(Part 2)
Survival from Algorithm.
A shell company is a legal business entity that exists only on paper. It has no significant physical presence (like offices or employees), no active business operations, and little to no assets. The “shell” is simply a corporate structure. Shell companies are not inherently illegal. They have legitimate uses. But they are also used for illegitimate purposes as well.
The Young Entrepreneur Mindset
Young tech founders often have two blind spots:
- Tech Hubris: They think because they can build sophisticated software, business compliance is “boring administrative stuff” they can figure out later.
- Optimism Bias: “Tax raids happen to other people, not to smart, legitimate operators like us.”
Then the Enforcement Directorate actually shows up, or their account gets frozen, and suddenly they remember every warning they ignored.
Therefore, try to follow the hints below carefully. The difference between a legitimate fragmented operation and a suspicious shell can determine whether the Enforcement Directorate comes knocking on your door.
Financial & Operational Red Flags:
As stated in part one of this article, often bona fide operations of a bona fide business entity may raise false flags in regulators’ data mining algorithms. A little precaution on a few obvious markers can save many days of explanations and harassment.
Nominal Paid-Up Capital:
A shell company starts with very little initial capital. The company may have a turnover which is hundred times more than the capital. Service companies often have a reasonable nominal capital but small paid-up capital to keep the cost of startup low, but this must be revised as soon as possible.
Fixed deposits in banks pay very low interest and they also deduct TDS. In 2026, bank FD rates hover around 6-7% while the company pays tax at 30%. After TDS deduction of 10%, the effective post-tax return drops to barely 4-5%. Meanwhile, the surveillance through AIS captures every rupee, yet provides no benefit since the company already files complete returns. This creates a lose-lose situation: low returns plus administrative friction.
It is also naive not to keep the money in case of a partnership company. A company can lawfully pay interest to the partners at 12% per annum, which is almost double the interest paid by banks. In a normal company, why would a partner not get paid the interest on capital and reduce the tax liability of the company? As prudent tax planning, the interest can be capitalized every year.
The capital thus accumulated can be deployed in fixed assets: cars, houses, or office space. Many companies maintain guest houses which also double as conference spaces and additional work space if need be. These actions fatten the main company. It grows a body around the shell.
No Physical Operations:
Shell companies often have no office, no full-time employees, or verifiable business location. Work from home may justify lack of office but not the lack of assets. Why does it have no computer? Why is there no car?
Unrealistic Employee-to-Revenue Ratio:
A company showing Rs 10 crore annual revenue with only 2-3 employees on payroll triggers algorithmic suspicion. While automation and outsourcing explain some efficiency, tax algorithms compare ratios against industry benchmarks.
A software company should show at least 8-12 documented workers (including contract staff with proper agreements) per Rs 5 crore revenue to appear normal. These need not all be on your main company payroll if you’re using the fragmented model, but the main entity cannot appear completely hollow.
Solution: Ensure the main company shows senior architects, account managers, and administrative staff on payroll. Satellite companies handle the bulk of development work, but the main entity needs visible human presence.
Cash Withdrawals and Usage
Despite India moving toward a digital economy, cash remains necessary for various legitimate expenses: small vendor payments, local transport, petty purchases, emergency supplies, and tips to delivery personnel. A company that never withdraws cash or shows zero cash expenses across an entire year appears artificial.
However, excessive cash withdrawals are equally suspicious. Withdrawing Rs 2 lakh in cash every week without corresponding documented expenses suggests fund diversion.
Solution: Maintain moderate, regular cash withdrawals (5-10% of monthly expenses) with proper vouchers documenting their use. The pattern should show routine business needs, not systematic cash extraction. However, maintaining a standing cash buffer of 1-2 lakhs as working capital is normal business practice and should not raise concerns.
Petty Expenses
A real company has a trail of daily expenses: tea, coffee, beverages, snacks, late-night meals during project deadlines, stationery, printer cartridges, courier charges, and office supplies. A firm which exists only in bank accounts and Excel sheets has no need for such expenses.
More importantly, entries if made fictitiously are tracked by data mining algorithms for price anomalies. A difference of even one rupee in the price of milk across multiple bills may flag the system. Tax authorities have databases of typical prices for common items by city and date. Fabricated bills with unrealistic prices or perfect round numbers (Rs 500.00 instead of Rs 487.50) create red flags.
Problems also arise from carelessness. Some people, flush with cash, ignore proper accounting and pay business expenses from personal cash or cards. This creates unexplained gaps. Remember: an operation is an operation. Treat it seriously. Every business expense must flow through company accounts, properly documented.
