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A case study of abnormally priced trades between the U.S. and the LAC Methodology, results, and their implications for Partner Countries Simon J. Pak Associate.

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Presentation on theme: "A case study of abnormally priced trades between the U.S. and the LAC Methodology, results, and their implications for Partner Countries Simon J. Pak Associate."— Presentation transcript:

1 A case study of abnormally priced trades between the U.S. and the LAC Methodology, results, and their implications for Partner Countries Simon J. Pak Associate Professor of Finance The Pennsylvania State University School of Graduate Professional Studies Tel: (610) Seminar on Public Finances and Tax Evasion in Latin America ICEFI, Tax Justice Network and Poder Ciudadano Under the auspices and participation of the European Union, ITC-GTZ, SOMO, KEPA and Latindadd Antigua, August 2010

2 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 2 Outline Abnormally priced export and import Guatemalas export examples – Bananas and Coffee Guatemalas import examples – Wheat and Light Crude Oil Causes and Effects of abnormal trade pricing Detection methods of abnormal pricing Arms length price (ALP) data Price filter matrix – a statistical approach Estimates of capital flows through abnormal pricing: LAC countries vs. U.S. Non-quantified trades Commodities with volatile price movements Summary Detection system – Price filter matrix & its limitation

3 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 3 Low Priced Banana Export from Guatemala Photo Source: In June 2009, Guatemala Exported Bananas to the U.S. 5,098 tons for $1.018 million Export price: $0.20/Kg Worth $4.338 mm at an Arms Length Price* of $0.85/Kg Underpriced by $3.32 mm $3.32 mm wealth outflow $3.32 mm less taxable income * IMF Primary Commodity Prices - Bananas, avg of Chiquita, Del Monte, Dole, US Gulf delivery

4 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … Guatemala Export to the U.S. BANANAS, Fresh (HS code: ) Total Bananas export in 2009: export value = $431 mm amount underpriced = $514 MM (=120% of total export value) IMF price data All Underpriced!

5 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 5 Bananas Export - Underpriced Amounts 10-year total: export amount $2.75 BN Underpriced amount: $3.3 BN (120% of exp amt) (Reference monthly prices from IMF Primary Commodity Prices)

6 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 6 Guatemala Coffee Export – Abnormally Priced Photo from Underpriced by $56,828 $56,828 wealth outflow $56,828 less taxable income Overpriced by $1.63 mm $1.63 mm wealth inflow $1.63 mm more taxable income

7 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … Guatemala Export to the U.S. COFFEE, ARABICA, NOT ROASTED, NOT DECAFFEINATED (HS code: ) Total for 2009: exp value= $287 mm amount underpriced = $5.4 MM (1.9% of exp amt) amount overpriced = $21 MM (7.3% of exp amt)

8 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 8 Coffee Export: under-, over- priced amounts 10-year total amount (Export value $1,897 mm) : $69 mm (underpriced, 3.6%) $278 mm (overpriced, 14.7%) (Reference monthly prices from IMF Primary Commodity Prices)

9 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 9 Guatemala Oil Import – Abnormally Priced Photo fromPhoto from Underpriced by $4.81 mm $ 4.81 mm wealth inflow $ 4.81 mm more taxable income Overpriced by $1.89 mm $ $ 1.89 mm wealth outflow $ $ 1.89 mm less taxable income * EIA Ref Price: No.2 Fuel Oil, not Diesel, monthly max/min prices

10 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … Guatemala Import from the U.S. LIGHT FULE OILS 25 DEG API (HS code: ) Total for 2008: exp value = $ 502 mm Overpriced amount = $6.0 MM (1.2%) --- negligible Underpriced amount = $11.7 MM (2.3%) --- negligible

11 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 11 Light Fuel Oil Import: under-, over- priced amounts 7-year total amount: import value = $769 mm underpriced = $24 mm (3.1%) overpriced = $11 mm (1.5%) (Reference monthly prices from IMF Primary Commodity Prices)

12 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 12 Guatemala Wheat Import – Abnormally Priced Photo from Photo from Underpriced by $319,694 $ 319,694 wealth inflow $ 319,694 more taxable income Overpriced by $2.16 mm $ $ 2.16 mm wealth outflow $ $ 2.16 mm less taxable income

