An essential component of any VIE structure is a service contract between the wholly foreign owned enterprise (WFOE) and the VIE. The purpose of this contract is to enable the WFOE (which is owned by the public company and its shareholders) to extract the profits from the VIE (which is owned by a Chinese individual). Without this contract the public company has no economic interest in the VIE, and cannot consolidate the VIE in its financial statements. More important than the issue of consolidation is that unless the contract is effective, the public company owns nothing and may be worthless.
The problem with these contracts is that companies selectively apply them, if they apply them at all. The contracts usually provide that the WFOE can charge a fee to the VIE for services rendered that is equal to the entire profits of the VIE. There are a bunch of problems with that.
First, these companies often need their cash in the VIE, not in the WFOE. So, if the profits are transferred from the VIE to the WFOE, the VIE may be short of cash. While direct loans between Chinese companies are not allowed, it is possible for the WFOE to loan the cash back to the VIE in the form of entrusted loans. Entrusted loans are permissible for the accumulated earnings of a WFOE, but cannot be used for funds that were contributed to capital of the WFOE.
But most VIEs do not pay the required service fees at all. The main reason seems to be the adverse tax consequences. At a minimum, any service fee payments from a VIE are subject to business tax at 5%. VAT is replacing business taxes. While VAT is at a higher rate, the VAT paid on the service charges can be recovered by the VIE from its VAT transactions.
I have reviewed a dozen or so financial statements of companies using the VIE structure, and it appears most of them do not pay out the profits of the VIE in service charges at all, and those that do usually do not pay out all of the profits as service charges.
Here is the accounting problem. In order to support the argument that the service contract operates to give the WFOE access to all of the profits of the VIE, the entire service charge should be accrued as income by the WFOE and as an expense by the VIE, even if it is not going to be currently paid. While those receivables and payables are eliminated in consolidation, the business tax on the entire service charge should be accrued as an expense, even if this tax will not be paid until the service charge is paid. That is true even if the company argues that the service charge will never be paid. I think that many companies have an error in their financial statements. If the SEC picks up on this, and I expect they will now, many companies may be required to restate.
The amount of the error is easy to calculate. Look at the retained earnings of the VIE, usually disclosed in footnote 1. Multiply that by 5%. That is your error – unless the company has recorded a liability for it already – I have yet to find one. The error is a non-cash item, so many analysts may not care.
That may not be the end of it. The VIE should get a tax deduction for the service payment and since the service payment is equal to its earnings, it should have no income subject to corporate income taxes. But the tax bureau might have a problem with this deduction. Is the service charge a fair payment for the services rendered by the WFOE? I expect many companies may have a hard time arguing that the transfer price is correct. Who signs an agreement with a service provider letting them charge you a price equal to all your earnings? So, if the tax bureau adjusts the price down, there will be taxes, interest and penalties for the VIE to pay. That could be a much bigger number than the business tax.
If the tax bureau makes a transfer pricing adjustment to the VIE, what happens to the WFOE? The tax bureau should make a correlative adjustment to the WFOE and reduce the services income it reported. That would give the WFOE a refund in about the same amount as the additional taxes that the VIE has to pay, so no real problem so far. But the cash still got from the VIE to the WFOE, so if it did not get there through a service fee, how did that happen? The tax bureau might argue that what must have happened in substance is that the VIE paid a dividend to the VIE shareholder who then turned the dividend over to the WFOE. The dividend would be subject to a 20% individual income tax payable by the VIE shareholder. The WFOE probably still has to report the cash received as income, although since it is not services income, it might be considered interest income from the loan it has made to the VIE shareholder. That would be a disaster scenario, since not only would a 20% withholding tax be payable on the deemed dividend, but also a corporate income tax of a further 25% on the cash received by the WFOE. That risk is probably one of the reasons companies don’t make payments on service agreements - they don’t even deduct the unpaid service payments on their tax return because they never plan to pay them.
Not paying the service charges required by the agreements defers paying the tax but it does not defer the responsibility of accounting for the tax consequences of the ultimate payment. But that appears to be what companies have done. They have not paid the service charges, yet they rely on the service agreements to justify consolidating the VIE. In order to justify consolidation, I believe the WFOE must accrue the full service charge from the VIE and the resulting tax consequences must be accounted for even if payment is delayed.
The SEC should probe this area in future comment letters.