Detecting Tax Evasion; a Practical Method

The last few years have been quite eventful for anti-money laundering specialists, due diligence gurus and other compliance enthusiasts. Not only has crime become more sophisticated, the attitude towards behavior that might have been frowned at but was mostly condoned has changed dramatically. 16 year old boys get arrested for making boisterous remarks on Facebook; the NSA tries to sneak a peak at everything you do online and you better make sure you pay your taxes in full or you’ll be lumped in with the terrorists, drug kingpins and other ne’er do wells of this world.

Regardless of one’s stance towards paying the emperor what the emperor is due, it is a fact that governments around the world have become acutely aware of their dependence on their constituency’s timely tax payments. Even the supposed inventor of money laundry, all-round bad guy Al Capone, was in the end only caught and convicted for tax evasion.

Singapore has made serious tax crimes a predicate offence to money laundering. Starting the 1st of July, financial institutions have to use their full suite of anti-money laundering systems and measures to detect and report serious tax crimes. Penalties for money laundering are severe and senior management (and compliance officers?) may be held responsible for the results. The big question that the compliance community seems to wrestle with is “How do I detect tax evasion?”

How to Start?

Most financial institutions take a risk based approach. If the risk of tax evasion is larger, they will review the account first. Some banks may have thousands if not tens of thousands of accounts which makes reviewing every account impractical.

What is a “tax evasion risk”?

There are a lot of ideas and definitions going around but a lot of them are based on the same methods that are used to detect money laundering. If tax evasion is a predicate offence to money laundering, it can’t be money laundering by itself. Nobody would say that prostitution, drug trafficking or kidnapping are money laundering but they certainly are predicate offences. Do banks have systems to detect prostitution? Are there vendors out there selling kidnap detection solutions to banks? Not to my knowledge.

A client that may be at high risk for money laundering may very well be paying all his taxes and vice versa. Simply using AML methods to catch tax evaders may very well give you a false sense of security.

So (as we say in Singapore) how then lah?

Risk vs Reward also known as Fear vs Greed

Apart from the moral and ethical implications, the temptation to evade taxes is a simple calculation of the money to gain versus the chance to get caught. It’s all about relativity. Albert Einstein once said “nothing happens until something moves” and this goes double for money. Look at anything that increases the chance to gain from tax evasion and decreases the chance of detection of said evasion.

For practical reasons let’s assume that if you earn a lot of money, you have to pay a lot of taxes. This leaves out the students that “forget” import tax on their new iPad that they bought tax free and the grandmother that sends some money to her grandchildren without realizing that she should have paid tax over that. Yes, they are evading taxes but most of the time they won’t open an off-shore account to do it. It also leaves out most low balance (retail) accounts as it would simply cost too much for a retail client to go through the trouble of off-shore tax evasion.

High Risk Jurisdictions

“The higher the risk of detection, the lower the temptation to move your money”

One of the most asked questions is “which jurisdictions are considered high risk from a tax evasion based perspective?” There is no easy to use list like the FATF list of high-risk and non-cooperative jurisdictions. Some senior bank managers close their eyes and stubbornly keep to the FATF list because “tax evasion = money laundering, so FATF must be right yes?” This would mean that a poor North Korean citizen would be a higher tax evasion risk than a wealthy German and an Iranian farmer would be more likely to evade taxes than a Japanese CEO. In my humble opinion this does not make a lot of sense but hey, whatever floats your pirate ship.

To determine risk, why not look at the taxes charged in the country of origin and the taxes charged at the destination? The higher the difference, the more tempting it is to move your money. You may also want to look at the risk of detection in the country of origin versus the country of destination. The lower the risk of detection, the higher the urge to move your money.This leaves out accounts that were moved between countries with an effective tax control framework and exchange of tax related information.

Since the 1st of July the risk of detection in Singapore went up more than a few notches. This is a good thing for everyone concerned except maybe for the tax evaders and the institutions with a lot of “legacy clients” that they accepted in the bad old days. Still, this may be a good time to weed out the few bad apples and become a truly world class bank.

High Risk Industries

Some industries are traditionally known for “under the table” payments and book cooking. This list may actually be surprisingly similar to the list of high risk money laundering industries. As with AML, look closely at any account movement that doesn't make economic sense.

Structures

Some people use complicated structures with multiple off-shore companies, trusts and other special purpose vehicles. There are many very legal reasons to structure your finances, even to avoid (not evade!) paying too much tax. The more complicated the structure, the more expensive it is to set up.

