National Audit Office: foreigners with a valid criminal penalty and business ban have become e-Residents – background checking needs fundamental changes

Priit Simson | 7/29/2020 | 8:00 AM

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TALLINN, 29 July 2020 – The background check on applicants for Estonian e-Residency and international information exchange need fundamental changes to reduce the opportunity for foreigners with a valid criminal penalty and business ban to become e-Residents, the National Audit Office finds in the audit report “Effectiveness of the e-Residency programme”, published today.

National Audit Office concluded that the revenues of the e-Residency programme launched in December 2014 have started to exceed the expenses by the end of its first five years. However, the current ex-ante and ex-post controls do not ensure that the participants of the programme are law-abiding. “The e-Residency programme is something that has added to the reputation of Estonia and brought income,” Auditor General Janar Holm said, pointing out that e-Residents have created more than 1,300 jobs in Estonia, with the average wages around the country’s average. “On the other hand, we must keep in mind that the more well known the e-Residency programme, the wider spread the news, should something go wrong. It has been stated in the e-Residency white paper that a small country’s greatest enemy is a poor reputation, whether it’s being thought of as a tax haven or a refuge for criminals. Major risks are not mitigated right now,” Holm added.

The National Audit Office identified that the Police and Border Guard Board (PBGB) has issued digital IDs of e-Residents to foreigners with valid criminal offences in a foreign country. “We made an inquiry to the Finnish criminal records database and it appeared that 48 e-Residents with Finnish citizenship had, during the application for the digital ID, a valid criminal penalty in Finland, whereas a quarter of them were serving actual prison sentence and a fifth had been punished for economic offences,” Auditor General Janar Holm commented. “They probably would never have become e-Residents, had this information been available to the PBGB earlier.”

According to the Police and Border Guard Board, they are unable to obtain information, during the issue of the digital ID of an e-Resident, from the criminal records databases of other countries if such information has not been entered in international databases. But information is not moving as smoothly as needed within the Police and Border Guard Board, either. The PBGB has not revoked the documents of some e-Residents who have committed a crime in Estonia during the validity of the digital ID. In Estonia, one of the obstacles in obtaining information in ex-post controls is that there are no IT solutions that would allow making mass inquiries to the Criminal Records Database. The required IT solutions have not been prepared due to the management and staffing issues at the Information Technology and Development Centre of the Ministry of the Interior. The Centre has admitted to having trouble completing the IT solutions related to the e-Residency on time.

Furthermore, the PBGB has issued digital IDs to foreigners with a valid business ban abroad and has not revoked the digital IDs of such foreigners. As a result, the e-Residents with business bans are board members in Estonian companies.

Estonia recognises Finland’s business bans. According to the PBGB, they were unable to use information on Finland’s business bans in ex-ante controls up to April 2019 due to the lack of IT solutions. In ex-post controls, the PBGB is still unable to verify Finland’s business bands for the same reason. With other countries there is no exchange of data on business bans as this presumes agreements between the countries.

As explained by the Tax and Customs Board, they have no means and options for assessing a person’s tax behaviour, including the presence of a business ban, which is why the Board makes inquiries to Estonian databases only. At the same time, most of the e-Residents have never been to Estonia or engaged in business here. Because of that, the use of Estonian databases only is not sufficient to assess the law-abidingness of the foreigners regarding taxes and business.

The National Audit Office does not find it reasonable that Estonia is issuing digital IDs to foreigners whose activities so far or intention of contributing to Estonia are completely unknown to authorities. The digital ID of an e-Resident is issued without an obligation for foreigners to contribute to the development of the Estonian economy, education, science or culture, even though it is the legal purpose of issuing the document. Also, the renewal of the digital ID does not depend on whether the foreigner has contributed to Estonia or not.

The National Audit Office found that the revenues of the e-Residency programme exceed the expenses by almost 10 million euros, but the income of the proramme depends on a small number of companies. 95% of the revenue is paid by 6% of the companies. However, Enterprise Estonia, the governing body of the programme, does not have a consistent and uniform overview of the total revenue and expenses of the programme. The National Audit Office has found that there is no accurate overview of the expenses of the first years of the e-Residency programme. Even though cost accounting has been improved since 2018, all expenses incurred by public institutions regarding e-Residency have still not been taken into account. Therefore, it is difficult to make informed decisions in managing the programme.

