Abuse of the transfer price: A scandal in Zambia

Is it possible that mere accountants have become the most successful money launderers in the business world, far ahead of other traffickers? In an analysis of the audit reports concerning Zambian mines in Mopani, several financial methods used by the shareholders raises questions about the quality of international regulations.

In summary, Glencore International AG and First Quantum Minerals Ltd have been accused of using the following accounting strategies to conceal their true records:

• Overstating their operational costs: In 2007 alone, auditors estimated the cost at $381 millions (Out of $804 million).
• Understating the amount of copper production: The revenue data from the Mopani mines states that it’s producing at half the rate in comparison to other mines in the area.
• Manipulating the transfer price: Between 2003 and 2008 auditors estimated $700 million were lost, which is suspicious when compared with traditional accounting practices.

Those three maneuvers have a common objective: pay the least amount of taxes as possible by leveraging the differences in international tax rules. Yet it has been 15 years since the OECD blew the whistle that these large companies are manipulating the transfer price. The rule is simple: if these exchanges are in line with the market price, they are legal – if they are over or under the international market price, then they are illegal. The OECD refers to this as the arm’s length principle.

60% of international exchanges are Intra-industry trade

The transfer price is an accounting technique which allows for the exchange of products belonging to the same industry, produced in country A and sold to country B. It’s used to calculate the tax of these goods which is then distributed by the countries, based on recent transactions. Let’s look at an example:

A bullet (country A, cost 1 euro, taxed at 30%) - A bullet sold (country B, cost 10 euros, taxed at 30%)

Result: tax paid in country A + tax paid in country B

Since the mid 1990s, international groups have used “creative accounting” and transported their goods through a third country where the tax to companies is close to zero. The aim is to be charged  for most of the capital gains in this fiscally attractive country. Returning to our bullet example:

A bullet (country A, cost 1 euro, taxed at 30%) Sold for 2 euros (Country X, taxed at 0%) and resold for 10 euros (country B, taxed at 30%)

Result: tax paid in country A in country X + tax + tax in country B

Of the “taxable” 10 euros, 8 euros will escape to any kind of tax and the two other countries (A and B) will just have 2 euros to charge to their income tax. This phenomenon has become a popular trend in the international market, since 60% of today’s exchanges are intra-industry trade.

Suspicion in Switzerland

In Mopani’s case, there is suspicion that the two companies are actively organizing fraud. The majority (73%) of the consortium is owned by Glencore International AG, based in Zug, Switzerland – the paradise of international taxes. This trading giant (specializing in oil, gas, and metals) is also the largest consumer of Mopani’s copper.

The “Copper Marketing and Off-take agreement”  was signed in 2001. According to Mopani, it sets the rules and regulation of sales between the company and Glencore UK Ltd., making Glencore the exclusive commercial agent for Mopani. The referent market is the London Metal Exchange (LME). Yet according to the audit report, nothing on Mopani’s balance sheets shows that this agreement has been respected.

To say these figures are alarming is an understatement. In 2004, 10% of Zambian copper was exported to Switzerland – In 2008, half of the production (the second largest in the world just behind Chile) was headed towards the Swiss Alps. This data is inconsistent with the audit, indicating that  Switzerland is used as a base to manipulate the transfer price.

Inequality in taxes between large enterprises and SMEs

Looking closely at the financial and legal structures that control the Zambian mines, it appears that tax avoidance is at the heart of their approach. Nothing really surprising for Glencore, whose record of being summoned to court has created a notorious reputation for the company. This approach is very subtle on a technical level, as techniques used for the transfer price makes it much more difficult for taxation authorities to detect fraud. Pascal Saint-Amans, a tax expert at OECD, explains to Le Monde:

The abuse of the transfer price comes with serious consequences, as it can be used to relocate taxable money…The IRS are extremely vigilant and aggressive in there measures whenever they discover fraud.

Since January 1, 2010, the French Ministry of  Economy requires companies to clarify how they calculate transfer prices. It’s a necessary measure, which could explain why big companies in France are paying an average 10% of taxes on profits, whereas French SMEs pay a rate closer to 30%. Not everyone is lucky enough to have a good accountant.

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Photo Credits: Flickr CC mtsofan