China crisis?

 For many years now foreign direct investment into China has routinely been structured through holding companies incorporated in jurisdictions outside China, particularly in the British Virgin Islands (BVI) and the Cayman Islands.

Billions of US dollars of foreign capital have flowed into China through these ­offshore vehicles. Many large companies, household names in China, provide goods and services to tens of millions of people both in China and around the world. Such companies, which include Baidu, Geeley and Alibaba, have benefited from funding through Cayman and BVI holding companies, and these companies continue to be structured in this way. Many smaller ­companies in China are in the process of following the same offshore route with the aim of becoming tomorrow’s household names.

What are the reasons for using companies domiciled in these small Caribbean islands, half a world away, for all this Chinese ­investment? Well, each case is different, but the main drivers have been:

• the preference of sophisticated investors to invest through a company formed under ­familiar legal principles in an internationally recognised financial centre located in a ­stable location;
• the fact that an exit via an IPO or a private sale is in many circumstances easier to ­manage and accomplish through the use of a Cayman or BVI vehicle;
• the ease and speed with which Cayman and BVI companies can be incorporated and the relative simplicity and cost-­effectiveness of administering a Cayman or BVI company; and
• the availability of Cayman and BVI legal advice during the business day in Asia, North America and Europe.

Tighter rules

However, regulatory and taxation policy changes in China in recent years have ­introduced new factors that need to be ­considered when structuring investments into China. The more significant of these are the regulations issued by the People’s Republic of China (PRC) government, ­colloquially referred to as ’Circular 10’, which require PRC nationals and residents to obtain government approval before ­transferring PRC assets into an offshore vehicle majority held by such PRC nationals to facilitate international investment - the so-called ’round trip’.

Such approval is difficult to obtain and may be practically impossible for all but the largest deals. There are also tax regulations that require any person (wherever located) disposing of Chinese assets (including ­indirectly via a non-Chinese holding ­company) to inform the PRC tax authorities of such a disposal, which may then seek to impose capital gains tax of 10 per cent, unless the gain has been subject to ­significant tax in another jurisdiction or the selling company has substance (in terms of having employees, premises etc). These ­regulations are very broad in scope and were issued only relatively recently, and it is ­anticipated that further clarification will be forthcoming, providing greater certainty as to the transactions that the PRC authorities intend to catch.

Further regulations have tightened up the circumstances in which double tax treaty relief may be claimed, requiring the claimant to show substance in the counterpart jurisdiction, although these regulations do not affect Cayman and BVI because, as tax-neutral jurisdictions not party to double tax treaties, they will probably impact ­negatively on places such as the Seychelles and Barbados, where a double tax treaty has been the main advantage.

Role reversal?

The introduction of these new tax ­regulations has led some commentators to question whether there is a continuing role at all for offshore vehicles in Chinese ­investment. However, such views seem to misunderstand or overlook the fact that in many cases the use of a Cayman or BVI vehicle is not wholly or even mainly for tax planning purposes; and in any event, the use of such vehicles could not put the investor in a worse position.

Furthermore, in terms of restrictions on a ’round trip’, PRC legal advisers working with PRC business owners and their international investors have established a number of deal structures that are compliant with the asset transfer regulations. These include: maintaining the assets within the ownership of a PRC entity, which contracts to provide the economic benefit of those assets to an offshore vehicle owned jointly by the foreign investors and PRC entrepreneurs; and the transfer of the assets to an offshore entity that is wholly owned by foreign investors and in which, over a period of time, the PRC founders may accumulate a stake.

The introduction of these regulatory and tax measures by the PRC government and its desire to keep a handle on foreign ownership of Chinese assets, and to prevent the ­potential misuse of offshore vehicles for an improper tax advantage, is perfectly ­reasonable and understandable. However, offshore vehicles have much to contribute, both now and in the future, as they have in the past, in many structures and contexts in facilitating the entry of foreign capital, to the advantage of both international investors and, above all, to China itself.

Greg Knowles is a partner at Maples & Calder