E-Residency programme has introduced new entrepreneurs to the Estonian business landscape. Of the more than 12,000 e-Resident entrepreneurs, most (82.5%) can be considered new. The rest of the e-Residents have had prior connections with Estonian companies.

The amendment to the law due to the e-Residency programme has increased the risk of reputational damage to Estonia. Due to the e-Residency programme, an amendment was made to the Commercial Code at the beginning of 2018, allowing a company’s management board to be located abroad. Together with the incomplete requirements for applying for licenses of virtual currency service providers, a situation has occurred in which a number of Estonian companies were established operating abroad and licensed by Estonia in a field that the Financial Intelligence Unit has assessed to be at high risk for money laundering and terrorist financing. The PBGB was unable to supervise the companies due to their location abroad.

Even though the management board of a virtual currency service provider is no longer allowed to be located abroad, this option was available for two years. Should it appear that any Estonian-licensed virtual currency service providers committed fraud, it could damage Estonia’s reputation.

The digital ID has been renewed by every tenth e-Resident whose digital ID card had expired (nearly 1,900 e-Residents in total). The results of the survey held among e-Residents showed that the e-Residents justified the non-renewal with the fact that the e-Residency programme did not meet their expectations. Problems with opening a bank account were mentioned the most.

The main reason for it being difficult for e-Residents to open a bank account in Estonia is that banks have no certainty that the e-Residents’ companies will be operating in Estonia. If the companies’ activities had a relevant connection to Estonia, it would reduce the risks for banks. The results of the survey showed that the public e-services and private services necessary for business are available to the e-Residents, on the whole, but the use of banking services is an exception. Therefore, the National Audit Office finds it important that the e-Residency applicants are explained the conditions for opening a bank account in Estonia and take these into account in marketing the programme.

Background

  • During the first five years of the e-Residency programme (2014–2019), Estonia has granted e-Residency digital ID cards to more than 63,000 foreigners from 174 countries.
  • Digital ID allows them to use the public e-services available in Estonia and create a company.

In the audit, the National Audit Office assessed whether

  • the e-Residency programme encourages the e-Resident companies to bring income to Estonia;
  • control systems ensure that the participants in the e-Residency programme are law-abiding;
  • the e-Residency programme has encouraged the creation of sufficient platforms for business and services for e-Residents;
  • the major risks involved in the implementation of the e-Residency programme have been mitigated.

 

Information explaining the results of the e-Residency audit in the form of questions and answers:

Criminals have also become Estonian e-Residents due to the inadequate control systems. Is this because the Police and Border Guard Board (PBGB) has not done its work?
No, the inadequacy of the e-Residency control systems is not only due to the work not done or failure of the PBGB. For the most part, the problem is that it is difficult for the PBGB to obtain information on punishments from foreign countries, and the PBGB nor the state of Estonia alone can change much about this. This requires international cooperation. The IT and Development Centre of the Ministry of the Interior who has been unable to develop the necessary IT solutions that would enable the PBGB to make mass inquires to the Estonian criminal records databases also plays an important role.

Why does the Tax and Customs Board (TCB) not assess the tax behaviour of foreigners abroad and only limits itself to making inquiries to Estonian databases? After all, many e-Residents have never been to Estonia or engaged in business here.
According to the TCB, they would only benefit from international databases where mass inquiries are supported. With individual inquiries, they would not be able to check the background of tens of thousands of e-Residents. Additionally, according to the TCB, many international databases do not contain the necessary information which would allow them to assess foreigner’s tax behaviour.

Estonia has e-Residents from 174 countries. Does Estonia receive the necessary information to do a background check on foreigners from all these countries?
Estonia does not exchange information on punishments with most countries. International exchange of information on offences usually only takes place in criminal proceedings and not in administrative matters (such as issuance of an e-Resident’s digital ID) and achieving this would require amendments to international agreements. Estonia cannot implement such a large-scale change alone. As the Director General of the PBGB has admitted in the audit response, Estonia alone could only urgently change that by a political decision, that would limit the granting of e-Residency to only the residents of the countries with which Estonia has cooperation in the field of justice and security.

