New Study on Shell Corporations for Various Forms of Illegality, Including Tax Evasion (10/27/12)

In a new study, the authors take a close, empirical look at the use of shell corporations to skirt the law.  Michael Findley, Daniel, and Jason Sharman, Global Shell Games: Testing Money Launderers' and Terrorist Financiers' Access to Shell Companies, (9/22/12), here.  Some of the findings of the study have been the subject of speculation.  The study confirms some of the speculation.  One interesting finding is that the countries complaining the loudest about tax haven use of shell companies are some of the biggest abusers.

Of course, we have seen shell corporations and other types of shell entities used with the offshore accounts to give added levels of identity protection.  Use of such entities are deemed particularly egregious by DOJ Tax and the IRS.  Indeed, virtually all of the prosecuted cases involving offshore accounts have involved such shell entities.

So, here are some selected excerpts:

Summary 

For criminals moving large sums of dirty money internationally, there is no better device than an  untraceable shell company. This paper reports the results of an experiment soliciting offers for these prohibited anonymous shell corporations. Our research team impersonated a variety of low- and high-risk customers, including would-be money launderers, corrupt officials, and terrorist financiers when requesting the anonymous companies. Evidence is drawn from more than 7,400 email solicitations to more than 3,700 Corporate Service Providers that make and sell shell companies in 182 countries. The experiment allows us to test whether international rules are actually effective when they mandate that those selling shell companies must collect identity documents from their customers. Shell companies that cannot be traced back to their real owners are one of the most common means for laundering money, giving and receiving bribes, busting sanctions, evading taxes, and financing terrorism.

The results provide the most complete and robust test of the effectiveness of international rules banning untraceable, anonymous shell companies. Furthermore, because the exercise took the form of a randomized experiment, it also provides unique insight into what causes those who sell shell companies to either comply with or violate international rules requiring them to collect identity documents from customers. Just as the random assignment to control (placebo) and treatment groups in drug trials isolates the effect of a new drug, so too the random assignment of low-risk “placebo” emails and different high-risk “treatment” emails isolated the effects of different kinds of risk on the likelihood of (a) being offered a shell company, and (b) being required to provide proof of identity. Key findings include: 

1. Overall, international rules that those forming shell companies must collect proof of customers’ identity are ineffective. Nearly half (48 percent) of all replies received did not ask for proper identification, and 22 percent did not ask for any identity documents at all to form a shell company. 

2. Against the conventional policy wisdom, those selling shell companies from tax havens were significantly more likely to comply with the rules than providers in OECD countries like the United States and Britain. Another surprise was that providers in poorer, developing countries were also more compliant with global standards than those in rich, developed nations. 

3. Defying the international guidelines of a “risk-based approach,” shell company providers were often remarkably insensitive to even obvious criminal risks. Thus, although providers were less likely to reply to clear corruption risks, those that did respond were also less likely than in the placebo condition to demand certified identity documents of potential customers from high-corruption countries who claim to work in government procurement. 

4. Corporate service providers were significantly less likely to reply to potential terrorists and were also significantly less likely to offer anonymous shell companies to customers who are possibly linked to terror. However, compared to the placebo a significantly decreased share of firms replying to the terrorist profile also failed to ask for identity documentation or refused
service. 

5. Informing providers of the rules they should be following made them no more likely to do so, even when penalties for non-compliance were mentioned. In contrast, when customers offered to pay providers a premium to flout international rules, the rate of demand for certified identity documentation fell precipitously compared to the placebo.

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Introduction 

For those engaged in money laundering, sanctions-busting, tax evasion, major corruption, the financing of terrorism and a wide variety of other financial crimes, untraceable shell companies provide a key resource. Such shell companies can be set up online in dozens of countries in days or even hours for as little as a few hundred dollars. Shell companies that cannot be linked back to the real individuals in control create near-insuperable obstacles for regulators and law enforcement officials.  

Reflecting the serious dangers posed by the illicit use of shell companies, prominent international organizations have instituted rules specifying that authorities must be able to access information on those who own and control such companies. The extent to which these rules are actually effective, however, is essentially unknown. We do not know how difficult or easy it is to obtain an untraceable shell company or what makes those who sell shell companies more or less likely to follow the rules requiring proof of customer identity. This study provides the best available answers to these questions and thus aims to improve policy devoted to countering the illicit uses of shell companies. 

