1. Shell companies: Putting tax evasion, money laundering under scanner

Shell companies: Putting tax evasion, money laundering under scanner

In December 2015, in another branch of another bank, CBI began investigating fake foreign exchange remittances aggregating R6,000 crore from non-existent imports through various accounts of 60 companies, all of them operating from a single branch of the bank and controlled by a group of individuals masterminding the fraud.

By: | Published: July 29, 2016 6:14 AM

 

In December 2015, in another branch of another bank, CBI began investigating fake foreign exchange remittances aggregating R6,000 crore from non-existent imports through various accounts of 60 companies, all of them operating from a single branch of the bank and controlled by a group of individuals masterminding the fraud. In December 2015, in another branch of another bank, CBI began investigating fake foreign exchange remittances aggregating R6,000 crore from non-existent imports through various accounts of 60 companies, all of them operating from a single branch of the bank and controlled by a group of individuals masterminding the fraud.

Shell companies, despite the unsavoury connotation, are legal entities, though often without tangible assets or business operations. They function as vehicles for pre-operation financing, control over conglomerates, tax planning, but most commonly for tax evasion or even money laundering. The last two are the most common uses and there are a few examples.

In May 2016, internal investigators of a leading public sector bank uncovered a fraud, wherein some individuals, along with their cohorts, cheated the government and banks of several crores of rupees using a maze of 24 ghost companies operating from a single branch of the bank in Delhi.

In December 2015, in another branch of another bank, CBI began investigating fake foreign exchange remittances aggregating R6,000 crore from non-existent imports through various accounts of 60 companies, all of them operating from a single branch of the bank and controlled by a group of individuals masterminding the fraud.

The recent leaking of offshore financial records from a Panama-based law firm again brings into focus the labyrinth of global network of shell companies operating from tax havens, used purportedly to illegally shift assets and cash from one country to another and using structured transactions to evade tax.

An OECD report (Misuse of Corporate Vehicles for Illicit Purposes) concurs that shell companies are increasingly being used for illicit purposes.

Traditionally, shell companies in India have been used for rotation and siphoning off of funds by the promoters through fictitious sales, inflated purchases, unjust commissions or for creation of equity for ultimate owners who are shielded by cloaks of deceit.

The modus operandi is simple. The perpetrator floats a number of companies usually with the same registered address and with directors who despite being ‘real persons’ are untraceable or completely unrelated, or are usually poor and unlettered lending their names for a token payment. Dummy directors are used for anonymity or deniability, who pre-sign cheques and documents and hand over to the principals.

All too often, bank officials are hand-in-glove in these operations, including overlooking KYC norms and background checks for accounts opened in their branches. Often, suspicious transactions are below the threshold of automatic banking software triggers and hence can go undetected for years unless they form part of other investigations. The ‘seed’ receipt is introduced as capital in the bank account of one shell company with the knowledge of bank officials; this money is rotated through bank accounts of a set of shell companies—all transactions being completed the same day in the same branch of the bank. Thus, each company shows identical sums as capital and instantly lends or invests in another company. The exercise is repeated several times. As banks need to balance their books only at the end of the day, colluding bankers ensure that the money rotates through 5-10 accounts in a day, i.e. the money multiplies 10 times in a day, not backed by real transactions, but the daily credit and debit balances in each account falsely display robust business activity. It is very much like the Panchatantra tale in which a fox shows one crocodile 10 times to its mother to convince her that there are 10 of them!

What happens to the capital when it is created? It is pledged for bank loans, or these shares are valued excessively by conniving valuers and then merged with listed companies which are dormant. Once merger fructifies, the fictitious investment gets converted into real shares at high prices, and more importantly, gets liquid in a stock exchange. The Supreme Court-appointed SIT noted in its report that investment in the secondary share markets to manipulate stocks and create non-taxable capital gains is becoming popular. With the collusion of promoters, some brokers arrange purchase or financing of scrips at nominal costs, and then manipulate their sales at exorbitant prices to create long-term ‘capital gains’ which attract nil or nominal tax.

In case of a fraud involving foreign exchange, large remittances are sent overseas towards fictional imports of stocks and machinery, advances, commissions, etc. Later, money is moved from such overseas accounts into another set of shell companies. Often, such money comes back through another bank account as receipts from exports or payments for share capital in listed and unlisted companies (called round tripping). SIT observed that investments from Cayman Islands, a tax haven, alone amount to R85,000 crore in India, highlighting the role of tax havens in money laundering. In either case, the perpetrators avail import credits from the government, like duty drawback on imports and export benefits. Otherwise, these shells hold properties or land on behalf of the real owners or hold payments for fictitious sale of goods or services in India till the money gets ‘bleached white’.

Another route of introducing black money into the banking system is by showing large income from agriculture, processing and milling of agriculture products and scarp sales, all outside the radar of tax nets. There are examples of tiny companies with very small landholdings showing agricultural income in tens of crores of rupees. It is not an exaggeration to say that the output of such land would be many times over the total output of the district or the total annual sales in the local mandi.

The effects of money laundering could be catastrophic. There is no official figure yet, but various agencies estimate India’s black money to the tune of 21-42% of its GDP.

How can India fight the menace? The symptoms are the best guide to some of the initial solutions. Real-time detection and monitoring of shell companies and oversight of unusual rise in the market price of companies with little business, empowerment of enforcement agencies to act without prior approvals and prompt enforcement action are some obvious answers.

MCA21, the portal on which all corporate filings reside, is a wonderful starting point for tracking and mining data for companies sharing characteristics like common directors, same registered address, little or no business, occasional large transaction, etc, to create early warnings against shell companies. A central KYC registry to track multiple transactions by one individual or entity will help create transaction histories of individuals and entities.

Once detected, action must be swift and act as a deterrent to others. Entities with no commercial substance for, say, five years, should be weeded out or frozen. Promoters and gatekeepers like bankers, accountants, auditors, valuers, etc, who facilitate shell operations, should be punished under the tough Prevention of Money Laundering Act and under the stringent provisos of the Companies Act 2013.

But these are short-run solutions. The long-run ones are a different order of collective efforts which need a strong, punitive and immediate deterrent mechanism brought about by diligent investigations backed by strong judicial decisions. The current level of conviction for white-collared crimes, as estimated by some experts at 0.006%, needs to significantly improve, if crime needs to be booked. In the process, projects across different enforcement agencies for preventive and punitive measures based on data and evidence are being put in place and that will create long-term impact on financial crimes. Let’s hope this is done soon.

Kshama V Kaushik & Kaushik Dutta are founders of Thought Arbitrage Research Institute, a not-for-profit think tank working in the areas of governance, economics & public policy

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