Is inadequate background check a problem specific to e-Residents? After all, ordinary non-residents also do business in Estonia.
It is not a problem specific to e-Residents. Members of management boards and owners of Estonian companies do indeed include a number of ordinary non-residents who do not have an electronic identity (e-ID). The primary problem is that the quality of data concerning these people in the Business Register is poor. For example, during the audit we found several instances where the name of the same person had multiple spellings. In such cases, it is difficult to even match up in which companies that one person operates. People who have e-IDs do not have this problem. Ordinary non-residents are also not subject to a background check comparable to e-Residents. Thus, the PBGB and the TCB have even less information about them than about e-Residents.
However, when ordinary non-residents commit fraud, for example, they cannot be linked to the Estonian e-Residency programme. There are companies established by ordinary non-residents in many countries. Therefore, non-residents can commit fraud elsewhere, too, and the risk is not specific to Estonia in any way.

The National Audit Office has stated in the audit report that the revenue of e-Residency exceeded the expenditure by nearly 10 million euros by the end of 2019. However, the e-Residency website states that e-Residency has brought in 42 million euros of direct economic income to Estonia. Where does this difference come from?
When calculating revenue and expenditure in the audit, the National Audit Office did not check the revenue and expenditure presented by the e-Residency team of Enterprise Estonia and calculated both by itself. The National Audit Office chose this approach because it became clear at the start of the audit that Enterprise Estonia does not have a uniform, consistent and accurate overview of the revenue and expenditure of the programme. For example, it appeared that Enterprise Estonia had not included in expenditure the costs of state authorities (e.g. Ministry of Foreign Affairs, the TCB) who significantly contribute to the programme. Enterprise Estonia also includes in revenue state fees for applying for e-Resident’s digital ID and establishing a company. At the same time, according to the law, the state fee rate is based on the cost principle, by which the rate is established according to the costs involved in performing an act. A certain difference in calculating revenue may also be due to the fact that the National Audit Office distinguished between residents that had a prior connection to Estonia and new e-Residents. The National Audit Office did not include the taxes paid by these companies whose owners had prior connection to Estonian companies before becoming an e-Resident.

The audit finds that a small number of companies pay a large portion of the programme’s revenue. Which e e-Resident companies are the ones that pay the most taxes in Estonia?
The companies that pay the most taxes are generally up to five years old and they have up to five employees in Estonia. These companies mainly operate in the following sectors: information and communication; manufacturing industry; professional, research and technical activities; wholesale and retail trade; and administrative and support activities. At the same time, the list of companies that pay taxes also include companies with several dozen employees and that have operated for over a decade. The latter have, understandably, been operating since before the e-Residency programme, and the e-Residents there have either acquired a holding or the entire company.
However, to be more precise, the top 25 tax paying companies have paid one-third of the revenue of the programme (8.7 million euros). Nearly half of these companies are operating in the manufacturing industry sector, the rest in the field of wholesale and retail trade and administrative and support activities. At the same time, the top taxpayers include, for example, labour leasing companies, an advertising agency, a manufacturer of pharmaceuticals and food supplements, and a bar in the Tallinn city centre. In 2015–2019, these companies employed an average of 14 employees per company in Estonia and the average turnover in 2019 was 1.4 million euros. The e-Resident shareholders of these companies are mostly Russian, Finnish, and Ukrainian nationals.

Can you be sure that all e-Resident companies that pay taxes in Estonia must do so in Estonia, not some other foreign country?
We cannot be completely sure. The tax auditors of the TCB are obligated to inform the tax authority of the e-Resident’s country of residence if it becomes clear during the proceedings that the activities of the company do not concern Estonia. When the actual place of business is the e-Resident’s home country, then this is where the company should pay their taxes. However, the TCB can determine this only during an individual procedure, i.e. so-called handiwork, regarding one company. E-Residents, however, have established thousands of companies, and the TCB is unable to assess the legality of the tax behaviour of all these companies.
In addition, the TCB also admits that they have no information at all about the activities of many e-Resident companies.

