China Law Insight : China Law Insight: China Commercial and Intellectual Property Lawyers and Attorneys, Full Service Law Firm: King & Wood

1  Overview

The VIE structure is also commonly referred to as the Sina-model structure, since it was first used by Sina in 2000.  In China, the foreign direct investment market is not totally open to foreign investors.  According to the Provisions on Guiding the Orientation of Foreign Investment, promulgated in 2002, and the Foreign Investment Industrial Guidance Catalogue revised in 2007, we understand that the industries are classified into four categories, namely, the encouraged, permitted, restricted and prohibited.  With respect to the encouraged and permitted industries, there are few restrictions on foreign investment, which means that foreign investors may usually make investments freely in those industries.  As to those restricted industries, higher conditions or qualifications or stricter requirements are provided for foreign investors.  Foreign investors are not permitted to invest in prohibited industries at all.  Those companies which adopted the VIE structure, in a sense, usually face restrictions on foreign investors, and for the purpose of attracting foreign venture capital or private equity financing in the early stages and completing offshore listings, the VIE structure was finally created by certain imaginative individuals in an effort to circumvent certain legal restrictions which they encountered in China.

In recent years, more than one hundred Chinese companies have adopted the VIE structure for their offshore listings, including internet companies such as Alibaba, Tencent, Baidu, Sina, Tudou, etc.; private education companies such as New Oriental, Global Education & Technology Group and AMBOW Education, etc.; media companies such as Focus Media, Vision China Meida and Bona, etc.; retail companies and companies in other industries.  The typical VIE structure is set up as illustrated in the following diagram:

As indicated in the diagram above, foreign investors and PRC individuals establish SPV1 in Cayman; then SPV1 sets up a wholly-owned SPV2 in Hong Kong; and then SPV2 establishes the wholly foreign-owned enterprise ("WFOE") in the PRC.  The domestic company usually is the one which owns licenses or approvals for the business.  However, due to restrictions on foreign investment, the WFOE cannot obtain licenses or approvals from the PRC authorities to operate in the desired industry.  Through a set of contractual arrangements among the WFOE, PRC individuals (usually PRC individuals are the companies' founders) and the domestic company, the WFOE may be able to actually control the domestic company as if it directly owned the equity interests in such domestic company.  Thus SPV1 may consolidate the financials of the domestic company into the group's overall financial statements, which is permitted and accepted by the US General Accepted Accounting Principles.

In practice, the contractual arrangements include:

(i) the Consulting and Service Agreement entered into by and between the WFOE and the domestic company, which provides that the WFOE shall provide certain services (for example, the consulting or strategic services and technical services) to the domestic company for a fee, typically determined by the WFOE with the intended result of shifting the domestic company’s profits to the WFOE;

(ii) the Asset License Agreement entered into by and between the WFOE and the domestic company, under which the WFOE licenses certain assets including intellectual properties to the WFOE for royalty fees;

(iii) the Voting Rights Agreement or Proxy entered into by and among the WFOE, PRC individuals and the domestic company, in which the domestic company’s shareholder--PRC individuals authorize the WFOE to exercise their shareholders rights in the domestic company, including voting rights, inspection/information rights, signing rights and election rights, etc.;

(iv) the Call Option Agreement entered into by and among the WFOE, PRC individuals and the domestic company, in which PRC individuals grant the WFOE an option to purchase all or a portion of their equity interests in the domestic company at a lowest possible price permitted by PRC law;

(v) the Equity Pledge Agreement entered into by and among the WFOE, PRC individuals and the domestic company, through which the PRC individuals pledge their equity interests in the domestic company to the WFOE as a guarantee of the performance of their and the domestic company’s obligations under other agreements among the three (3) parties in the VIE structure; and

(vi) the Loan Agreement entered into by and between the WFOE and PRC individuals, in which the WFOE extends a loan to PRC individuals to use for capitalization of the domestic company.

The cash flow goes like this:  SPV1 will fund the SPV2.  SPV2 will make a capital contribution to the WFOE.  The WFOE will extend a loan to the PRC individuals, who will in turn establish and finance the PRC domestic company.  When the PRC domestic company makes a profit, it will distribute a dividend to the PRC individuals.  The PRC individuals will make a repayment of the loan to the WFOE.  The WFOE will use the proceeds of the loan together with other funds to be discussed below to make a dividend distribution offshore to SPV2, which will in turn make a dividend distribution to SPV1.  In addition, through the contractual arrangements between the WFOE and the PRC domestic company, the domestic company will also make certain payments to the WFOE for provision of services.  This payment will be part of the dividend to be distributed by the WFOE offshore, thus completing the chain of cash flow.

At the beginning, the VIE structure was used primarily for asset-light companies, such as internet companies, advertising companies, software companies, education companies and media companies, etc.  However, after several years’ development, the asset-heavy companies also began to choose VIE structures for their financing or offshore listing and the typical example was China Qinfa Group Limited.  Recently, the VIE structure has been increasingly used by asset-heavy companies.

2  Risks

During the last decade, with various investors' efforts, the VIE structure has become more and more familiar to foreign investors, Chinese companies and the PRC authorities, and has been widely used in foreign investments in China, especially in the restricted or prohibited industries to foreign investors.  However, for foreign investors, the potential risks existing in the VIE structure and uncertainties in respect of government policies are just like the Sword of Damocles over their heads.  We will analyze the risks associated with the VIE structure in the following section.