13 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … Guatemala Import from the U.S. Wheat (HS code: , m. ton) Total for 2009: Import value = $ 85.9 mm overpriced amount = $12.5 MM (14.6%)

14 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 14 Wheat Import: under-, over- priced amounts 10-year total amount: imp value = $675 mm underpriced = $7.6 mm (1.1%) overpriced = $63 mm (9.3%) (Reference monthly prices from IMF Primary Commodity Prices)

15 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 15 Effects of Abnormally Priced Trades EXPORTUnderpriced ExportOverpriced Export Exporter Lower revenue Lower profit Higher revenue Higher profit Government Capital outflow Lower income tax revenue Capital inflow Higher income tax revenue IMPORTOverpriced ImportUnderpriced Import Importer Higher COGS Lower profit Higher duty Lower COGS Higher profit Lower duty Government Capital outflow Lower income tax revenue Higher duty revenue Capital inflow Higher income tax revenue Lower duty revenue

16 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 16 What Causes Trade Abnormal Pricing? May be related to Capital flight Import duty fraud Income tax avoidance / Transfer pricing Money laundering Other Explanations: Clerical/Recording errors Product heterogeneity for a given HS10 code $25,000 fax machine from Japan – prototype industrial sample

17 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 17 Outline Abnormally priced export and import Guatemalas export examples – Bananas and Coffee Guatemalas import examples – Wheat and Light Crude Oil Causes and Effects of abnormal trade pricing Detection methods of abnormal pricing Arms length price (ALP) data Price filter matrix – a statistical approach Estimates of capital flows through abnormal pricing: LAC countries vs. U.S. (tax haven?) Non-quantified trades Commodities with volatile price movements Summary Detection system – Price filter matrix & its limitation

18 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 18 How to Detect Abnormal Pricing? Money Laundering and Income Tax Evasion: The Determination of Optimal Audits and Inspections to Detect Abnormal Prices in International Trade, Journal of Financial Crime, Vol. 12, No. 2, (de Boyrie, M.E., Pak, S.J., and Zdanowicz, J. S.) Audits & Inspections Customs Agents Lack of benchmark pricing data (arms length price) - Difficult to determine abnormality Pre Shipment Inspection firms All specified inbound cargos inspected Challenges in Detection Over 70 million transactions annually in U.S. Exports and Imports Examination of trade documents Physical inspection of cargo Delays in the movement of goods

19 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 19 How to Detect Abnormal Pricing? Alternative Approaches: Computerized Filtering based on benchmark prices if available Low cost & efficient Accurate A statistical approach by estimating upper & lower bounds if benchmark prices not available Low cost and efficient Accuracy depends on the quality of the historical data in estimating the benchmark upper & lower bound prices

20 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 20 How to Detect Abnormal Pricing? Statistical Approach Estimate the benchmark upper and lower bounds of prices (Price filter matrix) Based on statistical Analysis of historical prices For each commodity category by country Transactions with prices outside the benchmark prices Higher probability of being abnormal than the population The narrower bounds of the benchmark prices, the more numerous the transactions with prices outside the benchmark prices Suspected trades with abnormal prices require inspections by Customs agents

21 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 21 DATA SOURCE Import and Export data from U.S. Customs and Border Protection Most detailed import and export records Not publicly available U.S. Merchandise Trade Data from U.S. Census Bureau Publicly available Import and export records grouped by HS10, Partner country, customs district, and month 8,750 export HS10 codes and 16,703 import HS10 codes in countries in customs district codes Quantity & Dollar value

22 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 22 Price Filter Matrix - Criteria for Price Abnormality Price Filter Matrix may be constructed from the U.S. Merchandise Trade data: For each commodity code and each country The average price, the standard deviation, upper- and lower- bound prices Upper bound = the mean + or Upper Quartile Price Lower bound = the mean - or Lower Quartile Price Total Number of Cells in 2009: 5.86 million cells Export: (8,750 items)x (233 countries) = 2.04 mm cells Import: (16,703 items) x (229 countries) = 3.82 mm cells

23 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 23 Price Filter Matrix - Bananas U.S. Bananas import US-World price filter: Upper and Lower quartile prices based on all U.S. import records from all countries US-Guatemala price filter: Upper and Lower quartile prices based on all U.S. import records from Guatemala Compare the results with IMF Bananas price

