Most of us have probably heard the term ‘shell company’ used in press coverage of political corruption and financial crime. But what exactly is a shell company? What purpose do they serve? And what do shell companies mean for AML compliance?

In this article, we provide a detailed explanation of what shell companies are and the purposes – both legal and otherwise – that they can serve. In addition to this, we also take a look at how these dummy companies work and why they can be a cause for concern for compliance professionals in regulated businesses.

What is a shell company?

A shell corporation is a mere illusion, existing only on paper. They don’t make money, nor do they provide any products or services to consumers. They are often created with the purpose of holding funds and facilitating financial transactions for another entity. These shell corporations lack physical offices, active business operations, and employees. They are nothing more than empty shells.

Despite this, these types of companies can open bank accounts, engage in financial transactions, purchase real estate and other assets, and be the registered owner of intellectual property such as copyrights and trademarks.

However, despite their hollow nature, shell companies can be established and owned from a different country. Certain countries, including the likes of the Cayman Islands, the Bahamas, Bermuda, the Channel Islands and Switzerland, are particularly popular due to their lax business and tax regulations.

What is the purpose of a shell company?

Shell companies are used for a variety of reasons by both large public companies and private individuals, ranging from legitimate business activities to illicit financial practices. Understanding their purpose is essential in comprehending the implications and risks associated with these entities.

Legitimate uses of shell corporations

While shell companies typically have negative connotations, they can serve as perfectly legal entities that are used for honest reasons, such as:

1. Fund holding: Shell companies can be used as temporary vehicles to hold funds during the pre-launch or fundraising stages of a startup. This allows for the separation of funds from operational activities until the business is ready to commence.
2. International operations: Established corporations may utilise shell companies to expand their operations into foreign countries or to crowdsource. By setting up a subsidiary or shell company in the target jurisdiction, businesses can navigate local regulations, access specific markets, or take advantage of tax incentives.
3. Asset protection: In some cases, individuals or businesses may establish a shell company to safeguard intellectual property rights.

Illicit practices & shell corporations

While many shell companies serve legitimate purposes, others exist in legal grey areas and even enable criminal activities that undermine the transparency of the financial system. Inappropriate use of shell corporations can contribute to the following:

1. Concealing ultimate beneficial ownership: One of the most significant reasons for establishing a shell company is to mask the true ownership of significant assets and wealth. By utilising nominee directors, shareholders, or complex ownership structures, individuals can obscure their identity and maintain anonymity. This practice may be employed to evade taxes, bypass financial regulations, or engage in illicit activities. They can even be used by individuals to conceal wealth or assets to avoid having them taken over during a merger or acquisition – or even to hide assets from an ex-spouse while navigating the process of a particularly nasty divorce!
2. Money laundering: Shell companies are attractive to money launderers due to their ease of setup and the ability to facilitate illicit financial flows. By funnelling funds through shell companies, criminals can obscure the origin of money and make it appear legitimate.
3. Tax evasion: Shell companies can be exploited to evade taxes by manipulating financial transactions, inflating expenses, or misrepresenting profits. Through complex ownership structures and the use of tax havens, individuals and corporations can reduce their tax liabilities or avoid detection by tax authorities.
4. Fraud and financial crimes: Fraudsters may utilise shell companies to perpetrate scams, Ponzi schemes, or other financial crimes. By creating a facade of legitimacy through these companies, fraudsters can deceive investors, creditors, or regulatory bodies.

How does a shell company work?

A shell company operates through a carefully crafted structure that enables its (generally) deceptive practices. The process typically involves several steps.

1. Incorporation

The first step in creating a shell company is its incorporation. This typically occurs in a jurisdiction with favourable business regulations and tax benefits. The process involves registering the company with the appropriate authorities, usually with minimal documentation and a nominal registration fee. The true owner or Ultimate Beneficial Owner (UBO) may employ nominee directors or shareholders to conceal their identity further.

2. Nominee directors

To maintain anonymity, shell companies often utilise nominee directors. These individuals or entities act as front figures, holding official positions within the company but having no real involvement in its operations. Their names are listed on official documents and filings, giving the appearance of legitimate governance and ownership.

3. Offshore bank accounts

Shell companies frequently open offshore bank accounts in jurisdictions known for their lax regulations. These accounts provide a layer of privacy and facilitate financial transactions without scrutiny. Funds can be transferred into the shell company’s accounts, further obscuring the origin and purpose of the money.

4. Complex ownership structures

Shell companies employ intricate ownership structures to distance the true owners from the entity. This may involve multiple layers of subsidiaries, trusts, or offshore entities, making it challenging to trace the flow of funds or identify the ultimate beneficiaries.

5. Transactional activity

Despite being mere shells, these companies engage in financial transactions, including purchasing assets, engaging in investment activities, and transferring funds. These activities serve to legitimise the company’s existence and create a semblance of business operations.

6. Legal and financial manoeuvring

Shell companies exploit legal loopholes and engage in financial manoeuvring to maximise their benefits. This can include taking advantage of tax havens, utilising transfer pricing schemes, engaging in complex loan arrangements, or exploiting weak regulatory oversight.

Why can shell companies pose a risk?

Shell companies contribute directly to the muddying of company structures, making it easier to hide the true source of assets and wealth. Using these companies in order to perpetrate crime, individuals are able to effectively mask the sources of their wealth, evade tax, hide the profits of crime and finance terrorism.

Shell companies are often used by money launderers as they are relatively easy to set up. Conversely, they are difficult for tax authorities and regulators to determine ownership. They are frequently used by those seeking to engage in illegal activities, such as funding terrorist organisations, without revealing their identity or the funds being traced back to them.

For compliance professionals, determining key information about companies and clients is a critical step in satisfying KYB/C requirements when onboarding clients and complying with Anti-Money Laundering (AML) legislation.

Having clear, accurate information about UBOs, politically exposed persons (PEPs), active directorships, criminal proceedings, involvement in money laundering and adverse media about businesses and individuals is key to avoiding the perpetuation of financial crime. Businesses found to be interacting with sanctioned persons not only expose themselves to regulatory fines but also reputational damage.

Shell companies can make identifying and verifying ultimate ownership and involved parties very difficult indeed – especially when companies cross borders and international information sources. However, there are software tools, such as NorthRow’s WorkStation, that can support businesses with their due diligence with automated tools to identify high-risk individuals that are hiding behind a shell company.

Last updated: Tuesday 25th July 2023