2.1 Risks associated with the VIE structure

From series of contractual arrangements elaborately designed by investors, companies and other market participants, it is not hard to find that the VIE structure is crafted to remove any risk of the WFOE losing control of the domestic company or its assets.  Due to the reluctance of the parties from disclosing the entire structure of the transaction, the enforcement of such contractual arrangements is likely to be difficult in China.  Moreover, even if the contractual arrangements are finally enforced under PRC law, the damages to the company will be significant for the investors.  After all, to some extent, the contractual arrangements cannot be compared with the direct ownership of the domestic company through equity investment.

For instance, if all parties to the contractual arrangements perform their obligations, everything is fine.  However, if, for example, the PRC individuals or the domestic company decide not to perform their obligations under the contracts, the WFOE may have a difficult time to maintain control over the PRC domestic company.  Consequently, we have known some limited but significant cases in which the offshore holding companies lost control over the domestic companies.  The result is typically difficult, expensive and time-consuming dispute resolution process, which may lead to some kind of settlement or, alternatively, the foreign investor giving up on the PRC domestic company and their presence in China.

Most of time, we only notice there have been more than one hundred Chinese companies which successfully achieved listing overseas.  On the other hand, we tend to pay little attention to such failed cases in which the domestic foreign investors even lost control over the domestic companies.  However, in any case, the potential risk still exists for each market participant and is worthy of consideration by foreign investors at the stage of designing the transaction structure.

In the listing process of Sina, when one Sina's founder was removed from Sina, the VIE structure was affected by such change of senior officers or shareholders of domestic companies.  Although the adverse effect was successfully eliminated and the VIE structure was retained at last, the instability from the structure is still a high profile case in the VIE's history.  Another case is Agria Corporation, a Chinese seed producer which completed its IPO on NASDAQ in 2007, and which also faced the risk of losing control of the domestic company and such risk was eventually settled through compensation in equity and cash to the founder of domestic company (he was also the former director and the legal representative of the domestic company) who claimed the ownership of the offshore parent company.

Sina and Agria Corporation both faced the risk of losing VIE structure, but fortunately, after hard negotiation, such risk was successfully removed and the VIE structure was retained eventually.  Certainly, there are also not so exciting examples for foreign investors.  One is GigaMedia and the other is Alipay.

GigaMedia is a listed company on NASDAQ, which owns online games business in China through the VIE structure.  In 2010, GigaMedia announced it was involved in the dispute with its former founder of the domestic company, who was removed from the domestic company but refused to return the company seal, financial chops and other documentation to GigaMedia.  As a result, such former founder in fact still controls the domestic company.  Even though there are a set of contractual arrangements, GigaMedia has no choice except to bring a series of legal actions against such former founder inside and outside of China.  Furthermore, even though GigaMedia may regain the ownership and control of the domestic company, it is undeniable that such event will bring adverse effect on its business in China and its actual control of such domestic company.  Additionally, GigaMedia has already had to announce that it would deconsolidate the financials of domestic company subject to the resolution of such dispute.

Alipay is another classic case which may be repeated by foreign investors and other market participants over and over again.  The VIE structure was set up between Alibaba Group and Alipay.  Alibaba Group's shareholders were Yahoo, Softbank, Jack Ma and other PRC individuals.  In 2011, Jack Ma, the founder of Alipay successfully severed such VIE structure between Alibaba Group and Alipay, and committed to make certain compensation to Yahoo and Softbank in the future.  From the announcement by Jack Ma, the reason of unwinding the VIE structure was to obtain the Payment Business License from the PRC authorities, because only those domestic companies which had the qualifications could apply for the Payment Business License and the VIE structure would not be accepted by the PRC authorities.  Alipay eventually set off a big bomb in the Chinese private equity market.  As a result, many investors began to re-examine the VIE structure.

From the above cases, it is not difficult to find that the VIE structure is not as stable as some have imagined, to say the least.  The founder, senior management or shareholder of the domestic company play a very important role in the VIE structure.  Once there are changes to such positions involving interests, potential risks of the VIE structure will appear.  The VIE structure helped over one hundred Chinese companies complete the offshore listings, but we should never forget such potential risks when we discuss the successful cases.

2.2 Risks from governmental policies

Why did Chinese companies, foreign investors and other market participants create the VIE structure?  They were not unaware of the potential risks of the VIE structure, but they still adopted it, because they had no other choices when faced with the restrictions on foreign investment in China.  In fact, most companies using the VIE structure have attracted foreign financings, but at the same time most of them face restrictions on foreign investment.  After obtaining supports from foreign funds or other foreign investors, Chinese internet companies got rapid and great development and some internet giants such as Baidu, Alibaba and Tencent, etc., have grown up in the last decade.  Of course, in those cases, Chinese companies avoided the restrictions on foreign investment and all relevant the PRC authorities' approvals by using the VIE structures.

Sina might have chosen to use the VIE structure in 2000, to some extent, because it obtained the tacit consent from the PRC authorities.  Over past years, the PRC authorities never formally confirmed the validity of the VIE structure under PRC law.  As a general rule, the PRC authorities typically do not like the idea of foreign investors using indirect ways to get around legal restrictions on foreign investment in the first place; however, in order to attract foreign investment in technology focused industries such as telecommunications and internet, the PRC authorities have tended to acquiesce the usage of the VIE structure in China.  That is beginning to change, because while the PRC authorities still welcome foreign investment, they have begun to be more concerned about "hot" money flowing into China through less than above-board means.  As a result, the scale has tipped from welcoming foreign investment to higher scrutiny of the legality of the transaction structure.  With prevalence of the VIE structures, some subsequent regulations or cases imply or reveal the PRC authorities' attitude which is not so positive at least at present.

