Shell Corporations

… from the desk of the CEO
David Fisher

A shell corporation is a corporation without active business operations or significant assets. These types of corporations are not all necessarily illegal, but they are sometimes used illegitimately, such as to disguise business ownership from law enforcement or the public. Legitimate reasons for a shell corporation include such things as a startup using the business entity as a vehicle to raise, funds, conduct a hostile takeover or to go public. A shell corporation is a company which serves as a vehicle for business transactions without itself having any significant assets or operations.

Shell corporations are used by large well-known public companies, shady business dealers and private individuals alike. For example, in addition to the legal reasons above, shell corporations act as tax avoidance vehicles for legitimate businesses, as is the case with Apple’s corporate entities based in the United Kingdom. They are also used to obtain different forms of financing.

However, the tax avoidance is sometimes seen as a loophole to tax evasion, as these corporations have been known to be used in black or gray market activities. It’s natural to be suspicious of a shell corporation, and it’s important to understand the various scenarios in which they arise. The number one reason for a domestic company to set up a shell company is to realize a tax haven abroad. Large corporations, like Apple, have decided to move jobs and profits offshore, taking advantage of looser tax codes. This is the process of offshoring or outsourcing work that was once conducted domestically. To remain within legal bounds internationally, American corporations will set up shell companies in the foreign countries in which they are offshoring work. This is legally allowed by the United States, and some say that it’s the U.S. tax code itself that’s forcing domestic companies to create shell corporations abroad.

Another way that shell companies help with taxes surrounds the need for financial institutions to conduct financial activity in foreign markets. This allows them to invest in capital markets outside of domestic borders and realize potential tax savings.

Even though there are legitimate reasons to set up a shell company, many wealthy individuals abuse shell companies for personal gain. Progressive taxation within the United States, that is, tax brackets, slowly caused people to seek personal tax havens. Significantly high earners set themselves up as shell companies in one or many locations, like the Cayman Islands. This is a gray area of tax evasion where people funnel earnings through shell companies in such a way that it isn’t counted toward personal income.

Some shell companies may have had operations, but those may have shrunk due to unfavorable market conditions or company mismanagement. A shell corporation may also arise when a company’s operations have been wound up, for example following a takeover, but the shell of the original company continues to exist.

Shell corporations are not in themselves illegal, and they do have legitimate business purposes. However, they are a main component of the underground economy, especially those based in tax havens. They may also be known as international business companies, personal investment companies, front companies, or mailbox companies.

It’s important, however, to understand that the term shell corporation does not describe the purpose of a corporate entity. In general, it’s more informative to classify an entity according to its role in a particular corporate structure; e.g. holding company, general partner, or a limited partner.

Shell corporations have been used to commit financial crime, by repeatedly creating an empty shell corporation with a name similar to existing real corporations, then running up the price of the empty shell and suddenly selling it.

A Cross-Firing scam is a type of scam in which a business transfers money between its various departments or shell companies in order to give lending institutions the impression that the business is financially healthy. A cross-firing scam seeks to exploit the difficulty in obtaining clear information on all transactions as different lending institutions may be involved. As a result, it makes creditors believe the company is still solvent, which is often not the case.

This type of fraud may also occur by having one department charge a shell company for work rendered, while having the shell company simultaneously charge the department for a different set of work. A cross-firing scam may be difficult for auditors to track due to the number of transactions flowing between the various components of the business. Tracking this sort of fraud is also made more difficult if inadequate information is available about the nature of all companies involved, or if the exchange is made between foreign companies

There are also shell companies that were created for the purpose of owning assets (including tangibles, such as a real estate for property development, and intangibles, such as royalties or copyrights) and receiving income. Reasons behind creating such a shell company may include protection against litigation and/or tax benefits (some expenses that would not be deductible for an individual may be deductible for a corporation). Sometimes, shell companies are used for tax evasion or tax avoidance.

In some developing economies (e.g. some of the post-Soviet states), shell companies allow private entrepreneurship to survive in an environment where an inadequate legal system leads to arbitrariness and corruption. In these challenging environments, entrepreneurs operating a relatively small private business with limited resources sometimes set up shell enterprises to lower or avoid taxes, because tax avoidance or evasion may be a necessity for business survival in situations where the level of taxation is penal, government officials (including tax officials) demand bribes, working capital is in short supply, and tax legislation is hostile to private entrepreneurial businesses.

The SEC and FINRA have noted that fraudsters can be quite adept at manipulating public perception and discussion around a penny stock shell company. The fraudsters might issue a company announcement stating that the company is under new management, that it has been re-incorporated—maybe under a new name, or both. Those changes might coincide with a reverse stock split that would make it seem like the company’s shares have increased in value.

You can read the full SEC and FINRA investor alert here, and you can check out other FINRA investor alerts here.

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