How do Shell Corporations work?

Most business owners have heard of shell companies but many will not know exactly what the term means or what the implication of a shell company is. 

Whilst a shell company can be completely legitimate and completely legal they are often involved in serious criminal activity, tax evasion or immoral dealings. In fact, they form an integral part of these schemes and and are crucial for their success. Being implicated in illegal activity via dealings with a shell company can have serious legal and financial consequences for you and your business, as well as causing severe reputational damage.

What is a shell company?

A shell company is essentially fake business that has been created on an official company register and so has a company number etc. but doesn’t have any significant assets or deliver any goods or services to generate revenue, and doesn’t appear to have any active business operations. They may have a registered address, but usually have no physical office or employees.

Shell companies can exist in any country but are most common in tax havens with low levels of banking regulations such as:

• Cayman Islands
• Bahamas
• Bermuda
• United Arab Emirates
• Malta etc.

These companies are set up by anyone (individual or organisation) and are used in a variety of different situations for legitimate businesses as well as criminal enterprises.

Why are there shell companies?

There can be legitimate and illegitimate reasons for shell companies, the most common being the latter. This is why a vital part of your AML defenses is the ability to identify and understand the warning signs of these unlawful shell companies:

Why have a legal shell company

One of the reasons it is so hard for regulators to stop illegal activity being conducted via shell companies is that they do have legitimate and legal uses. 

Some of the most common legal reasons for shell companies include:

• Avoiding the costs of AML compliance in countries with high regulations. By setting up a shell company in a foreign country with lower levels of regulations and listing that as a parent company, businesses are able to adhere to a more forgiving legal system. For example, the UK has relatively high levels of regulations regarding dealing with waste, a company can ultimately bypass these by registering a shell company in another country with lower standards. 
• Companies in volatile economies use shell companies to store money in more stable economies to eliminate the risk of being effected by inflation or a sudden drop in the value of a currency vs the rest of the worlds.
• They could be a precursor before a business becomes fully operational and may hold assets whilst it’s being set up.
• Tax avoidance is another common reason. For example, UK tax avoidance usually entails setting up shell companies generally in Ireland which has a lower corporate tax rate than the UK. As opposed to tax evasion, which is illegal, tax avoidance involves taxing advantage of legal initiatives and loopholes to lower a tax bill.

Illegal functions of shell companies

Money laundering is the main illegitimate reason for shell companies as they can be set up without naming the UBO. 

Shell companies usually come into play during the layering stage of money laundering, where the funds being washed are effectively split and shuffled up to thousands of times between complex networks of shell and real companies. The basic aim is to confuse and overwhelm any authority that may investigate the money trail, thus hiding the original source and owner of the funds. Crossing international borders, using fake invoices, and performing many transactions all help in doing this.

A list of countries that do not maintain sufficient AML regulations and represent a danger to other banking systems is maintained by FATF examples include:

• Iran
• Angola
• North Korea
• Ecuador
• Ethiopia
• Pakistan
• Turkmenistan
• São Tomé and Príncipe
• Caymen Islands 
• British Virgin Islands

These countries are popular for their lack of financial regulations and as local authorities would not generally aid in investigation. Vested interest allows these schemes to prosper as governments collect tax on the shell company’s funds without having to provide anything in return.

The other two main illegal reasons to use a shell company include tax evasion and concealing assets – in the case of divorces, court cases, mergers, or acquisitions. Hiding assets in this way is a form of fraud.

What are the signs I’m dealing with a shell corporation?

Being implicated in a money laundering scheme as serious consequences to both you and your business, so it is vital that you have the knowledge, training and ability to identify if you are dealing with a shell company. Indeed, UK AML regulations require this.

Lack of operational activity

Illegal shell companies do not have an operational function other than channeling funds and they will have no output or operations. If you can find no evidence of activity carried out by a company this is a major red flag. For example, they will likely lack a proper commercial grade website, public listing of contact information, no active social media presence, or advertisments.