(a) Circular  

The Circular on Strengthening the Administration of Foreign Investment in Value-added Telecommunications Services ("Circular") promulgated by the Ministry of Industry and Information Technology ("MIIT") on 13 July 2006 was the first attempt to explicitly circumscribe the use of the VIE structure.  In the Circular, it is provided that a telecommunications enterprise within the territory of China may not lease, shift or sell any license for telecommunications business in any form, or provide resources, places and facilities or any other conditions for any foreign investor to engage in any illegal telecommunications operation by any means within the territory of China.  Meanwhile, certain key assets including trademarks, domain names and servers shall be held by the value-added telecommunications service provider or its shareholder which holds the value-added telecommunication service license.  This Circular states that the PRC authorities do not welcome the VIE structure in the value-added telecommunications service area.  This Circular also requires that the telecommunications enterprise which plans to list oversea shall first get the approval from MIIT.

(b) Online Games Notice

The Notice on Further Strengthening of the Administration of Pre-examination and Approval of Online Games and the Examination and Approval of Imported Online Games  ("Online Games Notice") promulgated on 28 September 2009, provides that foreign investors are not permitted to invest in online games operating businesses in China via the WFOE, equity joint venture, or contractual joint venture, and it also expressly prohibits foreign investors from gaining control over or participating in domestic online games operators by indirect means, such as setting up other joint ventures, signing relevant agreements or providing technical supports.  We are not aware of whether any listed companies utilizing the VIE structure were penalized or required to take apart the VIE structure.

From the regulatory perspective, the Circular and Online Games Notice are both only regulations other than laws; however, such regulations at least send a signal on use of the VIE structure.  Meanwhile, most experts on VIE still believe that the PRC authorities are unlikely to prohibit all VIE structures.

(c) National Security Review

On 3 February 2011, the State Council released the Notice on Establishing National Security Review Mechanism for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors ("Notice").  To specify the implementation procedures of the national security review, later, on 4 March 2011, the Ministry of Commerce ("MOFCOM") promulgated the Interim Rules on Issues Related to the Implementation of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors ( "Interim Rules"), which is replaced by the Rules on the Implementation of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors ( "Rules") on 1 September 2011.

Article 9 of the Rules re-attracts concerns from the public, which provides that with respect to merger and acquisition ("M&A") of the domestic enterprise by foreign investors, whether the M&A transaction falls within the scope of national security review shall be judged from the substantive contents and actual influences of the transaction; and foreign investors shall not avoid national security review through any means, including without limitation commissioned shareholdings, trusts, multi-level investments, leases, loans, contractual control, overseas transactions, etc.

The "contractual control" mentioned in the Rules obviously refers to the VIE structure.  However, after reviewing the Notice and Rules, we may find that not all M&A deals will be subject to a national security review.  The national security review process will apply only if the target domestic enterprise is involved in a business that concerns either national defense security issues ("National Defense Security Businesses") or national economic security issues ("National Economic Security Businesses").  National Defense Security Businesses include military industry enterprises and supporting enterprises, enterprises adjacent to major and sensitive military facilities, and other entities relevant to the national security of China.  National Economic Security Businesses include enterprises involving major agricultural products, major natural resources and energy industries, important infrastructure projects, transportation services, key technologies, as well as major equipments that are related to national security.  It is worth noting that in relation to M&A deals involving National Economic Security Businesses, a national security review process may only be triggered if the foreign investor intends to acquire actual control of the target domestic company.

In addition, the M&A in the Notice refers to the following circumstances:

(i) Foreign investors purchase equity interests of domestic non-foreign invested enterprises or subscribe for capital increase of domestic non-foreign invested enterprises, which convert such domestic enterprises into foreign invested enterprises.

(ii) Foreign investors purchase equity interests of domestic foreign invested enterprises owned by Chinese shareholders, or subscribe for capital increase of domestic foreign invested enterprises.

(iii) Foreign investors establish foreign invested enterprises and purchase assets of domestic enterprises via agreements by such foreign invested enterprises and then operate these assets, or purchase equity interests of domestic enterprises by such foreign invested enterprises; and

(iv) Foreign investors directly purchase assets of domestic enterprises and establish foreign invested enterprises through such assets to operate such assets.

Combining the Notice and Rules, we may conclude that the VIE structure has attracted increased attention from the PRC authorities, and such regulations only indicate that the PRC authorities have the intention to restrict the use of the VIE structure in certain industries.  From existing PRC laws and regulations, it is hard to get a conclusion that the VIE structure will be prohibited in all areas.

It is also worth considering whether the existing VIE structures before promulgation of the Rules will be unwound or will face penalty.  Since there are no more supporting materials from practical cases, at least until now, we are not aware of any companies with existing VIE structure facing risks of penalty or risk of unwinding the VIE structure.  However, based on our experience, it is likely that previously established VIE structures may be left untouched.  In addition, investment into such pre-existing VIE structures on an offshore level might not attract the attention or objection from the PRC authorities.  However, foreign investors should examine all facts and review all relevant laws and regulations before making a decision to create a new VIE structure in certain industries on a case by case basis.

(d) Practice

The promulgation of the Provisions for the Acquisition of Domestic Enterprises by Foreign Investors ("M&A Rules") on 8 August 2006 by six (6) PRC departments, provides that the domestic companies, enterprises or natural persons shall, when they merger and acquire related domestic companies through companies legally established or controlled by them in foreign countries, report to MOFCOM for approval and the persons concerned may not evade the above requirements by re-investment of the foreign-invested enterprises or by other means.  The M&A Rules leaves a road for related M&A, i.e. to obtain the approval from MOFCOM.  However, during the five (5) years after the promulgation of the M&A Rules, there is no case where the approval was successfully obtained.

