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Home >> TII EDIT
Sanctions vs Shell companies - A Battle Royal!
By D P Sengupta
Jul 08, 2022

WHILE the recent sanctions imposed in the wake of the Russian invasion of Ukraine by the USA and the European countries on Russia and many of its oligarchs continue to inflict severe pain on the common people around the world, the jury is still out as to whether the sanctions have achieved their desired objectives. But quite apart from that question, another issue has come into prominence once again as a result of the genuine effort this time of the Western governments to come down heavily on the oligarchs close to the regime and holding assets in the West. Although we hear about the seizure of luxury yachts and luxurious buildings in the French Riviera belonging to some of them, the USA and its allies are finding it hard to locate many of the assets belonging to oligarchs because of the phenomenon of shell companies. ICIJ has been working on the assets hoarded by the kleptocrats across the world and in many instances, the intrepid journalists have been able to provide leads regarding the use of shell companies hiding ill-gotten wealth abroad.

For years, the reports and leaks were seen in the Western capitals as irritants and treated with benign neglect. Not any more though. The demand for getting a public registry of assets as advocated by TJN, ICRICT and other civil society organisations, is gaining some traction now. The OECD and the EU has been working for some time now on a coordinated response to the phenomenon of shell companies and considering the recent developments, it will be interesting to examine some aspects of the proposals in this respect.

The Tax Justice Network that publishes annually its transparency index has been consistently pointing out that the UK along with its overseas territories, in particular BVI, Guernsey and the Caymans constituting the so-called spider's web, were most notorious for their financial secrecy and enabled the kleptocrats from different countries to move their ill-gotten assets abroad. Similar apprehensions have been raised in regard to the USA with regard to transparency in Delaware, Wyoming and Nevada. In fact, the USA tops this year's TJN's financial secrecy index. Ironically, it is the ease of forming shell companies and the presence of competent enablers in London and such other financial centres who are famous for their financial acumen that make it difficult to trace and tackle such systematic loot of the resources from post-soviet era republics. The same methodology is followed in denuding the riches of the developing countries in Africa and elsewhere.

According to the TJN, the UK and its network of Overseas Territories and Crown Dependencies collectively inflict a tax loss of USD 87.9 billion on the rest of the world by enabling private tax evasion and the tally goes up to $189 billion when corporate tax avoidance through these same jurisdictions are taken into account.

In 2020 itself, the Intelligence and Security Committee of the UK Parliament in its Russia report while making an in-depth analysis of the security issues including cyber security, also referred to the issue of money laundering and the use of UK's Golden VISA scheme and such other measures that arise from the existing practice.

This report stated that while the Russian elite have developed ties with a number of countries, they viewed the UK as a particularly favourable destination owing primarily to the UK's investor visa scheme, introduced in 1994, followed by the promotion of a light touch regulation with London's strong capital and housing markets offering additional investment opportunities. The Committee was scathing in its observation:

"The UK welcomed Russian money, and few questions - if any - were asked about the provenance of this considerable wealth. It appears that the UK Government at the time held the belief (more perhaps in hope than expectation) that developing links with major Russian companies would promote good governance by encouraging ethical and transparent practices, and the adoption of a law-based commercial environment."

In the opinion of the committee this policy actually proved counterproductive and ended up offering easy ways of laundering illicit finance that prompted some to refer to the London laundromat. The easy money and coffer of golden visa and sometime citizenship afforded opportunities to the oligarchs not only to recycle their wealth but also indulge in what the paper calls reputation laundering through charities, donation to political parties, academia and cultural institutions. No wonder therefore, that the phenomenon is termed as Londongrad.

Of course, civil society organisations have long pointed out to this phenomenon but the action has been slow to come. Transparency International has also urged the UK government to put in place tougher laws and as a result in 2018, the UK government had introduced the Unexplained Wealth Order (UWO) following the passing of the Criminal Finances Act in 2017. The Provision is available to SFO, HMRC and others. The order has to be obtained from the court and requires the respondent to explain how an asset was acquired. But, according the committee the existence of the UWO has not been of much use in curbing the menace.

In December 2021, the same issues were also highlighted but in even greater detail in Research Paper by Chatham House titled- The UK's Kleptocracy Problem - How Servicing Post Soviet Elites weakens the rule of law. It gives many instances of reputation laundering through charities and donations. One particular instance cited here may be of interest, now that Mr. Boris Johnson has resigned as Prime Minister of the UK.

"Boris Johnson's nomination of Evgeny Lebedev to a life peerage in 2020 was not without controversy. Not only was it viewed by many as cronyism (Johnson and Lebedev have been friends and political allies since 2009), one expert on Russian security issues said it showed Johnson's ‘contempt for Britain's intelligence agencies', as Lebedev's nomination came days after the release of the UK parliament's Russia report which highlighted the risks posed to UK democracy by the Russian elite. Despite security agency concerns about Lebedev (who became a British citizen in 2010 but retained Russian citizenship) posing possible security risks because of his father, a former KGB agent, his confirmation was approved after discussions between 10 Downing Street and the House of Lords appointments commission. The peerage granted Lebedev the title 'Baron Lebedev, of Hampton in the London Borough of Richmond upon Thames and of Siberia in the Russian Federation' "(Emphasis added)

According to these reports, the main planks of the modus operandi in the UK seem to be the successful laundering of money, acquiring citizenship and gaining respectability. The detection of the laundering part is obviously made difficult by the liberal use of shell companies.

