VIE: Are Foreign Investments in China at Risk?
INTRODUCTION
According to the latest World Investment Report by the United Nations, China is the second Foreign Direct Investment (FDI) recipient in the world, and many Chinese companies have raised billions of dollars on foreign markets. This should come as no surprise, since China’s economy opened to capitalism under Deng Xiaoping, the size of the Chinese market and its pace of growth have made the country the biggest economy in the world[1]. An important role in this process has been played by a particular type of legal entity, called VIE, that has allowed Chinese companies to work around state restrictions on foreign investments. In this article the structure of these entities will be discussed, and we will try to understand if and how they could represent a risk for investors.
WHAT ARE VIEs?
VIE is an American accounting term that stands for Variable Interest Entity and can be defined as an “entity in which the investor holds a controlling interest that is not based on the majority of voting rights” (GMT Research 2019). The VIE, then, is not owned in the traditional sense of the term by the parent company, but it is only bound by a contract, or a number of them. In practice, VIE are used as shells companies for several purposes, not always legal, and this for two reasons: as the operating company does not own shares of the VIE, it did not need to consolidate (report on its balance sheet) the VIE (they were what it is called off-balance sheet item[2]); furthermore, and this is in particular the use that Chinese companies make of them, they can be a way for companies in not-easily-accessible markets to raise capital. In China, in fact, there are limitations to foreign ownership for companies in strategic industries (Internet, steel and education for example), and so they cannot simply list on markets outside of the country. This is where VIE come in: utilizing a chain of subsidiaries and specially designed companies, Chinese businesses can get access to market outside of China; we will go into more detail about the structure of this method later in the article
HOW DOES IT WORK?
Although VIE are not a Chinese invention (for instance, Enron made widely use of them to hide its massive debt in before 2000), many Chinese companies utilize this stratagem to list on foreign markets. How do they do it exactly? Without getting in too much detail, here are the main points to answer this question:
A company (SPV or Special Purpose Vehicle) is established in a tax haven, preferably with English law system (China adopts civil law), for instance Cayman Islands or Virgin Islands and listed on foreign markets;
The foreign company establishes a subsidiary in China, which is, under Chinese legislation, called Wholly Foreign Owned Enterprise (WFOE) and, being identified as foreign, is heavily regulated and can conduct only specific operations in China;
The VIE is established onshore, owned by Chinese individuals (the same founder of the company or trusted employee) and therefore can get all the licenses to operate in China (for instance providing Internet services);
The WFOE does not hold the VIE’s shares but through a series of agreements the WFOE holds a controlling interest in the VIE and can so consolidate it in its balance sheet. This way, the part of the business which under Chinese legislation and could not be held by foreigners are put into the VIE and the WFOE has a right to its profits (not through shares but contracts).
Source: Variable Interest Entities in China, GMT Research, March 2019
Companies utilizing this structure are telling two opposite stories to the Chinese government and foreign investors: for the former, the VIE is owned by Chinese nationals; for the latter, it is a foreign company controlling the VIE. Here lies one the ingenuity and at the same time the weakness of this method.
WHY USE THE VIE
Chinese companies are demanding ever more capital, growing fast in a market where public investment is naturally reduced due to an underdeveloped financial market, burdensome regulations and difficulty to obtain loans for private companies. In late 2006, a study found that 98% of Chinese companies could not access bank loans, and while public-owned ones like PetroChina had no problem obtaining the license to list abroad, it was not the same for private companies, especially in the Internet industry, deemed strategic by the PRC.
Therefore, many private companies in capital regulated industries decide to list on markets outside of China. The great success of this strategy is demonstrated by the number of Chinese private companies that have listed abroad in the last decades. Giants like Tencent, Alibaba and Baidu, with a combined market capitalization of more than one trillion US dollars, are listed respectively in Hong Kong, on the NYSE (and in Hong Kong) and on the NASDAQ.
WHAT ARE THE RISKS?
There are several risks related to the use of VIE and are mostly intrinsic in the nature of these entities and their precarious legal structure.
REGULATORY AND POLITICAL RISKS
One of the main risks posed by a VIE is its shaky legal structure. It has, in fact, never been ruled legal by Chinese authorities: the stability of this structure lies, then, on the tacit approval by China’s political system.
