This article has been written by Ruchit Pandey, pursuing a Paralegal Associate Diploma from LawSikho and edited by Shashwat Kaushik.
It has been published by Rachit Garg.
Table of Contents
Introduction
With the release of the Hindenberg Report, the Indian Governement has come under fire for its alleged role in supporting business tycoon Gautam Adani and his company, Adani Ltd. The role of shell companies allegedly linked to Vinod Adani, the elder brother of Gautam Adani, has been highlighted. This article explores the Indian legal provisions related to shell companies and provides solutions to the current problems faced in the Indian scenario.
What are shell companies
The lacuna of Indian legislation is that there is no current legal definition of a shell company. Neither the Companies Act of 2013 nor any other acts passed by the Indian Government speak of the definition of a shell company. Thus, to better understand the definition of a shell company, we can use foreign legislation, such as that of the USA. The US Code of Federal Regulations (CFR) Title 17 Chapter II Part 230 Section 405 specifies a shell company as a registrant other than an asset backed user, which has the following features:
- No or nominal operations; and
- Either:
- No or nominal assets;
- Assets consisting solely of cash and cash equivalents; or
- Assets consisting of any amount of cash, cash equivalents and nominal other assets
Shell companies are thus only paper based companies that are only registered on paper and have no real life operations or assets, which are usually created for the sole purposes of tax evasion and money laundering.
An alternate definition can be drawn from the Organisation for Economic Co-Operation and Development, which defines a shell company as a company that has been registered and incorporated in an economy but does not operate any legal operations in the economy or if it does, only in a pass through capacity.
How are shell companies created
A shell company needs to be registered according to the rules and regulations of the country that it is set up in. Shell companies are usually created in countries with relaxed tax systems and strict privacy laws. This is the reason why countries such as Cayman Island, the British Virgin Islands, Switzerland, the Bahamas, and the United States (Wyoming, Nevada and Delaware) have lax incorporation requirements and strict privacy laws.
A shell company shall not be illegal as per law, but it becomes illegal when it engages itself in various illegal operations, such as:
- Money laundering: The main objective of shell companies is to wash black money and convert it into white money. This black money is generated by various illegal activities such as the sale of narcotics, illegal gains, tax evasion, etc. The perpetrator of such illegal activities needs a method to store his black money in a safe way, which is provided through the operations of a shell company.
- Tax evasion: People looking to save up taxes in their own country set up shell companies of their corporations in countries with lower rates of taxes. These companies also use shell companies to park their assets in the shell companies to avoid paying taxes on them. Thus, corporations can get away with paying lower taxes.
- Ponzi schemes: Ponzi schemes are fake policies set up with the promise of delivering high gains to the investors in such schemes. These are set up to defraud investors of their money and thus the owners of such businesses are liable for fraud. Such business owners set up shell companies in the name of other persons and thus, when such schemes are discovered, it becomes really hard to actually discover the real persons behind the schemes.
Laws to punish illegal operations of a shell company
A shell companies engages itself in various illegal activities such as tax fraud, tax evasion, holding of assets under a false name,money laundering, fraud, etc. These companies would be held liable under various provisions, as follows:
Companies (Restriction on Number of Layers) Rules, 2017: These Rules were introduced to prohibit companies from creating an unlimited number of subsidiaries. The rule prevents a company from creating more than two layers of subsidiaries, which prevents the misuse of companies by diverting money or money laundering.
Cheating (Section 420, IPC): If the business of the company was fraudulent, such as the operation of a ponzi scheme, then the company would be liable under Section 420 of the Indian Penal Code, 1860, which defines cheating as fraudulently deceiving another person in order to induce that person to deliver a property.
Prevention of Money Laundering Act: Money laundering refers to the process of hiding the original illegal source of income and converting it to show that it accrues from a clean and legal source. This is done to avoid taxation, conviction and prosecution. This act of passing dirty money through a shell company and ‘cleaning’ it has been made illegal by the Prevention of Money Laundering Act, 2002.
Place of Effective Management (PoEM) Guidelines by the Central Board of Direct Taxes: In 2017, the CBDT issued PoEM Guidelines to effectively assess the place for effective management of a company and determine the country where tax liability is accrued. The main target of these guidelines was to bring shell companies having their major business operations and areas of interest in India but having been incorporated outside India to be brought under the tax liability in India.
