GLOBSEC report: the risk of shell corporations

What are tax havens and offshore companies

There is no single definition of what an offshore tax haven is. Even commonly associated term, such as shell corporation is not very clearly defined. The exact description varies depending on the jurisdiction (country) where any given entity is registered.

The common denominators for tax havens are: low or no corporate taxes; ease of establishing a business entity (e.g. corporation) without having any of the usual prerequisites, such as employees or offices; and finally, limits on public disclosure (ownership or accounts). Shell corporations are understood to be entities registered in a tax haven without any actual activities, employees or offices – hence the term ‘shell’, because there is nothing inside of the company.

Countries and territories that are called tax havens are generally located in exotic locations such as small islands, hence the term offshore. But tax havens exist all around the world, and their list is ever changing as some countries clean up and others decide to take steps to become more opaque.[1] Some are actual countries, like Panama, Malta or the Netherlands; others are territories, like Delaware in the US, or a territory belonging to a state, such as British Virgin Islands.

Secrecy, in this context also termed privacy, is a big advantage when individuals or actual companies wish to ‘optimize’ tax rates or hold luxuries such as properties, yacht, sports cars or intellectual property or indeed any other manner of goods that normally should be taxed. But ownership of businesses without disclosing who do those businesses actually belong to is a big factor in using shell companies.

This secrecy enables private individuals as well as legitimate companies to hide ownership. What purpose that could serve is as individual as the reason for using these types of companies. The undeniable fact is that such structures facilitate a large part of illicit financial flows around the globe. Who or why uses these companies remains a subject of extensive investigations, following a deluge of public exposures including the Panama papers and, more recently, the Pandora Papers.

The problmes with tax havens

Owning a shell company is not illegal. The way it is used, however, might be, and, as proven by the already mentioned series of leaks, very often is. ‘Hiding stolen assets abroad is clearly illegal but buying a yacht may not be.’[2] There are several issues with not just taking money, legitimately gained or not, out of a country and moving it to another.

One of the problems is unpaid tax. That is tax that would otherwise be paid in places where the actual companies or individuals make business. The outflow of money from any given country and into a tax haven hurts the country where the money is from, while it brings no discernible benefit to the tax haven itself. There are some fees, related to the establishment of business in tax havens, but flat fees could never leverage the sophisticated and generally quite high taxes in developed nations. The reason taxes are being paid is obvious to most people, that is: to pay for basic services, police, healthcare systems, roads and other national infrastructure. Furthermore, if the money is from illicit activities, then there is the adverse effects that money laundering has on any country. This includes criminal activities (potentially terrorists as well), some of which have the power, if unchecked, to destabilize nations and cause regional and global inequality. This is no overblown statement either. The vast sums of money that some of the aforementioned leaks identified only hint at the true scale of the problem.

On the domestic level, aside from unpaid taxes, the outpouring of money erodes trust in national institutions which are meant to abide by international standards of antimony laundering and due diligence. Inability to collect the tax that is due hampers every state’s basic functions. So a direct link can be made between money laundering, offshoring of funds and corruption. Even when investigations are painstakingly completed, recovering the money and assets is time consuming is difficult, bordering on impossible. Evidence on recovery of funds in back taxes and penalties following the leak of the Panama papers specifies over a billion USD in 24 countries, with many more proceedings still ongoing. It has taken five years and some countries have taken effective (if slow) steps in recouping the money and closing some of the loopholes. Other countries, sadly, have not moved beyond lip service, further eroding trust in political leaders in those countries and law enforcement agencies to effectively fight money laundering and corruption. [3]

Playing the legal system

Also related to the obtaining of justice is the way some of these cases have impacted the judiciary, not only domestically, but also internationally. There are recorded instances when, during litigation, a company without beneficial ownership declared can legitimately go to a EU court and receive judgement awarding it a financial award. Such was the infamous case with the so-called Russian Laundromat. [4] To get the money out of Russia, the scheme’s organizers devised a clever misdirection. They created fake debt among some of the shell companies and then got a Moldovan judge to order the Russian company seeking to launder funds to pay that debt to a court-controlled account. Moldindconbank in Moldova held those accounts. The companies involved in the fake debt also had accounts at the same bank. Soon, Moldindconbank was deluged with cash sent in from the Russian companies. About $8 billion was then withdrawn directly from these accounts in Moldova and spent around the world.

