Cayman vehicles have played a significant role in bringing foreign capital to China over the past two decades and continue to do so despite the changing regulatory environment – and now they are being used to take Chinese capital to the world.
International investors into China have traditionally favoured structuring their investments via holding companies or special purpose vehicles domiciled in jurisdictions outside China, with Cayman often being the favoured choice, particularly for larger investments or more complex structures.
Billions of US dollars of foreign capital have flowed into China through these offshore vehicles, domiciled half a world away. Many large companies, household names in China, provide goods and services to tens of millions of people both there and around the world. Such companies, which include Baidu, Geeley and Alibaba, have benefitted from funding through Cayman holding companies and these companies continue to this day to be structured in this way. Many smaller companies in China are in the process of following the same offshore route and aim to be tomorrow’s household names.
There have, however, been developments in Chinese tax and regulatory policy in recent times that must now be factored in to the structuring of investments via offshore vehicles, including those domiciled in Cayman.
One of the most significant sets of regulations are those referred to collectively as “Circular 10” which require PRC government approval for “round trip” transactions – the transfer by PRC nationals and residents of Chinese assets into non-PRC vehicles in which they hold at least a majority stake. Such approval has proved difficult to obtain and is unlikely to be forthcoming for anything other than the largest deals.
The most recent – and probably the most significant – development from the tax perspective is the issue by the PRC tax authorities of Circular 698 which sets out the basis on which a foreign company may be taxed when it indirectly disposes of Chinese assets. These regulations require any person, wherever located, to make a filing with the Chinese tax authorities when selling Chinese assets (including via a non-Chinese holding company). The PRC tax authorities may then impose capital gains tax of 10 per cent on any profit made on the disposal, unless those profits have been taxed at a rate of at least 12.5 per cent in another jurisdiction or unless a reason recognised as valid by the authorities can be given for interposing a foreign vehicle between the seller and the Chinese assets.
The introduction of these regulations has naturally caused legal practitioners and financiers to consider how China investment may best be structured going forward. Surprisingly, some pundits have even raised the suggestion that Circular 698 in particular may lead to a significant reduction in the use of Cayman vehicles in Chinese investment in the future. But such views apparently misunderstand or overlook the fact that in many, if not most cases, the use of a Cayman vehicle is not wholly or mainly for tax planning purposes; and in any event the use of such a vehicle could not put the investor in any worse position than if the investment had been structured through an onshore jurisdiction or held directly.
Further, it should be noted that these regulations do not just catch Cayman structures and in what appears to be the first enforcement of Circular 698, a local tax bureau in Jiangsu province is requiring the Carlyle Group to pay tax on the disposal of an investment structured as the sale of shares in the Hong Kong holding company – with no offshore element present in the transaction. And nobody could seriously suggest that Hong Kong companies have only a limited future as a vehicle for China investment.
In terms of the restrictions on a “round trip” transfer of Chinese assets into an offshore company, PRC legal advisers working with international investors and advising PRC businesses have established a number of deal structures which comply with Circular 10.
These structures include:
- (i) the transfer of assets to a Cayman company which is 100 per cent owned by the international investors, with a ratchet mechanism allowing the PRC founders to obtain a stake in the business and increase it over time and
- (ii) the so-called “VIE” or “variable interest entity” structure, involving the use of a Cayman vehicle held by both international investors and PRC founders which, via a Chinese company, enters into a network of contracts with a PRC operating company, the effect of which is to transfer the economic benefits of the business of the operating company to the Cayman entity.
So, why do advisers continue to work so hard to structure foreign investment into China through Cayman vehicles? In my view, the reasons are as follows:
- Cayman offers a simple incorporation procedure with low registration fees, no regulatory authority approval, no need for accounts or funds to be held in Cayman, same-day incorporation and Chinese names being permitted;
- Cayman is a recognised and well-established offshore financial centre;
- Cayman companies are simple to maintain and operate, and this provides costs and administrative savings – for example, there is no requirement to hold an annual general meeting or to conduct an annual audit;
- Company law in Cayman in principle follows the English/Hong Kong model and so is largely familiar to international investors and onshore practitioners – however, modifications such as no prohibition on financial assistance and the ability to repurchase shares/pay dividends out of any assets of the company, subject to no creditor prejudice, make for a more flexible, less bureaucratic and more investor-friendly environment;
- Cayman legal advice is available during the business day in Asia;
- The ability to dispose of an investment more simply via an international IPO or private sale of shares;
- Cayman companies do not require local directors or other service providers (except for a registered office);
- And of course – Cayman will not impose any additional taxes of any sort on such companies.
Up until very recently, China has been only an importer of capital. But now with the growth in domestic demand and a seemingly insatiable appetite for energy and natural resources fuelled by a burgeoning class of economically empowered citizens, particularly in the cities along the eastern seaboard, Chinese companies (including state-owned enterprises) are increasingly looking to make acquisitions overseas. In 2009, Chinese overseas direct investment was in excess of US$100 billion, with the figure for 2010 likely to be higher still.
And, of course, Cayman vehicles have had a significant role to play in these capital flows and we can expect that they will continue to do so. Cayman companies are being used for outbound transactions in many circumstances, including:
- for the holding of an overseas asset which is wholly-owned by one PRC entity;
- as a vehicle for co-investment by multiple PRC entities;
- as a vehicle for the formation of a joint venture between PRC and overseas parties in relation to assets overseas; and
- as a financing vehicle for the purchase of natural resources bound for the Chinese market.
Recent examples of Cayman companies being used in China outbound investment include transactions involving:
- the acquisition of petrochemical exploration and production companies in Gabon;
- the group financing of an independent oil and gas company with international operations; and
- the financing of an Indonesian-based energy operator active in the exploration, production and marketing of coal.
The introduction of 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, Cayman 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 and now the export of Chinese capital overseas to the benefit of the world economy – but above all, to China itself.
Note: a version of this article previously appeared in the “Hong Kong Lawyer” magazine.