The basis of the study was to impersonate 21 fictitious consultants representing various risk profiles, and then make more than 7,400 email solicitations for shell companies to more than 3,700 Corporate Service Providers in 182 countries. The outcomes of interest were, first, whether these providers responded with an offer of a shell company and, second, what identity documents  they required, if any. If the international rules were effective, providers would have required notarized identity documents from customers and applied enhanced scrutiny to customers with a high-risk profile. 

Given the centrality of untraceable shell companies for the crimes listed above, our findings about how easily these prohibited companies are available, even to obviously high-risk clients, are of serious concern. Overall, 48 percent of the replies received failed to comply with international rules on customer identification, and 22 percent failed to require any proof of identity at all.  

Running directly counter to conventional policy wisdom on the subject, providers based in tax haven countries were significantly more likely to follow the rules, to apply the “Know Your Customer” principle, than those in non-tax haven countries. Another surprise was that providers in poorer, developing countries were at least as compliant as those in rich, developed countries. Directly contradicting the principle of the “risk-based approach,” which supposedly governs company formation, providers were remarkably insensitive to even very obvious corruption risks. Although such risky customers were less likely to get a reply, providers were also
significantly less likely to demand certified identification. Services were more vigilant with potential terrorists, but even there they asked for identity documents at significantly lower rates, and sometimes explicitly offered anonymous incorporation. For example, one provider responded to a terrorist financing risk customer by saying “It sounds like you want to form your
company anonymously with the State, is that correct? We can do that for an extra $25. If we are just setting up a Corporation for you and that’s it we don’t require any documents from you at all.”  

Telling providers about the rules they should be applying made them no more likely to do so, even in cases where approach emails mentioned penalties for non-compliance. On the other hand, offering to pay providers a premium not to apply the rules did in fact encourage significantly fewer providers to follow these rules. 

We summarize all these results in a “Dodgy Shopping Count,” which shows on average how many providers a particular kind of customer would have to approach before being offered an untraceable shell company. 

These results present a far more accurate and robust picture of the true state of affairs on shell companies and the effectiveness of the international rules that supposedly govern them than any previous study. The cases of shell-company enabled crimes that come to the attention of law enforcement or the media are by definition unrepresentative, simply because they have become public. International organizations and government agencies often try to assess policy effectiveness by either just reading the rules on the books, which may have limited correspondence to what actually happens in practice, or by counting successful prosecutions or totals of dirty money seized, which again gives little idea as to how many violations occur without official notice.  

Isolated attempts to engage in similar sorts of solicitation exercises by journalists and academics provide a somewhat better indication of the ease with which would-be criminals can come by untraceable shell companies, but still suffer from severe limitations compared with this study. These earlier solicitations have either been for one or a few shell companies, or at most in the
dozens. In contrast, our conclusions rest on 7,466 approaches to 3,773 providers in 182 countries. Perhaps even more importantly, this study uses deliberately differentiated approaches to test what makes providers more and less likely to comply. 

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What are Shell Companies, Why do they Matter, and Who Sells Them? 

At most basic, in the eyes of the law all companies are simply a “legal person,” which, like real people, can sue and be sued, hold bank accounts, and own and sell property and other assets. In contrast to operating or trading companies that have employees who make a product or provide a service, however, shell companies are little more than this legal identity, and hence the “shell”moniker. Any country or jurisdiction that allows for the formation of companies almost by definition allows for the creation of shell companies, which take on the nationality of this jurisdiction. Although it varies from place to place, shell companies are often quick and easy to
set up, obtainable within a few hours or days and costing between a few hundred and a few thousand dollars. A large majority of shell companies are used for completely legal and legitimate purposes – for instance, as a holding company. However, a significant minority are central to a wide range of criminal enterprises. 

Shell companies are a threat when they cannot be traced back to the real person or people in control. Anonymous shell companies are so useful to criminals because they screen or veil illicit conduct. Because the companies themselves are largely expendable, it does little good if law enforcement officials can follow some criminal enterprise or trail of illicit funds back to a company, but no further. The defining metaphor is of shell companies functioning as a “corporate veil”: screening and separating criminals from illicit financial activities. Thus the crux of the issue is whether authorities can “look through” the corporate veil to find the individuals pulling the strings (referred to as the “beneficial owner”). There are many instances of shell companies’ being used in criminal schemes, with some examples presented below. 

