How shell companies are used in black money creation, laundering
11 min read . Updated: 18 Aug 2017, 07:43 AM IST
PremiumPost-demonetisation, the income tax department has had considerable success in tracing movement of cash through layers of shell companies
Kolkata: There used to be an old saying among businesses in Kolkata: “dhan maat dikhao", which means your wealth shouldn’t show. It dates back to the pre-1991 era of command economy, and evolved as one of the best practices of that time to fly under the radar of the tax authorities.
Even in a transformed economy in which wealth creation is much appreciated, some old wisdom, such as the one above, has not lost relevance.
Hours before demonetisation was announced on 8 November, the income tax (IT) department in Kolkata launched a probe into the operations of Anjali Jewellers Pvt. Ltd, a 25-year-old family owned enterprise, now a leading jewellery-maker in West Bengal.
“After closely tracking Anjali for years, it appeared to us that the company was expanding much faster than what its declared cash flow would permit," said a tax officer, who asked not to be identified. “There was some cash flow going into asset creation that the returns did not reflect."
Within days of starting the investigation, it was clear to the department that Anjali was struggling to reconcile its inventory with its books of accounts—there was more gold and jewellery lying in its stock than recorded in its books—and that the company bought “finished goods" from a clutch of vendors.
At the office of one such vendor, only a few hundred metres from the Aayakar Bhawan, which houses the tax department, in downtown Kolkata, tax sleuths stumbled upon ledgers. In them, every transaction with Anjali was neatly recorded with every detail—and for Anjali’s comfort, one detail too many: cash returned to the company for every transaction.
It was immediately clear to the department that these were “bogus transactions", shown in Anjali’s accounts to suppress profits, and all the “searching questions" about rapid asset creation were at once answered.
The department claimed Anjali had concealed at least Rs160 crore of income. Anjali disputed it, and after a few days of resistance, the company agreed to settle, admitting a tax liability of around Rs70 crore.
“As regards tax computations, we are legally analysing (the matter) and the process is on," Anargha Chowdhury, a director at Anjali, said in a statement. “We are cooperating with the department…it is improper to speculate on tax or income figures."
The probe into Anjali’s operations also led the department to 26 other beneficiaries, according to officers. They had one common connection: the Dhanuka brothers, at whose Waterloo Street office the telltale ledgers were unearthed. When contacted, Sunil Dhanuka admitted to having worked with Anjali, but denied having served any other client.
For seasoned tax sleuths, it was a rather underwhelming investigation. “There was hardly any layering to cover the cash trail and even the ERP (enterprise resource planning) software was easy to crack," said the officer cited above.
Normally, when dealing with such bogus transactions, the department has to dissect through “layers and layers" of shell companies, or ones that do not have any legitimate business and are used only for tax rationalization and money laundering.
Chowdhury claimed in his statement that Anjali did not have any shell company. The department isn’t alleging it does either.
But over the past two years, the department has identified around 16,000 shell companies based in Kolkata alone. Anjali had transactions with only a handful of them—all controlled by the same operator—a middle-aged chartered accountant, according to income tax officials.
Operators
Investigation shows this operator is in control of at least 322 companies, said one of the tax officers, but he is not on the board of any of them. He doesn’t own any shares in these companies either.
The directors and shareholders of these shell companies are mere “name-lenders"—they sign on documents for a fixed fee.
The operators seek out people in distress to be appointed as directors. The tax department once came across an old lady who was supporting her husband’s cancer treatment by signing on documents as a director of shell companies. Some, for sure, love the easy money.
In most cases, these directors are traceable. But even if the department gets to them, it doesn’t help because they know nothing—not even the operator who employs them from behind several layers of proxies, said tax officials.
“The whole game is played through proxies, with layers and layers of them acting as smoke screen," said a tax officer, who claimed that he once had to dig through 51 layers in a single circuitous transaction—the maximum in his career—to identify the beneficiary.
A number of operators have been identified, each controlling hundreds of firms. But because they leave no fingerprint, the department can’t do much to rout them from their trade.
Accommodation
The operators act like consultants, managing diverse needs of several clients at a time. And because the needs are different, they create so many companies.
To be sure, they create more than they need, and, according to the estimates of the department, only about half of the 16,000 companies identified as shell have been used. The others are ready, but have not been used yet, officers said.
The operators typically plan with 5-6 years in sight, always budgeting for some firms to be caught and mothballed, one of the officers said.
The main purpose of this elaborate operation, described by a leading Kolkata-based lawyer as “parallel banking", is “accommodation". For a substantial section of the economy, it is the key to efficient working capital management and tax rationalization, he said, asking not to be named.
For instance, a vast majority of real estate developers are known to “buy bogus invoices" to suppress profits. Often they end up holding a lot of cash in their hands, concealed from the tax authorities, and very little on their books to pursue new businesses.
When the accumulated cash needs to be brought back into the books, they approach the operator, said the lawyer. There are various ways to launder this cash and put it back into the books. One of the simplest and quickest ways—which may not lead to laundering—is to find a lender with legitimate funds on his books.
This person receives the cash from the builder, and in exchange makes an unsecured loan with proper documentation. The money is transferred through bank accounts and comes into the books of the builder as legitimate funds that can be deployed in business, according to the lawyer.
The loan is repaid over time from legitimate business income, and the cash returned to the builder—his need for temporary accommodation thus fulfilled. And the man with legitimate funds has in the process made some handsome gains, though perhaps in cash.
