This article is written by Shreya Kasale, pursuing 6-Month Growth Camp: Preparation for LLM Abroad from LawSikho. The article has been edited by Prashant Baviskar (Associate, LawSikho), Smriti Katiyar (Associate, LawSikho) and Indrasish Majumder (Intern at LawSikho).

This article has been published by Shoronya Banerjee.

Introduction

It is possible for a shell corporation to be legal or illegal. Many shell businesses operate within the confines of the law. A corporation may, for example, establish a subsidiary to handle exclusively its HR operations and not engage in its primary trade or business. It would be a shell corporation, but not in the sense that it would be unlawful.

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However, the phrase “shell company” is most commonly associated with unlawful shell firms, which should be recognised based on the reason for their formation. The goal is to divert money for tax evasion, channel money earned from unlawful operations to official financial institutions, and move assets from one business to another without transferring the old firm’s responsibilities in order to save money on taxes.

These firms are usually merely on paper; they are primarily based in tax havens, and they are mostly utilised to conduct financial transactions with no economic activity. Shell firms must be dealt with in order to combat black money and money laundering, to ensure “ease of doing business,” to safeguard investors’ interests, and to expand the tax base.

Shell companies in India

In the Companies Act of 1956, the Companies Act of 2013, or any other Indian statute, there is no precise definition of a shell company. To comprehend this phrase in the Indian context, court judgements (for example, Assam Company India Ltd. and Anr. v. Union of India), definitions in foreign legislation, or literature are utilised.

In India, shell firms are increasingly being used to conduct GST fraud. Shell corporations are formed using PAN cards and IDs of unaware employees (such as domestic help) to raise invoices and claim input credits against those invoices without delivering any goods or services, despite the fact that the Indian Corporate Registry provides good visibility into the ownership of registered entities. The tax authorities have suffered huge losses as a result of these crimes, which amount to thousands of crores of rupees. The government has entrusted regulators like the Income Tax Department, GST Department, SEBI, and law enforcement agencies like the CBI, FIU, and SFIO with identifying and scrutinising these pass-through organisations with no legitimate commercial interests.

Conducting business using shell corporations that have unclear beneficiaries might result in harsh fines, a ban, and a loss of reputation from regulators. Understanding who a company’s ultimate benefactor is critical to securing sanctions and regulatory compliance. Essentra FZE, a UAE-based firm, was sanctioned by the OFAC (Office of Foreign Assets Control – Sanctions Programs and Information) late last year for doing business with a Chinese shell company whose ultimate beneficial owners happened to be from North Korea, which was at the time an OFAC sanctioned nation.

Background

Originally, these businesses have been set up to take advantage of favourable tax treaties. This accounted for the lack of economic activity. However, over time, these seemingly innocent businesses were utilised for nefarious purposes.

The development of a shadow economy is no longer surprising. Though this structure has existed since the term “economy” was coined, the rapid growth of shell corporations throughout the world is startling. During times of financial turmoil, the clandestine activities that rule these shell organisations thrive, such as carrying out cash business transactions, avoiding taxes, and skirting authorities.

Purpose of forming a shell company

The following reasons are outside the legal bounds and can lead to the formation of unlawful shell firms:

  1. Companies are founded as numerous layers to conceal the names of the real/beneficial owners, making it impossible to pinpoint ownership, individuals, or company operations.
  2. Tax evasion/avoidance is a term that refers to the act of avoiding paying taxes
  3. For the purpose of money laundering and syphoning off black money. This is one of the main reasons why, during the November 2016 demonetization effort, shell firms began to be identified all of a sudden. A large number of shell companies were formed to deposit extra funds in order to prevent excessive cash deposits by the original holders. Shell firms have been founded using stolen/fake identities of persons who had no knowledge of how their identification cards were being exploited.
  4. For the purpose of Pyramid schemes. Shell corporations can be used to swindle people through Ponzi schemes, such that when the scam is detected, the box or the company is all that is left, and the true persons behind the entity have disappeared, most often out of the country.
  5. For the purpose of relocating income to tax-free areas. This occurs in overseas transactions to avoid paying taxes in the destination country.

Violations of the laws

The following are the primary laws that shell corporations with links to India have broken by engaging in the aforementioned activities in an unauthorised manner:

  1. The Companies Act Rules, 2017.
  2. Securities and Exchange Board of India Act.
  3. Benami Transactions Prohibition (Amendment) Act, 2016.
  4. Prevention of Money Laundering Act, 2002.
  5. Black Money and Imposition of Tax Act, 2015.
  6. Indian Penal Code, 1860.
  7. The Income Tax Act, 1961.

In India, there are several challenges relating to the shell companies

To begin with, under the Companies Act of 2013, or any other corporate legislation, there is no legal definition for a shell company. Moreover, there is no unique legislation that governs exclusively shell corporations. The current processes are governed by the Benami Transaction (Prohibition) Amendment Act of 2016, the Prevention of Money Laundering Act of 2002, the Companies Act of 2013, and the Black Money (Undisclosed Foreign Income and Assets) and Taxation Act of 2015.

Lastly, gathering transaction data and distinguishing between legitimate and criminal shell firms is challenging. Tracking transactions from several accounts may be tricky. It is particularly difficult to locate shell businesses in India due to the country’s complicated corporate structure.

