The Mystery of the Mushrooming Companies
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Over a two-week period in March 2012, thousands of shell companies are believed to have been formed all over the country. A look at why this happened, and what it tells us about an industry that largely exists in the shadows
On March 16, 2012, then finance minister Pranab Mukherjee made his budget speech in parliament, like so many finance minis ters had done before him, and as many will do in later years as well. However, that speech was to have one fairly unusual ef fect. In the two weeks following it, and be fore the beginning of the new financial year on April 1, thousands of small companies were incorporated across the country. ET Magazine estimates that the number of private limited companies formed in Kolkata alone, between March 16 and March 31, 2012, was around 3,173 (possibly more). The financial year which was to end two weeks after that budget speech was to set a record of sorts, with more companies being incorporated during that year than any other across India.
The Registrar of Companies (RoC) in West Bengal, under which companies domiciled in that state are incorporated, reported that 16,477 private limited, nongovernment owned companies were incorporated that year. Thus, a fifth of those were incorporated in just the last two weeks of March in Kolkata. On March 29 alone, around 416 companies were regis tered in Kolkata.
Why the sudden rush to incorporate so many new companies? And what purpose were these companies set up to serve?
Start-up Tax
One of the big highlights of Mukherjee's speech was what was to be later criticized as the startup tax. The FM had tightened income-tax laws that affect the way investors put money into new private limited companies. Any investments in those companies at a share price above what the law called `fair market value' was to be treated as the income of the company and taxed. Little wonder then that start-ups and entrepreneurs were nervous as it was seen as hurting the flow of venture funding into new companies (however, the law did exempt investments by recognised venture funds).
In that respect the burst of new companies being formed seems perfectly understandable. Entrepreneurs rushed to incorporate new companies before April 1 to avoid being affected by the new law which would kick in on that date.
But this still left several questions unanswered, the main one being: Why Kolkata? The city, known more for industries such as coal and steel, was hardly a thriving hub of start-up culture. And then there were other oddities. Of the 3,173 companies formed in those two weeks, around 294 were located in just one building, on one street in the city.
As an income-tax officer later termed it, those companies were a form of `inventory' for an industry that is largely unknown, unless you happen to be an accountant, or a lawyer, or an executive wellversed in the ways that Corporate India manages money. Especially black money.
The Shell Company Business
Last year ET Magazine had written about what is blandly called the `accommodation entry' business, or, to give it its colloquial Kolkata name, the `jamakharchi' business. It has been around in one form or the other for decades, but began to get organized and streamlined into what in management-speak would be called a `scalable' business in Kolkata in the '80s. Since then it has spread to other cities. However, Kolkata, at least till a couple of years ago, was its epicentre.
The jamakharchi business exists for one big reason -to help its `customers' convert black money into white, or vice versa. Given that unaccountedfor money is a part and parcel of how Corporate India operates, it raises the very immediate problem of how that black money is to be created and converted. On the one hand, large listed companies with foreign investors have to report audited accounts and ostensibly account for each rupee spent. On the other, while the companies may run perfectly legitimate businesses, they often have to deal with entities that aren't very transparent and which would prefer to be paid, or pay, in cash.And this is just those companies which don't want to evade any tax at all.
The `jamakharchi' business exists to make such transactions happen by the tens, or even hundreds or thousands of crores. "It's important to point out that the jamakharchi business is, strictly speaking, not a money laundering business, though they share similar aspects," says the tax official ET Magazine spoke to. While money-laundering aims to convert money earned from criminal activity into legitimate income, the jamakharchi business may deal in unaccounted-for money earned as part of a perfectly legal business.
One of the more common ways to do this, till the change in tax law in 2012, was as follows. If a company had black money, which it wanted to channel as seemingly legitimate investments back into itself or group companies, it would get in touch with one of many `accommodation entry' operators in the country. Some of the largest ones manage a portfolio of thousands of companies, either on their own, or through `sub-operators' whom they habitually do business with.
When the deal is struck (often through a broker rather than with the operator directly), the `customer' buys shares at face value in one of the operators' companies.This can be worth just a few rupees. He hands over the black money to the operator, who has it deposited into bank accounts he controls (with the help of amenable bank managers). The money is invested and re-invested in dozens of other companies controlled by that operator, and into the target company, now owned by the `customer', at a hefty premium to the share price. This can be shown on the balance sheet of the customers' company as a legitimate investment. The black money has been laundered. If tax authorities try to trace the antecedents of investors who put money into a company (which does no business at all) at a steep premium to the book value of the company, they will likely find other shell companies behind those investors, and still others behind them. It's a bit like peeling an onion. This layering not only makes it difficult to trace the original source of funds, it acts as a way for the `customer' to deny any knowledge of where the money comes from.
Directors in such shell companies are often just employees, or even the drivers and servants of the operator who for a few hundred rupees will sign their name on company papers. In Kolkata and elsewhere, say tax officials, there are those who actually act as `freelance' professional directors of such companies. That too for a meagre `1,000 or so. Operators actually prefer such people since that puts even more distance between themselves and the `directors' who eventually get hauled up by law-enforcement.
