Shell Companies in India: Fundamentals; Issues and Policy Actions

The term shell company is derived from a shell which has an outer covering but nothing inside. By nothing inside means – it does no substantial tangible business. Here are some basic and general questions on shell companies.

Is a shell company always illegal?

A shell company may be legal or illegal. There are many shell companies which work within legal limits. For example, a company may create a subsidiary to look after only its HR functions but not to engage in its main trade or business. It would be a shell company but not be illegal.

However, the term shell company is mostly used for illegal shell companies and such companies should be identified on the basis of purpose of their creation. This purpose is to divert money for tax evasion; route money generated from illegal activities to formal financial institutions; and transfer assets from one company to new company without the transfer of liabilities of the former company, to save tax.

Such companies are generally only in papers; mostly established in tax havens; mostly used to make only financial transactions without no economic activity.

Tackling shell companies is important for the sake of curbing black money and money laundering; to ensure “ease of doing business”; to protect investors’ interest; and increase tax net.

Issues around shell companies in India

There are three major issues as follows:

• Firstly, there is no legal definition for Shell Company, they are also not defined under companies’ act 2013. However, out of 15 Lakh registered companies, only 6 Lakh file their annual returns and this leads to a suspicion that there may be a huge number of illegal shell companies in India.
• Secondly, there is no specific law to deal with only shell companies. The current procedures are done under Benami Transaction (Prohibition) Amendment Act, 2016; Prevention of Money Laundering Act, 2002 and Companies Act, 2013.
• Thirdly, it is difficult to gather data on transactions and also difficult to distinguish between genuine and illegal shell companies. Transactions from multiple accounts can make tracking difficult. Existence of complex corporate structure in India also makes it difficult to find shell companies.

Recent steps taken by government against shell companies

The centre is dealing with shell companies with Iron hand. Recently, the Ministry of Corporate Affairs cancelled registrations of over 1.62 lakh companies for not filing financial returns for the immediate two preceding fiscals. The key measures taken by centre are enumerated below:

1. A ‘Task Force on Shell Companies’ under the Joint Chairmanship of Revenue Secretary and Secretary, Ministry of Corporate Affairs was constituted in February, 2017 for effectively tackling the malpractices by shell companies in a comprehensive manner.
2. Government had requested the Reserve Bank of India (RBI) for freezing of accounts of the defaulting companies who have long exceeded the stipulated time limit, for filing of Financials Statements and returns, under the Companies Act.
3. SEBI has asked exchanges to verify credentials / fundamentals of suspect companies by appointing an independent auditor. If exchanges do not find appropriate fundamentals about existence of the company, the stock can be delisted.
4. Centre has initiated action against more than two lakh shell companies as part of Operation Clean Money.
5. Ministry of Corporate Affairs (MCA) and Central Board of Direct Taxes (CBDT) have signed MoU for automatic and regular exchange of tax information. The purpose of the MoU is to curb the menace of shell companies, money laundering and black money in the country and prevent misuse of corporate structure by shell companies for various illegal purposes.
6. Income tax act provides that a company is resident in India if it fulfils either of the following two conditions: It is an Indian company or during a particular financial year, the control and management of its affairs is situated wholly in India. The second condition leads to formation of shell companies. So, the government introduced Finance act 2015, as per this act a company would be treated as resident in India if its Place of Effective Management (PoEM) in the previous year was in India.
7. Serious Fraud Investigation Office is creating a database of shell companies.

Steps that should be taken

The government can consider enacting a law that is specifically related to Shell companies. This law can provide a clear definition of shell companies based on parameters such as revenues, assets, employee strength apart from requirement of filing returns etc. Secondly, the government must ensure that every company discloses the information to the tax department even if they have zero income. Thirdly, a permanent body under MCA can be created to oversee all agencies so that a better coordination can be achieved. Fourthly, signing of double tax avoidance agreements with tax havens and imposing minimum operational expense criteria on shell companies. Lastly, the government can simplify the corporate structure and mull / make efforts to use big data to track tax evaders.

Other Notes

Dormant versus shell companies

As per Section 455 of the Companies Act, 2013, a company that does not have significant financial activity or has been inactive can apply to the RoC (Registrars of companies) and obtain the status of a dormant company.

A dormant company gets its title in two ways: it has chosen to get a ‘dormant’ status from the RoC by way of an application or a company has not filed financial statements or annual returns for two financial years consecutively, the RoC shall issue notice and include it in the register of ‘dormant’ companies.

But a shell company is one which is typically suspected of illegal activities.

POEM

The Place of Effective Management is defined in the Income Tax Act to mean “a place where key management and commercial decisions that is necessary for the conduct of the business of an entity.

Topics for Exam

Prelims

This is a general topic and no suitable question can be framed for prelims. However, you can give some time to read about Benami Transaction Act, 2016 here and POEM here covered in previous year documents.

Mains & Interview

The basic issues and government steps discussed above can be asked. You may also be asked some advanced questions such as – Analyze the pros and cons of having a separate law on shell companies and how its provisions may involve conflict with other laws. In interview, a question may be thrown such as Can the shell companies create problems in internal security?