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Home > Competition
Will China illegalize VIEs?
By Henry Chen | 2019/3/22 23:06:01

1. Background

On March 15, 2019, the second session of the 13th National People's Congress passed the Foreign Investment Law of the People's Republic of China, which will come into effect on January 1, 2020.

The Foreign Investment Law contains six chapters and a total of 42 articles.  As a basic law of the new foreign investment legal system, the Foreign Investment Law establishes the basic institutional framework and rules for opening up to the outside world in a new form.

China will introduce measures to help implement the Foreign Investment Law as Chinese Premier Li Keqiang said.  As such, the legislative branch will enact more subsequent implementation regulations, detailed rules, and local rules and regulations.  In particular, in order to thoroughly implement the principle of "consistency between domestic and foreign investment", legislatures at all levels will sort out existing laws and regulations and various normative documents as soon as possible.

Among many excitements to Chinese and non-Chinese investors, there is a great news or heart balm that the Foreign Investment Law did not illegalize VIEs as the Foreign Investment Law (draft) suggested.

Article 15 of the Foreign Investment Law (draft) explicitly provided that “For the purpose of the present Law, the term "foreign investments" refers to the following investment activities conducted, directly or indirectly, by foreign investors:… (6) Control domestic enterprises or hold equity in domestic enterprises by contracts, trust or other ways,” which is “notoriously” known as Variable Interest Entities ("VIE").  

2. What is VIE?

The “variable interest entity” structure (“VIE Structure”) has been the investment structure of choice for foreign investors to navigate through the grey areas of PRC law on foreign direct investment (“FDI”) for over two decades.  The VIE Structure was first made famous by in its 2000 listing on NASDAQ as a workaround structure in the value-added telecom services sector, where FDI is subject to substantial PRC regulatory restrictions.  Since then, foreign investors have replicated the VIE Structure in many other sectors of China’s economy where FDI is either restricted or prohibited under PRC law.

China has not totally opened its industries for non-Chinese investors to invest in.  It remains to see that many VIEs will be structured to turn around the areas not available for non-Chinese investors.  Take the Special Administrative Measures (Negative List) for Foreign Investment Access (Edition 2018) for example, the Chinese government still holds administrative restrictions on 48 areas (although reduced from 63 areas).  Among them, following areas are still a taboo for foreign investment, namely Internet news information services, online publishing services, network audiovisual program services, Internet cultural management (except music), and Internet public information services (except those promised at China’s WTO accession).

3. How is VIE structured?

The VIE Structure is designed to allow foreign investors to hold a controlling interest in a business that operates in one or more of China’s many restricted or prohibited sectors.  The VIE Structure is also used as a method for Chinese domestic entities to gain access to international capital markets through offshore listings.  

Typically, the VIE Structure is used in China’s restricted internet or e-commerce sectors.  The VIE Structure is a workaround structure where one or more foreign investors (“Foreign Investors”), together with one or more PRC natural or legal persons (“PRC Founders”), form an offshore entity (“ListCo”) that owns or controls an onshore wholly foreign-owned enterprise (“WFOE”), or similar foreign-invested enterprise (“FIE”) in China.  This foreign-controlled WFOE (or FIE) has control over the ownership and management of a domestic licensed company that holds the necessary license(s) to operate in a sector where FDI is restricted or prohibited (the “Domestic Licensed Co”, also commonly referred to as the variable interest entity or VIE).  Investors, ListCo, WFOE or FIE are collectively referred to as the Contractual Controllers.  

The key concept that underpins a VIE Structure is that control over the Domestic Licensed Co is obtained through various service agreements (“VIE Contracts”), rather than through share ownership.  Through the VIE Contracts between the WFOE (or FIE) and the Domestic Licensed Co, the foreign investors are able to obtain de facto control over the ownership and management of the Domestic Licensed Co.  The VIE Contracts also enable the ListCo to consolidate its financial statements, as well as participate in the economic gains and losses of the Domestic Licensed Co.  These features are crucial for the purposes of (1) any future listing of the ListCo on an international stock exchange, and (2) achieving tax efficiency for cross-border transactions.  An illustration of a typical VIE Structure is set forth below. 

4. What are statistics on VIE arrangements?

Statistics from the US Securities and Exchange Commission (“SEC”) and the Hong Kong Exchange (“HKEx”) show that in between 1999 and 2010, more than 91 Chinese domestic entities listed on American stock exchanges, including Nasdaq, the New York Stock Exchange and the American Stock Exchange, and eight on the HKEx using the VIE Structure.

In 2010, there were 38 domestic entities listed by VIE Structure on foreign stock exchanges, including 34 on US Stock Exchanges and four in Hong Kong.  

By the end of August of 2011, 96 of 213 Chinese companies listed in New York Stock Exchange adopted VIE structure.  Just in the Internet area, there were almost 40 Chinese VIE-related enterprises listed outside China (mainly in NASDAQ and NYSE), with total market capital of 160 billion dollar.