The instability of the structure is mostly given by the separation between what the shareholder own (publicly listed shares) and the activities in the VIE. Courts will not enforce contracts that clearly attempt to violate the law. The contractual agreements could be either challenged at any time by the Chinese government or simply not be respected by the owners of the VIE. For example, an insider can subtract valuable assets from the VIE or refuse to share the profits with the WFOE. In this case, the shareholders of the listed company could do nothing. This was the case of Alibaba’s founder and former CEO Jack Ma who, in 2010 separated Alipay (now Ant Financial), China’s biggest online payment service, from Alibaba, putting it into a VIE 100% owned by him, as it could not operate as a WFOE. Later, as Chinese regulators would not give the necessary licenses to the VIE, Ma ended up owning 100% of Alipay by himself. Yahoo!, which at the time held more than 40% of Alibaba’s stakes, would later disinvest completely from Alibaba but will never regain control over Alipay, at the time valued at 5 billion and now at around 150 billion (Ziegler 2016).
OWNERSHIP
In most cases, the owner of the onshore VIE is either the founder of the company (a PRC citizen eligible to obtain the necessary licenses) or a trusted employee. Nevertheless, the are exception to this and while the contract between WFOE and VIE are standardized, the ownership is not. As a result, there is not always an alignment between the interests of the VIE’s owner and of the other shareholders, simply because he or she owns 100% of the VIE but less of the listed company. Moreover, this system puts a single person in command, making the whole company dependent from him or her, and therefore unstable.
OPERATIONAL RISK
Running a VIE can be expensive if most of the business is done through it.
In 2016 China implemented a value added tax (VAT) on VIE’s profits at about 8,5% (Whitehill 2017). After that the taxation would depend on the interpretation the state would make of the payments through which the VIE gives its profits back to the WFOE. It is possible that the transfer would be considered first a dividend to the VIE owner (20% individual income tax rate) and then transfers it to the WFOE (25% corporate income tax rate). Finally, extracting the profits back from China to the listed company would be subject to a 10% withholding tax (Whitehill 2017). The final applied tax rate would then be above 50%. Because of the risk of payments being heavily taxed, many VIE have not been making these payments, also because they may need the cash to conduct the actual business.
Source: Council of Institutional Investors Report, December 2017
FOREIGN EXCHANGE RISK
China has a very strict regulation on exchange, requiring control on virtually any foreign currency transaction. The capital raised abroad is usually in dollars, which are transferred from the listed company to the WFOE in China and converted into renminbi. Moving to money from the WFOE to the VIE, though, it is much more difficult. It is in fact prohibited for the WFOE to loan to the VIE or invest in it (GMT Research 2019).
WHY ARE VIE A PROBLEM?
So far, we have examined how VIEs work and what risk they potentially represent. Let’s now see why they could be a problem.
Western investors, mostly from the U.S., are heavily exposed to Chinese companies listed on foreign markets, which are more than half of the total (Michelle Ker 2017). All in all, the market capitalization of Chinese companies listed via VIE structures in the Cayman Islands is about $1.7 trillion, of which $747 billion corresponds to equities listed on the NYSE or NASDAQ (Coppola, et al. 2019). Most of these investors are U.S. mutual funds, whose investors could potentially not be aware of the risks related to VIE structures.
So far, the SEC has started in 2012 an investigation in a US-listed Chinese company[3] that uses a VIE structure. The U.S. are the market in which most Chinese companies using VIE structure are listed. The trade war between China and the U.S. and the White House often expressed desire (McKeef 2019) to limit cross country investment could pose a threat to Chinese companies. But how the FT said not long ago (Powell 2019), a complete revoke of this structure is highly improbable.
The Chinese government, after a first legislation draft against VIE in 2015, has inverted its route: in October 2019, China Securities Regulatory Commission spoke in favor of removing some restrictions on foreign ownership of Chinese industries. Moreover, on January 1st, 2020, the new legislation approved last March by the National People’s Congress will come into effect, with the aim to improve the business environment for foreign investors and equal playing field for foreign and Chinese owned companies (Zhou 2019).
CONCLUSION
VIEs are not a problem, until they are a problem. It looks like China has no immediate intention to prohibit VIE structure, instead, moving towards opening more to foreign investments. Therefore, we would probably see VIE continue to be used in the foreseeable future. Nevertheless, the other risks of VIE remain; it is important to be aware of the possible implications related to this structure, considering the exposure of investors.
[1] As for GDP based on Purchase Power Parity (IMF 2019)
[2] This was true before the change in regulations in what is now known as FIN 46R, the interpretation of U.S. Accounting Rules, implemented in 2003, stating the principle that whenever a company has a controlling financial interest in another entity it must consolidate it. A similar principle exists also in the EU.
[3] New Oriental, an educational service provider
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