Legal Implications of Shell Companies

Narendra Kumar

13 Dec, 2021

Normally, people would go through the pains of setting up a company and endure the consequent compliance obligations only if the pains only if they are forecasting the business growth to be higher than the compliance cost. But shell companies, unfortunately, the minds if the law-breakers operate beyond the realm of ‘normal’.

What are Shell Companies?

The term ‘Shell Company’ has not been defined anywhere, but shell companies can be understood to mean companies that are set up only since it leads to the creation of a separate legal person and does not actually have any business operation. Sometimes, these may be set up solely with the objective of doing business in the future, but more often than not, the promoters never intend to carry on business through these companies.

For reference, we can draw upon the definition of Shell Company as contained in the US Code of Federal Regulations (CFR) Title 17 Chapter II Part 230 Section 405. It specifies a shell company as having the following characteristics:

1. Either no or nominal operations;
2. Either
   • No or nominal assets;
   • Assets consisting solely of cash and cash equivalents; or
   • Assets consisting of any amount of cash and cash equivalents and nominal other assets.

Shell Companies are therefore like mailboxes (and are often referred to as such) which are used to deposit and remove letters without retaining anything inside it. There are no operations and no or nominal assets, but the legal personality can be used as a ‘pass-through’ for some transactions other assets.

Though the government has followed a pro-active approach for shutting down the shell companies yet the investigative agencies like the Enforcement Directorate and Serious Fraud Investigation Office have faced serious difficulties due to the lack of a proper definition of ‘shell companies’. MCA has been looking to plug this breach by defining such firms and has sought inputs from SEBI in this regard a few weeks back.

Why do you need to know about Shell Companies?

If you end up investing in a shell company, or in entities that set up a shell company, your money could be used for illegal purposes and may not even be recoverable given the government crackdown on these entities.

In August 2017, investment of approximately 36 lack stock investors got stuck when SEBI placed trading restrictions on 331 stocks suspected to belong to shell companies.

Why are Shell Companies Formed?

Following are some purposes for which the shell companies can be formed:

1. As layers to hide the identities of real owners
   In the case of shell companies, it will be difficult to locate the precise ownership, the registered office of the company or directors and whatever minimal assets the company may have will also be an entirely different place than the location of the registered office as may have been filed with the registrar. In short, it will be difficult to locate any people or business operations.
2. Tax evasion
   Shell Companies can be sued to create a separate tax entity and the income of a person or entity will be transferred or shifted to the shell company so that the tax on the original recipient of such income can be reduced/ avoided entirely.
3. For money laundering and siphoning off the black money
   this is the actual reason why Shell Companies suddenly started being discovered during the demonetization drive of November 2016. A significant number of shell companies were used to deposit surplus cash so that there would not be excessive deposits of cash by the original holders. There were instances of shell companies being created on the basis of stolen/ fake identities of people who had no idea about how their identity documents were being used.
4. For Ponzi schemes
   fraudsters can use shell companies for defrauding people by creating Ponzi schemes so that eventually, when the fraud is discovered, the box or the company is all that remained and the real people behind the entity would have escaped, probably out of the country.
5. For shifting incomes to tax-neutral jurisdictions
   this happens in international transactions and may be on the borderline of being within or outside the law, depending upon how efficiently the tax treaty provisions are used.

What Laws are Violated by the Shell Companies?

Given the objectives of the formation of a Shell Company, it ends up violating the following laws:

1. The companies (restriction on the number of layers) rules 2017
   In September 2017, MCA notified the Companies (Restriction on Number of Layers) Rules, 2017 (the Notification) which prescribed those classes of companies, not permitted to have layers. Under these rules, companies other than banks, NBFCs, insurance companies or government companies are not permitted to have more than two layers of subsidiaries barring one layer of the wholly-owned subsidiary. Permitted layering (other than for above-mentioned sector) can be explained as under:

OR

1. Benami Transactions Prohibition (Amendment) Act, 2016
   this act gives the government the power to confiscate benami assets i.e. assets that have been held in the name of another person or fictitious person to avoid taxation or conceal the wealth unaccounted for.
2. Prevention of Money Laundering Act (PMLA)
   When the money on which tax has not been paid i.e. unaccounted or black money is passed through a shell company to reflect it as untainted money, it results in the offense of money laundering under Section 3 PMLA and is punishable with rigorous imprisonment for a term of 3 to 7 year and a fine.
3. Indian Penal Code
   where the shell companies are used for Ponzi schemes, it results in the commission of an offense under Section 420 of the Indian Penal Code relating to cheating, which is punishable with imprisonment or a term extending up to 7 years and a fine.
4. PoEM Guidelines issued by CBDT
   Shell companies can be set up in tax havens out of India and the income can be artificially shifted to such jurisdictions which are liberal in taxation. The place of effective management (PoEM) guidelines provides for determination of the place of effective management for an entity and if this is in India, Indian tax laws shall apply.

What Actions are Taken by Regulators on the Shell Companies?

The actions began with the regulators launching a two-pronged attack on shell companies. A task force on shell companies was set up under the joint chairmanship of the Revenue Secretary and Secretary, Ministry of Corporate Affairs^[1] in February 2017.

An investigation by the income tax department led to the identification of shell companies that were being used as conduits and criminal prosecution was launched by the income tax department against the beneficiaries of non-genuine transactions.

The ministry of corporate affairs targeted the shell companies with deregistration. The first point of attack was the companies that have not filed their financial statements. Section 248 of The Companies Act 2013 authorizes the Registrar of the Companies to strike off a company from register of companies when the company has failed to commence business within one year from the date of its incorporation or upon notice to the company and the directors where the company has failed to carry on business for two financial years and has not applied to obtain the status of dormant company.

Last year, over two lakh companies were struck off under this section and MCA placed a list of these companies ROC wise on their website. Further MCA has also put up a list of directors associated with these companies. The directors of the companies were disqualified to act as directors of any other entities for a period of five years. The banking operations of these companies were also restricted and the directors were disallowed from operating their bank accounts.

In the last few months, the Ministry of Corporate Affairs has now zeroed in on another 2, 25,000 suspected shell companies. The ministry has sent notices to these companies, asking whether they had filed statutory financial returns.

Also, the Ministry of Corporate Affairs (MCA) following demonetization has secured a leap in its investigation of using shell companies for depositing cash of large amounts in banks. According to a report, “Four Maharashtra-based companies admitted to investigators that they were merely being used as a front face to carry the acts on money laundering. These four companies mainly dealt with items on which no tax has to be paid.”

Given that the government is keen on its objective of increasing the ease of doing business and this is directly proportional to the reduction of corruption and parallel economy, it can be said that the existence and operation of shell companies will continue to get increasingly difficult. However o the account of there being huge opposition to the disqualification of the directors, MCA has come up with the Condonation of Delay scheme, 2018, vide General Circular dated 29^th December 2017 offering relief to such disqualified directors. One of the reasons why this might have been implemented is that disqualifying the directors took away the chance for the company to rectify the defect and complete annual filings.