Shell Companies And Money Laundering: Identifying Beneficial Owners

What Are Shell Companies?

Shell companies are such companies that only exist on paper. They are purely notional in nature as they do not conduct any business, or deploy any operating staff, or for that matter, they are even bereft of any authentic location. Shell Companies are set up with a mala fide intent in such a manner so as to conceal information as regards their actual ownership from other businesses, law enforcement agencies and the general public. Creation of such Shell Companies allows their original creators (‘beneficial owners’), to primarily engage in a varied set of illegal practices such as tax evasion and money laundering.

In the case of Assam Company India Ltd. And Anr vs The Union Of India (WP(C) 2572/2018), the Hon’ble Gauhati High Court had observed that there is no statutory definition for shell companies under the Indian law. Although, the Concise Oxford English Dictionary, 11^th Revised Edition, defines a shell company as “a non-trading company used as a vehicle for various financial maneuvers”. It was observed that merely being a company on paper is no offence under the Indian law.

Legitimate Uses of Shell Companies

There are some legitimate purposes for creating shell companies that are mentioned as under: –

• If a company is interested in carrying out business in a foreign market, it may establish a shell company in that nation, in order to facilitate transactions within a single regulatory framework and avoid obstacles with crossing borders and regulatory rules that may hamper its activities if it were to conduct such business in its own name. In such a situation, the original company would conduct lawful business in its home country, while in the foreign country, it would appear as if they were doing business through the shell company.
• Shell companies can temporarily hold the assets of the original company while the latter is still being set up and finding its footing.
• If a company wants to conduct business with an entity that has a negative reputation, it may do so through a shell company rather than using its own name so as to avoid attracting any attention to itself.
• If a company wants to stage a hostile takeover, by buying out another company without the approval of its management of the company being taken over, it can use shell companies to do so.
• Shell companies can hold the assets of the original company to protect them from lawsuits.

Illegitimate Uses of Shell Companies

Although shell businesses can be established for many legitimate reasons, however, during the majority of the time, they are utilized for illegal purposes. They are usually connected with criminal activities such as money laundering and tax evasion. Shell companies are used to move or hold assets in a manner where it would not be immediately obvious, who the ultimate beneficiaries of those assets are. These companies are usually set up in foreign countries with low regulatory and tax-paying standards, far away from the beneficiary owners.

The following are some illegitimate purposes for setting up of shell companies: –

• It is difficult to locate the true owners of the shell companies. The registered office of the shell company will be in a completely different place from the beneficial owner. The place it is registered is likely to be a mailbox or an address that is shared by many other shell companies.
• Shell companies can be set up in foreign nations. The countries in which such shell companies are set up usually impose low taxes. These countries are called as ‘Tax Havens’. Panama and Switzerland are examples of such tax havens. This is how companies evade taxes. The company’s assets are placed in the shell company established in the concerned foreign country which would enable such the owners to pay much lesser taxes in relation to their home country.
• Shell companies are widely used in Ponzi schemes. Ponzi schemes are fraudulent investment schemes in which investors are promised large profits at a very low risk. The fraud can be committed by offering the Ponzi scheme to potential investors using the shell company’s name, and when such fraud is discovered, the shell company is the only representative, and it would then be difficult to track down the true owners.

There is one more illegitimate use of shell companies that is part of the subject of this article will be discussed in the next section.

Shell Companies and Money laundering

Money laundering is the process through which illegally obtained money is hidden by concealing the source from where the money was obtained and making it seem as if it was obtained from a legitimate source. To accomplish this unlawful activity, shell companies happen to play an instrumental role for the benefit of the beneficial owners of such shell companies.

There are three stages in money laundering: –

• Placement – The money that is obtained illegally is placed into the banking system, where the money notes are converted into digital money and are stored in the bank account.
• Layering – The digital money is then passed through a complex series of transactions to hide the original source of the funds.
• Integration – At this stage, the original source of the money is essentially untraceable and can be used as normal funds.

