tax audits, transfer pricing has been one of the hot subjects.
Transfer pricing is not cast in stone. A lot factors are considered to arrive at certain pricing, where different pricing strategies are adopted taking into account both quantitative and qualitative considerations, i.e. business strategies, characteristics of services, functions performed, and economic conditions.
For example, companies may go on a low pricing strategy of certain products, as they are able to recover profitability based on volume (economies of scale).
Or they could also be the need to maintain low margin products where profitability can be recovered through high margin products. The numbers do tell a story.
Something wrong in monitoring system
However, having said that, not all are fairy tales. There is no denying that MNCs do get their transfer pricing wrong at times, and from my years of experience, it is rather that companies have got their projections wrong or made bad business decisions.
And in some cases, as a consequence, transfer pricing adjustments running into hundreds of millions in additional taxes were paid. Not to mention, penalties as well.
More likely than not, where there are cases of transfer mispricing, MNCs would always step forward and rectify the situation.
This is so because being in the corporate and business environment, getting caught by authorities in doing illegal activities will most likely cause serious damage to business integrity and reputation.
Compliance is one of the most stringent as far as I understand from a corporate culture perspective, or at least for cases I have seen.
The Kota Belud MP also suggested that there was not enough information disclosed by MNCs, hence it is hard to trace IFF due to transfer mispricing. I beg to differ.
There are actually considerable amount of information disclosed in the Form C for monitoring and triggering transfer pricing or tax audits.
In addition to related companies’ transactions that need to be disclosed as explained earlier, companies will also need to disclose details of main shareholders in Part P of the Form C if it is a controlled company.
Similarly, the related party’s transactions and details are disclosed in the notes to profit and loss accounts; and disclosure requirements are even more stringent if it is a public-listed company.
The Kota Belud MP has brought out the point where MNCs were using tax havens as a conduit for the IFF.
I do not deny this happening, but based on experience, a lot of MNCs have a strong requirement in terms of substance over form and more often than not, IRB is able to pick up these structures in the first instance.
Let us not forget that our very own Labuan, an international financial centre, is deemed a tax haven by other foreign jurisdictions. It would be interesting to know how much financial transactions flow through Labuan.
Perhaps, the question to ask is what is wrong with our current monitoring, enforcement and implementation system that despite having the necessary laws and conducting rigorous audits, there are still such leakages. This is something that the Kota Belud MP should look into.
Local conglomerates and GLCs
While I have mentioned that MNCs are subjected to more scrutiny on its cross-border transactions, the same cannot be said for local conglomerates and government-linked companies (GLCs).
Based on past experience, local conglomerates and GLCs have not been the main focus of IRB and I have not seen as much transfer pricing audit being carried out (perhaps this has changed).
Mind you, local conglomerates and GLCs have a lot of cross-border dealings and transactions as well.
Let’s us then theoretically apply the same collection amount to the 2009 figure, taking into account half – i.e. 50 percent is caused by the GER – and it still leaves US$16.43 billion (RM50.9 billion) unaccounted for.
Could all this amount due to transfer mispricing caused by MNCs? How much of this unaccounted amount can be apportioned to local conglomerates and GLCs? Do they also have some form of tax haven structures in place as well? And I have not yet mentioned dealings of the rich and powerful individuals.
This is something I would love to find out and I do agree with the Kota Belud MP on this with regards to a more detailed analysis on Malaysia.
Bribery, theft and kickbacks
Interestingly, what has not been pointed out by the Kota Belud MP is that Malaysia’s IFF was also caused by CED, which relates to illicit transfers of the proceeds of bribery, theft, kickbacks, and tax evasion.
It is pointed out in the study that Malaysia is the only country where IFF is caused by a comparable portion of CED and GER.
So what does this mean? It is effectively saying that an IFF totaling US$21.47 billion (RM66.6 billion) in 2009 alone was due to the activities of involving bribery, theft, kickbacks and tax evasion.
The comparable size of 50 percent to transfer mispricing is definitely an alarming cause of concern itself, would it not?
It is not known what proportion relates to bribery, theft, kickbacks and tax evasion.
So far, where tax evasion is concerned, there has not been any reported case where large MNCs were caught in such an act, which carries a fine and/or imprisonment with an additional penalty of 300 percent on amount undercharged.
And the inspector-general of police has openly acknowledged that such IFF is not something new and is aware of such leakages. So my question would be what has been done to address this?
This is extremely worrying as there are no accounts or methods to track such IFF, as these outflows are not available to public eyes.
Instead of trying to just point fingers to the MNCs, I believe efforts should be channeled by the government to work on addressing these issues. I rest my case.
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