The issues e-Residents face when opening a bank account have been often discussed in the public. Why do banks not want to open accounts for e-Residents?
According to the banks, one of the main reasons why they refuse to open accounts for non-residents (incl. e-Residents) is the lack of connection to Estonia. This makes it more difficult to ensure that the account is used exclusively for legitimate activities.
It is also worth remembering that the idea of the original concept of e-Residency was to make administration easy for foreigners and their businesses operating in Estonia. According to the original concept e-Resident companies would have had a connection to Estonia and it would also have been easier for banks to verify their activities.
However, the government changed the original concept in 2016 by removing the requirement of a connection to Estonia and thereby expanding the circle of e-Residency applicants. The justification for the change was that the requirement of a connection to Estonia increases the workload and time required for processing applications to determine the connection. This change is one of the reasons why e-Residents face difficulties in opening a bank account in Estonia.
The terms and conditions for preventing money-laundering and terrorist financing also tightened in 2017. The new guidelines for the implementation of due diligence measures of the Financial Supervision Authority issued in 2018 state that the lack of connection to Estonia as a separate risk. Thus, the main reason why it is difficult for e-Residents to open a bank account in Estonia is that banks have no certainty that the business activity of the e-Resident companies will be connected to Estonia.

The audit report states that the digital ID of an e-Resident is issued without an obligation for foreigners to contribute to the Estonian economy, education, science, or culture, even though it is the legal purpose of issuing a digital ID. How has it happened that Estonia issues documents to people who are not actually intended to receive a document by law?
As noted, according to the original concept of e-Residency, the precondition for issuing a digital ID was a connection to the state of Estonia and a justified interest in making use of the Estonian e-services. In 2016, however, this precondition was abandoned. The Minister of the Interior replied to the National Audit Office that contributing to Estonia is a value norm where e-Residents contribute to the achievement of the goal set as a whole, not each individual personally. The Minister also argued that assessing the personal contribution of each e-Resident would not be expedient or proportionate, as it would be a condition that would be complicated, subjective, and resource-intense to assess.
In the opinion of National Audit Office, however, what is written in the law must be followed and the purposefulness must be assessed. The National Audit Office does not consider it reasonable that Estonia is issuing digital IDs to foreigners whose activities, incl. contributing to Estonia, are completely unknown to the authorities.

Do e-Residents want to extend their digital ID when it expires?
At the time of conducting the audit, the majority of the e-Residents (approx. 70%) had their first digital ID, i.e. they have not yet had to decide whether or not to extend it. The digital ID has been renewed by every tenth e-Resident (nearly 1,900 e-Residents) whose digital ID card has expired. According to the results of a survey conducted among e-Residents, the majority (72% of the respondents) plans to extend their digital ID, nearly one-fourth (24% of the respondents) had not decided yet at the time of the survey, and a little over 4% is not planning to do so.

The audit report states that the amendment to the Commercial Code adopted due to the e-Residency programme which allowed the management board of the company to be located abroad has increased the risk of damage to the reputation of Estonia due to potential fraud in virtual currencies. Is the e-Residency programme to blame for this risk?
No, it is not. The problem was rather caused by the legislator who wanted to facilitate the international business opportunities for e-Residents, but failed to consider the risk this amendment would cause in applying for authorisations for virtual currencies.

The audit of the National Audit Office gives an impression that e-Residency has brought significant risks to Estonia. Does the National Audit Office recommend terminating the e-Residency programme?
No, it does not. In the course of the audit, the National Audit Office found several shortcomings and made proposals on how to solve them. The aim of the recommendations of the National Audit Office is to ensure that those foreigners who need it can continue using the Estonian e-services safely and engage in business comfortably. However, the risks identified have to be mitigated in order to prevent problems in business (e.g. tax fraud, use of figureheads, etc.) and potential international reputational damage.

 

 

Priit Simson
Head of Communications of the National Audit Office of Estonia
priit.simson@riigikontroll.ee
+372 640 0777
+372 5615 0280
www.riigikontroll.ee

  • Posted: 7/29/2020 8:00 AM
  • Last Update: 8/3/2020 12:32 PM
  • Last Review: 8/3/2020 12:32 PM

During the first five years of the e-Residency programme (2014–2019), Estonia has granted e-Residency digital ID cards to more than 63,000 foreigners from 174 countries.

National Audit Office

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