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What is a variable interest entity (VIE) structure for foreign investment in China (PRC)?
A variable interest entity (VIE) refers to a structure in which an entity established in China which is fully or partially owned by a non-Chinese company, through certain contractual or services arrangements, has control over a Chinese operating company holding the necessary licenses to operate in a foreign direct investment (FDI) restricted/prohibited sector in China.
Why use a VIE structure?
In China, depending on the sectors in which a foreign investment takes place, the investment falls into one of the following categories. Each category has its own levels of foreign ownership restrictions, governmental approvals and tax policies:
The VIE structure was developed to circumvent restrictions on foreign investment into the “restricted” sectors. Examples of “restricted” sectors include telecommunications and media.
Under a VIE structure, foreign investors do not own the equity of the operating Chinese subsidiary and do not have to obtain PRC approvals for a foreign direct investment. Nevertheless, foreign investors still enjoy the economic benefits of the Chinese operating subsidiary through the ownership of a wholly foreign owned entity (WFOE or WOFE) which has certain contractual or services arrangements/agreements with the Chinese operating subsidiary.
The VIE structure is very popular and many leading Chinese internet companies with this structure are listed on NASDAQ or NYSE or HKSE.
Examples of VIE structure
Listed on NASDAQ or NYSE: Sohu, Netease, Ctrip, Baidu, Youku, Dangdang
Listed on Hong Kong Stock Exchange (HKSE or HKEx): Tencent, Alibaba.com (delisted in 2012)
What are the risks and problems of a VIE structure?
Contractual risks: Under a VIE structure, foreign investors do not have a direct equity ownership of the Chinese operating company and rely on contractual agreements to exercise effective control over the Chinese operating company. These agreements have not been tested in PRC courts and in the event that the Chinese owners breach the agreements, it is unclear whether the rights of the foreign investors under the agreements will be enforced by PRC courts.
Regulatory risks: There is a risk that the PRC government or authorities may require the VIE structure to be unwound or rectified as a VIE structure could be seen as a way of circumventing PRC foreign direct investment restrictions. However, many experts are of the view that this is unlikely because there have been many successful and well-known companies with VIE structure listed on overseas stock exchanges. A ban on this structure can have significant implications on these overseas listed companies.
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