Tax haven connections

Some locations are so rife with money laundering activity that any sort of connection to them is a red flag. These locations have lenient regulations which allow criminals to exploit tax benefits and conceal illicit funds, authorities that are susceptible to bribery, and even financial institutions that actively participate in money laundering. The presence of an organisation in an offshore jurisdiction or a recognised tax haven is a major warning sign.

Minimal employee presence

All legitimate companies have employees, and any that is in a position to require large and/or regular monetary transfers is likely to require multiple in order to function. If this is the case there will likely be some sort of evidence of this available online, especially on professional sites like LinkedIn. Similar to a lack of evidence of operational activity, a seeming lack of employees is a important warning sign.

Low capitalisation

If a company has an unusually low capitalisation compared to the industry standard, or the nature of their operations doesn’t seem right, it could be a front for illegal activity. Shell companies have little to no capitalisation meaning they have limited financial resources outside of the funds they are seeking to wash.

Lacking physical presence 

Shell companies will likely only have a registered address and this is frequently an address which is a glorified P. O. box and serves as a registered address for up to thousands of other companies. It is also common for fraudsters to choose a random residential address to register a company to and hope the innocent homeowner will ignore any communication from Companies House. 

It is best practice to search for the address of any company you are doing business with and see if it is in keeping with how they present themselves.

Non-disclosure of beneficial owners

Whilst legitimate businesses frequently disclose their ownership structure, shell companies work to conceal the true UBOs. If a company is unwilling to reveal the identities of its owners, or offers inaccurate and incomplete information, you can easily identify it as a shell company. There is no legitimate reason why company is not transparent about who their UBO is.

High-risk industries

Much like countries, certain industries also represent an increased risk of money laundering. If you notice a company usually operating in high-risk sectors like finance, real estate, banking, and cross-border trade, you should be conscious that these industry sectors provide opportunities for financial crime such as tax evasion and money laundering. If you notice a company in these sectors, you should apply additional scrutiny.

Unusual financial transactions

Disproportionate economic activity could be an attempt to obscure genuine fund sources/launder money. Shell companies may conduct unusual financial transactions e.g., frequent fund transfers to offshore accounts, intricate deals involving many countries, or large volumes of unrelated transactions.

Lack of transparency

Insufficient details regarding ownership, management, or financial standing are red flags as shell companies often provide limited or insufficient information within public business records. Illegal shell companies may also show reluctance to disclose information.

Unusual corporate structure

Complex structures are intended to conceal ultimate beneficial owners making it a challenge to track the flow of funds and identify perpetrators. These companies frequently have intricate ownership structures, a network of interconnected entities and numerous levels of subsidiaries which can be a warning sign.

As a method of explaining their lack of online presence a shell company will usually present itself as a smaller business but will generally have a complex ownership structure. Should you notice this in a potential client it is a clear warning of illegal activity.

This importance of a solid due diligence process

A solid due diligence process which includes regular risk reviews, staff training, robust processes and technological solutions goes a long way to meeting your compliance requirements and protecting you and your business.

It is also extremely important to keep an extensive audit trail of all activity pertaining to AML activities, including any reviews and planning, as you will be required to evidence this if you are ever subject to an investigation or review. In the UK your AML compliance processes can be reviewed at any time and if you can't evidence that they were up to standard you will receive a sizable fine.

How Red Flag Alert can help

Protect your business from dealing with criminally linked shell companies by streamlining your onboarding process with Red Flag Alert using our all-in-one platform.

Red Flag Alert AML check software offers:

• Unbeatable match rates with a referral rate if just 2%
• Document verification
• Digital platform takes just 30 seconds to send a check
• Real time PEPs, sanctions checks and adverse media checks with live monitoring
• Director Search capability 
• AI powered IDV checks
• Checks delivered in your branding
• Full and easy to understand UBO structures

To find out more about, check out our guide to shell companies. And to make sure you protect your business from the risk of shell companies, start your seven-day free trial today.