As for the USA, in a recent article in the Washington Post (11/4/2022)- US Hunt for Russian Oligarchs' Huge Fortunes faces barriers Offshore, we find some instances of difficulties faced by the enforcement agencies due to the use of multiple offshore shell entities. The Post quotes a senior treasury official as saying:

"Russian elites and oligarchs are probably some of the best in the world at hiding their wealth," said a senior Treasury official involved in directing the sanctions policy. The official spoke on the condition of anonymity, citing the sensitivity of the subject. Luxury yachts, lavish homes and private jets are relatively easy to pursue because they are "out in plain sight," the official said. "The thing that's going to be hardest is places where people have set up front companies to hide their assets."

The Panama Papers, Paradise papers and Pandora Papers all have exposed how shell entities are used for holding, maintaining and passing on properties as also transferring money offshore through the use of such entities. In the context of international tax avoidance and evasion, the phenomenon of shell companies has therefore acquired traction.

The OECD has focussed on the enablers of the shell companies. As per the report- Ending the Shell game- Cracking down on the Professionals who help enable Tax and White Collar Crimes - the enablers, by offering non-transparent structures and schemes to conceal the true identity of the individuals behind the illegal activities make it easier for taxpayers to defraud the government and evade their tax obligations. Considering that the scandals exposed in the media lays bare the broader problem of tax evasion in society that undermines public confidence as well as the government revenue and gives rise to an increasing sense of instability caused by inequality, Governments have recognised the need to target the professional enablers, in order to disrupt a crucial part of the planning and pursuit of criminal activity.

The OECD paper recommends certain steps that are in the nature of awareness and educational campaigns within the government and the society and the professional bodies. It suggests consideration of the need for a common definition of professional enablers, recognising the role and different levels of culpability within different sectors and develop risk indicators for identifying professional enablers, drawing on a wide range of available data sources. In this regard, the OECD paper refers to the Indian experience in data mining.

In 2017, the government of India set up a special task force dedicated to the identification and eradication of shell companies. Shell companies are recognised as a risk to the tax base due to their usage in the commission of tax crimes and other financial crimes. As a country with a large population, information in India on individuals, taxpayers, corporations and directors are held in different databases by separate government departments and ministries. Information on individuals is maintained by the Unique Identification Authority using "Aadhaar" numbers. Information on taxpayers is held by the Income Tax Department through permanent account numbers (PANs), a unique taxpayer identity number that is mandatory for all taxpayers. Finally, the Ministry of Corporate Affairs manages the register for corporate entities and directors through the registering of corporate identity numbers (CINs) and director identification numbers (DINs). One of the key tasks in identifying shell companies was to be able to perform data analytics across the information held by the three different government departments and data-mine between the three databases. By linking the information between Aadhaar numbers and PANs, many ghost PAN holders, duplicate PAN holders or fake PANs were identified and removed from the system. Cases of fraudulent non-quoting of PANs were also identified, which was previously a common way for fraudsters to remain undetected by the Income Tax Department, leading to high value transactions being concealed and fraudsters escaping investigation or audit. The crosschecking of information with DINs and CINs also revealed the identify of fraudulent directors and shell companies. This was evident when anomalies were found for companies that had filed financial statements but failed to file an annual tax return, or vice versa, where companies had filed an annual tax return but failed to file financial statements, as required. This resulted in the disqualification of 309 000 directors, and 226 000 companies being struckoff by the Ministry. Furthermore, in the process of this crackdown on fraudulent activity by directors, fraudulent PANs and companies, approximately 400 professional enabler s were identified as responsible.

The OECD paper says that this straightforward action of combining information and databases that were already in the Indian government's possession, was able to root out thousands of cases of basic fraud and non-compliance by individuals, companies, directors and other professional enablers such as accountants. In particular, the triangulated information also gave the Indian authorities a clearer picture of where wrongdoing was being perpetrated by the same sets of persons repeatedly, which indicated where professional enablers might be involved and further investigation would be warranted.

The OECD paper goes on to suggest a host of measures that include creation of voluntary disclosure, reporting and whistle-blowing facilities, introduction of mandatory disclosure rules to report on possible schemes early in the life cycle, cross- agency co-operation and, of course, heightened use of the exchange of information mechanism besides adopting a whole of government approach and increased discussion with the civil society, academia and professional bodies and provision of adequate resources for the effective implementation, amongst others.