It is clear that since the issuance of the M&A Rules, more and more Chinese companies have adopted the VIE structure.  In the early stage, the VIE structure was almost only used on the asset-light companies.  However, after 2006, those asset-heavy companies also chose to utilize the VIE structure.  It is believed that one of the reasons for the increasing use of the VIE structure is that the VIE structure may avoid obtaining the approval from MOFCOM.  In fact, it is unimaginable and unreasonable that such asset-heavy companies may move enormous assets out of China only by several agreements without any governmental approval or other legal procedures.  The PRC authorities may also be on the alert for the abuse of VIE structure in asset-heavy industries.  There are some cases which adopted the VIE structure in the asset-heavy industries and successfully listed overseas, but unfortunately we also understand there are cases which have been rejected at IPO just for using the VIE structure in the asset-heavy industries.

In early 2011, Buddha Steel withdrew its IPO in USA, citing that the company was advised by local governmental authorities in Hebei Province that its VIE structure contravened the current Chinese management policies related to foreign-invested enterprises.  On the one hand, this case might simply reflect the local government's attitude towards specific companies or industries, not towards the VIE structure itself.  On the other hand, it reveals that different local governments may hold different views regarding the VIE structure.

Above all, no matter from the legislation perspective or on a practical level, it is clear that the VIE structure faces the risks of uncertainty on policies from the PRC authorities.

3  Conclusion

In summary, the VIE structure has brought the prosperity to the Chinese internet market, and the VIE structure also had potential risks due to governmental polices in the past ten years or so since its appearance.

With respect to the risks from the structure, from the above analysis we may find that the certain persons in the domestic companies usually play a critical role in the VIE structure, and we all understand it is very important for the WFOE or offshore companies to avoid the risks from such persons.  To better maintain the stability of the VIE structure, the following options may be adopted:

(i) Diversify the shareholding of the domestic company.  If no shareholder alone or in conjunction with other shareholders, over whom he/she may bring influences, may control the domestic company, at least, it may help to reduce the risk of losing control of the domestic company.  The perfect arrangement would be that each shareholder alone or in conjunction with other related shareholders holds less than 33% equity interests of the domestic company.

(ii) Carefully appoint the directors and the legal representative of the domestic company.  In the GigaMedia case, the former legal representative refused to return the chops and documentations of the domestic company.  In order to avoid such similar events from occurring again, when appointing directors and the legal representative, the WFOE or offshore companies should carefully consider the proper persons who will represent the interests of the WFOE or offshore companies.

(iii) Balance the interests between the persons controlling the domestic companies and those representing the offshore companies.  Once the persons who control the domestic companies may get reasonable or greater returns from the offshore companies, the risk on severing the VIE structure by them will be reduced accordingly.

In respect of the risks from governmental polices, before establishing the VIE structure, the companies should ensure that the VIE structures are in compliance with PRC law and may be enforceable in the future.  Considering the limited cases on national security review or other polices in practice, we would suggest that the companies should communicate with the PRC authorities first, obtain professional advice on a case by case basis, and then make a decision whether to utilize the VIE structure or how to use it properly.

对于国内企业而言，尤其是固定资产规模较小限制类（例如网络和电信企业）外商投资企业，VIE结构被广泛用于海外上市和海外融资。一些有大量固定资产的公司也开始采用VIE结构实现海外上市。与此同时，一些海外壳公司也开始使用VIE结构以规避《关于外国投资者并购境内企业的规定》（2009年修订） 所要求的审批手续。

从政府监管的角度来看，尽管在中国没有明令禁止VIE结构，但也没有明确支持该结构。因此，VIE结构一直以来都是中国法律监管的“灰色”地带。尽管VIE结构使得境内外投资者避开了中国政府的监管，但这也同时意味着VIE结构没有得到中国政府的支持，因而VIE结构具有一些天生的弊端和潜在的法律及监管风险。

一、 近期阿里巴巴案件

如上所述，尽管广泛被应用，但VIE结构有一些天生的弊端和潜在风险，包括：（a） 根据VIE的安排，最终受益人获得的保护远不如通过直接持有运营公司的股份而获得的保护；（b） 运营公司的法律上登记的股东和实际受益人可能产生潜在的利益冲突；且（c） 如果产生争议，在执行控股公司和运营公司之间签订的协议安排时，存在不确定性。

最近发生的阿里巴巴事件（阿里巴巴2007年在香港联交所成功上市，是一家广受欢迎的网上商城）就是一个凸现VIE结构潜在风险的好例子。阿里巴巴事件预示着未来政府介入VIE结构的可能性。

阿里巴巴的结构是一个典型的VIE安排：浙江阿里巴巴乃是一个马云控制的私人公司，其实际上担任运营公司的角色，并由阿里巴巴集团通过VIE安排所控制。该安排一直相安无事，直到马云未经阿里巴巴集团控股股东（即雅虎和软银赛富）同意，便单方面决定完成支付宝70%的股权从阿里巴巴集团向浙江阿里巴巴的转让。马云的理由是如果支付宝由外国投资者持有，则其无法从中国人民银行获得必要的运营许可。

支付宝事件引起了社会对VIE结构的广泛讨论。而随之而来的广泛报道则是中国证监会向国务院提交一个内部报告（“报告”），该报告要求中国政府打压VIE这个被广泛使用但又饱受争议的结构。这使得投资者更加担心VIE结构的前景，并对今后使用VIE结构的可行性表示质疑。

