Breaking the shell of tax evaders
In his Independence Day address to the nation from the ramparts of Red Fort, Prime Minister Narendra Modi declared that the government has identified 300,000 shell companies, out of which the registration of 175,000 companies has been cancelled. The Prime Minister also highlighted that some 400 companies were being run from the same address. These numbers give a broad sense of the scale of the problem of tax evasion through shell companies.
Earlier this month, the Securities and Exchange Board of India, the capital markets regulator, directed stock exchanges to initiate action against 331 listed companies. The regulator has asked stock exchanges to independently audit these entities as they are suspected to be shell companies. This regulatory action is based on directions from the Union ministry of corporate affairs. While the investigation will reveal whether these companies were actually involved in tax evasion or not, the government needs to be very careful as an action like this can affect business and market sentiment. Many of the listed companies under the scanner were actively traded in stock exchanges and such an action can destroy value and affect common shareholders.
To be sure, there is no clear definition of shell company in India. Companies that are not in operation are commonly put in this category. However, in the US, shell company is defined as “a registrant with no or nominal operations and 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”. But there is nothing illegal if a company is not engaged in any economic activity at a given point in time.
There could be multiple reasons for that. It is possible that it had operations in the past and has gone out of business owing to purely economic reasons. It is also possible that companies were registered but could not start operations because of some economic reason—or that companies are created for the purpose of layering. It could be done for legitimate corporate purposes, but it could also be done to evade taxes by showing bogus transactions. There could be other reasons as well, such as distancing the identity of owners.
Therefore, it may not always be easy for tax officials to pin down illegitimate activities carried out for the purpose of tax evasion. But shell companies were used to deposit large amounts of cash during the period of demonetisation, and this attracted the attention of law enforcement agencies. As has been reported in this newspaper and elsewhere, Kolkata is a hub of such companies—and about 145 entities under the securities market scanner are registered there.
The government has taken several steps over the years to check tax evasion through shell companies. For instance, in 2012, it amended the law to tax share premium in excess of fair market value. In 2017, the government amended the law to account for other than a quoted share sold at less than fair market value. While these changes have made tax avoidance difficult through the sale and purchase of shares in unlisted companies, it can still be done through listed companies as the long-term capital gain tax is nil and the short-term capital gain tax is just 15%, provided the securities transaction tax is paid. So it is likely that some operators push prices of smaller companies in the market and help their clients show capital gain and get compensated in unaccounted cash. This could be done through transactions from multiple accounts to make tracking difficult. The government would need to use information technology more effectively to track such transactions.
The crackdown on shell companies is part of a bigger process to contain the menace of black money. The government is on the right track here. It has also been reported that the government intends to make the Aadhaar of key managerial personnel mandatory for regulatory filing. This will help track individuals indulging in illegitimate activities. For example, a person on the board of a large number of companies not engaged in any significant economic activity would automatically raise a red flag. The government also plans to use Big Data for tracking tax evaders. However, it should be careful while taking action against companies in the listed space as it could affect other stakeholders, including the normal shareholder, who have done no wrong. In such cases, the government would do well to first target individuals who are suspected to be avoiding taxes.
Reducing the menace of black money will over time result in higher tax revenue which will not only help the government enhance public spending, but will also lower the tax burden on honest taxpayers.
Will the crackdown on shell companies help reduce tax evasion? Tell us at email@example.com
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