The Magic Weapon for Red-Chips Companies – VIE structure

An increasing number of companies are expanding overseas, and noticeably companies going public through the VIE structure has become the mainstream market trend. Many Chinese firms face obstacles in getting through reviews and obtaining approvals in actual operations of listing overseas. The prevalence of VIE occurred due to local Chinese enterprises adopting this unique entity type to circumvent the approval requirement stipulated by relevant China authorities.  

 

Introduction of VIE

VIE structure is a popular choice amongst domestic companies for the following factors:

  1. Companies that are registered in China find it difficult to get listed overseas. One of the reasons is the absence of the country where the business is registered during the IPO registration. E.g., China is missing from the selection in the place of business registration of the New York Stock Exchange (NYSE)
  2. In terms of policies, the Chinese government prohibits and mandate certain restriction for foreign investors in specific fields to enter the market, such as the Internet, media, education and technology industries. Yet ironically, the development of these industries requires foreign capital, technology and experience.

Evidently, the VIE structure enables local Chinese enterprises to get listed and provide channels for foreign capital successfully. In recent years, the VIE entity type has been widely used in food, biomedicine, financial services, construction, energy and other fields.

 

What is the VIE structure?

Variable Interest Entities (VIEs) refers to the separation of overseas-registered listed entities from domestic business operating entities. Overseas listed entities control domestic business entities through agreements so that business entities are VIEs of listed entities.

In order to achieve overseas listing, many companies to be listed usually adopt the VIE structure to achieve their goals. First, establish an offshore company in the Cayman Islands or the British Virgin Islands, and then use the offshore company as the main body of future listing or financing. Its shareholding structure reflects the real situation of the company to be listed.

After a series of arrangements and investment activities, the company is finally established in China as a Wholly Foreign-Owned Enterprise (WFOE). Using the WFOE entity, the company proceeds to sign a series of agreements for the firm to be listed after passing the relevant IPO authorities’ strict reviews. Most of the profits are transferred to the WFOE to start operations in foreign capital markets to ensure the smooth running of operations.

 

How to build the VIE structure?

SINA Corporation was the first to use the VIE structure in China. The global Internet media company adopted the VIE structure when preparing to go public in the United States. Simply put, the offshore island company controls the operating entity company in China, and the offshore company is the main body to list on the selected securities exchange market to achieve overseas financing. The infographic below briefly illustrates the most commonly used VIE architecture:

Infographic 1: Common VIE architecture

  1. Establishing an Overseas Entity – Registered Offshore Company

BVI is the preferred area for offshore company registration. BVI is one of the fastest-growing overseas offshore investment centres globally and a stable political climate. The establishment of a BVI offshore company has simple procedures and low costs under strict confidentiality. It can also achieve tax savings through local preferential policies.

Unfortunately, some major global stock exchange markets do not recognise the BVI companies for IPO registration. Thus, many companies will register a Cayman Islands company to enable the listing.

  1. Establishing a Second Overseas Entity—Registered Cayman Islands company

The Cayman Islands is highly reputable in the global stock exchange market amongst the other offshore jurisdictions. Setting up a company in Cayman is relatively simple, but it mandates strict supervision and regulatory guidelines to meet the stock exchange requirements. Therefore, most companies will choose Cayman companies with more rigorous oversight as the overseas listing’s main body. In fact, most of the world’s listed companies are Cayman companies.

  1. Establish a Third Overseas Entity — Hong Kong Company (Aged Company)

Chinese companies that are listed overseas usually set up a Hong Kong company. The reason is to benefit from the double taxation agreement between China and Hong Kong. The dividend income that meets Hong Kong companies’ requirements can be levied at a minimum tax rate of 5% withholding income tax. Besides, Hong Kong is a well-known international financial centre and practices the common law system. Coupled with convenient financing and a financial service system, it is not surprising that enterprises generally select hong Kong as its final step.

  1. Establish a Wholly Foreign-Owned Company (WFOE) in China

In the VIE structure, the primary role of WOFE is to control operating entities through a series of agreements to ensure that the interests and control rights of operating entities belong to WOFE. The holding relationship belongs to the listed company established in the Cayman Islands. According to the “Company Law”, foreign companies must be approved by the Chinese authority to establish branches in China before engaging in commercial activities in China. Therefore, the establishment of a WFOE agreement to control domestic operating entities is the only approach.

  1. Agreement to Transfer Profits

Under the VIE structure, profits are generally generated in domestic operating entities.
The usual profit transfer path flows as below:
Domestic operating entity → WFOE → Hong Kong company → Overseas holding company

The WFOE is 100% controlled by the Hong Kong company and the Hong Kong company is 100% owned by the overseas holding company (Refer to the Cayman Islands company in Infographic 1). Therefore, the profit flows from WFOE to the Hong Kong company and from the Hong Kong company to the overseas controlled company. All the transfers is in the form of dividend distribution from the “subsidiary to the parent company”.

 

Advantages of VIE architecture

  1. Tax advantages
    The Cayman Islands company and BVI company offer tax benefits such as low-income tax and a modest tax cost of share transfer. The entity structure also circumvents existing foreign exchange control issues.
  2. Opportunity for IPO
    Using a Cayman company as a listing entity, companies can apply for listing in Hong Kong and other countries.
  3. Open New Doors for Foreign Investment
    The entity allows more foreign investment to flow into the domestic company. The firm can successfully list and raise funds overseas – United States, Hong Kong, and other regions through the reverse engineering of company incorporation.

 

Establish your VIE with a Step-By-Step Approach

Essentially, setting up the VIE structure can be very arduous. The process also contains several possible risks such as default risks, legal risks caused by loopholes in policy supervision, foreign exchange control risks in the process of foreign investment, and tax risks. From diversifying risks, protecting your privacy and obtaining the best entity type for your company, it is advisable to engage a business consulting expert.

Led by the world’s leading management team and with long years of experience providing company management advice, Desfran is your one-stop business consultancy. We continuously keep abreast of the latest financial market trends, support your business development by providing comprehensive customised solutions, and elevate your business to a global stage.

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