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Comprehensive understanding of 'shell companies'
Shell corporations or Shell companies are entities that do not have active business operations but are set up to achieve specific business goals such as lowering tax liabilities, shielding an entity from legal risks, raising capital, and, in some cases, for illegal purposes such as money laundering, hiding beneficial ownership from law enforcement, or circumventing sanctions. While shell companies are often viewed negatively, large corporations and individuals use them legally too which will be discussed in detail in this article. A Special Purpose Acquisition Company, or SPAC, for example, is used to raise capital by issuing shares to the public to acquire an existing private company as SPAC may not have any business operations or employees on their own, so they are referred to as Shell Companies.
Shell companies are merely an 'outer cover,' or a 'protective layer,' that exist only on paper and have no real assets, liabilities, or operations. As a result, they don't generate any economic activity, but they do give the structure a distinct corporate legal personality. There haven various news publications and ministry circulars that highlight the efforts being made in India to prevent the emergence and regulation of shell corporations. Despite the government's proactive measures, significant issues remain in the operation, implementation and harmonization of the system.
The Organization for Economic Co-operation and Economic Development (OECD) defines a shell company as ‘a firm incorporated or organized or registered in the economy but does not take part in the economic operations (other than pass-through capacity)’. In layman’s terms, it can be construed that shell companies are entities that only exist on paper without having any assets, liabilities, or employees and they are structured like a company without any actual business activities.
The Securities and Exchange Board of India (SEBI) has also come up with certain parameters that could be taken into account while gauging the active status of the company, or lack thereof and hence according to reports, SEBI has suggested that any entity with no significant operational assets or business activity of its own but acts as a conduit in a pass-through capacity is referred to as a shell company.
A Task Force on Shell Companies in February 2017 was set up by the Prime Minister's Office, under the joint chairmanship of the Revenue Secretary and Secretary, Ministry of Corporate Affairs (MCA) with a "mandate to check systematically, through a coordinated multi-agency approach, the menace of companies indulging in illegal activities including facilitation of tax evasion which is commonly referred to as shell companies."
The major achievement of the Task Force was the compilation of a list of companies under three lists such as the Confirmed list, Derivative list and the Suspect list. The basis of compilation when seen was that the confirmed list of 16,537 companies was information from various agencies regarding their indulgence in illegal activities. The derivative list of 16,739 companies was prepared based on a common directorship with the confirmed companies and the suspected list was prepared based on certain red flag factors.
Out of these lists of companies, the Securities and Exchange Board of India (SEBI) had released a list of 331 ‘shell companies’ back then in August 2017. On the release of the list, a host of actions were promptly initiated against these companies and instructions were given to various stock exchanges to restrict or suspend trading of their shares, which meant that their shares could be traded only once a month. A laundry list of notices was served upon them, pulling management’s time away from core business activities.
Some companies had been included because they had a connection with any of the confirmed companies could be even if such connection related to a time many years before preparation of the list or was of remote significance to the present operations of the company or even if there had already been a change of hands from such directors. In many cases, the current management seemed unaware of any association with such individuals and was mystified as to why their names were put on the list. There were companies on the list that was tremendously profitable, paid significant taxes, complied with the law regularly, and employed a huge number of people.
Recently, in a written response to a question in the Rajya Sabha, Minister of State for Corporate Affairs Rao Inderjit Singh said the government had discovered 2,38,223 shell businesses in the last three years (2018-2021). The databases that had been compiled, and had more than 2 lakh companies were identified and their names werestruck off the Registrar of Companies (RoC) under Section 248 of the Companies Act, 2013 that would be discussed in detail further.
Having a brief idea on the subject now, let's have a look at some of the laws that a shell company infringes when it engages in illegal activities now that we know what they're for. The major law if seen are:
Benami Transactions Prohibition (Amendment) Act, 2016, which prohibits anyone from holding assets under a fake name to avoid taxation.
The companies (restriction on the number of layers) Rules 2017, which restrict the number of layers of subsidiaries a company can have.
Prevention of Money Laundering Act (PMLA): When black money is passed through a shell company, it is presented as tainted money. This is punishable under Section 3 of PMLA.
Indian Penal Code: In case the shell company is used for engaging in Ponzi Schemes, the owners and anyone involved can be punished under Section 420 of IPC which prohibits cheating.
Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015.
The Income Tax Act, 1961: PoEM Guidelines issued by the Central Board of Direct Tax.
Because the entire exercise is founded on the assumption that these organisations are shell companies, it is critical to comprehend the concept of a shell company under the law as well and not merely with the literal meaning.
To begin with, section 248 of the act when seen is the crux, and at present, one of the few provisions in the legislation that seeks to curtail shell companies. This provision vests the power with the Registrar to remove the name of any such company from the RoC where a company has failed to commence business within one year of incorporation or where the company has not been carrying on any business or operation for a period of the preceding two financial years and has not applied for dormant company status. The Companies (Amendment) Act, 2019 which received the President's assent on July 31, 2019 supplements the provisions of Section 248. Some of the measures contained in the Amendment act are that:
A new Section 10A has been inserted which stipulates that a declaration is to be filed by a director within 180 days from the date of incorporation of the company in the manner prescribed with the Registrar, affirming that every subscriber to the Memorandum has paid the value of the shares agreed to be paid by him on the date of making such declaration. And, where no declaration has been filed under Section 10 A, and the Registrar has reasonable cause to believe that the company is not carrying on any business or operations, the registrar may initiate action for removal of the name of the company from the ROC.
