The end of VIEs? | China Accounting Blog | Paul Gillis

The end of VIEs?

There is a potential development with variable interest entities (VIEs) that could threaten many US listed Chinese companies that use this structure. It has been reported in Chinese forums. The documents are all in Chinese and I may have misinterpreted them. I am sure lawyers are going to be pouring over this in the coming days – I will add links to their analysis when they publish.

Today, January 19, 2015, the Ministry of Commerce (MOFCOM) released a draft of a new foreign investment law for public comments. What is notable about this new law is that it appears to introduce an actual control rule for determining when an enterprise has foreign investment and is thus subject to regulation as such. What that appears to mean is that a VIE that is controlled by an offshore company will be treated as a foreign invested enterprise (FIE).

The nature of VIE arrangements in China is that they give control to an offshore company (typically the listed Cayman Islands company or its Chinese subsidiary (WFOE)), yet argue to Chinese regulators that the VIE is a local company owned by locals, and therefore not subject to foreign investment restrictions. The proposed law appears to change that interpretation. Instead, a VIE controlled by a foreign company will be treated as a foreign invested enterprise.

Since foreign investment is restricted in the sectors favored by most US listed Chinese companies (internet and education), the ruling could have significant impact. If implemented, most overseas listed Chinese companies, including giants Alibaba, Baidu, and would appear to have a big problem with their VIEs. They would have prohibited foreign investment in the Internet sector, which could lead to loss of their Internet content provider licenses.

Separately, the Ministry of Industry and Information Technology (MIIT) is said to have announced that wholly foreign owned ecommerce businesses could be set up in the new Shanghai Free Trade Zone. They may not be thinking of Alibaba, but at face value this would appear to allow Alibaba to move its current VIEs to Shanghai and to convert them into WFOEs – owned directly by the Cayman Islands incorporated Alibaba Group. Business operations are likely minimally effected. The VIE would be incorporated in the FTZ and perhaps servers would need to be relocated there. But allowing direct ownership of the VIE would be a huge win for shareholders. Alibaba’s VIEs were a cause for considerable concern during its IPO process. A solution to the VIE problem for Internet companies may be at hand.

The Third Plenum reforms promised a revision to the foreign investment rules for education. Perhaps they will also be allowed to incorporate in the Shanghai free trade zone.

I have long said that the VIE structures are unsustainable. I am hopeful China is beginningthe process to regularize them, but not by putting them out of business.

Paul Weiss analysis of proposed law.

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