二、 报告对VIE结构未来的影响

如上文所述，一直以来对VIE结构的合法性就存在极大的争议，主要因为VIE结构 （a）绕开了对外商投资的产业限制，使外国投资者可以投资于国家限制或禁止外商投资的领域；（b）其规避了商务部根据《关于外国投资者并购境内企业的规定》所要求审批的流程，尤其是针对境外壳公司进行返程投资（即中国公民通过境外的壳公司收购其境内的资产）的审批程序；及（c）在某些情况下可能构成转移定价并有逃税嫌疑。

该泄漏的报告对VIE结构的合法性进行了论述，同时分析了中国互联网公司通过VIE结构进行海外上市的现状。更加重要的是，其建议未来通过VIE结构进行海外上市必须首先通过商务部和中国证监会的同意。由于没有得到官方确认，更没有进一步的规定，该篇泄漏的报告给国内外投资者带来了极大恐慌。
尽管有上述报告，但是根据上海证券报最近的报道，上述报告乃是中国证监会内部研究部门的一篇报告，仅为内部学习交流之用。因此，这不是一个提交国务院的正式报告，因此其实际的可执行性目前尚不明朗。

尽管如此，投资者应当注意：由于通过VIE结构规避中国政府监管进行海外上市已经逐渐从传统的轻质资产领域向重资产领域演变（例如铁路和矿产领域），因此中国政府监管VIE结构的动机变得愈发强烈。尽管我们预计短期内政府不会对VIE结构采取严厉措施，但长远来说，这是一个中国政府极有可能会处理的问题。

三、 国家安全审查对VIE结构的潜在影响

尽管目前没有任何法律、法规直接监管VIE结构，但如果目的是规避中国政府的安全审查，则最近中国政府建立的国家安全审查制度可能会阻止该类外资并购境内企业的交易。如同许多其他国家的类似制度一样，如果外资并购涉及一些可能影响中国国家安全的关键领域（如军事、核心技术和农产品等），则国家安全审查制度已赋予政府相应权力，来审查及批准此类拟进行的外资并购。尽管如此，由于新实行的国家安全审查法律规定比较宽泛、且在实践中自由裁量的空间很大，外国投资通过VIE结构投资关键产业是否会被认为是一项并购交易因而被要求进行国家安全审查尚不明朗。
国家安全审查制度可能成为商务部否决使用VIE结构的一个途径。然而，由于目前实践中尚没有先例，目前尚不确定中国政府是否会将国家安全审查制度作为一种手段，对通过VIE结构进行的外商投资行为进行监管。

（本文原文为英文，中文为译文。）

1. Scope of Offshore RMB

The Offshore RMB mainly includes (1) RMB legally acquired by foreign investors through settlement of international trade; (2) RMB remitted outbound which acquired through  profit distribution, equity transfer, reduction of registered capital, liquidation or early return of investment in mainland China and (3) RMB legally acquired or raised through issuing RMB bonds or stocks outbound and other legal channels.

2. The Industries the Offshore RMB Can Be Invested in

The Circular provides that Offshore RMB investment shall comply with foreign direct investment rules in China, and it also provides some exceptions for Outbound RMB investment, such as the securities or financial derivatives in mainland China. In addition, the Outbound RMB can not be invested in entrustment (inter-company) loans.

3. Investment Approval Procedure

Generally, the approval authorities are unchanged. The commerce departments at all levels are responsible for examination and approval of offshore RMB direct investment review. The provincial authorities must submit with MOFCOM for review before approving of investment under the circumstances that: (1)investment amounts to RMB300 million Yuan or above or investment  in financing guarantees; (2) investment in foreign invested investment companies ; and (3) investment in sectors that are subject to macro-economic control of the State, such as sectors as cement, steel and iron. MOFCOM will gradually simplify the procedures concerned based on the practice of cross-border RMB direct investment.

It can be inferred that Offshore RMB can be used to invest in a foreign invested investment company (e.g. a PE firm) in China.  However, in addition to the usual approval procedures for all foreign investments, it is also subject to MOFCOM approval (as described above). The prolonged approval procedure may cause more uncertainties.

1. 境外人民币的范围

境外人民币主要包括：（1）通过跨境贸易人民币结算取得的人民币；（2）汇出境外的人民币利润和转股、减资、清算、先行回收投资所得人民币；（3）在境外通过发行人民币债券、人民币股票以及其他合法渠道取得的人民币。

2. 境外人民币投资流向

《通知》规定境外人民币直接投资应符合现行外商投资管理体制，并且规定了一些禁止投资的行业，例如跨境人民币直接投资在中国境内不得直接或间接用于投资有价证券和金融衍生品，以及用于委托贷款。

3. 境外人民币投资许可

《通知》总体上没有改变现有外商直接投资的审批权限，由各级商务主管部门按照现行外商投资审批管理规定审批跨境人民币直接投资。对于（1）3亿及3亿以上投资项目以及融资担保；（2）外商投资性公司；（3）宏观调控行业等项目，省级商务主管部门需报商务部审核同意后予以批准，商务部将根据跨境人民币直接投资的实践情况逐步简化有关程序。
从上面可以看出，境外人民币可以投向外商投资的投资性公司或私募公司，但除了通常的外商投资审批程序，投资还要经商务部进行批准，这无疑对投资过程造成更多不确定性。

In essence a VIE structure refers to a structure whereby an entity established in China which is fully or partially foreign owned ("Controlling Company") has control over an operating company ("Operation Company") which holds the necessary license(s) to operate in a FDI restricted/prohibited sector. As such sector is restricted/prohibited by the PRC authorities, the foreign investors are not able to directly invest in such Operation Company. Accordingly, the foreign investors adopt various contractual arrangements between the Controlling Company and the Operation Company in order to obtain de facto control over the operation and management of the Operation Company. The profits of such Operation Company would also flow back to the Controlling Company and then ultimately be consolidated by the foreign investors.

