Introduction
Financial institutions are facing an increasingly interconnected global financial system, where financial transparency has emerged as a critical element of fiscal systems worldwide. With new technologies emerging that have revolutionized the way we conduct financial transactions, new threats have naturally emerged to financial and tax integrity and the stability of the financial system, posing the challenge to local authorities and regulating bodies to ensure they have ready measures to combat these concerns.
With the widespread adoption of digital payment systems giving rise to new channels for funds to be transferred away from the established regulatory monetary ecosystem, this article looks to explore how local authorities and regulating bodies have turned to cooperation to retain transparency and the integrity of their fiscal systems, within the context of Know Your Customer (KYC) and the Common Reporting Standard (CRS) processes. Financial institutions grappling with increasingly complex layers of global and local compliance are encouraged to take immediate action to review their risk management systems and ensure that they are prepared to identify and manage tax evasion and money laundering tactics.
Threats to the global financial order
Tax evasion
The past 10 years have seen the tax world rapidly turning its focus to global tax transparency, with cross-border transactions, offshore sheltered assets and corporate profit shifting all being scrutinized through the lens of tax evasion. Transfer pricing, shell companies and offshore trusts have all emerged as common means taken to evade taxes. These tactics, together with the reduced transparency of the digital economy, pose a significant threat to the global financial order. Financial institutions must now be vigilant as problematic tax-driven strategies are increasingly being implemented through their operating systems.
- Transfer pricing – Transfer pricing poses a clear tax risk where related parties price their transactions in a way that results in noncommercial amounts of profit sitting in low (or zero) tax jurisdictions. As globalization and digital technologies push cross-border transaction volumes to new heights, the opportunities for transfer pricing to facilitate the flow of profit into low tax jurisdictions have rapidly materialized and have greatly increased the financial damage caused by deliberate tax base erosion in legitimate operating jurisdictions.
- Shell companies – With minimal or no genuine operations or employees, shell companies pose a significant risk of being utilized to conceal the true ownership within an interconnected and complex structure, enabling the manipulation and shuffling of assets and profits on a global scale for the purpose of evading taxes.
- Offshore trusts – Offshore trusts, acting as hidden asset shelters, have offered individuals and families a secure haven for their assets in remote offshore jurisdictions. By placing their assets in these trusts, bad actors can exploit favorable tax regulations and the shield of confidentiality to minimize their tax obligations.
Money laundering
While a globally connected financial system brings convenience to people, others seek to exploit this network to move illicit funds across borders.
Bad actors make use of technology such as deepfakes to falsify documents even facial features to trick financial institutions' KYC process. We are also seeing an increased number of money mules across the globe because crime syndicates hire foot soldiers with ease through digital platforms. The use of deepfakes, money mules and cryptocurrency aids bad actors in money laundering, posing additional challenges for financial institutions combating illicit financial practices.
With its comparatively free and relatively unregulated nature, cryptocurrency has emerged as a new method for money laundering. Criminals exploit the pseudo-anonymity of cryptocurrency to launder illicit funds from both off-chain and on-chain crimes and convert them into cash. According to research, in 2023 illicit addresses sent $24.2 billion worth of cryptocurrency to services, and centralized exchanges remain the main destination of illicit funds 1. Criminals also use fiat off-ramps by exploiting centralized platforms to convert cryptocurrency into cash. In fact, money laundering concentration at fiat off-ramps increased from 68.7 percent in 2022 to 71.7 percent in 2023 2.
Fighting back and the emergence of global cooperation
Against the rising tide of digital payment providers and individuals exploiting the reduced transparency in digital channels, globally coordinated efforts continue to strengthen and broaden global frameworks to facilitate governmental cooperation and provide the impetus to retain financial integrity and maintain global fiscal transparency. Concurrently, local authorities and regulating bodies are actively cooperating to retain transparency retain transparency and integrity of their fiscal systems, notably by adopting KYC and CRS processes.
Coordination and leadership in global tax reform has become increasingly apparent as the solution to rising tax evasion, with the OECD assuming the leading role in spearheading these efforts through numerous projects.
