Tax evasion, financial secrecy and misuse of corporate structures

Ahead of the UK general election in May 2015, the issue of corporate transparency has become a key political item. Ed Miliband, leader of the Labour Party, announced his intention to give tax havens six months to open up their books or face international sanction.
In response, the Chancellor, George Osborne, has announced a renewed crackdown on tax evasion and anyone facilitating tax evasion as part of the forthcoming budget.

That the UK’s leading political parties have taken such an interest in the matter reflects the scale of the issue. Tax Justice Network, an independent research group, has estimated that between $21 trillion and $32 trillion in untaxed wealth is deposited in offshore jurisdictions. At the higher end of the scale, that’s approximately double the GDP of the United States or the European Union. The Guardian has estimated that China has lost between $1 trillion and $4 trillion to capital flight via offshore structures since 2000. The World Bank reported in 2011 that 70% of cases of grand corruption from 1985 to 2010 involved the use of shell companies. More recently, the New York Times has conducted research into the purchasers of high-value property in Manhattan, finding that, in 2014, 54% of real estate sales of properties over $5 million involved the use of shell corporations. Such figures, when contrasted with austerity measures in Europe and declining growth rates in a number of emerging economies, have given rise to public dissatisfaction and pressure on politicians to tackle the misuse of corporate structures; whether for tax evasion, money laundering, or other illegal practices.

There is no doubt that certain corporate structures provide an inviting means to unscrupulous individuals to hide ill-gotten gains. Some jurisdictions still allow bearer instruments. Companies can be established quickly and easily, often online with no need to physically visit. Add to that the availability of pre-registered “mature” companies, the use of nominees, minimal public filing requirements, and/or layering of companies across multiple jurisdictions, and it becomes extremely difficult to unpick just who really is the ultimate beneficial owner. Complex, multi-jurisdictional structures including financial secrecy locations also frustrate attempts by creditors to recover assets. It is also not only “offshore” jurisdictions that feature prominently on the list of favoured locations for company incorporation: the UK and the US (including states such as Delaware and Nevada) have been commonly used as part of financial secrecy structures.

The international community is however beginning to move on the issue. In 2014, the UK used its presidency of the G8 group to announce plans to create a register of beneficial owners. Subsequently the G20 group also issued a statement on High-Level Principles on Beneficial Ownership Transparency. In parallel with these initiatives, the Economic and Monetary Affairs Committee and the Committee on Civil Liberties of the European Parliament have now voted in favour of the fourth EU Money Laundering Directive, which includes provisions for the establishment of central registers of beneficial owners across EU member states. The full vote is expected to be passed in March/April 2015, after which member states will have two years to implement the directive.

Although the exact details for disclosure of beneficial ownership are still to be finalised, in the UK the requirement will be enacted through the provisions of the Small Business, Enterprise and Employment Bill that is currently making its way through Parliament and which is expected to be enacted by May 2015. This will establish a requirement for companies to investigate and disclose their beneficial owners. The provisions will broadly cover limited companies and limited liability partnerships – public listed companies on the LSE or AIM will be excluded as they are already subject to requirements to disclose significant beneficial owners. Excluding those listed on LSE or AIM, companies will be required to maintain up-to-date information on significant shareholders (over 25%) or controllers, which will be registered with Companies House.

The Small Business, Enterprise and Employment Bill will also introduce several other key changes relating to corporate transparency. Firstly, it will ban the use of bearer shares. Although there are only around 1,220 UK companies that have issued bearer shares, it has been acknowledged that such instruments give rise to significant risks of criminal misuse. For existing bearer shareholdings, companies will have a window of within one month and no longer than nine months after the provisions come into force to convert bearer shares to registered shares. For any bearer shares not surrendered for conversion, the company must apply to the court for their cancellation.

The second major change impacts the use of corporate directors. Going forward, the use of corporate directors will be heavily restricted and, in general, they will only be allowed in cases where there is a very low risk of money laundering, where corporate governance procedures are already strong or where there is existing regulatory oversight. Examples include large group companies, open-ended investment companies, charities and corporate trustees. To overcome the issue of misuse of “shadow” or “front” directors, the Government is also proposing a new regime which makes it clear that a “shadow” director assumes the full accountability of a true director. The Government is proposing to tighten up the directors’ disqualification regime accordingly.

So will these proposed changes work? They will send out a clear message that misuse of corporate structures will not be tolerated and more disclosure will increase the chances that illegitimate activity will be detected. Greater public disclosure of beneficial ownership will also increase access for investigators to identify relevant connections that may reveal wrongdoing. Critics of the proposed approach, however, point out that the additional disclosure may not have the intended effect, for a number of reasons. Firstly, public disclosure of information relating to trust arrangements has been carved out of the approach, following intense lobbying activity. There are an estimated 1.5 million trusts in the UK, and it was argued that public disclosure of beneficial ownership information was unwarranted, given many exist to protect vulnerable individuals. Secondly, it remains unclear how far companies will be expected to probe into ownership via complex offshore structures. Thirdly, criminals intent on money laundering may not be dissuaded and may continue to make use of unscrupulous nominees or those who are “wilfully blind” to their role.

The fourth Money Laundering Directive also contains some new provisions relating to identification of ultimate beneficial owners. Under the directive, ownership of 25% plus one share shall be evidence of control and will apply to every level of direct and indirect ownership. This is significant because, under the third Money Laundering Directive, member states had adopted differing interpretations on identification of ultimate beneficial owners – either a “top-down” approach (used by 13 member states) or a “bottom-up” approach (used by 11 member states). The top-down approach considers the owners of the customer and stops at the point the effective ownership drops below 25%. So, for example, a direct owner of a 30% stake is an ultimate beneficial owner, as is a 50% owner of a legal entity that holds 60% directly in the customer entity. But consider if the 60% owner was in turn owned 30% by another legal entity in which an individual had a stake of 70%. Although their effective stake is 12.6% (70% x 30% x 60%), the fact that the shareholding at each level does not fall below 25% warrants the identification of them as an ultimate beneficial owner under the “bottom-up” approach. It also increases the burden on regulated institutions seeking to on-board new customers, although arguably it mitigates against the risk of shareholder collusion.

Forthcoming changes to corporate transparency rules are significant and the detail is yet to be fully addressed. The changes will take time to become effective and, inevitably, criminals will continue to exploit weaknesses and benefit from inconsistent worldwide standards and approaches. However, as the bar continues to be raised, so will the risks and costs of exploiting the system.

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