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Are laws designed to prevent money laundering, terrorism-finance and sanctions violations unintentionally hurting people in poor countries? That’s the question a recent CGD report seeks to address. Anti-money laundering/combating the finance of terrorism laws (AML/CFT) are grounded in reasonable national security concerns – to prevent the cross-border flow of funds to terror or criminal groups. Banks, if unable to identify the end-customer of an international transaction, could find themselves (unwittingly or not) in breach of these laws, and facing stiff penalties.
The report identifies the practice of de-risking – whereby banks deny services to customers in countries that are deemed too risky. This may prevent some nefarious activity but it can also hurt those in developing countries who depend on such funds, including families of migrant workers, small businesses that need access to capital, and NGOs and their clients.
How can we make AML/CFT laws more equitable without going soft on national security?
"We don't see solving this problem as a tradeoff with solving the security problem," CGD Senior Fellow Vijaya Ramachandran, the director of the AML Working Group, tells me in the podcast. "We actually think if you can address this problem you may well make the security system stronger as well."
I sat down with Vijaya and Clay Lowery, the chair of the Working Group, to discuss the Unintended Consequences of Anti-Money Laundering on Poor Countries.
Earlier this year, The Centre for Research on Multinational Corporations (“SOMO”; a Dutch NGO) issued a report about an international mining company they said had avoided paying $232 million USD in taxes in Mongolia.
The mine in question is the Oyu Tolgoi (OT) copper and gold mine and the company is Turquoise Hill, a Canadian company, 51 percent owned by the Australian mining giant Rio Tinto. The Oyu Tolgoi mine is considered a big deal in Mongolia and has been subject to lengthy negotiations on how to split the risks, costs, and profits of the project between the company and the government. While this question is of primary interest to the people of Mongolia, I think that delving into the detail of individual cases like this is also important for clarifying the broader debates and understanding of tax issues.
SOMO say their report “reveals how Rio Tinto has managed to pressure the Mongolian Government into signing deals that are detrimental to its own interests” and in this way “been able to design and preserve a tax dodging scheme that has allowed it to persistently avoid substantial tax payments to Canada and Mongolia.” Oxfam uses it as an example of “how poor countries like Mongolia may be losing millions because of corporate tax practices and legal loopholes.” Turquoise Hill in response say that the report is inaccurate and misleading. They say the investment deal was openly agreed with the Government of Mongolia and that the company’s structure (which involves subsidiaries in the Netherlands and Luxembourg) does not reduce tax in Mongolia, and is in compliance with Canadian tax laws.
Both the NGO’s allegations and the company’s defence rest on the same core documents—in particular, the investment agreements between Turquoise Hill and the Government of Mongolia. It is widely accepted that such contracts should be out in the open. The idea of contract transparency is that it will result in more stable and durable contracts, both because they are less subject to public suspicion and because governments and companies will negotiate better deals. Several governments have made commitments to contract transparency on natural resource concessions, and supporters include the World Bank, the IFC, the IMF, the Publish What You Pay coalition, and the Natural Resource Governance Institute (NRGI). As one report puts it:
States and companies may not be hiding anything of great import, but so long as contract disclosure is scattered and leaked materials suggest hidden horrors, that perception will persist—providing easy fodder for demagogues and politicians to make calls for expropriation and renegotiation in cases where it is not merited.
All of the OT Investment agreements have been published and Turquoise Hill is covered by Canadia’s “ESTMA” revenue transparency regulations, while Rio Tinto produces an extensive “taxes paid” report. However, the Oyu Tolgoi case shows that just having these documents and data in the public domain may not be enough. It also matters what you do with them.
Open Oil (a social enterprise that specializes in public interest financial modeling) points out that debates about these kinds of deals often fall into the trap of the single term dilemma: you can point to any one element and argue that it is too high or too low, but what really matters is the overall division of earnings over time; when will each party start to see a positive return from the project, and what will their revenues look like over the 50+ years of operation? Is that fair? And is the investment viable?
