Games shell companies and tax havens play

Shell companies and tax havens are back in news. Notwithstanding the merits in charges and counter-charges around the Hindenburg-Adani episode, few will dispute the continued activities of shell companies and tax havens in India and across the world. These two entities merit closer attention because their presence is a threat to most, if not all, oversight mechanisms and good corporate governance. Essentially, they facilitate money laundering, hide financial transactions and properties and assist in tax evasion by exploiting legal and regulatory loopholes and more often than not, work in tandem.

In other words, shell companies (corporate entities with little business on ground) and tax havens (secretive and zero or near-zero tax jurisdictions) are the black holes of financial world – which is well recognised for many years. India is cracking down on shell companies for years and introduced anti-tax evasion General Anti Avoidance Rules (GAAR) in the Income Tax Act of 1961 in 2012, but it became operational a decade later, from April 2022.

India is also a signatory (along with about 135 other countries) to the global anti-tax evasion initiative, OECD-G20’s Action Plan on Base Erosion and Profit Shifting (BEPS), which too started in 2012 and a decade later, it remains a work-in-progress. Except, on February 2, 2023, the BEPS released a “technical guidance” to implement 15% minimum corporate tax on “large” corporations.The US passed this (15% minimum tax) in mid-2022, which too comes into effect in 2023. This is the first big bang move, out of many in the BEP’s list.

Why such a lackadaisical attitude persists is not difficult to fathom, even when the BEPS says “$240 billion are lost annually due to tax avoidance by multinational companies”. A 2019 IMF-University of Copenhagen study found $15 trillion (37% or equal to combined GDP of China and Germany then) of the total $40 trillion global FDIs were “phantom” FDIs, channeled through tax haven-based shell companies just to avoid tax.

Therefore, it is time to re-examine how credible India’s efforts have been to deal with the twin menace.

What empty shells and tax havens mean for corporate governance

To understand the impact of shell companies and tax havens in India, recollect that they are conduits to 85% or more FDI inflows and outflows.

This would mean, so far as FDIs goes, (a) little transparency, accountability and regulatory oversight and (b) a litany of bad governance practices like: (i) tax avoidance and evasion (revenue and profit shifting) (ii) unhindered flow of unaccounted (black) money (iii) round-tripping (iv) related-party transactions (v) insider trading (vi) stock manipulations (vii) maze of subsidiaries and associate companies to avoid detection and (viii) violation of 25% public float the SEBI mandates.

If government support (state capture) is available to a corporate using shell companies and tax havens, this would further mean (ix) crony capitalism and (x) regulatory laxity (in detection and investigation of corporate frauds) or regulatory capture. These are recipe for (xi) bigger economic disasters (stock market bursts and damage to investors and ‘real’ sectors growth).

Indestructible empty corporate shells

At first glance, the very talk of shell companies sounds surrealistic because India is actively purging them for years.

Three big pushes came since 2016. One, a series of investigative reports of 2016-2021, popularly known as ‘Panama Papers’, ‘Paradise Papers’ and ‘Pandora Papers’, exposed the role of empty corporate shells and tax havens in money laundering, hiding money and properties, tax evasion and other financial frauds and on each occasion, India ordered “multi-agency” probes.

Two, when banks and shadow banks started facing financial frauds and began to collapse one after the other, beginning in 2018 – PMC Bank, Punjab National Bank, ICICI Bank, Yes Bank, Lakshmi Vilas Bank, IL&FS, HDIL, DHFL etc. – hundreds of empty shells tumbled out of the woodwork. Central agencies like the CBI, Income Tax Department (ITD), Enforcement Directorate (ED) and Serious Fraud Investigation Office (SFIO) had a tough time chasing them.

Three, action had begun with the crackdown on black money with the demonetisation of 2016 (99.3% banned currencies returned to banks, the rest locked in legal cases or with Nepali citizens and financial institutions) but empty shells stayed. The Prime Minister said so in his national address on August 15, 2017: “Post demonetisation, the reports from data mining astonishingly revealed that there are 3 lakh shell companies dealing in Hawala transactions. Can anyone imagine? Out of these 3 lakh shell companies, registration of 1.75 lakh companies were cancelled.”

