How shell companies turn black money of India Inc, politicians into white and vice versa

On May 19, 2010, one of India’s largest engineering and construction companies paid a small amount — around Rs 1.38 crore — to a Kolkata-based company. The money was ostensibly payment for a contract that the Kolkata firm had fulfilled. For the engineering firm, the money was less than the average revenue it earned in an hour over the course of that year.
But as income tax sleuths later discovered, the way that money flowed to the Kolkata firm, through it, and then out of it, provided an all-too-rare insight into a business that has always existed in the shadows. It’s a business that serves the needs of India’s biggest and most well-known companies, and in many ways is essential to the way Corporate India functions. A trade that has existed for decades, it became an organised business in Kolkata around the 1980s.

At the heart of this business, and what ensured its survival and growth, is the reality that the Indian economy has a kind of dual personality, split as it is, into the ‘white’ and the ‘black’ economy, with cash transactions (though not always of an illicit nature) dominating the latter. But these economies don’t exist separately from each other. They drive each other, and feed off each other, and money flows from one into the other, depending on the economic cycle and entrepreneurs’ ‘animal spirits’.



The Kolkata company, and thousands of others like it across the country, sit squarely at the junction between white and black. They perform what is an essential function — that of converting, or laundering, black money to white. But they do the reverse as well, converting white money to black. And in the same way that a stockbroker brings together buyers and sellers of a share, and ‘makes’ markets, such companies, and the people who operate them, bring together buyers and sellers of another, much sought-after commodity.

Cash for Pay-offs

When the infrastructure company mentioned earlier wrote a cheque to the Kolkata company — call it LNP Ltd (not its real name) — it received its money back in the form of cash, say investigators ET Magazine spoke to. “Many infrastructure or construction companies in this country operate in an environment where they have to make payments in cash to various players,” points out an income tax official.

Such cash payments are necessary to pay off everyone from a local politician or bureaucrat opposing a project, to even a local Naxalite commander. But being a company which prepares formal accounts that are audited and will be pored over by investors, it has to account for that money, even if it involves such minor amounts. The cheque that the infra company wrote was recorded in its books as a commission payment.

This then was the first leg in a series of transactions, and it involved the conversion of white, accounted-for money, into black. The infrastructure company is now out of the picture, having achieved what it set out to do, while keeping any future over-eager auditors happy. And in the process it is able to claim the ‘expenditure’ in its tax return as well. It’s interesting to note that on the eve of the transaction, LNP Ltd’s own profit and loss account showed a total income of Rs 190 crore for 2009-10, on an asset size of Rs 37 crore.

LNP Ltd ‘invested’ the money it earned from the transaction, through another intermediary company, into a set of four other companies. Those companies accounted for such investment as share capital. It’s worth noting that all of these are transactions that occur only on paper, with no real cash flow or assets backing them.



But what the operator has done is infuse capital, on paper, into a set of companies that are now ready and waiting for a new set of owners. Such companies will be sold off to anyone looking to launder black money, converting cash they have into an asset that has documentation backing it, and can be audited by anyone who cares to look.

A buyer starts off by buying the shares of such a company at a steep discount to the ‘paper’ value of the company. He pays, say, one rupee for a share, which on paper, is worth fifty rupees. This is the white money leg of the transaction, and in effect, is the commission paid to the operator (in this case the commission is 2%). All that remains is for the black money to be brought in. How does that happen?

A manual that the Gujarat income tax department prepared for its officers, and which devoted an entire chapter to such companies, summarised the tried-and-tested way of doing so: “The method...entails breaking up large amounts of money into smaller, less suspicious amounts. In India, this smaller amount has to be below Rs 50,000 as deposit of cash below this amount does not require providing PAN of the depositors. The money is then deposited into one or more bank accounts either by multiple people or by a single person over an extended period of time. Also, even larger amounts are deposited in the banks with PAN numbers of individuals who are mostly illiterate and work for these...operators for small salary or commission. The money is then routed through paper companies controlled by these operators.”

These paper companies then invest this money into the target company as share capital. Money laundered. And while this last step seems a tad labour-intensive, even this process can be speeded up and costs cut, if bank officers are amenable enough (a recent investigation by Cobrapost revealed the role banks had to play in money laundering). And it is the operators who will carry out this last step for their customers. This, in a nutshell, is how the process works. At the start and end of the process are ‘customers’ who have opposing aims. Between them sits the operator who brings the two together.

On Paper

On February 14, 2008, 18 companies based in Delhi, Mumbai, Guwahati but predominantly in Kolkata invested Rs 10 crore in a company called Ganga Builders. Registered at the same address as some of the companies who invested in it, Ganga Builders was a company floated in 1982. Between 1982 and 2007, little is known of what business the company did.