Making sense of Oyu Tolgoi
The Oyu Tolgoi project is a massive, technically and operationally complex project. By the end of 2014 almost $7 billion had already been spent on developing it, and the total investment will be around $12 billion.
The thing that complicates the fiscal side of the deal is that the government is getting a 34 percent “carried interest.” Turquoise Hill and its shareholders are covering 100 percent of the upfront exploration and development costs but will only end up owning a 66 percent share of the project, while the government will not put up any of the up-front investment but will end up with a 34 percent share (through the state-owned enterprise Erdenes).
For this deal to work, it has to be acceptable on both sides, taking into account all of the costs and revenues and how they are distributed over time. The main ones are illustrated below:
Table 1. Costs and revenues: Government of Mongolia and Investors
0 percent of project costs upfront
Loss of amenity and natural resource
100 percent of project costs upfront
(+ risks, including fiscal regime issues)
Import taxes on inputs to the project
34 percent of dividends (-interest and principle on loan)
Corporate Income Tax
66 percent of dividends (post tax profits)
Interest on money loaned to government (payable out of future cashflows)
Management fee to Rio Tinto
+ economic spillovers, employment, technology, etc.
Reputation for developing a successful project >> future investment
Scale of the project
Open Oil has previously developed a model of Oyu Tolgoi’s finances and revenues. As it shows, Oyu Tolgoi delivers early revenues in the form of VAT, royalties, and customs and withholding taxes to the government—long before investors begin to receive dividends. Turquoise Hill say to date the project has paid out $1.7 billion in taxes and royalty payments and that the investor side will not commence to be cash flow positive until around 2026.
Figure 1. Open oil model of Oyu Tolgoi government revenues
(base case scenario, with 20 percent withholding taxes)
Are reduced withholding taxes “shameless abuse”?
SOMO’s belief that tax revenues to date should have been $230 million higher in Mongolia than they were, is based on the argument that the project ought to be paying a 20 percent withholding tax on cross-border interest on loans from the parent company (as is shown in the Open Oil base case) whereas in practice this has been reduced to lower levels.
Withholding taxes are taxes on the gross value of cross border payments such as interest. They are simple for governments to collect (compared to profit taxes), and are an important safeguard against companies shifting profits from high tax to low tax jurisdictions. Even in the absence of profit shifting, withholding tax are relatively attractive for governments because they start to generate public revenue early in the life cycle of an investment, rather than waiting for the project to be in the black.
However, a large tax on interest is like an import tariff on borrowing money; it raises the cost of capital. Therefore countries seeking inward investment often sign double tax treaties, which reduce withholding tax rates.
SOMO argues that the 10 percent WHT rate is abusive because it was secured using a double tax treaty with the Netherlands, which Mongolia has since unilaterally cancelled. However as Turquoise Hill points out, had the loans come from directly from Canada the interest would have been subject to the same 10 percent tax rate. Similarly, if the loans had come from the UK, France or Germany the rate would also have been 10 percent. In fact, when the Investment Agreement was signed Mongolia had 30 double tax treaties and only four of them had a withholding tax rate on interest that was different from 10 percent (one higher and three lower). When the IMF undertook a review of Mongolia’s Tax Treaties it recommended that Mongolia adopt a standard WHT rate of 10 percent for interest.
So the 10 percent rate seems unexceptional. However, SOMO also highlights an additional complication: the tax is only paid on the private investor’s portion of interest payments, and not on the portion that relates to the government’s share. Thus the 10 percent goes down to 6.6 percent in practice. SOMO sees this as a further (retroactive) lowering of withholding taxes. Its reasoning is that withholding taxes are formally a tax on the party that receives the interest payments—and not the party that makes the payments. It argues that therefore that “the logic behind this arrangement seems awed [sic].”