• In December 2009 a plane searched in Bangkok was found to be carrying North Korean arms bound for Iran, in violation of international sanctions. The plane had been leased by a New Zealand shell company, but there was no information on the individual who controlled the company. 

• The Iranian government used shell companies from Germany, Malta, and Cyprus to evade international sanctions by concealing the ownership of its oil tankers. 

• The British arms firm BAE Systems pleaded guilty in 2010 in connection with case which saw it pass secret funds through a series of middle-men and shell companies incorporated in Britain and the British Virgin Islands to key Saudi officials responsible for approving a massive arms purchase from BAE. 

• Teodorin Obiang, son and heir-apparent of the president of the oil-rich West African nation of Equatorial Guinea, laundered corruption proceeds in the United States by using a series of Californian shell companies to hold bank accounts and title to his $35 million Malibu mansion. 

• Corrupt Russian tax officials used shell companies from Cyprus and the British Virgin Islands to steal hundreds of millions of dollars in a case that led to the imprisonment and death of Russian whistle-blower Sergei Magnitsky. 

• Recent cases against Swiss banks like UBS and Wegelin have often turned on the tendency of American clients to evade US tax obligations by the ruse of holding their accounts through shell companies controlled by these clients. 

• Russian arms dealer Viktor Bout was convicted in November 2011 of conspiracy to provide aid to a terrorist organization. Bout’s illicit activities were crucially dependent on a network of shell companies in Texas, Delaware, Florida, and elsewhere around the globe. 

• The Mexican Sinaloa Drug Cartel employed New Zealand and other shell companies to launder tens of millions of dollars of cocaine profits through Latvian banks. 

As a result of these and many other instances, time and time again international organizations, national governments, and NGOs have emphasized that progress in combating these and other financial crimes depends on the effective regulation of shell companies, especially in terms of being able to establish the link back to the beneficial owners.   

In most of these cases Corporate Service Providers (CSPs) acted as crucial intermediaries supplying individual clients with shell companies.  These firms make a living by receiving orders for shell companies from clients, lodging the official paperwork, and paying the government fee necessary to create a company. They also offer various auxiliary services, ranging from virtual office facilities to filling important corporate roles as nominee directors, secretaries, or shareholders. CSPs may be sole traders forming companies on a bespoke basis, or wholesalers responsible for the formation and on-going support of tens of thousands of companies through a network of dozens of associated retailers. These firms may be law or accounting firms creating shell companies on an incidental basis, or specialized concerns that do little else. As described below, CSPs are the crucial point at which regulators may intervene to impose a duty to collect customer identity documents.

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Conclusion 

As noted at the outset, organized crime and terrorism depend on financial secrecy. Untraceable shell companies are the most important means of providing this financial secrecy. Recognizing this danger, the international community has responded by mandating that authorities must be able to look through the corporate veil to find the real individuals in control of shell companies. Yet until now, no one has known how effective these policy measures have been. Our study goes a long way to remedy this fundamental ignorance. By identifying the serious weaknesses in  the existing regime we hope to provoke governments to much greater efforts in enforcing  corporate transparency

Some excerpts from a Tax Notes Today Report, Kristen A. Parillo, A New Score Card in the War on Shell Companies: Do as I Say, Not as I do?, 2012 TNT 206-2 (10/24/12)):

[The study] revealed that corporate service providers (CSPs) in "traditional" tax havens are more likely to request documentation from customers seeking to open a shell company than are those located in OECD countries. The study's research team posed as 21 fictitious consultants representing various risk profiles -- from low-risk customers to money launderers, corrupt officials, and terrorist financiers -- and sent 7,400 e-mails to 3,773 CSPs in 182 countries expressing an interest in forming a company for the purposes of limiting legal liability, reducing taxes, and preserving confidentiality. 

The e-mails were generally designed to ask how much incorporation would cost and what documentation was necessary. The research team developed varying approaches to test the CSPs' response to different kinds of customers, different amounts of information, and different risk levels. For example, some e-mails informed CSPs of the international identification standard they should be following, while others also mentioned the possibility of sanctions enforced by the FATF (or, for U.S. providers, the IRS). Other e-mails added a sentence offering CSPs an extra payment if they waived the requirement to ask for identification documents. 

The authors reported that 48 percent of all replies received failed to ask for proper identification and that 22 percent asked for no identification documents at all. Bucking the conventional policy wisdom, the study found that CSPs from traditional tax havens such as Jersey, the Cayman Islands, and the Bahamas were significantly more likely to comply with the FATF standard than those in OECD countries. Another surprise was that CSPs in poorer, developing countries were also more compliant with the FATF standard than those in rich, developed countries. 