On the exact same day that this transaction happened, another much bigger one took place -- one which was to eventually catch the eye of a range of investigative agencies including the Central Bureau of Investigation (CBI) and the Income Tax Department. That was principally because of the person at the centre of the investigation --Jagan Mohan Reddy, son of former Andhra Pradesh chief minister YSR Reddy. Seventeen companies, many of them belonging to wellknown industrial groups, injected a total of Rs 121.24 crore into Jagathi Publications, the flagship media company owned by Jagan Reddy.

Ultimately, according to news reports, the CBI would go on to investigate a total of over Rs 1,100 crore worth of investments into Jagathi over a period of years. Among those Valentine’s Day investors into Jagathi in 2008 were a smaller clutch of Kolkata and Mumbai-based firms and this is where their paths cross with Ganga Builders. For many of the investors into Ganga, and many of the investors in Jagathi, were common.

Ganga then went on to buy the shares of Jagathi over 2008-09, though the exact amount it invested could not have been more than a few crores. Currently all the shares of Ganga are now held by a clutch of other ‘paper’ companies. But more than the transaction, Ganga, and its sister companies, exemplified the classic traits of such companies.

Income tax investigators visited Ganga’s address, situated in an office complex in a commercial area in the heart of Kolkata. It was an address that the company shared with a few other paper companies who had invested in Ganga. All they found was a single office with a peon who confirmed that the companies indeed operated from there, but could give no other details about its owners.

At some point after this, Ganga’s address changed, and a new set of companies was moved to its old address. Ganga itself was exiled from the heart of the city to an industrial area on the far outskirts of the city in Budge Budge in the North 24 Parganas district bordering Kolkata.

ET Magazine visited both the old and new address of Ganga Builders. At the old address, it found the office locked. When it attempted to visit the company’s new address in Budge Budge, the trail ran cold. It could not locate the plot in the industrial area where the company said it resided, and workers at other units in the industrial complex could not even direct this reporter to the address given in the company’s regulatory filings.

“Often the directors of such companies are cooks or drivers or peons of the person who really runs the show,” says a senior IT official. Such directors, who can be appointed to dozens of such companies, have little clue about what these companies are used for. There is little else about these companies that is ‘real’. Addresses are fake, or function merely as ‘postboxes’ to receive mail. Financial accounts are largely fictitious and rarely backed up by actual assets or cash flow.

“These companies are incorporated by taking care of all formalities such as registering with RoC [registrar of companies] but having only postal addresses with no real office or employees. The directors of such companies are again individuals who are mostly illiterate or semiliterate and work for the...operators for small salaries or commission,” says the income tax manual. But what about the auditors?

Origins

Auditors play a special role in the story of the rise of the shell company business or, as is known colloquially, the ‘jamakharchi’ or ‘accommodation entry’ business (so called because such companies provide paper entries on companies’ accounts to facilitate the movement of cash). As IT sleuths describe it, the rise of the jamakharchi business occurred in Kolkata at some point in the 1980s and grew to be a business managed by a group of chartered accountants in that city (though CAs are not the only ones who provide such services).

“Some CAs only do this kind of work here,” says an IT official. And even paper companies require work. They have to be set up (often with just a few thousand or a few lakh rupees in initial capital), and have to regularly submit regulatory filings with the RoC, even if they do no business. Such companies therefore are managed by the CA and his staff.

When ET Magazine compiled a tentative list of companies managed by the same operator who ran LNP Ltd in 2010 (said to be one of the city’s largest such jamakharchi operators), by tracing companies with related directorships and addresses, it came up with a list of well over 100 companies. All these companies had two common characteristics — one, they were all registered with the RoC of West Bengal. Second, almost none of these companies were listed as ‘defaulters’ with the RoC. In other words, their paperwork was clean and they had been regular in filing their annual paperwork with the registrar.

According to the information the IT department has, the operator who set up LNP Ltd runs a set of well over 200 companies. While few CAs are willing to talk about the business on or off record, there is evidence in income tax cases over the years to glean an understanding of how the business is run. In February 2004, for instance, the Income Tax Department searched the premises of Pawan Kumar Ruia, founder of the Kolkata-based Ruia group. Ruia started his career as a CA in Kolkata and a senior income tax official describes him as a “brilliant man”.

According to excerpts of the report on the 2004 search, which were quoted as part of an Income Tax Appellate Tribunal (ITAT) order, “Mr Ruia took up activity in the eighties and by now he has floated hundreds of companies. The purpose of floating these companies was to meet the demand of those beneficiaries who wanted to buy some readymade companies. These companies were sold to different beneficiaries as commodity for a lump sum amount... The real game was played with the companies who were formed and used for the purpose of giving entries. These companies were formed in batches. The bank accounts of all these companies were intentionally opened in one branch. The process of forwarding entries in the beneficiaries was done by ‘layering’ the cheques i.e. cheques were routed through many paper/dummy companies of Shri Ruia before reaching its destination the beneficiaries. This is done by way of simultaneous clearance cheques drawn by one company favouring other through a series of credit/debit entries to hoodwink the Department.”