But their interpretation does not reflect the way that withholding taxes work in commercial practice. The cost of the tax has to be priced in and it typically raises the cost for the borrower, rather than lowering the return that a lender is willing to accept. In practical terms, interest rates are usually specified as “net of all taxes” with the borrower required to gross up the payment to cover any withholding tax. That means that if WHT was charged on Erdenes’ share of borrowing, it would be the government paying it to itself (by borrowing additional money from the project). This would bring forward revenues, but the value of the withholding tax would need to be taken off the value of dividends which might be received in later years, with added interest.
While it seems like an exaggeration (or a misunderstanding) by SOMO to call these issues “abuse,” their report does highlight a question about whether the implications of the treatment of WHT for the overall deal were fully understood. This is perhaps even more important going forward than in assessing the taxes paid so far. Using Open Oil’s base case model the difference between a 20 percent or 6.6 percent withholding tax on interest could be worth around $1.3 billion over the life of the mine (undiscounted), while the difference between a 20 percent or a 0 percent dividend withholding tax (as secured by the Netherlands treaty) is worth around $3.7 billion.
Turquoise Hill argue that it was always clear that the equity investor was a Dutch entity, and would therefore use the Dutch tax treaty. We cannot simply assume, as SOMO do that the project would be viable (or that there would not have needed to be concessions in other areas of the deal) if loans were subject to an additional 13.4 percentage points of withholding tax on interest (as well as a 26 percent tax on the interest received in Canada as SOMO also argue).
While it seems unlikely that the negotiators on either side would simply have left the question of withholding tax rates unsettled, what is not clear whether the implications for project’s revenues were clearly understood and communicated across the government and to wider stakeholders. The fact that neither the IMF nor Open Oil’s models of the project seems to correctly reflect the Netherlands tax treaty suggests that the implication of tax treaties were not widely obvious even to careful observers. Turquoise Hill and the Mongolian tax authority have also had large differences of opinion about how much tax is due from the company. In 2014 a bill was issued for $127 million USD for unpaid taxes from 2010 to 2013, which was subsequently cut by more than 75 percent on appeal. Turquoise Hill is currently in dispute with the Mongolian revenue authority over whether their outstanding taxes for 2013 to 2015 are $5 million or $155 million (it has been suggested by industry analysts that this also relates to withholding taxes).
Could contract transparency be better?
Natural resource contracts are increasingly put into the public domain. But as this case highlights, making sense of the numbers and the legal documents is not straightforward and deals remain open to claims of abuse and loopholes, which may not necessarily be well founded.
The World Bank, NRGI, and the Columbia Center on Sustainable Investment have sought to bridge the knowledge gap with the ResourceContracts.org database which annotates contracts to make them easier to find and understand. NRGI provides training and support to civil society organisation and parliamentarians in analysing contracts (including in Mongolia). Open Oil develops open source fiscal models of oil, gas and mining projects.
However, contract terms alone don’t tell the full story, and are easy to misinterpret. Ali Readhead and David Mihalyi argue that it would be beneficial if the Government of Mongolia and Turquoise Hill produced a joint communique on which WHT rates apply for the shareholder loan, the project finance loan, and future dividends.
More generally, perhaps what might be helpful would be to develop open public “term sheets” for oil, gas, and mining contracts which set out the basic variables contained in contracts and the relevant laws and treaties needed to develop a fiscal model. This would provide a crucial link between open contracts and fiscal models, and by using a standard template might be able to make clear whether each party, and the public have adequate information to judge the deal. Companies and governments could support public understanding by providing such information proactively, alongside publishing the detailed contracts.
If transparency about contract terms matters, then so too does the way that this information gets interpreted and shaped into stories. The SOMO report was developed according the organisation’s own quality standards: a draft was sent to Rio Tinto two days before Christmas and the final report published at the end of January, giving little time to engage with the company’s response. A single unnamed “fiscal practitioner” was consulted as peer reviewer. It is not clear whether this person had good knowledge of project finance, but it seems unlikely. Oxfam judged this to be good enough to take the story at face value, without a second opinion, and amplified it to a broader audience.
