A variable interest entity (VIE) refers to an entity that is consolidated into another entity (i.e., the investor) for financial reporting purposes. Thus, the investor becomes the VIE’s primary beneficiary, which is achieved by de facto control instead of equity shareholding. This disparity between equity ownership and economic benefits is the key to getting around foreign ownership restrictions in sectors that are not fully open to foreign investors, particularly for floating such businesses in international capital markets such as New York and Hong Kong.
In the People’s Republic of China (PRC), VIE structure has been used in telecommunications, e-commerce and other “sensitive” businesses that are restricted to foreign investments under the Foreign Investment Catalogue and its successive updates for the last two decades. In the last few years, a trend of dismantling the VIE structure has emerged. Initially, such dismantling was aimed at facilitating the privatization of overseas-listed Chinese companies seeking domestic listing in the PRC. Recent deals were structured to move the holding vehicle into the PRC to facilitate financing or acquisition by cash-rich PRC funds and other buyers. Apart from the overseas investors’ changing sentiments on China-concept companies and the progressive relaxation of the PRC’s foreign investment restrictions that paved the way for this process, the uncertainties around the future of the VIE structure highlighted in the PRC’s draft Foreign Investment Law have stirred up substantial anxieties amongst the stakeholders since its release in early 2015.
Typical VIE Structure
As illustrated in the graph below, a typical VIE structure comprises a special purpose vehicle (SPV) group and an operating group. The SPV group is generally foreign-funded, with its founders (who are usually PRC citizens) and other investors holding equity shares in a Cayman or similar offshore vehicle (HoldCo), which in turn holds a wholly foreign-owned enterprise established in China (WFOE). The operating group is purely domestic, with two or more PRC individuals owning one or more operating companies (each referred to as an “OpCo”). The SPV group controls the OpCo group via a nexus of contractual arrangements, effectively exercising de facto control over the OpCo group and stripping cash revenue from them. In such a structure the WFOE owns the intellectual property rights and other key assets, whereas the OpCo entities hold the necessary operating permits and licenses that are not obtainable by the WFOE.
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Key Steps and Considerations in the Dismantling Process
To transition into a domestic holding structure, the control agreements have to be terminated. A new holding company will be created in the OpCo group (either by adding an investment holding SPV or restructuring the shareholding of an existing OpCo). The relevant OpCo(s) can then acquire the key assets from the WFOE, which will distribute the sale proceeds received to the HoldCo and commence liquidation. The HoldCo will use those distributions received from the WFOE to buy back or redeem all issued shares from its shareholders, before being put into liquidation.
The key considerations are as follows:
Existing shareholders may or may not keep their shareholdings in the new structure. Commercial considerations aside, foreign ownership restrictions may apply and limit the aggregate foreign shareholdings. In some cases, the investors may take advantage of concessions made available in the free trade zones.
Furthermore, it is increasingly common for PRC parties to form their investment holding and fund-raising entity as a limited liability partnership to take advantage of the flexibility of such structure in terms of corporate governance, investment return distributions and tax planning. Where legally permissible, the lead investor tends to set up parallel offshore and onshore investment platforms to tap into available investor pools outside and inside the PRC.
The most straightforward option is to obtain RMB financing onshore. Previously there have been residue concerns over whether PRC non-financial enterprises may lawfully lend money to other legal entities. A set of judicial interpretations from the Supreme People’s Court in August 2015 now makes it clear that genuine lending and borrowing between individuals and non-financial enterprises are legally enforceable.
A key objective is to structure and time the restructuring steps in such a manner that cash movements are minimized.
Employee Incentives Scheme
If a HoldCo has set up an employee stock option plan (ESOP) to incentivize its management personnel and other employees qualified to participate, it will also have to be “migrated” onshore. Qualified employees holding a foreign passport would often participate via an offshore SPV.
When the offshore investors exit from the HoldCo, they will be faced with the Chinese anti-tax avoidance rules that seek to “see through” offshore transfers and treat them as a transfer of the underlying China assets. The risks are particularly heightened when the HoldCo does not have substantial business operations, thereby exposing the transfers to being deemed “without reasonable commercial purpose.” The other major tax exposure relates to the asset transfers between the HoldCo group and the OpCo group. The parties shall expect extensive discussions with the China tax authorities on the fair value of the assets being transferred.
Where the founders have filed recordal with the foreign exchange authorities in respect to their round-trip investments at the time of setting up the VIE structure, they need to de-register their ownership in the SPV upon exit.
Commercial Negotiation Points
When a new substantial investor finances the offshore-to-onshore migration, it will often seek a package of preferential deal terms, ranging from indemnification for pre-restructuring liabilities, veto rights on major matters, to most-favored-nation treatment.