Benami Transactions (Prohibition) Amendment Act, 2016: The Act prohibits any financial transaction done where consideration of the property has been made by a different person than the person under whose name the property has actually been transferred. The shell companies holding the assets of the corporation for the purposes of evading tax liability are liable under this Act.
What are the steps taken to prevent illegal operations of a shell company
Task Force on Shell Companies
As part of its campaign of weeding out black money, a ‘Task Force on Shell Companies’ in 2017 was set up by the Prime Minister’s Office under the joint chairmanship of the Revenue Secretary and Secretary, MCA. It was set up with a view to systematically stop the illegal money laundering operations by finding out the shell companies engaged in the same. Between 2018-2021 the centre identified 2,38,223 shell companies that will be struck off by the Registrar of Companies under Section 248 of the Companies Act, 2013.
Apart from this, around 3 lakh directors have also been disqualified for non-filing of financial statements or annual returns for a continuous period of the immediately preceding 3 financial years. The power to do the same has been given to the Registrar of Companies under Section 164(2)(a) of the Companies Act, 2013.
Lifting of Corporate Veil
A company is regarded as a separate legal entity in the eyes of the law and can sue or be sued in its own name. It is dependent upon human agents to function on its behalf, who may misuse this privilege and take advantage of it. To prevent this, the doctrine of lifting the corporate veil was first discussed in the landmark case of Salomon vs. A. Salomon and Co. Ltd. (1897), where the court observed that the doctrine allows to unmask the people having actual control of the company who have used the corporate veil as a camouflage to prevent liability from being incurred upon them.
It was held by the Supreme Court of India in Delhi Development Authority vs. Skipper Construction Co. (P) Ltd. (1996) that the doctrine of corporate entity was evolved to facilitate trade and commerce and the same cannot be used by human agents to carry out illegal activities in the name of the corporation. Thus, where the corporation has been used for the purposes of committing fraud or illegal operations, the Court would ignore the separate legal entity and the people having active control over the corporation would be held personally liable for the illegal acts.
Rule 25B of the Companies (Incorporation) Rules, 2014
With its recent drive to eradicate the existence of shell companies, the MCA has added a new rule that allows the Registrar of Companies to physically verify the existence of a company’s office. It was found that in several cases, companies were created by giving out false information about the registered office addresses, which served merely as a place for receiving of posts and no actual company existed in such a place.
Section 248 of the Companies Act, 2013
This section empowers the ROC to strike off the names of the companies that have failed to commence business within the first year of business or when the company has failed to conduct any business within the preceding two continuous years when the company has failed to obtain the status of a dormant company.
Other regulatory measures
The Indian Security Regulator, SEBI, regularly identifies and imposes trade restrictions on shell companies. The trading of all such identified companies is placed under Stage VI of the Graded Surveillance Measure (GSM), which imposes several restrictions on the companies.
Financial Action Task Force (FATF)
The Financial Action Task Force (FATF) was the first international agency in 2003 to set up beneficial ownership reporting requirements on a global level. These requirements were further refined by the agency in 2012, 2014, and 2019 and list the following practises to be followed by member countries:
Countries should ensure the existence of more than one mechanism (registry approach, company Approach and existing approach) to ensure that the information regarding the true location of a company is certified, or if not immediately, it can be certified in the near future by a competent authority.
Sharing of important financial information, such as financial and ownership records, among member states to help the global fight against financial crimes.
Conclusion
Shell companies are being used as a method to bypass the legal instruments put in place to keep illegal operations in check. There needs to be a stricter international agreement to solidify the prevention of illegal operations by such companies. Furthermore, countries that are providing tax havens and have lax incorporation rules should also tighten up their rules for incorporation, which would lead to fewer shell companies being formed for illegal purposes.
References
- https://www.tookitaki.com/compliance_hub/shell-companies-money-laundering
- https://sanctionscanner.com/blog/shell-companies-and-money-laundering-455
- https://www.fbi.gov/news/testimony/combating-illicit-financing-by-anonymous-shell-companies
- https://pib.gov.in/newsite/PrintRelease.aspx?relid=179863
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