"The significance of this finding is that it does not seem to be particularly expensive to enforce the rules on shell companies, given that poor nations do better than rich countries," the study says. "This suggests that the relatively lackluster performance in rich countries reflects a simple unwillingness to enforce the rules, rather than any incapacity." 

The United States, Canada, Ireland, and the United Kingdom ranked near the bottom of the study's "Dodgy Shopping Count," which measured the average number of providers a particular kind of customer would have to approach before being offered an untraceable shell company (the lower the Dodgy Shopping Count, the easier it is to get an anonymous shell company). However, the authors noted that there was a substantial difference between U.S. business law firms and incorporation services in their compliance rates (law firms were more compliant), as well as major variations in compliance among U.S. states (Nevada, Delaware, and Montana had the lowest compliance rates, while West Virginia, Vermont, and Utah were among those with the highest). 

"It is easier to obtain an untraceable shell company from incorporation services (though not law firms) in the United States than in any other country save Kenya," the study says. 

The study also found that despite the FATF guidelines mandating a risk-based approach, CSPs were often insensitive to even obvious criminal risks. The authors said it is particularly worrying that e-mails displaying an obvious corruption risk actually reduced compliance significantly, despite FATF guidelines specifying enhanced scrutiny of those customers. The results of e-mails displaying a terrorism financing risk were mixed but not completely reassuring, the authors said. Though CSPs were less likely to reply to potential terrorists, those who did reply were less likely than those who received the "placebo" e-mail to ask possible terrorists for at least some form of identification. The study also found that potential terrorists received fewer refusals in the United States compared with the placebo. 

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Sharman, one of the study's authors, told Tax Analysts that the traditional tax havens had a higher compliance rate because groups like the OECD and the FATF have been effective at applying pressure on tax havens to tighten their regulations. 

"But the OECD and FATF have given their own members a much easier ride than nonmember tax havens," Sharman said. "In the absence of such pressure, OECD member states have not improved their beneficial ownership standards. The same goes for the U.S., even more so -- beating up on small tax havens is much easier than taking on the American Bar Association, the Chamber of Commerce, or Delaware." 

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British journalist Nicholas Shaxson, author of the 2011 book Treasure Islands: Uncovering the Damage of Offshore Banking and Tax Havens, said the study provides a nice complement to the Tax Justice Network's Financial Secrecy Index, which looks at how the laws and regulations in a jurisdiction change the behavior of those outside that jurisdiction. The Tax Justice Network released the first index in 2009 and, after revising its methods to give greater weight to a jurisdiction's secrecy score rather than the relative size of its financial center, released another index in 2011. Both indices found that OECD countries, EU members, and their dependencies are among the biggest providers of financial secrecy (the United States was the top-ranked secrecy jurisdiction in the 2009 index, while Switzerland topped the 2011 index).  

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According to Sharman, the solution to anonymous shell companies is simple and reasonably cheap: license CSPs, impose a duty on them to collect documentation on beneficial owners, and audit them to ensure they're actually doing that. "Given that small and often quite poor tax havens can manage this, there is no reason OECD states can't," he said. "Many of the latter have simply made a political calculation that it is not worth their while doing so." 

Sen. Carl Levin, D-Mich., and Senate Finance Committee member Chuck Grassley, R-Iowa, have cosponsored a proposal, the Incorporation Transparency and Law Enforcement Assistance Act, three times since 2008 that would require states to collect information on the beneficial owners of corporations and limited liability companies and to conduct background checks on all owners. Bills introduced in 2008 (S. 2956) and 2009 (S. 569) failed to move beyond committee. The latest version, S. 1483, was introduced in 2011 and moved to the Senate Homeland Security and Governmental Affairs Committee and the Foreign Relations Committee. (For S. 1483, see Doc 2011-16839  or 2011 TNT 149-16 .) 

In an October 17 statement to Tax Analysts, Grassley said the Findley-Nielson-Sharman study reinforces the need to improve U.S. state incorporation procedures. "If you want to create a corporation, law enforcement should be able to figure out who you are," he said. "Untraceable shell companies promote crimes from drug and weapons dealing to money laundering. There's no excuse for the Unites States to rank near the bottom of the barrel when it comes to incorporation transparency."