Beware of large dividends | China Accounting Blog | Paul Gillis

Beware of large dividends

The variable interest entity (VIE) structure has many problems. Every Form 20F of a Chinese company using the VIE structurewarns investors that Chinese regulators may decide that the VIE structure is ineffective at circumventing Chinese rules that restrict foreign investment in certain sectors, effectively putting the company out of business. Or the shareholder of the VIE might just decide to disregard the VIE arrangements and take the operations for himself. That has happened a couple of times, often enough to put a permanent VIE discount on the value of these stocks.   

One of the other problems with asset heavy VIEs is that they become impossible to operate over time. The idea behind a VIE is that the public company can get access to the VIE's profits through service charges. That does not work well in practice. It is difficult to explain to tax authorities that all of the profits of the business should be extracted through service charges by a wholly foreign owned enterprise (WFOE) that does not actually do much to deserve them. If the tax authorities disallow a deduction for the service charges to the VIE, the tax rate soars. Even if the deduction is allowed, service charges are subject to business tax at 5%. The other problem is that if all the profits are taken out of the VIE, the cash ends up in the WFOE. The business scope of the WFOE will not allow it to loan the cash back to the VIE, where it is needed for working capital. Because of these problems, many VIEs just continue to accumulate cash in the VIE. 

From the VIE owners perspective, that might be considered an ideal situation.  The VIE owner controls 100% of the cash. But that is not good enough for some VIE shareholders. The cash is stuck in the VIE, and even though VIE owner might just take it, enhanced audit procedures mean he will likely get caught. Plus, the cash is in RMB, and any self-respecting Chinese tycoon needs US$ to buy yachts in Hong Kong and mansions in America. For a Chinese tycoon, exchanging RMB into US$ is a pain. Chinese law allows them to convert only $50,000 worth of RMB per year. So many have resorted to the black market, using small armies of people to use their annual limits, or finding people with money offshore willing to trade their US$ for RMB. Those are risky transactions, and authorities have been cracking down on them. 

The founders of some U.S. listed Chinese companies have used a new, bolder transaction. The listed Cayman Islands offshore parent company borrows US$ from the overseas branch of a Chinese bank. The RMB deposits of the VIE are used as security for the loan. Chinese banks are apparently willing to do these transactions because they hold the deposits and can easily seize the collateral. The listed Cayman Islands company then pays a massive dividend to the public company shareholders, of which the VIE owner typically gets the biggest share. Voila! RMB cash in the VIE converted into US$, tax free and without exchange controls. 

The transactions obviously violate the spirit of China’s exchange controls, and as such they could be shut down should SAFE focus its attention on them. There are lots of tax problems. But the biggest concern is how does the Cayman Islands company ever pay off the loan? In these situations all of the cash flow is in the VIE, and the whole reason for doing this transaction is that it is near impossible to get that cash out. Obviously, the loan is going to have to be rolled over forever. If the Cayman Islands company defaults, it is the public shareholders who lose. The founder will have gotten his money out through a dividend, the bank will get its money back by taking the collateral, and the public shareholders will have worthless shares in a bankrupt Cayman Islands company. 

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