24 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 24 U.S.-World Quartile Prices (Bananas 2009) Upper Quartile Price US-World data Overpriced Underpriced Normal

25 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 25 U.S.- Guatemala Quartile Prices (Bananas 2009) Upper Quartile Price US-Guatemala data Lower Quartile Price US-Guatemala data Normal

26 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 26 Which Arms Length Price? IMF, US-World, US-Guatemala

27 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 27 Over/Under-priced Amounts,

28 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … Guatemala Export to the U.S. COFFEE, ARABICA, NOT ROASTED, NOT DECAFFEINATED HS10 code:

29 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 29 Over/Under-priced Amounts,

30 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … US Import Prices (cif) from Guatemala COFFEE, ARABICA, NOT ROASTED, NOT DECAFFEINATED ( HS code: )

31 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … Coffee Prices (IMF vs. US Import Price Statistics,cif) IMF: Coffee, Other Milds, El Salvador and Guatemala, ex-dock New York US-Guatemala Price: Coffee, Arabica, not roasted, not decaff HS10:

32 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … Coffee Prices (IMF vs. US Import Price Statistics, cif) IMF: Coffee, Other Milds, El Salvador and Guatemala, ex-dock New York US-World Prices: Coffee, Arabica, not roasted, not decaff HS10:

33 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … Guatemala Import Prices (f.o.b. US) from the U.S. Wheat (HS: , USD/MTon)

34 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 34 Over/Under-priced Amounts,

35 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … Guatemala Import Prices (fob US) from the U.S. Light Fuel Oils, not Diesel, 25 DEGREES API (HS: )

36 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 36 Over/Under-priced Amounts,

37 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 37 Detection of Abnormal Pricing Physical auditing/inspection Too many to inspect – costly & delayed cargo flow Benchmark prices available for limited number of items Computerized detection with benchmark prices Low cost and accurate Benchmark prices available only for limited number of items Computerized detection with statistically estimated Price Filter Matrix Less accurate than with benchmark prices Possible underestimation of abnormality Efficient and low cost detection of importers/exporters with frequent mispricing when combined with inspection/audit by Customs specialist

38 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 38 Outline Abnormally priced export and import Guatemalas export examples – Bananas and Coffee Guatemalas import examples – Wheat and Light Crude Oil Causes and Effects of abnormal trade pricing Detection methods of abnormal pricing Arms length price (ALP) data Price filter matrix – a statistical approach Estimates of capital flows through abnormal pricing: LAC countries vs. U.S. (tax haven?) Non-quantified trades Commodities with volatile price movements Summary Detection system – Price filter matrix & its limitation

39 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 39 Estimates of Capital Flows using Price Filter Matrix METHOD: Estimate upper and lower quartile prices for: Every commodity Every country Calculate overpriced amount and underpriced amount for every trade with prices outside the interquartile range Aggregate overpriced amounts and underpriced amounts for all trades CAUTION: The method cant be applied to non-quantified trades The price filter method will not work for commodities with volatile benchmark prices such as crude oil in 2008

40 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … US Export to LAC - 1 * Tax haven country list from OECD Progress Report 2April2009,

41 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … US Export to LAC - 2

42 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … US Export to LAC - 3

43 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … US Import from LAC - 1 * Tax haven country list from OECD Progress Report 2April2009,

44 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … US Import from LAC - 2

45 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … US Import from LAC - 3

46 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 46 Chen/Sunrider was accused of over-invoiced imports Imported herbs at very high prices from China and Taiwan between 1989 and 1991 to evade U.S. income tax Two Court Cases IRS vs. Chen/Sunrider: IRS Section 482 violation The US vs. Chen/Sunrider: US Customs Document Fraud case (Simon Pak was the expert witness consultant for the U.S. Attorneys office along with Dr. John Zdanowitz) Price Filter Application to a Court Case

47 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 47

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50 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 50 IRS vs. Chen/Sunrider On the IRS Section 482 violation charge, Mr. Chen paid IRS over $48 million for tax and penalty (6 Transfer Pricing Report 842, 3/25/98) According to the Wall Street Journal (7/3/1997), Mr. Chen paid $93 million without admitting any wrongdoing. The US vs. Chen/Sunrider On the Customs Document Fraud charge, Mr. Chen Paid $4 million fine to US Customs and sentenced to a two-year jail term Chen/Sunrider case - The Results

