The erection of a red-chip structure generally involves the founding shareholder of a domestic company first establishing an offshore special purpose vehicle (SPV) in the British Virgin Islands or Cayman Islands, using the SPV to establish a wholly owned subsidiary in Hong Kong, then having the Hong Kong subsidiary establish a wholly foreign owned enterprise (WFOE) in mainland China, which executes various agreements with the domestic company for the control of domestic equity, and finally having the SPV, as the financing platform, sell preferred shares or convertible loans to a fund to carry out private financing and realise the overseas listing of the SPV.
Where a company abandons its overseas listing plan to list domestically instead, it is known as an “unlisted red chip return”. The clearest and most straightforward model of red-chip return is the complete dismantling of the red-chip structure. When carrying this out, it is necessary not only to pay attention to the method of buying back the equity of the other offshore investors in the entity that was to be listed offshore, but also to the issue of compliance in the buyback procedure, and of the buyback funds.
The basic method of dismantling a red-chip structure is to carry out the operations in reverse. If the actual controller is a domestic enterprise or natural person, it or he/she should proceed in a manner that is the reverse to that when the red-chip structure was erected, and repatriate the relevant equity to China. The usual dismantling procedure will see the domestic company establish a wholly owned subsidiary offshore – generally Hong Kong – to acquire all of the equity of the other offshore investors in the offshore company, thereby severing control of the offshore structure. Once the offshore red-chip structure has been eliminated, the offshore company correspondingly begins the deregistration work, and the deregistration of the WFOE established in China, as well as the negotiated control model, also need to be carried out and a series of termination agreements executed.
When dismantling a red-chip structure, the deregistration of the WFOE established in China or its conversion from a WFOE into a wholly Chinese-owned enterprise needs to be carried out, a process which involves corresponding back tax risks. Furthermore, part of the profit remaining after the dismantling will be returned to the domestic company, giving rise to the issue of how taxes are to be paid on such profit. In numerous instances, the pricing of the series of connected transactions under a red-chip structure will not have been at arm’s length, giving rise to the additional risk of tax adjustment by the tax authorities.
Source of offshore funds
Many companies that need to dismantle a red-chip structure will raise funds from domestic investment institutions – private equity (PE) – to pay the moneys for the buyback of the equity of the offshore enterprise. The PE investment models used can essentially be placed into the following three categories:
Domestic security for foreign loan investment model. Under this model, the PE can, through the opening of a joint account with the domestic company, maintain control over the investment moneys in such an account until the red-chip structure is dismantled, and thus minimise to the greatest extent possible the uncontrollability of being unable to recover the investment moneys. Additionally, until completion of the dismantling, no direct investment relationship is created between the PE provider and the domestic company. Accordingly, even if the dismantling of the red-chip structure fails, the PE provider can dissolve the security relationship with the domestic bank once the offshore company repays the offshore bank loan.
However, such factors as foreign regulators tightening oversight over domestically secured foreign loans, the relatively large number of parties involved in domestically secured foreign loans, and the uncertainty of the time required for approval by the domestic bank make control of the overall timing for the dismantling of a red-chip structure difficult.
Debt to equity investment model. Under this model, the legal relationship between the PE provider and the domestic company is relatively clear, namely it is a claim/debt relationship arising between them due to the loan, which endures until the domestic company dismantles the red-chip structure. Even if the dismantling of the red-chip structure fails, the PE provider may still demand repayment of the loan on the basis of the loan relationship. However, under the current regime of Chinese laws and regulations, there remain large risks in terms of the determination of the nature of the act of lending between enterprises. Additionally, in comparison with the direct capital increase method, there is more red tape involved when amending business registration where debt to equity is involved, and issues of income tax and deed tax also come into play.
Direct capital increase model. The PE provider directly increases the capital of the domestic company through executing a capital increase agreement with it. After making an injection, the PE provider will carry out the procedures for registration of the change in equity, followed by the domestic company completing the buyback of the equity of the offshore investors and dismantling the red-chip structure.
As compared to the first two capital increase models, the third one in which the PE provider directly becomes a shareholder of the domestic company through the execution of a capital increase agreement with it is relatively simpler and easier when it comes to the change of business registration formalities, the foreign exchange review for the increase of the capital of the offshore affiliates, etc.
However, the investment risks of the direct capital increase model are greater. Given that the investment amount required to buy back the offshore equity is generally quite large, and that the uncertainties involved in the dismantling of a red-chip structure and a domestic listing are relatively numerous, once the PE provider has made the direct investment and become a shareholder of the domestic company, it is unable to recover its investment through a direct divestment method.
However, it needs to be specially mentioned that although the actual controller of a company is a Chinese citizen or legal person, if sufficient evidence can be provided to show that the source of the funds is offshore funds, in certain cases they need not be accounted for.
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