With changes in policies towards variable interest entities (VIEs) in China, and in foreign capital market environments, the dismantling of well-erected red-chip structures followed by the seeking of domestic listings has become the choice of quite a few enterprises.
Compliance in the processes of erecting and dismantling a red-chip structure are the focus of attention of regulators. When carrying out an analysis of compliance, particular attention needs to be paid to investment oversight, administration of foreign exchange registration, tax issues, shell company issues, extent of information disclosure, special attention on VIE enterprises, etc.
This mainly includes: approval and registration procedures for offshore investments designed when erecting the offshore red-chip structure; approval and registration procedures for the direct foreign investment or cross-border mergers and acquisitions (M&A) involved in investment round tripping to establish a new, or acquire an existing, domestic enterprise; and approval and registration procedures involved when returning to China and dismantling the red-chip structure.
Foreign exchange registration
On 14 July 2014, the State Administration of Foreign Exchange (SAFE) issued the Notice on Issues Relevant to Exchange Control in Connection With Offshore Investment/Financing and Investment Round Tripping by Domestic Resident Through Special Purpose Vehicles and its annexes, the Operational Guidelines for Matters Relating to Exchange Control in Connection with Investment Round Tripping and the Application for Foreign Exchange Matters Relating to Direct Investment on the Capital Account.
The domestic wholly foreign-owned enterprise (WFOE) or equity joint venture involved in investment round tripping is required to carry out with SAFE the relevant registration or amendment of registration of the basic foreign exchange information for the foreign-invested enterprise (FIE) in accordance with regulations on foreign exchange registration by FIEs. According to most recent policy, after June 2015, relevant foreign exchange registration in connection with offshore investment is to be carried out at a commercial bank.
When foreign exchange needs to be purchased in the course of dismantling a red-chip structure to pay the transfer consideration to the offshore shareholder that is proposing to divest, the source of the outgoing funds and withholding tax on the payment and outward remittance is subject to regulatory requirements, including Hui Fa  No. 30, announcement No. 40 (2013) of the State Administration of Taxation (SAT) and SAFE, as well as the previously applicable Hui Fa  No. 64, Guo Shui Fa  No. 122 and Hui Fa  No. 52).
Document No. 10 of the Ministry of Commerce (MOFCOM) specifies that where a domestic company, enterprise or natural person acquires, in the name of a company abroad that it/he/she lawfully established or controls, a domestic company with which it/he/she has a connected relationship, the FIE is ineligible for treatment as an FIE. In other words, an FIE that arises through a connected acquisition in the course of the erection of a red-chip structure is not eligible for tax breaks.
In reality, a significant number of enterprises have enjoyed the “two exemption, three reduction by half” tax break. In the course of the erection of the red-chip structure, when the foreign investor acquires the domestic enterprise, the acquisition should be carried out based on the appraised net asset value of the enterprise. At such time, the original shareholders of the enterprise face being required to pay a large amount of individual income tax. In the course of dismantling the red-chip structure, there may also exist an issue of individual income tax due to the premium on the equity transfer.
Disposal of shell companies
Among the companies in a red-chip structure, there will be several shell companies, whereas when a domestic enterprise wishes to list, the requirements regarding the clarity of the equity are very strict. The process of dismantling a red-chip structure is also a process of deregistering overseas shell companies, and ensuring that the actual controller directly controls the company entity. Accordingly, before an enterprise submits material for a domestic listing, it must complete the deregistration of the important shell companies.
In practice, a company intending to list abroad might establish a conditional employee incentive plan to be exercised either before or after the offshore listing. If the company decides to carry out a “red-chip return” and list domestically, the establishment of an employee option incentive plan that straddles the period before and after listing before completion of a domestic A-share listing is not supported.
The employee option incentive plan under the original offshore red-chip structure should not be simply translated to the company that is to be listed domestically after the red-chip landing. Rather, appropriate adjustment measures should be taken based on the circumstances of the enterprise, for example, accelerating the exercise of the option incentive plan that has already been distributed abroad, or cancelling the exercise to procure a stable and clear state for the equity structure.
Attention on VIE enterprises
In the actual performance of a VIE agreement, the regulator will usually pay attention to specific arrangements of the VIE agreement, relevant beneficiary entities involved, performance of the provisions of the agreement, etc., when carrying out its review, and the enterprise is required to show it did not actually perform the agreement.
When terminating the VIE agreements, the enterprise is required to execute a termination agreement with all of the signatories to the VIE agreement, confirm that the negotiated control documents originally executed by the parties are terminated and that the relationships of rights and obligations of all the parties under the above mentioned agreements have been terminated, and confirm that there is no negotiated control relationship between the corporate entity and the WFOE.
The dismantling of a red-chip structure involves complex legal and regulatory issues. Once the intent to return has been reached, it is necessary to commence scrutinising compliance of the various matters of the enterprise as soon as possible, and to draw up a plan based on the newest regulatory trends, laws and regulations.
Sun Jian is a senior partner and Wang Junlu is a lawyer at Zhong Yin Lawyer
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