I don’t think those quality standards are adequate if what we want is serious and credible analysis. Getting better depends on consumers demanding better.
The consumers in this case are the community of people who think that it is worth reading, writing and funding (and quoting, retweeting, remembering, and using…) public analysis about the extractive sector and public revenues (if you got to the bottom this blog post you are part of this club). Accepting lower standards of analysis and review means giving up on trying to tell a real scandal from a sensational headline.
With thanks to Rhodante Ahlers and Vincent Kiezebrink, Ross Lyons, Ali Readhead, David Mihalyi, Dan Neidle, Alistair Watson, and Paddy Carter for thoughts and comments.
The Sustainable Development Goals (SDGs) include a target to “significantly reduce illicit financial and arms flows, strengthen the recovery and return of stolen assets and combat all forms of organised crime” (Target 16.4). However, there is no globally agreed upon definition for “illicit financial flows” (IFFs). My new CGD paper looks at why there is so much disagreement and confusion over this term.
Sandwiched between gun running, stolen assets, and organised crime in the Global Goals, it is clear that the core idea of illicit financial flows is concerned with “dirty money” that crosses international borders—one common formulation is money that is “illegally earned, transferred, and/or utilized.” This includes the proceeds of crime and corruption: illegal trade, embezzlement, bribes and kick-backs, terrorist finance, and misreported transactions that evade tariffs or taxes. In countries with foreign exchange controls, movements of money dodging currency controls would also fall under the definition. The idea of illicit financial flows is important because it highlights that crime and corruption are not just the problem of the country where they happen, but of the countries that allow their financial systems, goods trade or real estate markets to be used as getaway vehicles for ill-gotten loot.
Figure 1. Core concept of illicit financial flows
All of this seems relatively clear (although difficult to measure—such financial flows are obscured and hidden by design). However a case has also been made, for example, by coalitions such as the Global Alliance for Tax Justice and the Global Financial Transparency Coalition that illicit financial flows should be defined more broadly in relation to breaking some line of moral acceptability.
In practice this argument does not aim to draw up a list of morally acceptable and unacceptable things that people could do with their money (which would of course be impossible), but is focused on a particular issue; that “tax avoidance” should be included within the IFFs definition. This would bracket legally compliant taxpayer behaviour into a single category with criminal and corrupt money flows.
I argue that this broad approach is not coherent, and undermines the rule of law.
Grey areas on tax planning and tax evasion: not really so grey
One argument for taking the broad approach, which is often seen as compelling is the idea that there is a large “grey zone” reflecting an absence of clear defining lines between legal tax planning and tax evasion. Transfer pricing and trade misinvoicing are often highlighted as representing this overlapping practice. This is usually illustrated with big estimates, such as that trade misinvoicing drains $800 billion (USD) annually from developing countries, or that it is responsible for $50 billion of illicit flows from Africa.
While there are of course real legal uncertainties and enforcement failures, it is becoming clear that these issues are not well represented by adding up gaps and mismatches in trade data, which often do not reflect misinvoicing at all. Even more fundamentally it is a mischaracterisation to interpret “misinvoicing” as an example of the same kind of thing as legitimate questions over transfer pricing. On the one hand is customs fraud and smuggling, which is a channel for illicit financial flows, and on the other there are ordinary questions over determining acceptable “arms-length” prices for subsidiaries of a multinational corporations to charge between themselves.
For example, a report by Olivier Longchamp and Nathalie Perrot of the Swiss NGO Public Eye provides a good outline of how commodity price manipulation can be used as a means to enable illicit (i.e., illegal) financial flows. They map out several different arrangements between trading companies, “politically exposed persons,” and state-owned enterprises to transfer bribes and kickbacks by misreporting the value of commodity trades (the diagram below is only the simplest of a series).
