By Walter Amoko | Lena Onchwari

The integration of national economies alongside an increased appetite for investments by national Governments has brought to the fore a problem that affects all tax authorities; access to financial information of private corporations. This problem tends to affect the less developed countries (LDCs) more acutely, as they have to contend with an eroded tax base amidst limited fiscal resources.

There are several aspects to the difficulty in accessing financial information, with LDCs particularly vulnerable. Firstly, aggressive tax planning by multinationals and high net worth individuals as they seek to minimize their tax obligations through schemes which sometimes skirt the limits of legality. Second is the illicit transfer of funds as unscrupulous corporations and individuals seek to hide their wealth “under the table”.

Co-ordinated efforts between Governments

In view of the foregoing, the authorities have finally shaped up with the international tax scene experiencing a rapid change owing to co-ordinated efforts between Governments in actively working together and cracking down on various tax avoidance schemes with statutory tax anti-avoidance provisions e.g. the arms, length principle, enacted with the intention of tackling base erosion and profit shifting (BEPS) and aggressive tax avoidance schemes of multinational entities. The Organisation for Economic Co-operation and Development (OECD) has been the driving force behind the BEPS project, which was published in October 2015. It establishes an international tax framework by which profits of a company are taxed on the basis of where economic value was added.

The “Panama” effect

Another area of concern is offshore accounts which are hidden from view by the veil of bank confidentiality and secrecy. The recent disclosure of the Panama papers has provided us with a peep into the sheer scale of the offshore accounts. As summarised by Edward Luttwak:

“It is just a matter of numbers: Mossack Fonseca’s 214,000 offshore companies alone (and there are many other such shell companies, formed by many other law firms) handled not millions or billions but trillions of dollars in their totality, thereby wholly subverting the presumptively equalizing effect of taxation. When the less affluent must pay their payroll taxes and income taxes in full and the more affluent with offshore companies do not pay their own taxes, the total effect of the taxation system is regressive, even without adding the inherently regressive effects of sales and value-added taxes. Once we recognise the sheer magnitude of “offshored” income flows, and once we take into account the strongly regressive effects of supposedly progressive taxation systems, the phenomenon of rising inequality in affluent societies may not need much additional explaining – and it hardly matters if those were tax-avoidance or tax-evasion trillions.”

Initial efforts albeit with local/regional benefits

The initial efforts to address this problem by requiring disclosure and exchange of information seemed designed for the benefit of a small group of western tax authorities. For instance, since 2005, the European Union (EU) has had the European Union Savings Tax Directive (EUSTD) which is an agreement between EU member states that compels the exchange of relevant financial information between them. In the United States (US), the Foreign Account Tax Compliance Act (FATCA) has recently come into force. The Act ensures that financial institutions all over the world provide relevant financial information on US taxpayers.

Working under the auspices of the OECD, governments started addressing even “bigger evils”; bank secrecy and many other forms of financial opacity. In 2013, finance ministers of the G8 (now G7) and G20 endorsed automatic exchange of information as a new mode of exchange of information. Previously, information was exchanged on either an “upon request” basis or spontaneously. However this did not seem to be effective in preventing illicit financial flows across jurisdictions. OECD was thus tasked to come up with an international standard framework for automatic exchange of information between different jurisdictions.

OECD Framework

The OECD framework is composed of two key components. Firstly, it promulgates the Common Reporting Standards (CRS) which detail the scope and procedures of automatic exchange of information and due
diligence procedures to be carried out by financial institutions in participating, countries. Secondly, while its scope is not geographically limited, like EUSTD, or nationality based like FACTA, it is not universal as it still ,requires individual countries to sign up.

CRS became effective on 1st January 2016 in fifty six (56) countries. A total of more than one hundred (100) jurisdictions have signed up to the new regime. The Kenyan Government has not been left behind having recently been the 94th jurisdiction to sign the multilateral agreement, although like Panama and Bahrain, it has not committed to a date when CRS will take effect.

The main objective of CRS is the sharing of information by financial institutions in all participating countries so as to enable tax authorities of different jurisdictions to obtain information about their tax residents’ affairs, that would otherwise have been undisclosed. Unlike FATCA which is based on citizenship, CRS is based on the tax residence of the individual.

A key feature of CRS is that it will result in information exchange between countries on an unsolicited basis. This is a significant departure from the current process of formal requests having to be made on a case by case basis. This includes virtually all major onshore financial centres. It is expected that the first flow of information will take place under CRS in 2017 amongst the so-called “early adopters” group. In addition to this group, there are over thirty (30) countries which have committed to CRS and are targeting the first exchanges of information in 2018.

How does CRS work?

Under CRS, financial institutions located in participating countries will be required to carry out enhanced due diligence procedures to both their existing and new financial account holders. These are aimed at establishing the tax residence of the holders of financial accounts, including individuals who control such accounts through conduit investment entities.

Subsequently, details of these financial accounts are then automatically exchanged annually between tax authorities of participating countries The result is that any disparity between the information given and the tax resident’s declaration raises a red flag that may lead to further investigation by the tax authority.

Scope of CRS

The OECD has designed CRS to cover a broad scope that runs across four key areas namely:-

1. Reportable income

One may wonder what income is considered to be reportable income. This includes all types of investment income including interest, dividends, annuities and other similar income, proceeds from sale of financial assets and account balances. It is noteworthy that this list is not exhaustive.

1. Reportable accounts

In the event that a tax resident holds a financial account in a country that has signed up to CRS, such account is referred to as a reportable account. But who is a tax resident individual for CRS purposes? If a person is liable to tax in a certain country by virtue of being domiciled, resident or having its place of management in that country, then that person will be considered to be tax resident in such a jurisdiction. Where a person is tax resident in multiple countries, their account balances and income will be reported to each of the participating countries.

iii. Financial institutions

The financial institutions required to report under CRS include banks, brokers, trusts, custodians, certain collective investment vehicles and certain insurance companies. The term “financial account” under CRS has an even broader meaning than depository accounts. It also refers to any custodial accounts and certain types of insurance policies.

“Financial accounts” under CRS also relates to any debt or equity interests that are held in investment vehicles such as trusts. In corresponding fashion, a “financial institution” has a broad definition that goes beyond banks; it also means investment managers and trustees.

Conclusion

Though noble, CRS will probably face a number of challenges. It was developed by the OECD which is perceived to be a pro-developed countries institution. As such, there is a risk that there may be subdued political goodwill from LDCs especially when some of the likely targets are running and/or influential within those very countries expected to sign up. Moreover, there are no incentives for LDCs to sign up and commit the resources required to make CRS work.

As critics have also noted, CRS has some loopholes. For example, CRS only applies to financial institutions located in the participating jurisdictions and therefore does not have universal application. “Clever” individuals may thus escape disclosure by playing around with their residency for example establishing fictitious residences in non–participating jurisdictions. There also seems to be scope for individual countries to limit their co-operation to only those countries they would like to. While financial institutions are broadly defined, there is still room left for manipulation so as to avoid disclosure such as on trusts.

Despite these shortcomings, if CRS is implemented, even to a limited number of countries worldwide, it would represent the best hope yet in piercing the cloak of secrecy that has thus far protected illicit funds transfers globally.