The order concerned a company which had allegedly benefited from Ruia's 'services' — the ITAT eventually ruled in favour of it and against the tax department. ET Magazine found no evidence that Ruia himself was ever prosecuted for allegedly providing such ‘services’. Questions submitted to Ruia did not elicit comment. Even if a CA audits, and signs off on the accounts of a paper company, it’s not necessarily the case that he is part of the game. While there are CAs who run and maintain a set of dummy companies, at the other end of the spectrum is a clutch of auditors who, desperate for business, are willing to sign the books of a paper company without asking too many questions.

“The fact is that business is so bad in this city, and there are so many CAs, that you will find people willing to sign off on a company’s accounts for as little as a thousand rupees or even less,” says an accountant who began auditing the financials of a company a year or two after that entity was involved in certain transactions to route funds to a senior political figure. This CA incidentally earns most of his income not from auditing companies but from holding coaching classes for aspiring accountants sitting for the CA exam. Until ET Magazine met him, and described the transactions to him, the CA claimed he had no clue about the bona fides of the company.

“When you are earning such little money, where is the incentive to even ask probing questions of a company’s accounts,” he asks. The CA says he came into the picture when another person, who worked for another accounting firm, was put in touch with him through an acquaintance. “This person asked if I would be willing to audit a bunch of companies and I saw no harm in it,” he says. “But for such little money I don’t need the headache,” he added, saying he was not going to audit these companies again. “But many people don’t have the luxury of saying no.”

“Kolkata has always been a hub for CAs, but with the industrial decline of the city, there is less work and many CAs have de facto entered this business,” says an IT official. He adds that while the jamakharchi business has now moved well beyond the city into places like Delhi or Mumbai, there are differences in the ‘commission’ charged: “In Kolkata, the commission can be around 2% plus an additional half percent for keeping the regulatory paperwork up to date,” he says. “In Mumbai, it will be higher.”

One interesting fact: despite the state’s supposed industrial decline over the years, the number of new companies registered with the RoC of West Bengal in 2010-11 was comparable with that of more industrially vibrant states (see Corporate Growth...). But the average authorised capital of new companies in the state was far less — only Rs 18 lakh, compared with Rs 40-50 lakh in the other states.
Corporate Growth by the numbers
Catching Them

The problems for authorities when faced with such companies are both legal and logistical. Take the Madhu Koda case for instance. When investigators began looking into the trail of funds linked to the former Jharkhand chief minister, they ran into a massive logistical exercise —the CM’s accountant Manoj Punamiya had routed cash through more than 200 companies.

Payments were layered — instead of funds being routed from A to Z directly — they were routed from A to B, B to C, D to E and so on, eventually to Z. “It was found that there were as many as 17 steps in which funds were transferred across accounts of various companies in the space of a single day,” said an IT official. And even if you painstakingly go through each of those layers, you can hit a brick wall — an investor located in an offshore tax haven like Cayman Islands or Mauritius.

"Politicians started using such companies from about 2005 and started parking scam-tainted money in them," says Kirit Somaiya, the founder of the Investors' Grievance Forum, which supports the interests of small investors. But layering of funds — moving cash from source to beneficiary indirectly through a number of intermediaries rather than just one or two — isn’t done just to create a lot of work for investigators. It performs a legal function as well.

The legal defence of such companies is summed up in a statement that former Samajwadi Party senior politician Amar Singh gave to the newsmagazine Tehelka in context of an investigation that the publication ran into various funds routed into Singh’s companies from a series of other entities, again many of them being based in Kolkata. “All this money received by my companies came through cheques. There is not even a single transaction that was done in cash. The law point is well established.

The recipient of the cheque is not responsible for any illegality or tax evasion done by the giver. It’s the issuer of the cheque who has to explain the source of his money,” Singh told the magazine. In other words, you can ask Singh about the source of his funds, but you cannot ask him about the source of his investors’ funds, because that is not his responsibility.

But starting this year, it may become harder to make this claim; a recent amendment to the Income Tax Act requires private companies to prove the source of their funds, and even the ‘source of the source’.

Another amendment requires that funds entering a private or public unlisted company’s books from the issue of shares at prices well above fair market value will be treated as income and be subject to tax. IT officials hope that with these amendments, the jamakharchi business will take a serious hit. But then again, don’t rule out the odds of enterprising accountants and business persons unearthing new and innovative ways to route illicit funds.

One last bit of information about LNP Ltd, with which we started off this story. In 2011, it acquired new investors, changed addresses and got a real job. It is currently part of a joint venture manufacturing high security number plates in various states.

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