The following are some instances of major fraud discoveries involving Shell companies:

Offshore Leaks in 2013:

More than 120,000 offshore corporations and trusts were described in a major leak of 2.5 million privately owned business papers, revealing the hidden transactions of politicians and billionaires throughout the world. The International Consortium of Investigative Journalists (ICIJ) discovered hacked papers that revealed facts and numbers of cash transactions, formation dates, and linkages between organisations and persons that show how offshore financial secrecy has grown rapidly throughout the world. Offshore holdings in more than 170 nations and territories were revealed in the documents.

Panama Papers in 2016:

The Panama Papers were a significant leak of financial records from Mossack Fonseca, the world’s fourth-largest offshore law business. The data were released to the German publication Süddeutsche Zeitung anonymously (SZ). The documents revealed a network of 214,000 tax havens including affluent individuals, government officials, and companies from over 200 countries. The papers were leaked by an unidentified source from Panama, thus the moniker Panama Papers. The majority of the records revealed no evidence of wrongdoing, but some of Mossack Fonseca’s shell firms had been used for fraud, tax evasion, or evasion of international sanctions.

The government has recently taken the following steps to combat shell firms:

With an iron fist, the centre is dealing with shell firms. The Ministry of Corporate Affairs has terminated the registrations of nearly 163k businesses for failing to file financial returns for the previous two fiscal years. The following are the primary steps done by the centre:

  1. In February 2017, a ‘Task Force on Shell Companies’ was established under the joint chairmanship of the Revenue Secretary and the Secretary of the Ministry of Corporate Affairs to effectively combat shell company malpractices.
  2. The government had asked the Reserve Bank of India (RBI) to freeze the accounts of defaulting firms that had missed the deadline for filing financial statements and reports under the Companies Act.
  3. SEBI has requested exchanges to engage an independent auditor to assess the credentials and fundamentals of questionable entities. The stock can be delisted if exchanges cannot uncover adequate fundamentals concerning the company’s existence.
  4. As part of Operation Clean Money, the government has taken action against almost two lakh shell firms.
  5. The Ministry of Corporate Affairs (MCA) and the Central Board of Direct Taxes (CBDT) has inked an agreement to share tax information automatically and on a regular basis. The goal of the MoU is to reduce the threat of shell businesses, money laundering, and black money in the country, as well as to prohibit shell corporations from abusing corporate structures for different illicit reasons.
  6. According to the Income Tax Act, a company is considered to be resident in India if it meets one of the following two criteria: it is an Indian company or the control and management of its operations are located entirely in India within a given financial year. Shell firms are formed as a result of the second criterion. As a result, the government passed the Finance Act 2015, which states that a firm is considered to be a resident of India if its Place of Effective Management (PoEM) was in India the previous year.
  7. The Office of Serious Fraud Investigations is compiling a database of shell corporations.

Steps that should be taken include the government considering establishing legislation that is particular to shell firms

  1. Apart from the obligation of submitting returns, this regulation can offer a precise definition of shell firms based on characteristics such as revenues, assets, and staff strength.
  2. The government must ensure that every firm, even those with little income, reports information to the tax department.
  3. A permanent entity under MCA may be established to monitor all agencies in order to improve cooperation.
  4. Negotiating double tax treaties with tax havens and requiring shell businesses to meet minimal operational expenditure standards. Finally, the government can streamline corporation structures and consider/make attempts to pursue tax evaders using big data.

Shell companies v. dormant corporations

A business that does not have a substantial financial activity or has been inactive can apply to the RoC (Registrars of Companies) to be designated as a dormant company under Section 455 of the Companies Act, 2013. An inactive company is identified in one of two ways: it has applied to the RoC for ‘dormant’ status, or it has not submitted financial statements or annual reports for two consecutive financial years, in which case the RoC will give notice and include it on the register of ‘dormant’ firms. A shell firm, on the other hand, is usually associated with criminal activity.

Assam Company India Ltd. and Anr. v. Union of India

In this instant case, the Petitioner was a company with multiple tea estates in Assam, he is involved in the business of tea cultivation and manufacturing. Respondent No. 2, the Securities and Exchange Board of India (SEBI), had started proceedings against Petitioner No. 1 by instructing the Bombay Stock Exchange, National Stock Exchange, and Metropolitan Stock Exchange to restrict and/or suspend trading of Petitioner No. 1’s shares based on a letter received from the Government of India’s Ministry of Corporate Affairs forwarding the database of 331 listed shell companies for initiating necessary action.

The question to explore in this case was whether the SFIO was right in branding a corporation as a shell company. Was it also fair for the SEBI to investigate the petitioner Company as a shell company?

In the Court’s judgement, given the severe consequences of being labelled as a shell business, the SFIO or SEBI were not justified in treating the petitioner Company as a shell company right away and then launching an inquiry to justify such branding. Petitioner No.1 should have been given notice and a reasonable chance to respond as to why and on what grounds it was suspected of being a shell business, and only if the response was determined to be unsatisfactory could such a finding have been recorded, according to natural justice principles.

Given the negative ramifications and substantial repercussions, a judgement of a shell corporation dehors any notice or hearing would not be justifiable. The conditions and context in which the petitioner Business was designated a shell company is a virtual condemnation, but it is condemnation without a hearing. Aside from that, there’s the issue of the State or its agencies employing a term that isn’t specified in any legislation.

The court quashed the letter branding the Petitioner’s company as a shell company, given by the Government of India.

Conclusion

Shell companies are being prosecuted aggressively in India to protect investors’ interests and ensure ease of doing business. Reducing the threat of black money will result in increased tax revenue, which will help the government increase public spending while also lowering the tax burden on honest taxpayers.

References

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