The Amendment Act has also inserted sub-section (9) in Section 12 of the Act, which empowers the Registrar to cause a physical verification of the registered office of the company on reasonable cause. The Amendment Act has also widened the ambit of powers assigned to the Serious Fraud Investigation Office (SFIO) to ensure speedy and more effective enforcement.
While the changes brought about by the Amendment Act are laudable, the major hurdle that hampers investigation and identification of shell companies in India is the lack of a proper and uniform definition of what are these 'shell companies’.
A parliamentary panel asked the Ministry of Corporate Affairs (MCA) to define 'shell companies' and to differentiate between fraudulent conduct and cases of irregular filings. The process to define 'shell companies have been in the works for quite some time and several definitions and parameters have been received and contemplated by the MCA as well. One of the definitions under consideration is the definition of 'shell companies’ used by the Organization for Economic Co-operation and Development (OECD) which was mentioned initially in this article. In addition, there are other parameters also that have been put forth by other agencies to be looked into such as the:
entities with insignificant business or assets;
entities set up to mainly facilitate cross-border currency and asset transfers along with transfer of large sums to related entities;
firms having no economic rationale in their banking transactions;
multiple companies having the same address;
no physical existence at the given address;
high ticket transactions inconsistent with the business of the company; and
rotational transactions with no apparent legitimate business group.
As rightly known, there is no specific definition of shell companies mentioned in the Companies Act, 1956, or the Companies Act, 2013, or any other Indian law until now but, even with the discrepancies due to inconsistency in the definition of shell companies, the matter has been addressed in the court, with the most recent example being the case of Assam Co. India Ltd. vs. Union of India [Case No. WP(C) 2572/2018, decided on 7 March 2019], whereinto say in a line it was a company owning a substantial number of tea estates, producing millions of kilograms of tea on an annual basis and feeding thousands of families was termed a 'shell company'.
In this case, the Hon’ble High Court of Gauhati held that “considering the negative implications of being branded as a shell company, it was not justified to treat the company as a shell company straightaway and thereafter to initiate an investigation to justify such branding. Principles of natural justice would require that before such branding, the company should’ve been given an opportunity of being heard as to on what grounds it was being branded as a shell company and only if the reply was not found to be satisfactory should action be initiated. A finding of shell company dehors any notice or hearing would not be justified having regard to its negative implications and serious consequences. In the case of petitioner No.1, the circumstances and the context in which it has been declared as a shell company is a virtual condemnation but it is condemnation without a hearing. That apart, there is also the question of the State or its agencies using an expression which is not defined in any law.” Therefore, the court held that considering the negative implications of being branded as a shell company, it was not justified to treat the company as a shell company in this case.
Moving on to the next aspect under the shell companies in the legal reasons for which a shell company can be created. They are as follows:
to hold or store money temporarily when the main company or the owner of the shell company is planning to start a new company.
If a company wants to hide its dealings with another company, which has a bad reputation, it may create a shell company solely to engage with the other company.
A shell company may be created to stage a hostile takeover. This happens when a company buys another company, without the approval of the management of the target company.
To protect assets from lawsuits.
In case a company is working in a dangerous country, for instance, with rampant terrorist activities, then people may formulate shell companies to hide money to avoid being a target of criminals and thieves.
Shell companies can also be created to gain access to foreign markets.
As mentioned, the creation of shell companies as such is not an offence. However, some issues arise with establishing a shell company which are mainly in case a company forms a shell company offshore, it can lead to bad publicity as profits are being sent out of the nation and secondly, although not necessarily illegal, using a shell company to hold assets in it, falls in a legally grey area, and could lead to legal issues. Hence, it is advised not to create shell companies. Therefore, a coherent structure to deal with shell companies is essential, as it needs to ensure that such regulation does not inadvertently create unnecessary obstacles for perfectly legal entities. Hence, a careful balancing act is necessary while deciding the definition of shell companies.
Mainly, the lack of a proper definition of ‘shell companies’ has led to inconsistent application of the concept and has hampered the investigation of the same. The term has been understood based on judicial precedent, definitions given in foreign statutes or literature, its dictionary meaning, and the usage in common parlance. And like said, at present, it is understood as companies that only have a paper existence with no assets, liabilities, employees where they only have an outer cover of a company without any actual business activities.
The other commonly heard term to be known is the Front companies, even though it is quite different from the Shell companies. The reason to know this is those front entities too have ongoing business operations but the true nature of the business is masked which is sort of similar to the shell companies if just looked at as both Shell Companies and Front Companies are used for money laundering purposes.
Therefore, the Shell companies it is said are increasingly used to commit GST fraud in India as these 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, even though 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 wrongdoings, which amount to thousands of crores of rupees. The government has tasked regulators like the Income Tax Department, GST Department, SEBI, and law enforcement agencies like the CBI, FIU, and SFIO with identifying and scrutinizing these pass-through organisations with no legitimate business interests.
To conclude, we can say that engaging in tax evasion, money laundering acts, the shell companies engaged in illegal transactions, as that can be a huge hurdle for the economy and that’s the reason in India, there is a big issue with regards to dealing with these companies mainly because of no specific provision or law which explicitly deals with these shell companies. Furthermore, there is no legal definition or criteria for recognition. The need for a well-structured approach to dealing with shell businesses is essential and in addition, such a framework must ensure that such regulation does not erect additional barriers for legal entities that appear to be shell companies. Like said, a precise and balanced definition of shell companies is needed firstly, one that is broad enough to meet all the criteria for identifying illicit shell companies while being narrow enough to exclude all legitimate shell companies as well.