For domestic companies, especially companies in the restrictive industries without much physical assets (such as internet or telecommunication), the VIE structure was widely used to enable them to obtain financing from overseas market through overseas listings. Gradually, companies from heavy industries also started to adopt the VIE structure to list overseas and the overseas shell company started adopting such VIE structure to circumvent the approval requirement stipulated by relevant PRC M&A Rules[1].

From the government's perspective, although there is no clear prohibition against the VIE structure in China there has also been clearly no express endorsement of the VIE structure either. Accordingly, the VIE structure has always been a grey area in the Chinese legal system.  Although the VIE structure allows both the domestic and foreign investors to circumvent government reviews and regulation, this also means that the VIE structure does not have the backing of the authority and therefore the VIE structure possesses inherent defects and potential legal and regulatory risks.

Recent Alibaba case

Despite its popularity there are inherent defects and risks for the VIE structure involving: (a) the level of protection enjoyed by the beneficial owners from VIE arrangement is far lower than a direct equity holding in the Operating Company; (b) the potential conflict of interests between the legal shareholders of the Operating Company and the beneficial owners; and (c) the level of uncertainty in the enforceability of the VIE contractual arrangements between the Controlling Company and the Operating Company in the event of a dispute.

The recent case of Alibaba, a wildly popular shopping website which had a successful IPO on the Hong Kong stock exchange in 2007, is a good example illustrating the potential risks of VIE structure and that illustrates reason for possible government intervention in the future.
 

Alibaba's structure is a typical VIE arrangement: Zhejiang Alibaba, a private company held by Ma Yun and acting as an operating company, was in fact controlled by Alibaba Group Holding through a VIE arrangement. No problem arose until Ma Yun decided to complete a 70% equity transfer of Alipay from Alibaba Group Holding to Zhejiang Alibaba allegedly without majority shareholders' approval on the part of the Alibaba Group (i.e. Yahoo and Softbank). The argument from Ma Yun was that Alipay would be unable to acquire the necessary operational license from the People' Bank of China if it was held by foreign investors.

The Alibaba matter shone a spotlight on VIE arrangements and it has been widely reported that CSRC[2], China's securities regulator, submitted an internal report to the State Council asking the government to clamp down on this controversial yet popular corporate structure. This has resulted in even greater concerns on the part of investors and cast doubts as to the feasibility of the VIE structure going forward.

The Implication of the Report on the future of VIE structure

There have always been great controversy regarding the legality of the VIE structure, mainly because (a) it circumvents the restrictions on foreign investors making it possible for them to invest in restricted/prohibited industries in PRC; (a) it circumvents approval requirements by Ministry of Commerce ("MOFCOM") in accordance with the M&A Rules, especially by offshore shell company making round trip investments (i.e. where PRC owned businesses and assets are owned by an offshore entity owned by the PRC owners); and (c) it may constitute price transferring and consequently result in tax evasion in some cases.

The leaked report supposedly analyses the legality of the VIE structure as well as the current status of PRC internet companies listed overseas by using VIE structure and more importantly, it recommends future overseas listings using a VIE structure should first obtain MOFCOM and CSRC approval. The leaked Report, is causing gave concerns for foreign and domestic investors alike as nothing has been officially confirmed much less what requirements will be introduced.

Notwithstanding the above, it was recently reported by the Shanghai Securities News that the Report, which was allegedly drafted by a research department of CSRC, was created solely for internal study and communication. Therefore, it is not an official report submitted to the State Council and therefore the actual implementation, if any, is unclear.

However, the investors should note that since the overseas listing of domestic companies by way of VIE structure has gradually been extended from the traditional light industries to heavy industries involving material assets (such as railways, minerals) and therefore also avoiding PRC government supervision, the motivation for the PRC government to regulate the VIE structure has become greater. Although we expect the government will not launch a severe clamp down upon the VIE structure in the short run, it is an issue very likely to be tackled by the government at some time in the future.

Potential effect from NSR system on the VIE structure

Even though currently there are no laws or regulations directly regulating the VIE structure, a newly established National Security Review ("NSR") system by the Chinese government may prevent foreign acquisitions of domestic companies if the purpose is to evade the governmental security review. This system, similar to those in many other countries, bestows upon the government the authority to review and approve a proposed foreign M&A transaction if it involves one of several key sectors (i.e. military, key technology and agricultural products) that have a bearing on China's national security. However, since these newly enacted security review regulations are broad and highly discretionary in practice, whether a foreign investment which uses a VIE structure in a key industry will be constituted as a M&A transaction and consequently be required to go through NSR procedure is unclear.

The NSR review may be a means by which MOFCOM may strike down transactions using the VIE structure. However, as currently no precedent case has occurred it is still uncertain whether the NSR system would be used by the government as a step to bring foreign investments using VIE structure under their supervision

(This article was first published on XBMA.com)

Notes:

[1] Rules on the Merger and Acquisition of Domestic Enterprises by Foreign Investors, revised in 2009.
[2] China Securities Regulatory Commission.

A.  Establishment of an FIE and acquisition of PRC companies by using RMB

MOFCOM takes the role as the regulatory authority to approve RMB FDI transactions, including greenfield FIE project, capital increase or acquisition of PRC companies.  The local counterparts are authorized to approve such transactions with the following exceptions which require the preliminary approval by the provincial counterpart of MOFCOM and final blessing of the head office of MOFCOM: (i) the capital contribution is more than RMB 300m; (ii) the transactions involving investment in guarantee companies, finance lease companies, micro-finance companies and auction houses; (iii) the transactions involving investment in foreign-invested holding companies, venture capital or equity investment enterprises; or (iv) the transactions involving investment in iron & steel, electrolytic aluminum, shipbuilding and other policy sensitive sectors.

