Ten questions about ‘dismantling the red chips structure’

By Xu Jingke and Fan Jianhong, Dentons
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Due to the introduction of the registration system of the Star Market and Growth Enterprise Market (GEM), many startups that set up an overseas shareholding structure plan to change their listing destinations one after another. To carry out an A-share listing, a company might need to dismantle the overseas shareholding structure, that is, “dismantling red chips”. Should a company dismantle the structure or not? If so, how? What are the important issues to consider during the process? Here we provide a short list:

red chips 徐劲科Xu-Jingke-Dentons
Xu Jingke
Dentons
Senior Partner

To dismantle red chips or not? Red chips don’t have to be dismantled. If the corresponding conditions are met, overseas entities such as CR Micro and Ninebot can be directly listed on domestic markets. The Star Market and the GEM have listed a series of financial and non-financial indicator requirements for overseas red-chip enterprises to be listed directly in China, which can be carefully compared.

Is the red-chip structure a direct shareholding or a Variable Interest Entity (VIE)? According to overseas shareholding platforms controlling domestic operating entities, red chips can be divided into two types: “direct shareholding red chips” and the commonly known VIE structure. There are also great differences in the paths and considerations for dismantling the structure of different red-chip enterprises, which requires a prudent arrangement with practical considerations.

red chips
Fan Jianhong
Dentons
Partner

How to choose the future listed entity when dismantling the VIE structure? There are two domestic companies in the VIE red-chip structure, one is a whollyowned subsidiary of the overseas shareholding platform in China and the other is a domestic operating entity controlled through an agreement. When considering which entity is to be used as a listed entity, it is generally necessary to consider: (1) whether the industry of the company and its main business restrict or prohibit foreign investment; (2) whether the VIE agreement has been implemented into effect; (3) the relative volume of the VIE and wholly foreign-owned enterprise (WFOE), e.g. its asset distribution, business operation, financial indicators, business income; (4) change of control rights and management.

Has domestic resident or natural person gone through registration according to Document No.37? Have the formalities for overseas direct investment (ODI) of domestic resident enterprises been completed? Domestic residents who set up overseas shareholding companies need to go through the initial registration according to Document No.37 (the full name is “Notice of the State Administration of Foreign Exchange on Relevant Issues Concerning Foreign Exchange Control of Overseas Investment and Financing and Return Investment of Domestic Residents through Special Purpose Companies”). Similarly, if a domestic enterprise as a legal person holds shares in an overseas enterprise with a red-chip structure, then it needs to go through all the examination and approval/filing procedures (with the National Development and Reform Commission, and the Ministry of Commerce banks) required for overseas investment.

Will overseas investors come back? If the business of the entity to be listed in China falls within the negative list of foreign investment, the overseas investor cannot come back to directly hold shares, and must withdraw from the company first through a repurchase by the founder and transfer to other investors. Of course, the foreign investor can also arrange for its domestic parallel fund or its domestic related investors to hold shares in the entity to be listed, and go through the corresponding procedures of equity transfer or capital increase.

Tax issues? Companies to be listed need to meet tax compliance, which includes not only in the establishment of an overseas structure and previous changes, but also tax compliance in the process of dismantling a red-chip structure. In the process of dismantling red chips, the company should try to optimize the scheme, and reduce the tax burden and tax base loss of actual controllers and investors.

Fund planning issues? In the process of dismantling red chips, especially if the overseas investors have to or choose to withdraw, the actual controller may need to buy back the investors’ equity with funds, and the occupation of related funds between domestic and foreign companies may also need to be solved through fund flow. The existing funds of each company should be made good use of and new investors may need to be introduced or a bridge loan needs to be established to solve the funding problem.

Do the actual controllers, directors and officers of the companies to be listed meet the stability requirements? Domestic IPOs require that the actual controllers of companies to be listed have not changed in the past two or three years, no significant changes in directors and management in the past two years and the Star Market additionally requires that key technical personnel have not changed significantly in the past two or three years. In the process of dismantling red chips, it may involve the adjustment of the equity ratio and voting rights ratio of the entities to be listed, and the change of the board of directors, etc., so the company should try to avoid triggering the change of actual controllers and significant changes of directors, officers and key technical personnel.

The stability of the main business? The issuer can apply for listing only after operating the entity to be listed one fiscal year following restructuring. This applies if the total assets of the restructured parties under the same control, or their business income or total profit of the previous fiscal year reaches or exceeds 100% of the corresponding items of the domestic listed entities before restructuring. Therefore, in the process of selecting the listed entity when the VIE structure is dismantled and restructured before listing, it is necessary to consider comprehensively the timetable for listing, as well as the business nature and financial indicators of the restructured parties.

Is there an Employee Stock Ownership Plan (ESOP)? Have employees exercised their rights? If an ESOP has been set up on the overseas platform and the employees have exercised their rights, it is necessary to check whether the employees have completedthe foreign exchange registration of Document No.37 when holding shares overseas. At the same time, after the termination of the ESOP on overseas platforms, the ESOP of domestic entities to be listed is generally placed before the investors are determined, and the impact of share-based payment on the company’s performance should be fully considered.

Bailey Xu is a senior partner at Dentons. He can be contacted on +86 139 1660 7001 or by email at bailey.xu@dentons.cn

Yuna Fan is a partner at Dentons. She can be contacted on +86 185 1669 2183 or by email at jianhong.fan@dentons.cn

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