- The first significant milestone was the release of the Base Erosion Profit Shifting (BEPS) Action Plan in 2015. The BEPS Action Plan set out 15 recommended actions to guide governments in how to enhance their local tax regulations to address modern tax evasion strategies. To date, the BEPS project has brought together over 140 countries to participate in the project and simultaneously implement new tax and transfer pricing legislation to tackle global tax evasion.
- The second and most recent wave of reforms under the OECD/G20 BEPS Project came in October 2021, as the Global Anti-Base Erosion (GloBE) Rules were released to revamp an international tax system that was increasingly no longer fit to fairly regulate a globalized and digitalized economy. The GloBE Rules further stretched the once fanciful idea of a centrally coordinated regulatory offensive to ensure money stayed within its rightful regulatory environment.
- In conjunction with the OECD/G20 BEPS Project, the OECD also introduced the Common Reporting Standard (CRS) in 2014 to address the issue of taxpayers using the global banking system to conceal taxable income. CRS has emerged as the most significant and complex development for financial institutions to adopt into their operations. The release of the Crypto-Asset Reporting Framework (CARF) and CRS 2.0 are examples of tax authorities, governments and providers working together to gain better insight into the different types of transactions to identify suspicious activities that may be indicative of tax evasion and money laundering.
Alongside global tax reforms, governments and financial institutions are also finding ways to work together to ensure transparency. For example, financial institutions and service providers in different countries are creating information-sharing platforms and messaging tools to aid the detection of money laundering and fraud. Countries with information-sharing platforms include the U.S., U.K., the Netherlands and Estonia 3. In 2023, the Hong Kong Monetary Authority (HKMA), the Hong Kong Association of Banks (HKAB) and the Hong Kong Police Force (HKPF) also launched the Financial Intelligence Evaluation Sharing Tool (FINEST), a bank-to-bank information-sharing platform. This initiative, together with information-sharing among governments, financial institutions and service providers, further enhances the capabilities to detect and disrupt fraud and mule account networks more effectively.
KYC and CRS – Vital frameworks to promote tax transparency
As noted above, KYC and CRS are both regulatory frameworks designed to address the dangers of tax evasion and money laundering by ensuring information transparency and promoting tax compliance. Whilst they serve distinct purposes, there are areas where these processes overlap, creating synergies that would enhance your onboarding process.
For example, both KYC and CRS involve conducting due diligence to capture and validate customer information, build a customer risk profile and conduct appropriate review and validations, and perform adequate screening and ongoing monitoring. By integrating KYC and CRS processes, financial institutions can streamline their compliance efforts and reduce duplication of data collection and reporting.
While KYC and CRS serve distinct purposes, the overlapping elements create opportunities for stronger financial transparency, enhancing accuracy and risk assessment. Integrating these processes can therefore enhance efficiency and aid in the fight against money laundering and tax evasion. Financial institutions must navigate the challenges and considerations associated with this integration to ensure compliance and maintain the integrity of their operations.
Actions going forward
Given the constantly evolving nature of the global financial system, keeping abreast of the latest financial regulations and compliance requirements has emerged as the most critical practice for financial institutions to adopt in their risk management operations. Effective integration of KYC and CRS processes have materialized as a vital area to holistically combat money laundering and tax evasion, ensuring greater transparency and accountability in cross-border transactions and offshore activities.
- Alvarez & Marsal's team of tax and financial compliance experts are on hand to advise on navigating problematic tax strategies and optimizing financial compliance frameworks.
- TAINA's fully automated Foreign Account Tax Compliance Act (FATCA) and CRS Validation platform can help create operational efficiencies and align with the KYC process.
Please get in touch to ensure that you are dynamically positioned to professionally handle the complexities of new tax and regulatory requirements.
Footnotes
2: Money Laundering Activity Spread Across More Service Deposit Addresses in 2023, Plus New Tactics from Lazarus Group: https://www.chainalysis.com/blog/2024.
3: Banks Start Using Information-Sharing Tools to Detect Financial Crime: https://www.wsj.com/articles/banks-start-using-information-sharing-tools-to-detect-financial-crime-11658741402
Originally published 27 May 2024
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.