A striking feature behind many of the high-profile scams in recent years has been the involvement of Kolkata-based shell companies. In the 2G scam, for instance, part of the money trail went through Kolkata.
Seeking Out the Taxman
It was these kinds of transactions that the new tax law aimed at. Any investment at a substantial premium to book value would now lead to the very effect that the customer wanted to avoid -to be taxed on that money. In the process, though, genuine entrepreneurs and start-ups ended up being collateral damage, though the tax authorities have said that they will not target legitimate businesses.The companies set up in the last few days of March 2012, say tax officials, are essentially an inventory of companies to be used in future years and for future customers.
But the battle continues. And one of the tools the tax authorities plan to use is in response to an unusual and counter-intuitive tactic adopted by many jamakharchi operators. That instead of seeking to avoid the taxman, they actively seek to get their shell companies selected for scrutiny by tax authorities.
Shell companies that have had their books scrutinized by a tax officer and pronounced to be clean are more highly valued by `customers' than a brand new company which has never been looked at closely by the tax man. "The value of an older company that has been given a clean chit is higher than a new company," says a tax investigator ET Magazine spoke to. Commission rates charged by a jam akharchi operator (as a percentage of the equity capital of the shell company that a customer buys) are 2-3% in Kolkata for a company that has undergone such scrutiny, as com pared with 0.3% for a brand new compa ny.
"Kolkata's operators did well because they were relatively cheaper than in other places like Mumbai where com mission rates were as high as 5-6%," says the tax official. "Also, they tended to be more `honest' in their dealings than similar operators in Delhi who would probably cheat by offering you an untested company but try and pass it off as one that was investigated and pronounced clean by the tax authorities."
Another reason why Kolkata was preferred even by companies located in Mumbai or Delhi was simply because routing money through a company located in a different city than the customer made it all that harder for investigations to be pursued.
But given that nowadays tax returns are picked for scrutiny by a computer algorithm located at a data centre in Delhi, rather than by local tax authorities, how did operators ensure that their companies got picked? What operators did after filing a shell company's return was to file another application stating that they had omitted to disclose some income in the original return -often a small sum of a few thousand rupees -and offering that money up to be taxed. If the application came to an assessing officer who was pliable enough, and bribable enough, he would certify as well that the share capital of the company was in the clear and appeared to come from legitimate sources. In any further tax proceeding, which might come up as a result of that shell company being used to route black money, this would be valuable testimony.
The Loopholes
Tax authorities in Kolkata have com piled a database of shell companies known or suspected to be used by well established accommodation entry op erators to route funds. They are aiming to ensure that as and when such compa nies come up for scrutiny before them (including those companies set up in March 2012), they will be declared as shell companies by the assessing officer, thus rendering them worthless in the eyes of customers. "Further, we want to ensure that any `customer' who deals with shell companies on that database will automatically face scrutiny," says the tax official.
Tax authorities claim that because of the 2012 law and other measures, the jamakharchi business in Kolkata has been dealt a body blow. Certainly, new company registrations in Kolkata are sharply down, to half of what they were in 2012. But in other states such as Mumbai or Delhi, new registrations have actually risen since then, though no estimate exists of how many of these new companies are legitimate businesses and how many are used for accommodation entries.
"A review of the impact of the tax changes is yet to take place," says Kirit Somaiya, member of parliament for the BJP from Mumbai, who has headed the investor grievances forum. "It is a step forward in combatting black money, but it may not be sufficient."
Others are sceptical. "People have al ready found a way around the legal pro visions," says Hiten Shah, a Mumbai based chartered accountant and head of Darsh Ventures, an advisory firm. The law itself had specifically exempted in vestments by registered venture capital firms. The government, under its FDI policy, also allows the `fair' valuation of shares issued by unlisted companies to foreign investors to be done in such a way as to take into account future ex pected cash flows -a method which while widely used and accepted, allows for a fair amount of leeway in determin ing a company's valuation. "Further, valuing other aspects of a company's balance sheet such as intellectual prop erty rights is also very subjective," says Shah. "A CA can easily certify a certain value of IPR." And other methods, such as the use of listed penny stocks to con vert black money to white, still exist.
Moreover, even if the 2012 law does reduce the ability of corporates to use shell companies and fictitious transactions to bulk up their balance sheets (and that's a big if ), the damage is done. Using fairly simple yardsticks (see How Much Black Money...) and basic assumptions, several tens of thousand crores of black money are estimated to have been moved through Kolkata alone in any given year, according to income tax investigators.
Further, shell companies are still be ing used for other purposes than simply evading tax or converting unaccounted for money. Companies for instance still use shell entities to bulk up their balance sheets through fictitious sales for pur poses such as taking out bank loans.
The other tax official ET Magazine spoke to says that around half of all jam akharchi transactions are now done with the aim of faking accounts to take bank loans. "The NPA levels that we see now are only the tip of the iceberg," he says.
Regards
Prarthana Jalan
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