B.  PBOC's approaches to regulate the RMB FDI transactions

RMB Registration: PBOC requires FIEs (newly-established or PRC companies acquired by foreign investors) to conduct a registration with the local branch of PBOC after the completion of the relevant RMB FDI transaction.

Account Control: PBOC sets out the RMB accounts that foreign investors, FIEs and PRC parties selling stake in their companies to foreign investors should open for different types of transactions.  The account control system is quite similar to that adopted by SAFE.  For example, a foreign investor is free to open a RMB Expense Account (人民币前期费用专用存款账户) to reimburse some expenses before the establishment of an FIE and the balance in such an account can be transferred to the RMB Capital Account (人民币资本金专用存款账户) of the FIE when it is established.  If a foreign investor intends to use its RMB proceeds from distribution (dividends or otherwise) by its existing FIE subsidiaries, the foreign investor may open a RMB Re-investment Account (人民币再投资专用账户) to pool the RMB proceeds.  Considering its nature being a non-resident account, the SAFE's approval for RMB re-investment may not be required anymore.  The PBOC Rules also allow the PRC parties selling stake in their companies to foreign investors to open RMB accounts and receive the purchase price in RMB.  This will help resolve the situation where PRC sellers had to open a foreign currency account to receive the purchase price in foreign currency under SAFE Circular No. 142 if they want to sell their companies to foreign investors.

C.  Usage of RMB Capital

PBOC Rules provide that all RMB proceeds should be used for any legitimate purpose but keep silent on the specifics.  The MOFCOM Circular clarifies that such proceeds may not be used towards investment in securities, financial derivatives or entrustment loans.

D.   Entities will benefit from the new rules

The PBOC Rules and MOFCOM Circular clarify that foreign investment in real estate sector may be denominated in RMB although RMB foreign debt remains unavailable to FIEs in this sector.  We anticipate that this would incentivize the developers to money via issuing CNH bonds.

It is worth noting that foreign-invested partnership enterprises ("FIP") are also allowed to receive RMB capital contribution from foreign investors and in turn use RMB to invest in portfolio companies.  This new scheme to some extent may cool down the appetite of foreign investors to set up RMB funds using the pilot QLFP scheme in Pudong, Shanghai, whose primary objective is to help convert the foreign currency capital injected by foreign limited partnersinto RMB for the purpose of portfolio investment.

E.   RMB-denominated shareholder loan and foreign debt

The PBOC Rules clarify that an FIE can borrow foreign RMB debt from its parent, offshore affiliate and offshore financial institutions so long as it has sufficient foreign debt quota.  PBOC special approval for RMB shareholder loan which is required by PROC Circular No. 145 is no longer necessary.  We understand that MOFCOM will not approve the specific foreign debt transaction and instead it will only state in its approval whether RMB foreign debt can be used to solve the funding issue of the FIE when approving the relevant RMB FDI transactions.  The PBOC Rules do not release the FIE's obligation to follow SAFE’s existing rules to complete the foreign debt registration.

F.    Repatriation

Based on the PBOC Rules and MOFCOM Circular, we tend to view FIEs may pay dividend/liquidation proceeds to its foreign parent in RMB regardless the capital contribution is made in RMB or not.  This may not be applicable to RMB shareholder loan or foreign debt as the flexibilities of such transactions would provide too much room to arbitrage the appreciation of RMB exchange rate.

Contacts
For further information on the matters covered in this newsletter, please contact:

BEIJING OFFICE

Wang Ling
King & Wood
40th Floor Office Tower A, Beijing Fortune Plaza
7 Dongsanhuan Zhonglu
Chaoyang District Beijing 100020
China
Tel: +86 10 5878 5016
Fax: +86 10 5878 5599
Email: wangling@kingandwood.com

SHANGHAI OFFICE

Roy Zhang / Zhong Xin
King & Wood
16-18/F, One ICC, Shanghai ICC,
999 Huai Hai Road (M),
Shanghai, 200031,
China
Tel: +86 21 2412 6053 / 6055
Fax: +86 21 2412 6350
Email: roy.zhang@kingandwood.com
            zhongxin@kingandwood.com

一、以人民币设立外商投资企业和并购中国企业

商务部在批准人民币外商直接投资交易中扮演审批机关的角色, 包括新设外商投资企业项目、增资或并购中国企业。 地方商务主管部门被授权批准上述交易, 但属于下列情形的需经省级商务主管部门初步批准后报商务部审核: (i) 出资金额达3亿或3亿人民币以上; (ii) 交易涉及投资于融资担保公司、融资租赁公司、小额信贷公司和拍卖行; (iii) 交易涉及投资于外商投资性公司、外商投资创业投资或股权投资企业; 或(iv) 交易涉及投资于钢铁、电解铝、造船等政策敏感行业。