On February 6, 2023, Lok Sabha was told that in three years since 2019, 1,12,509 shell companies were closed.More had been shut in the interim (2017-18). Presumably, none would have survived till 2023 but when taxmen went to the BBC offices in Delhi and Mumbai for “survey” on February 14, 2023, shell companies hit the headlines. The taxmen were looking for them, among others.

Not just that, amidst the crackdown, an investigative report of 2019 revealed that a big corporate house had “at least 122 companies” with “little or no business” located at “the same address” in Mumbai. This was years after the same corporate house was alleged to be linked to shell companies named after animals (Tiger Traders, Zebra Consultants, Parrot Consultants, Swan Telecom) during the 2G spectrum trial of 2013.

Yet, no Indian law defines a shell company.

As late as February 6, 2023, the Centre told so to the Lok Sabha (in the same reply mentioned earlier), explaining that what it “struck off” were domestic companies “which had not filed their Financial Statements and/or Annual Returns for a continuous period of two immediately preceding financial years”. It was closer to defining shell companies in its reply of July 18, 2022. It said, it “normally refers to a company without active business operation or significant assets, which in some cases are used for illegal purposes such as tax evasion, money laundering, obscuring ownership, benami properties etc.”

The problem with shell companies is that many are registered with tax havens and tax havens are too powerful to be touched. Apart from the CBI, ITD and ED, regulatory bodies like SEBI and RBI also know about them but no tangible effect is visible.

Mighty tax havens

British tax expert Nicholas Shaxson wrote in his book “Treasure Islands: Tax Havens and the Men Who Stole the World”: “...tax havens are projects of the world’s rich and powerful people. And there's no group richer and powerful than the rich and powerful”. He and many other experts have pointed out how tax havens, rich and powerful countries like the US and UK, big banks and big accounting, auditing and consulting firms are actively involved with tax haven activities.

Besides, India’s own policies of promoting private business and free capital flows (FDI and FPI/FII) come in the way.

Here are a few examples.

The Department for Promotion of Industry and Internal Trade (DPIIT) data shows, between April 2000 and June 2022 (22 fiscals), more than 86% of FDI came through 20 known tax havens – 49% through Mauritius and Singapore; 9.2% through the US; 5.3% through the UK; 2.4% each through Cayman Islands and the UAE; 2% through Cyprus 2% and 1.5% through Switzerland. Not only this. On average, 85% of FDI outflows from India is also through ten known tax havens during nine fiscals of FY14-FY22 – the RBI reports show.

Ironically, though tax havens have zero or near-zero tax, yet, India has Double Taxation Avoidance Agreement (DTAA) with those very tax havens for years, turning DTAAs into Double Non-Taxation Agreements (DNTAs) in reality. More than 100 countries are listed on the Income Tax Department’s website for DTAA.

India did rework the treaties with Mauritius, Cyprus and Singapore in 2016-2017 but this was half-hearted. Global anti-tax evasion group Tax Justice Network (TJN) analysed the reworked agreements with Mauritius and Singapore in 2019 to point out that while capital gains is taxed, other securities like exchange-traded derivatives, convertible or non-convertible debentures and mutual funds aren’t, thus keeping the door partly open. Even then, these revisions had salutary effects, it said, as FDI flows from Mauritius slowed down but that from Singapore increased (due to Singapore’s other strengths as a financial hub, such as availability of funds at lower rates, effective dispute resolution system, it said); FDI flows from the UK increased but from the Netherlands decreased though no revision had happened with them.

Mysteriously, no such DTAA revision with other tax havens was heard of thereafter. Given that the TJN listed and ranked 70 tax havens for 2021, it is open for shell companies to shift to other tax havens to pump funds in and out.

The only other tool available to India is the GAAR, which requires companies to disclose “impermissible avoidance arrangement” and give their details in tax audit reports. Since it was operationalised from April 2022 it is too early to know how it works.

Notice how all these issues are in the air in the past few weeks.

Audit failure is kept aside as auditing system comes with in-built conflicts of interest. Companies pay for their own audit (‘he who pays the piper calls the tune’) and so, audit failures don’t need shell companies and tax havens. It was so spectacularly demonstrated by the overnight collapses of Satyam Computers in India and Enron Corporation in the US not very long ago. As banking frauds tumbled out in India since 2018, many such instances tumbled out.