Of course, a structure also decreases the chance to get caught tax evading so unless the reason for the structure makes perfect sense, an account that involves a structure should be looked at more closely.

You may want to flag any account that isn’t a direct personal or business account and get legal and tax advice if things get too complicated.

Hold Mail

Most private banks offer clients the option to collect mail at the branch office instead of receiving it through the mail. In this age of internet, SMS and cloud based services there is little reason for someone to refuse receiving any kind of statement from their bank, especially if that bank is on the other side of the world. Sure, the NSA may be able to read your statements but if you really don’t want to know what is going on with your money you have other issues. Hold Mail without a very good reason should be regarded as a “red flag”.

Using a list of “red flags” to determine tax evasion risk may be too simple. There are many factors that cannot be caught by looking at red flags.

Let’s look at the definition of tax evasion:

“An illegal practice where a person, organization or corporation intentionally avoids paying his/her/its true tax liability.”

An important factor here is the intention of the individual. So why not ask a potential client why he wants to open a bank account, in your country, with your bank? If the reason is plausible, the account may be deemed a lower risk. There are many reasons to open an account in another country. The political climate may be stable. Lack of corruption and privacy laws make sure that nobody runs off with your money. Competent financial experts and a highly regulated environment keep your savings safe. All these factors and more make Singapore an excellent (if not the best) financial center in the world as well as a springboard to the growing markets in Asia.

What to do if a client opened the account and never visited? What if he kept his relationship manager in his own country and never even corresponds? If a client from a relatively high tax jurisdiction opens an account in a low tax jurisdiction without any reason or if he provides a reason that doesn't make economic sense, the account should be regarded as “increased risk”.

If you have a proper review process, existing accounts shouldn't prove too difficult. Your account managers will be revisiting their accounts regularly anyway. Most banks would have asked their clients a reason for opening the account, especially if the client is a non-resident. If your bank has not, it is time to revisit the client and find out. Excuses as “we don’t want to rock the boat and scare off our existing clients” will not work out in the long run as recent scandals have shown.

Mitigating factors

Anything that raises a “red flag” can be mitigated by an explanation. If a company gives full insight in their tax affairs and/or can provide audit reports will probably have a lower risk score. Individuals that are willing to provide a signed declaration or can provide an official declaration from the local tax authorities that all taxes are paid will be less of a risk than those who won’t.

Classification

Although tax evasion and money laundering seem to be used interchangeably, even by the regulators, I think that it merits having two kinds of classifications. One for money laundering risk and one for tax evasion risk. There are ways to score a “potential” client that are a bit more precise than the usual three or four tier risk classifications that most banks use. In the end it is the aggregated “compliance risk” score that should determine what kind of relationship (if any) you want to have with your client.

Moving Money

After classifying clients, it is time to monitor behavior. This is where traditional AML detection techniques come in handy. Are there any unexpected transactions? Attempts to avoid detection, like old fashioned structuring and layering?  Payments from third parties or countries that are known for tax evasion? Keep in mind though that it is very difficult, if not impossible to detect tax evasion in a single transaction unless it’s crystal clear what the origins of the funds were. Most money laundering methods need multiple transactions. Tax evasion can be committed without transacting at all, simply don’t pay taxes!

Conclusion

The methods described above may help to keep out tax evaders but will do less to catch tax evasion as it occurs. They won’t detect the merchant that keeps profits off the books or the plastic surgeon that receives payments under the operating table. Existing money laundering typologies can be used to detect tax evasion but don’t forget that there are other forms of money laundering and other predicate crimes. The job of a money laundering reporting officer is to report suspicious activity regardless of what the actual crime (if any) is.

Nobody don’t want to bank with an institution that is a known tax-evaders haven. Most wealthy individuals prefer privacy, which is hard to maintain if your bank is being investigated and in the news. Trust and reputation is everything, especially if you are a small private institution with few clients.

As I learned the hard way, bank management might be sorely tempted to tweak definitions and results to leave the majority of their clients off the hook and with the bank. In the long run, brutal honesty (at least internally) goes a lot further than self-delusion and willful blindness. It is the role of compliance to keep the bank operating inside the law but in the end it is senior management that makes the decision how to do that. Without a proper framework and established definitions it is still difficult to implement proper anti-tax evasion controls.

Please note that this post is based on personal experience  only, contains suggestions and is in no way intended as legal or regulatory advice. Feel free to contact me or post your questions or suggestions below. I am always willing to share some ideas.