二、人民银行监管人民币外商直接投资交易的方式

登记: 人民银行要求外商投资企业(新设或并购中国企业设立的)在完成相关人民币直接投资交易后, 向人民银行地方分支机构办理登记。

账户监管: 人民银行规定, 外国投资者、外商投资企业和中方股东向外国投资者出售其股权时, 应开设不同类型的交易账户。该账户监管系统与外管局所采用的十分类似。 例如, 外国投资者可以开立人民币前期费用专用存款账户用于支付外商投资企业设立之前产生的费用, 该账户的剩余资金可以转入外商投资企业的人民币资本金专用存款账户或原路退回。 如果外国投资者希望使用其从现有外商投资企业获得的人民币利润进行再投资, 外国投资者可以开立人民币再投资专用账户以归集该等人民币资金。由于该账户具有非居民账户的性质, 外管局的人民币利润再投资批准有可能不再需要。人行办法也允许向外国投资者出售股权的中方股东开立人民币账户以收取人民币股权转让对价款。这将有助于解决中方股东根据外管局142号文必须开立资产变现账户收取外汇转让对价款的问题。

三、人民币资本金的用途

人行办法中规定, 所有人民币资金均应当用于合法用途, 但并未作出更具体的规定。 商务部通知则明确指出, 该等资金不得用于投资证券、金融衍生品或委托贷款。

四、受益于新规的企业

尽管外资房地产企业仍不被允许借取人民币外债, 但根据人行办法和商务部通知, 境外人民币可投资于房地产行业。 我们预计, 该等规定将会鼓励开发商通过发行CNH债券募集境外人民币资金进行融资。

值得注意的是, 外商投资合伙企业("外资合伙")也可接受境外投资者的人民币出资。 外资合伙可将人民币用于对被投资公司的股权投资。上述新规在一定程度上可能会削弱境外投资者通过在上海浦东试行的合格外资有限合伙设立人民币基金(该机制下, 境外投资者投入的外币资本金可以结汇进行股权投资)的积极性。

五、人民币股东贷款及外债

根据人行办法, 只要外商投资企业拥有足够的外债额度, 其可从母公司、境外关联企业和境外金融机构借取人民币外债。 银发(2011)145号文项下规定的针对人民币外债的人行特批已不再需要。 我们理解, 商务部将不会对人民币外债进行个案审批, 而仅会审批在相关人民币直投交易时明确外商投资企业可否通过人民币外债解决其资金问题。人行办法并未免除外商投资企业根据外管局现有规定进行外债登记的义务。

六、对外汇出

根据我们对于人行办法和商务部通知的解读, 我们倾向于认为, 无论投资是以人民币进行还是外币进行, 外商投资企业均可向其境外母公司以人民币形式分配利润或支付清算资金。但鉴于该等交易的灵活性, 在人民币升值的大背景下, 较容易被用于套利, 前述观点未必适用于股东贷款或外债。

联系方式

如您需要任何进一步的信息，请联系：

北京
王玲
北京市朝阳区东三环中路7号
北京财富中心写字楼A座40层
100020
电话：+86 10 5878 5016
传真：+86 10 5878 5599
Email: wangling@kingandwood.com

上海
张宁/ 钟鑫
上海市淮海中路999号
上海环贸广场写字楼一期16-18层
200031
电话：+86 21 2412 6053 / 6055
传真：+86 21 2412 6350
Email: roy.zhang@kingandwood.com
             zhongxin@kingandwood.com

2. Pursuant to the Notice, MOFCOM will adopt a filing system for the establishment of new branches by FIEs. The Notice clarifies that establishment of a branch by a FIE does not require MOFCOM or local counterpart approval unless specific regulations state otherwise. This clarifies a previously unresolved issue in that MOFCOM local counterparts had varying practices in such regard from region to region (some local MOFCOM counterparts required approval for FIEs to set up a branch engaged trading). The Notice implies that if the FIE’s business scope relevant to a restricted area has been approved, then no additional approval from MOFCOM is required to set up a branch for the approved business. Furthermore, the Notice regulates that if a FIE intends to set up a branch abroad, then this should be approved by the provincial MOFCOM with the consent of the Chinese embassy’s commercial department in the country where such branch is to be located.

B. Ease of Approving Holding Companies

On March 6th 2009, MOFCOM also issued the Notice on Delegating the Approval Authority for Foreign Invested Holding Companies to streamline the establishment of foreign investment holding companies.

This notice provides:

1. Proposed holding companies with a registered capital of USD 100,000,000 or less will be examined and approved by the competent MOFCOM counterparts at the provincial or vice-provincial city level. Previously, the establishment of a holding company required MOFCOM level approval regardless of scale.

2. Any amendments to established holding companies (i.e. such as name change, revisions to business scope, normal changes to capital structure) can be approved by lower level MOFCOM counterparts except for cases where a single capital injection increases its value by over USD 100,000,000.

3. Despite the positive developments, MOFCOM also reinforces in the Notice that holding companies cannot invest in areas that are restricted or forbidden to foreign investment. Further, if required by relevant industry rules, investments by holding companies will still need approval from the industry authorities even if approved at the local MOFCOM level.

Summary
The devolution of approval competency for most projects will simplify and speed up the approval process for foreign investors as well as lower the work burden of MOFCOM. In addition, the new policy will make the operations of existing FIEs easier in that many will be able to now bypass central MOFCOM approval for operational actions such as capital increases.
Although, there is no apparent negative impact upon foreign investors in such notices it should be also noted that MOFCOM and other approvals still remain in place under specific circumstances. Foreign investors will need to carefully check which approvals at which level will be required in order to have a valid establishment.

[1] Vice-provincial cities, as an administrative division in China, are not treated as a province from an administrative perspective, but are distinct from a financial perspective.
[2] According to a notice issued by National Planning Commission (the predecessor of National Development and Reform Commission), central government reliant projects include the FIEs using state subsidies, FIEs investing in infrastructure, etc. But this notice was issued in 1999 based on the old Industry Category for Foreign Investment in 1997 which has been revised largely afterwards, thus may be out of date.