Meanwhile, nearly $13 billion more was transferred to Trasta Komercbanka in Latvia. Some of the money disappeared into the maze of these same shell company accounts. Trasta Komercbanka’s location in the European Union made the transactions less likely to be questioned by other banks. The money was now considered ‘clean’ money in Europe – money that could be spent on anything the Russians wanted, without having to worry about international sanctions.

Unfortunately this was not the only case; rather, it was merely a pre-cursor. Nor are EU courts the only ones suffering from this ailment. A report published in January 2020[5] described a method witnessed by courts in the UK. Two individuals agreeing in advance that one would bring breach of contract charges against the other. Lawyers are instructed, proceedings are initiated, and after an expensive judicial process the claimant wins. Damages are awarded by the court, and dirty funds are used to pay. Those funds, precisely because they are awarded as a court settlement, are now clean — whatever their provenance. [6] Again, the true scale of this judicial abuse is hard to estimate. Most courts are only monitored on a national level, while some of these arbitrations take place across multiple jurisdictions.

Complex court proceedings with potential awards running into billions where the parties’ identity remains shrouded in secrecy are no strangers to established court jurisdictions. In the Irish press, concerns were raised and questions asked over the multi-billion ToAZ dispute, originating in a shareholder disagreement and criminal charges laid in Russia[7]. Both parties have no presence in Ireland, one being a Russian conglomerate headed by a businessman with alleged links to the ruling elite, the other a group of Caribbean shell entities engaged in no specific trade. Clearly, the absence of a requirement to disclose beneficial ownership in proceedings of this type gives rise to at least a possibility, if not temptation, to abuse the system, and exploit a reputable legal forum, in this case the Irish Courts. Any damages paid out to the group of shell companies that are the plaintiffs in the case will disappear in a complex multi-jurisdictional web of interrelated entities, nominal directors and corporate service providers, the existence and extent of which was suggested by the Pandora’s Papers leak[8]. Crucially, is it not clear where the plaintiffs' funding for this litigation comes from and whether the origin of that money has been sufficiently scrutinized.

The principle of aligning the entities involved in litigation and the final beneficiaries and financiers of that litigation is accepted in New York law, as part of the champerty statute. The champerty doctrine was developed to prevent or curtail the commercialization or trading in litigation, and disincentivize frivolous claims. In 2010, a publicly unknown company incorporated in the Cayman Islands commenced a lawsuit against a large German bank, Westdeutsche Landesbank AG (“WestLB”), in New York. The Claimant asserted that WestLB’s alleged fraud in managing two investment vehicles caused a steep decline in the value of some notes purchased from WestLB. These notes, in turn, were acquired by the claimant days before commencing the lawsuit from a nonparty – Deutsche Pfandbriefbank AG (“DPAG”). Notably, the claimant, Justinian Capital SPC, was an offshore shell company with few or no other activities. In the course of consideration of the case, it was established that in fact this lawsuit was orchestrated by DPAG who would otherwise not pursue the claim given other stakeholders in the process including the German State.[9] The court dismissed Justinian’s claims on that basis, finding that there was no evidence of the acquisition of the notes being for any purpose other than the lawsuit itself.

Limited partnerships

Nor is the abuse limited to offshore companies or courts. UK and Irish limited partnership companies (LPs)  are increasingly suspected of involvement in international crime, money laundering, corruption, tax evasion and other criminal activities. This includes cases such as a fraud equal to 1/8th of Moldova’s annual GDP[10] (the aforementioned Laundromat) as well opaque deals in Uzbekistan[11]. LPs are an attractive vehicle because they are subject to minimal disclosure agreements. For example, they are not required to disclose their accounts, unlike general partnerships, who must be registered with Companies House. This means they can issue a certificate proving their existence, which may also imply some level of government recognition or approval. Equally importantly, LP’s are not taxable. Only the partners are required to pay tax – and those partners are frequently based in offshore jurisdictions where they pay little or no tax. Suspicious LPs cannot be terminated, and an LP may have no real connection to the UK or Ireland, leaving little opportunity for interaction with the relevant law enforcement or tax authorities. Unsurprisingly, therefore there is a number of UK  and Irish LPs in Pandora papers. [12]