It is sometimes argued that excluding legal tax planning or resulting “misalignment” from the definition of illicit financial flows means excluding multinational corporations from the scope. However, this is not true, instead it draws the line between corporations acting lawfully and acting in ways that break the law or that abet crime and corruption.
The Swiss Eye report highlights cases such as abuse of the Iraq Oil for Food program involving Glenclore, Vitol making payments to individuals close to the President of Congo-Brazzaville, Glencore (again) over-billing ore from Kazakhstan and paying commissions to a close advisor of the president, and Alcoa’s involvement in trade price manipulation in order to make side payments to a minister in Bahrein. Other cases such as Siemens historic bribe paying and Operation Car Wash in Brazil (involving many companies including Petrobras and Odebrecht) are also well known.
Another recent report The Plunder Route to Panama by the African Investigative Publishing Collective highlights how international financial centres (including London) become the end point for resources plundered through corrupt deals involving politicians and well-connected people. The South African Centre for Investigative Journalism amaBhungane has tirelessly investigated the use of manipulated contracts and misreported payments to deliver kickbacks and embezzle funds from public enterprises in South Africa. In the UK, Lord Peter Hain called for the government to seek a criminal investigation into whether HSBC and Standard Chartered banks facilitated the illicit transfers from South Africa.
There is perhaps a fear that multinational tax avoidance will fall off the international development agenda altogether if it is not included in the SDGs under target 16.4. But there is a better place for considering the tax affairs of multinational corporations in the global goals. That is under target 17.1: strengthening domestic resource mobilization. Rich countries should consider how their tax rules and treaties, the development of international tax norms, and the conduct of multinational corporations may support or undermine tax collection in developing countries.
Strengthening the consistency of international tax rules and the administration of tax law so that they are neither weakly enforced, nor capricious and predatory would be positive for citizens, businesses, and public budgets, and is good for both inward investors and host countries. Bundling everything under a weakly specified and easily sensationalised category of “illicit financial flows” undermines trust, understanding, and the ability to have constructive conversations about how to do this.
A recent article in the New York Times on the current situation in Gaza vividly illustrates what can happen when an entire community loses financial access. Because of Israel’s longstanding blockade of the territory and more recent decisions by Egypt and the Palestinian Authority to cut off financial support to Hamas, money no longer flows in Gaza. Without cash or credit to pay for critical supplies, the Gazan economy has seized up: unemployment is near 50 percent (and even higher for young people), electricity use is limited to 6 or 7 hours per day, and 95 percent of water is undrinkable. The dire situation has created a powder keg that many regional experts believe could lead to a new round of violent conflict with Israel.
The situation highlights the simple fact that goods only flow to the areas where they are needed when money is available to facilitate their purchase and transport. Gaza is not the only region suffering from loss of financial access: a growing number of humanitarian aid organizations operating in conflict zones are also having trouble finding banks willing to work with them. Notably, many humanitarian organizations working in Syria and Yemen report having difficult conducting payments.
Nonprofits cut off from bank accounts and wire transfers
In recent years, many large international banks have either ended or restricted their relationships with certain countries and types of customers. This process, commonly referred to as “de-risking,” is driven by a host of changes to banks’ business and regulatory environment since the global financial crisis, including stricter enforcement of laws and regulations designed to counter money laundering, terrorist financing, and sanctions evasion. In some cases, banks have concluded that certain types of customers pose too great an illicit finance risk, or else are not worth the rising cost of compliance.
The nonprofit sector is among those affected by de-risking, with NPOs reporting a range of financial access problems. This is especially true with respect to Islamic charities, humanitarian organizations operating in high-risk countries, and small nonprofits with limited compliance capacity. In some cases, NPOs have been denied bank accounts or have had their existing accounts closed. More frequently, they have had their transaction delayed. These delays can last for weeks or even months, which in a crisis can be the difference between getting life-saving materials or services to a vulnerable population in time or not. Unable to rely on the formal banking system, some NPOs have resorted to transporting cash or turning to money transfer operators.