Solution: Maintain genuine petty cash expenses with real receipts. The amounts need not be large, but they must be authentic and consistent with business operations.
Missing Utility Bills:
Real businesses consume electricity, internet bandwidth, water, and telephone services. A company with Rs 50 lakh annual revenue but electricity bills of only Rs 2,000 per month appears suspicious. Even work-from-home setups show regular utility consumption.
Solution: The main company should have commercial internet connections, landline phones, and electricity consumption consistent with its claimed office space. These create digital exhaust that validates physical presence.
Absence of Routine Business Expenses:
Legitimate businesses pay for:
- Professional services (legal, accounting, consulting)
- Drivers, maids, peons and other support staff
- Software licenses and subscriptions
- Insurance (professional indemnity, office assets)
- Marketing and business development
- Travel for client meetings
- Professional memberships and certifications
A company showing zero such expenses while claiming Rs 1 crore revenue looks like a pass-through entity.
GST Input-Output Mismatch:
Tax algorithms cross-reference income tax returns with GST filings. A software services company showing Rs 80 lakh revenue in ITR but only Rs 20 lakh in GST returns creates immediate suspicion. Similarly, claiming ITC (Input Tax Credit) without corresponding asset purchases or operational expenses raises flags.
Solution: Ensure GST and income tax filings are consistent. Document all B2B transactions properly in GST returns. Maintain invoices for all input tax credits claimed.
Layered Transactions:
Funds pass through multiple shell companies in different jurisdictions in a complex, illogical pattern (“layering”) to obscure their origin.
Ordinarily a company works with a limited number of clients or customers at a time and they keep repeating orders and payments. But in case of a shell company, random transactions are noted with complete strangers. Often these transactions take place with people in different cities.
High-Volume, Rapid Movement of Funds
The account shows large transactions inconsistent with any plausible small business activity (for example, a consulting firm moving tens of millions).
Round-Trip Transactions
Money is sent out and quickly returned, or circulates between related shell companies to create the appearance of legitimate trade. In reality, all the dealing companies are shell companies sharing the same suspicious features cautioned above. If your legitimate company transacts with such entities, you will be treated with suspicion by association, even if you have followed all the precautions mentioned earlier. Remember, under the Money Laundering Act, the burden is on the citizen to prove the genuineness of a transaction. Better to avoid working with strangers. Guilt by association is real in legal matters.
Guilt by Association
Once I dropped by an office of a friend. He was complaining about the need to have a driver. We were having coffee when a young lady appeared. She was representing a placement company. She gave her card and explained in a very professional way how they were working. My friend nodded, put the date on her card, and kept it in his drawer after she left.
I asked him, “Why did you not ask for a driver? You needed one.”
His reply was interesting: “I will order a driver next year, if their business still exists at that time.”
Most placement companies are fly-by-night operations. Often their supplied employees commit theft or robbery. Therefore, trusting an absolute stranger without a reference, especially a new placement company, was not wise.
Similarly, in Part 1 of this article I mentioned the seizure of a company’s bank account. That was also a case of guilt by association. The company accepted online payment from what turned out to be a shell company and supplied goods. They had an oral reference who later denied any connection. The account was frozen immediately and only unfrozen after a High Court intervention.
Solution: Verify new clients and vendors thoroughly before transacting. Maintain documentation of due diligence (company registration checks, GST verification, reference checks). For high-value transactions, insist on advance meetings and physical verification. Your bank account can be frozen for merely receiving payment from a shell company, even if you acted in good faith.
The Algorithm-Proof Checklist:
To avoid being flagged as a shell company, ensure your main entity shows:
✓ Adequate paid-up capital (minimum 10% of annual revenue)
✓ Reasonable employee count (documented on payroll with PF/ESI compliance)
✓ Physical office with utility bills (electricity, internet, phone)
✓ Regular operational expenses (tea, stationery, travel, software licenses)
✓ Professional service payments (legal, accounting, audit fees)
✓ Fixed assets on books (computers, furniture, vehicles if applicable)
✓ Moderate cash usage (5-10% of expenses) with vouchers
✓ GST and ITR consistency
✓ Genuine client diversity (not just one or two related parties)
✓ Banking pattern showing vendor payments, salaries, and routine expenses
The goal is not to become inefficient, but to ensure the main company has enough “body” around the “shell” to satisfy algorithmic scrutiny while keeping satellite operations lean.
References:
- Interest on Capital: Section 35(e)(iv) of Income Tax Act, 2025