Limited partnerships are an archaic type of business partnership – used as an investment vehicle to limit debt liability of limited partners, while the liability of the general partner is without limit. The problem is not that these forms exist. In and of itself these partnerships are not problematic. They become problematic when the role of limited partners is taken over, for instance by a shell company. There is no way for e.g. Irish Tax and Customs to levy tax on these partners. Limited partners should pay tax on their profits, but if these are offshore they become unreachable and untaxable, opening a way for the forementioned opaque corruption and other harmful activities to come into play. As was illustrated, this is problematic not only for Ireland, but also beyond, as Irish judicial and business registration system become accessories in wider money laundering and tax evasion schemes, harming countries and persons far beyond Irish borders.[13]

Possible solutions

Entities and individuals involved in devising schemes to ‘minimize’ tax burdens and launder money are varied as are the schemes being used. Similarly, the steps that are either being taken or proposed to remedy this are complex and not without problems.  There is a universal feeling that something must be done, and momentum is building, but this is not without risks and limitations: some of the  collateral victims are evidenced by Not for profit organizations being unfairly targeted and labeled as terrorist vehicles[14]. The discussion around various steps often reminds one of the prisoner’s dilemma [15] , although the need to cooperate on an international scale is undeniable. The problem is that cooperation of all actors is required. No single actor can act on its own, lest they pay the highest cost.

The usage of champerty doctrine in the US and the possibility to use similar principles in Ireland and the UK is tantalizing. It remains to be seen whether this will prove to be possible, though Ireland has an appropriate case law in place.[16]

EU is taking concrete steps, such as the EU tax blacklist first implemented in 2017 to combat tax evasion and harmful tax practices. The majority of the countries on the list are engaged with the EU on mitigating illegal non-payment or under-payment of tax, the use of legal means to minimize tax liability, and also on concealment of origins of illegally obtained money.[17] These are largely holistic in nature, as they also take in account non-tax measures that the EU is prepared to take that could have an impact on EU foreign policy, developmental and economic relationship of EU with the listed countries. A more concrete proposal is the proposed EU Anti-money laundering and countering the financing of terrorism legislative package. The biggest innovation would be an EU-wide coordination of national Financial Intelligence Units and their information sharing. This should have a profound effect on final beneficiary of ownership lists. At present these are at a national level and do not necessarily reveal the whole picture. A company registered in Germany, for instance, can bid for contracts with the Slovak government. However the final ownerships can, through third countries registered holding companies (e.g. UK based LPs), lead to foreign governments or persons that no EU country would want to do business with. The weakness is speed of implementation and willingness of all member states to abide by these rules. There remains the final caveat that these are regional steps, not global.

A more global step is Base erosion and profit shifting (BEPS) [18] a global OECD initiative aimed at countries and jurisdictions to reform international taxations rules to ensure that multinational corporations pay a fair tax wherever they operate. This introduces a specific 15 step plan promising to ‘restore trust in domestic and international tax systems’. A ‘historic’ deal from June 2021 to back a universal minimal corporate tax [19] is a step in the right direction, proving that states are aware and can reach an agreement when pushed. Again, this has not been without its criticism.[20] Private companies and financial institutions will also have to take steps.

A lot of the issues described in this analysis are possible because there is no universal legal framework. Such activity is therefore not technically illegal, just immoral. Ethical standards are cheap, in that they are easy to declare, but much harder to explain to shareholders whose profits might be affected.

Moral integrity is an underlying theme when talking about the broad as well as the specific issues around offshore companies. Ultimately, with every company there is a specific person behind it, and despite the opaque structures a significant number of highly educated and often public figures are involved. And while they may not be breaking a particular letter of law, their breaking of morality is undeniable.

[1] There are benefits to being a tax haven, especially for small underdeveloped island economies. Mauritius estimates some 5000 jobs to be related to the maintenance and upkeep of this status.