Shell companies are instrumental in the first two stages of money laundering. In the placement stage, once the illegal funds reach the destination economy, they are placed anonymously in the bank accounts of the shell companies, or else they can be used to purchase property and assets in the shell company’s name.

Shell companies are further essential to the second stage of layering in money laundering. To make multiple transactions, the money is sent to multiple shell companies, especially those registered in foreign countries. The goal of creating multiple transactions is to make it difficult to trace the money trail back to the source of the money or its destination. Shell companies facilitate this by making cross-border transactions much easier. Money laundering schemes that cross international borders make it difficult for investigative agencies to track them as they only have jurisdiction in their own countries and collaborations with the police forces in other countries may be a time-consuming process. Further, there could be regulations in different countries on how much information on the legal entities can be shared with foreign entities.

Identifying Beneficial Owners

The real power behind a shell company lies with its beneficial owners—individuals who directly or indirectly benefit from its activities. Identifying these individuals is crucial in the effort to combat financial crimes like money laundering. However, uncovering beneficial ownership remains a formidable challenge due to various factors. The shell companies are either created by the beneficiary using a false name or the same are run by nominee directors. Using the process of money laundering, shell companies end up forming a complex chain network of transactions that further obscures the beneficial owners.

Countries should collate the beneficial ownership information of companies and other such legal organizations registered within their borders and make such companies’ information public in central registers. Such information would make it substantially convenient for investigative agencies to counter money laundering and other criminal activities committed through shell companies.

The Financial Action Task Force (FATF) is an intergovernmental organization made with the aim to combat financial crimes such as money laundering, terrorist funding and many other threats to the global finance system. This organization makes recommendations for other countries to guide them in dealing with such financial crimes. In March 2022, the FATF revised one of its recommendations, called ‘Recommendation 24’, to allow for stricter ownership standards of companies. Under this recommendation, countries would need to ensure that the competent authorities have access to appropriate, accurate, and up-to-date information on the beneficiary owners of the companies. The FATF has provided further recommendations to assist countries in implementing Recommendation 24. The recommendation aims to assist countries in identifying, designing, and implementing appropriate measures in accordance with the revised Recommendation 24, to ensure that the beneficial ownership information is held by a public authority or body acting as a beneficial ownership registry, or another mechanism that allows efficient access to the information. 

In addition to the measures recommended by the FATF, the firms should focus on adopting risk-based anti-money laundering procedures to effectively address the risk posed by shell entities, while also complying with the domestic legislation as well as the FATF principles. Firms must collect detailed information on their clients and carry out rigorous risk assessments to determine the appropriate response to money-laundering. Clients of the firm must be properly authenticated to see if they are, in truth, a shell company through examining their ultimate beneficiaries, business ties, and their transactional behavior.

Conclusion

It is abundantly clear that immense damage can be caused by way of money laundering through shell companies. Money laundering eventually, ends up corrupting and corroding the financial nerves of an economy, resulting into causing damage to the growth of the financial sector by encouraging criminal activities and corruption. This further results in slowing the economic growth and reduction in efficiency of the economy.

It becomes imperative to take note of the fact that the mere existence of shell companies is not problematic, however, their exploitation as a medium for layering the illegally acquired funds ends up becoming a major problem. There are many valid reasons to create one that do not violate the law, as explained above. They are merely a tool deployed by the beneficial users to streamline their business activities. However, most of the beneficial owners abuse the tool for unlawful gains and end up becoming a catalyst for the damage that is caused through shell companies. Nevertheless, the solution cannot be to declare creation of shell companies as illegal as it does not remove the issue of money laundering. The root of the issue dwells in the actions of the beneficial owners of the shell companies and accordingly a mechanism to track their activities must be established and executed. This can be accomplished by way of promoting international cooperation with other countries to reduce the time consumed in conducting investigations and enhancing transparency of shell companies in foreign jurisdictions. Although, it is a challenging process to strike the right balance between privacy concerns and transparency, yet it is all the more crucial for fighting against money laundering.  

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