51 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 51 Limitations of Price Matrix Filter Approach For highly heterogeneous HS10 categories The price filter matrix may introduce biases Wider upper/lower quartile ranges mitigate the biase problem somewhat Aggregated data By HS10, Month, Country, and Customs District No distinction between Related party transactions v.s. unrelated party transactions HS10 categories without quantity reported No price filter matrix can be constructed

52 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 52 Limitations of Price Matrix Filter Approach Inter-quartile price range is somewhat arbitrary Automatically classify top 25% and bottom 25% as abnormally priced But the U.S. IRS transfer pricing regulation (IRC 482) specifies that an inter-quartile range is an acceptable arm's length transaction range

53 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 53 Why use Price Filter Matrix? A good first-order approximation in estimating abnormality Detection of abnormality The price filter approach based on the inter- quartile range is an effective initial step in investigating and identifying truly abnormally priced trades Needs follow-up inspections

54 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 54 Proper Application of Price Filter Matrix Examine the frequency of abnormally priced trades for a particular importer or exporter The probability of a randomly selected transaction to be above upper-, or below lower-quartile range is 25%. The probability for a half or more of 100 transactions to be above upper-, or below lower- quartile range is 1 in 47 million chances! Therefore, the price filter approach based on the inter-quartile range can be an effective tool in detecting importers/exporters with frequent mispriced transactions.

55 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 55 Other Factors in detecting Suspicious Cargo Easy computerized detection: Suspiciously high/low shipping cost per unit weight Abnormal weight: a spark plug weighting 4 pounds?

56 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 56 What about High Shipping Cost? Why would Shipping Costs be higher than Customs Values? For Exporters: Another way of moving capital/wealth through trade For Importers: Raise the cost of goods reducing taxable income Reduce customs duty

57 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 57 High Shipping Cost > Customs Value ? 2006 US Imports (freight/insurance charge) Item Exporting Country Amount (Customs Value) QTYUnitFreq Shippin g Cost Weight (KG) Shipg Cost/KG Shipg Method Reference Average Shipping Cost /KG Mont h Customs Dist (entry) MEN'S COTTON OTHER T-SHIRTS, KNITTED OR CROCHETED El Salvador$14,463482DOZ12$32,3641,714$18.88Air$1.4007Cleveland SACKS & BAGS OF OTHER PLASTICS Indonesia$4,2001,840KG1$23,5521,840$12.80Air$3.4011Cleveland THERMOSTATS, NESOIChina$205,095106NO1$205,1551,164$176.25Air$3.2212Minneapolis STATIC CONVERTERS FOR TELECOMMUNICATION APPARATUS Korea, South $228,10052,100NO3$229,6405,438$42.23Air$ Dallas/Fort Worth BOOKS, BROCHURES, LEAFLETS AND SIMILAR PRINTED MATTER Egypt$4,200950KG1$18,6301,000$18.63Air$2.0606Chicago GEMSTONES, CUT BUT NOT SET SUITABLE FOR USE IN JEWELRY South Africa $7,500 X1$23,62515$1,575.00Air$ Washington DC BALL POINT PENSChina$390,232584,956NO79$409,19916,358$25.02Ocean$0.2005Los Angeles POLYSULFIDES, POLYSULFONESGermany$175,4018,000KG1$905,2828,616$105.07Ocean$0.1103Norfolk FIGURINES OF SEMIPRECIOUS STONE Congo Brazzaville $3,000 X1$6,545313$20.91Ocean$0.0112Nogales

58 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 58 SUMMARY Abnormally high or low priced trades May be due to: Recording error Product heterogeneity in a given HS code Transfer pricing & tax avoidance Money laundering Capital flight Duty fraud Impacts on the country Reduced tax revenue Capital flight Distort balance of trade statistics

59 Seminar on Public Finances and Tax Evasion in Latin America, Aug 25-26, 2010 … 59 SUMMARY Price Filter Matrix Can be built for each HS code & country combination May be effective in identifying abnormally priced import and export transactions when combined with inspection by customs specialists Can be used for real-time inspection of cargo


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