The roots of the problem
While banks might have any number of reasons for deciding to exit a particular relationship, concerns about the cost of compliance associated with illicit finance risks often loom large.
Banks’ aversion to working with such NPOs may stem from the fear of inadvertently facilitating illicit finance—particularly terrorist financing and sanctions violations—and of the resulting fines, regulatory scrutiny, and reputational damage. The risk of personal liability for compliance officers undoubtedly fosters even greater caution. In recent years, regulators have consistently emphasized that banks should follow a risk-based approach; however, it appears that many banks and NPOs remain concerned that under US law, terrorist financing and sanctions violations remain “strict liability” offenses. Banks also say they fear being second-guessed by their examiners.
Some banks and bank examiners mistakenly perceive NPOs to be uniformly high risk. This is partly a legacy of the September 11 attacks and their aftermath, during which time NPOs were labeled as “particularly vulnerable” to terrorist financing by the Financial Action Task Force (FATF), the global standard-setting body for anti-money laundering and countering the financing of terrorism (AML/CFT) regulations. Although FATF retracted this language in 2016, the perception that NPOs are especially risky endures. While it is true that some NPOs do need to strengthen their AML/CFT controls, the sector has made important strides in recent years—as recently recognized by the UK government.
Banks’ misperception of NPOs’ riskiness is often exacerbated by a mutual lack of communication and understanding between banks and NPOs. Bank officers may lack a firm grasp of how NPOs operate or how they manage their risk exposures. NPOs, in turn, may not always be cognizant of how banks perceive them or why banks might require certain information of them.
Tackling the problem: advice for policymakers, banks, and NPOs
Due to the multifaceted nature of the problem, tackling it will necessarily entail a coordinated effort on the part of policymakers, banks, and NPOs.
Policymakers should continue to work with banks and NPOs to ensure that regulatory guidance is properly understood and followed. To its credit, FATF now regularly consults with the private and nonprofit sectors. However, given banks’ enduring uncertainty regarding the proper treatment of NPOs, it is clear that more needs to be done to ensure that the risk-based approach is implemented correctly. In addition, policymakers should consider expanding the use of humanitarian exemptions, which can smooth the way for humanitarian organizations to operate in high-risk jurisdictions. Currently, only in Somalia are humanitarian organizations exempted from UN sanctions.
While banks must make decisions based on their bottom line, they can also take an expansive view that recognizes the reputational benefit that providing services to NPOs can provide. Indeed, some banks make a point of doing business with charities and humanitarian organizations for precisely this reason. In addition, banks may wish to consider adopting sector specializations, as Barclays has done, so that they have dedicated staff who understand how NPOs operate and can therefore manage these relationships—and their attendant risks—more effectively. Finally, we encourage banks to continue working with policymakers and NPOs to develop a standardized customer due diligence template tailored to NPOs. Such a template, which the World Bank and ACAMs are working to develop, would be useful for establishing mutual expectations about the baseline information NPOs should be ready to provide their banks.
For their part, NPOs should continue to strengthen their own AML/CFT risk controls and to be proactive in managing their relationships with their banks. In addition, large NPOs might consider how they can provide compliance or financial-management support to the smaller NPOs they often work with to provide last-mile services, often in the most volatile circumstances.
If all three sets of actors can’t find a way to solve the problem, more radical solutions may be necessary. These could include setting up alternate payment channels where humanitarian aid can flow outside of the traditional banking sector but with government oversight (similar to the UK’s Safe Corridor Pilot for remittances to Somalia which was designed but never implemented). NPOs are also exploring whether tracking aid transfers on a permissioned blockchain network would give banks greater confidence and lead to easier access to finance.
The international stakeholder dialogue successfully brought together policymakers, banks, and NPOs to develop a common understanding of the problem and a shared purpose for addressing it. The priority now will be to maintain momentum and close cooperation moving forward.