The report also discusses the results of India's efforts in tackling the professional enablers. Although several companies were struck off the record and about 400 enablers consisting mostly of chartered accountants were identified and shared with the Institute of Chartered Accountants of India (ICAI), for disciplinary action of its members, nothing much happened and the report mentions that due to conflicts of interest with members of the ICAI, disciplinary proceedings stalled and never proceeded. The ICAI was a previously self-regulating professional accounting body. A new oversight body for the accounting and audit professions was legislatively provided for by parliament in 2013, but was not properly implemented until the recent creation of the National Financial Reporting Authority (NFRA). The NFRA is charged with powers to investigate matters of professional misconduct by chartered accountants or chartered accountancy firms, with the ability to impose penalties, and debar the chartered accountant or firm for up to 10 years. However, only one order is available on the website of the authority and that does not seem to relate to the case of enablers.

In the context of the discussion on shell companies, we should also note the EU Commission proposal for the EU Council to issue a directive to the EU members called the UNSHELL DIRECTIVE. The Commission proposal was published in December 2021.

According to the Commission, Shell companies are often used for aggressive tax planning or tax evasion purposes. Businesses can direct financial flows through shell entities towards jurisdictions that have no or very low taxes, or where taxes can easily be circumvented. Similarly, some individuals can use shells to shield assets - particularly real estate - from taxes, either in their country of residence or in the country where the property is located. The proposal was to ensure that shell companies in the EU that have no or minimal economic activity are unable to benefit from any tax advantages, thereby discouraging their use.

The proposed new measures will establish transparency standards around the use of shell entities, so that their abuse can more easily be detected by tax authorities. Using a number of objective indicators related to income, staff and premises, the proposal will help national tax authorities detect entities that exist merely on paper.

The EU proposal does not directly define shell companies but lays down some filters that eliminate the genuine ones from the shells. The Commission calls these gateways. The proposal set out three gateways. If a company crosses all three gateways, it will be required to annually report more information to the tax authorities through its tax return.

The first level of indicators looks at the activities of the entities based on the income they receive. The gateway is met if more than 75% of an entity's overall revenue in the previous two tax years does not derive from the entity's business activity. In other words, if more than 75% of income is from passive income. Or, if more than 75% of its assets are real estate property or other private property of particularly high value.

The second gateway requires a cross-border element. If the company receives the majority of its relevant income through transactions linked to another jurisdiction or passes this relevant income on to other companies situated abroad, the company crosses to the next gateway.

The third gateway focuses on whether corporate management and administration services are performed in-house or are outsourced.

An entity crossing all three gateways will be required to report enhanced information in its tax return related, for example, to the premises of the company, its bank accounts, the tax residency of its directors and that of its employees. These are known as "substance indicators". All declarations need to be accompanied by supporting evidence.If an entity fails at least one of the substance indicators, it will be presumed to be a ‘shell'.

If a company is deemed a shell company, it will not be able to access tax relief and the benefits of the tax treaty network of its Member State and/or to qualify for the treatment under the Parent-Subsidiary and Interest and Royalties Directives. To facilitate the implementation of these consequences, the Member State of residence of the company will either deny the shell company a tax residence certificate or the certificate will specify that the company is a shell.

Moreover, payments to third countries will not be treated as flowing through the shell entity and will be subject to withholding tax at the level of the entity that paid to the shell. Accordingly, inbound payments will be taxed in the state of the shell's shareholder. Relevant consequences will apply to shells owning real estate assets for the private use of wealthy individuals and which as a result have no income flows. Such assets will be taxed by the state where the asset is located as if it were owned by the individual directly.

Given the cross-border nature of aggressive tax planning, tax avoidance and tax evasion, Member States' authorities will automatically exchange information on all entities in scope of the Directive, regardless of whether these are shell entities or not. Most importantly, the proposal will enable Member States to request another Member State to conduct a tax audit of any entity that reports in the latter State and communicate the outcome to the former Member State in a reasonable time frame.

Of course, Entities that do not meet all substance indicators will still have the opportunity to rebut the presumption of being a shell. They will have to present additional evidence, such as detailed information about the commercial, non-tax reason of their establishment, the profiles of their employees and the fact that decision-making takes place in the Member State of their tax residence.

Besides, there are certain carve outs in respect of well-regulated entities such as traded companies on one or more recognised stock exchanges, regulated financial undertakings, low-risk holding companies, companies engaging at least five full time persons in performing their activities and the possibility of exemption for lack of tax motives.

There is also a provision of penalty in the proposed Article 14 whereunder at least 5% of the undertaking's yearly turnover will be levied as penalty in case of fake/ lack of statement.

The proposal has now been approved with some minor changes by the European Parliament although in academic circles, there is some disquiet about excessive burden being put on taxpayers. Before its final adoption which is likely to be in January 2024, there may still be some more changes. Although there are interesting elements in the EU proposal, its spread is now limited to the EU members and therefore will not affect shell companies in other jurisdictions though these may be covered by other changes brought about in regard to transparency by the BEPS project. In 2022, the Commission is likely to come up with a new initiative for dealing with non-EU shell companies. It will indeed be interesting to watch further developments in this space.

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