Tips on VIE liquidation practices

By Ji Fei, Merits & Tree Law Offices
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In the past two years, the central government has de facto established a new access regime for foreign investors by further relaxing the foreign investment threshold and updating the negative lists. The requirements set out in the Foreign Investment Industries Guidance Catalogue, and some restrictive or prohibitory conditions promulgated in other applicable rules and regulations, are further loosened in some industries.

In practice, foreign investors would set up variable interest entities (VIEs) as their Chinese operation entities and apply for licences through these entities to ensure compliance. With the implementation of the new negative lists, some of the foreign investment access restrictions are removed and purely foreign-owned operations are allowed, so the VIEs are no longer necessary. The liquidation of the VIE is now on the agenda.

This article aims to share some tips on VIE liquidation practices with recent cases the author has dealt with, and to shed some light on the risks and corresponding solutions.

Controlling interests and liquidation resolution

liquidation
Ji Fei
Partner
Merits & Tree Law Offices

In general, the shareholders of VIEs are Chinese natural persons who are senior executives appointed by foreign investors and responsible for Chinese business, and who, in name, own the right to decide whether or not to liquidate the VIEs. To make sure that the liquidation practice is legitimate, the foreign investor should arrange for the shareholders and board of the VIE to properly pass the relevant resolution as soon as the decision of VIE liquidation is made, and sign the relating documents, to avoid any hindrance to the liquidation because of the lack of resolution.

Given that the stamps, licences, certificates and financial materials will be frequently used during the liquidation process, the author suggests that the foreign investor appoint professional consultants (lawyers, accountants, etc.) to compose a liquidation team responsible for the management and usage of the corporate stamps, licences, certificates, financial material and accounts, to secure full control of the VIE.

Termination of a VIE agreement and the legal ramifications

When establishing a VIE, the foreign investor would normally sign a framework agreement (VIE agreement) with the shareholders of the entity. The agreement is the legal foundation of the VIE architecture, formulating a full spectrum of arrangements covering the establishment, operation and exit of the VIE.

Upon passing a liquidation resolution, the shareholders of the VIE will no longer perform the major obligations within the VIE agreement. However, as it typically takes at least six months to liquidate a VIE, the foreign investor should sign a termination agreement with the shareholders to make sure they fully exit from the entity. This termination agreement should specifically set out the obligations of the shareholders to give assistance during the process, such as signing documents and going through the application processes.

After the VIE is liquidated and de-registered, the shareholders are obliged to return the residual assets of the VIE (such as distributable profits) to the foreign investor. To prevent any “moral risks”, setting up a jointly managed account or asking the shareholders to sign a commitment letter, or letter of authorization, or other methods, are recommended to make sure that these residual assets are returned safely and timely.

Tax and unfulfilled contract

The tax cost as a result of the liquidation is an issue that cannot be dodged. In principle, the VIE shareholders shall file a return and pay taxes to the Chinese tax authority on the residual assets (generally involving the undistributed profits) gained. We suggest a comprehensive audit of the VIE is conducted when the liquidation process is kicked off, to estimate and write down the possible tax cost of the shareholders after liquidation. The investor should also actively co-ordinate and make sure that the shareholders pay tax in a timely manner to the authority during the process.

The VIE may sign a number of agreements (e.g., consultancy service agreement, IP licence agreement, etc.) with the affiliates of the foreign investor in China, or other countries/regions during the operation. Before the entity is officially liquidated, the foreign investor should arrange for the VIE to perform or otherwise clear these agreements (end, terminate or transfer the agreement), to avoid any possible debt or legal disputes, or even litigations because of the unperformed agreements.

Employees settlement and disposal of intangible assets

The dismissal of a VIE does not necessarily mean the end of the Chinese business of the foreign investor. The business of a VIE may be relocated to the wholly foreign-owned company set up by the foreign investor in China. During the business relocation, employee settlement is time consuming and the probability of labour disputes is high.

In this light, the author recommends that the employee settlement starts before the liquidation process. Agreements may be signed with the retained employees to continue and pass their lengths of service onto the new entity. The employees should be treated on an equal footing; too many “personalized” arrangements are not preferred. The company should also start the departure negotiations with other employees as early as possible, and pay the economic compensations and other severance fees according to the law.

Asset disposal is more controllable and easier, compared with the settlement of employees. But the disposal of intangible assets (domain names, trademarks, software copyright, etc.) and the changes of some licences and certificates can take a longer time, and are often neglected.

The author suggests that the investor starts checking the intangible assets of the VIE before the liquidation, and arranges the transfer of the rights of these assets with forward-looking vision. The pricing and operation of the transfer of these assets should be in compliance with the applicable rules and regulations of China. The author recommends that the company refers to a professional tax consultant to avoid the situation where the tax authority raises objections and the liquidation process is lengthened, and tax risks are increased.

Ji Fei is a partner at Merits & Tree Law Offices

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