It’s a huge market of people with legitimate cash and those with concealed income, all trying to maximize returns from their accumulated wealth while dodging the tax authorities. The operators’ job is to pool the diverse resources in this market and provide win-win solutions for all stakeholders, said the lawyer.
And because the ecosystem is well evolved, transaction costs are low. The cost of accommodation could be as little as 3% of the amount in question, according to the lawyer.
Beneficiaries
Income tax officers, however, have a completely different view: they don’t see this as any “benign mechanism" for tax-efficient management of working capital. They see this only as “unmitigated tax evasion by entrepreneurs who swindle funds from banks and shareholders" and by politicians. “At the root of all these shenanigans, are greed and unaccounted income," one of the officers said.
It is evident that banks will have to write down their loans to several steel and power companies, some by as much as 50%, said this officer. It is also clear that the cost of setting up certain new factories has far exceeded established benchmarks. Clearly, bank loans have been diverted from projects in many ways—false invoicing being the most common among them.
“How has this money wound back to the promoters?" he asked, adding that there’s a lot of politicians’ money as well stashed in benami and shell companies.
Calcutta Stock Exchange
The capital markets regulator last week imposed trading restrictions on 331 companies listed with stock exchanges after they were identified as shell, based on inputs of several agencies such as the income tax department and the Serious Fraud Investigation Office.
It was found that around 145 of these companies were registered in Kolkata.
Shares of several of these companies were once traded on the Calcutta Stock Exchange (CSE), which effectively collapsed after brokers defaulted in March 2001. The investigation that followed in the Rs120-crore payment shortfall exposed serious deficiencies in market surveillance.
Surveillance tightened, trading in frontline stocks shifted from CSE within months to the Mumbai-based bourses with better liquidity. Trading at CSE plummeted to a trickle, threatening its survival. Still, some shares continued to be traded only on CSE until in 2013 the securities market regulator ordered the exchange’s trading platform to be wound up.
These were shares of so-called jama-kharchi companies, a variant of shell companies, which were used by stockbrokers and traders to rationalize their tax liabilities. Because these were illiquid stocks in which no one was interested, a clutch of traders could easily manipulate their prices through collusive trades.
Brokers would “buy losses" from trading in these shares to set off their short-term capital gains against such losses—another form of accommodation that CSE or the income tax department could not stamp out despite knowing that these were collusive trades aimed at reducing tax liabilities.
“Every year, we would be flooded with queries from the tax department," recalled one former CSE official from its surveillance team. Only if these trades could be expunged or the malfeasance behind them established, the department could lodge tax claims, this person said, asking not to be named. “Everyone knew what these brokers were up to, but how could you prove in a court of law that there was any foul play at all in the order matching?" he asked.
For the exchange, there was a bigger dilemma: trading in jama-kharchi companies was its only source of revenue post 2001. Stamping it out, if at all possible, would mean driving into sunset.
Needle in a haystack
In financial year 2008-09, the income tax department was alerted that a whopping Rs78 crore had been deposited into the account of one Kishan Sharma. It came in small bits into his account, and a matching amount transferred out the same day in even smaller bits to various accounts.
The department launched an investigation, but till this day, Sharma remains untraceable.
“Money sometimes travels faster than light," chuckled an officer who investigated Sharma. Digging into his KYC (know your customer) documents, the department found pictures on his PAN (permanent account number) card and electoral photo identity card were different and the address given in both couldn’t have been his home.
Most surprisingly, no one at the bank could remember seeing Sharma; no one knew if he existed at all.
It was clear that the money that came into Sharma’s account had been transferred through layers of shell companies to unknown beneficiaries. For closure, the department raised a tax claim of Rs26 crore against Sharma even though officers knew he was never going to be traced.
Similarly, one Arjun Sonkar sits on the board of at least 23 companies as director. He continues to sign cheques and other documents, but the department has given up chasing Sonkar. And because they are unable to trace and seize him for questioning, the department has not been able to make much headway into cash trails where Sonkar is a front.
Layers are created with the knowledge that the department is short-staffed, said officers. The whole idea is to make it humanly impossible to get to the bottom of most circuitous transactions. “Even our tools are dated," regretted one officer. “For instance, we don’t have a tool that links every bank account with the same PAN."
The result: even with real time alerts, it is impossible for the department to keep pace with the movement of cash through intermediaries.
Epilogue
In the narrow alleys of Burrabazar, a wholesale market in central Kolkata, Ganesh Jhawar once had a thriving clientele. In the wake of demonetisation, business peaked, until one day this “cash operator" in his late thirties was rounded up by tax sleuths and hauled to the Aayakar Bhawan for questioning.
Even after three days of questioning, the department couldn’t extract much from Jhawar. He was only a “cash operator" who collected cash hoards, often from unknown beneficiaries, and hid them in bank accounts. He knew little else.
Admitting collusion with bank officials, whom he would not name, Jhawar said, “demonetisation got me greedy. It was easy money. But it also taught me that I am not cut out for this game." Once caught, the trade distanced itself from him, said income tax officers. Jhawar, though, claimed he had given up on it.
A certain degree of fear has crept into the system, claimed tax officials, echoing Jhawar.
The reason: the massive crackdown post-demonetisation combined with deterrents introduced by the department lately such as hefty fines.
Post demonetisation, the department had considerable success in getting to cash hoarders because time was limited and even at the risk of being caught, they spun the money through a limited number of layers—two or three at best, according to officers.
There is palpable fear in the ecosystem now—transaction costs have gone up, but even by officers’ own admission, it’s only small change compared with what’s at stake.