There are some other statistics from other resources.  From 2015 to 2017, there were 43 China-concepted companies listed in the U.S., 34 of which used VIE.  From 2000 to today, there were about 250 domestic Chinese companies getting listed by use of VIE.

The VIE Structure has become a trendy method for Chinese entities to list abroad.  However, this structure brings about more investment and legal risks compared to other forms, such as an equity merger.

5. What are the possible risks of the VIE structure?

5.1. Investment risks of the Contractual Controllers

Although the Contractual Controllers “control” VIEs contractually, PRC Founders may nonetheless frustrate the VIE Structure because these founders are, as a matter of law, the holders of the equity interests of the VIEs, which is well illustrated by the case of Alipay below.

At the press conference in Hangzhou on June 14th, 2011, Alibaba Group Chairman Jack Ma admitted that he terminated Alibaba Group’s VIE structure with Zhejiang Alibaba E-commence Ltd. (now the parent company of Alipay) in the first quarter of 2011, without the clear agreement of the board of directors.

Alipay ownership had already previously been transferred from the Alibaba Group to Zhejiang Alibaba E-commerce Limited, but Alibaba Group held control of that company via a VIE structure and stakeholders Yahoo and Softbank expected that contractual arrangement to suffice for obtaining the license.

Jack Ma’s statement appears to add credence to Yahoo’s claim that it was not notified of a material change in the ownership of Alipay until March 31, 2011. Yahoo thus faces at least two class-action lawsuits, from Kendall Law Group and Robbins Geller Rudman & Dowd, alleging that Yahoo knew about this material information earlier, but failed to disclose it in a timely manner.  An illustration of Alipay as a VIE is set forth below.  

Please note that the VIE Structure in relation to Alipay below is slightly different from the VIE Structure as above mentioned.  The biggest difference is that Alipay as an VIE is under the control of a non-PRC company (i.e., Alibaba Group as incorporated in Cayman Island), but the VIE as mentioned in above Item 2 is under the direct control of PRC Founders.  The reason why a non-PRC company can hold Alipay is that Chinese law had not prohibited a non-PRC company from holding an online payment service provider such as Alipay.  In any way, Yahoo! and Soft Bank nonetheless functioned as the Contractual Controllers while Jack Ma directly controlled Alipay.

5.2. Legal risks of being illegalized

In addition to the above mentioned investment risks, the VIE structure is also susceptible to an outright attack by the Chinese government because the structure is designed to circumvent the prohibitive or restrictive foreign investment industry policies in relation to telecommunication services, e-commerce, online gaming business, advertisement as well as some other laws and administrative regulations: 

5.2.1. Investment industry policies

As mentioned above, the VIE Structure was first made famous by in its 2000 listing on NASDAQ as a workaround structure in the value-added telecom services sector (“Class II Telecommunications Services”),  where FDI is subject to substantial PRC regulatory restrictions.  Since then, foreign investors have replicated the VIE Structure in many other sectors of China’s economy where FDI is either restricted or prohibited under PRC law.

5.2.2. Roundtrip investments

A roundtrip investment scheme means that a PRC citizen or enterprise sets up a non-PRC company outside China, and then uses the non-PRC company to make a foreign direct investment or an M&A inside China for the purpose of getting some privileges that non-PRC companies are entitled to (including tax incentives, IPO conveniences).

The VIE Structure actually avoids “Regulations of Foreign Investors Merging Domestic Enterprises (Document No.10)”, which provides that “any Chinese company, enterprise, or individual person, who wants to merge a related Chinese company in the name of its leally established overseas company or an overseas company it controls, should report the merger to the Department of Commerce for examination. The Chinese company, enterprise, or individual person cannot invest in domestic companies as foreign investors, or avoid the above requirement by any means.” 

Because non-Chinese investors are not entitled to tax incentives as they used to, tax incentives are no more a lure for a round-trip investment.  However, some other privileges such as an easier access to non-Chinese capital market are still attractive to Chinese individuals and/or enterprises.

5.2.3. Foreign Exchange Restrictions

The SAFE 75 Registration (“SAFE 75 Registration”) is a required registration application by which the Chinese government regulates the shareholding arrangements, foreign currency flows, and tax issues involved in VIE Structures and Roundtrip Investments. SAFE successively promulgated three circulars to clarify the SAFE 75 Registration, namely, Circular Notice No. 75 (Notice of the State Administration of Foreign Exchange on Relevant Issues Concerning Foreign Exchange Administration for Domestic Residents to Engage in Financing and in Return Investments Via Overseas Special Purpose Companies) (“Circular 75”), and its two ancillary circulars, Circular 106 and Circular 77 (together, the “Ancillary Notices”). 

The Ancillary Notices are SAFE’s internal notices that are usually issued and addressed to SAFE’s local counterparts as guidelines for implementing a ministry level rule.  In accordance with the Ancillary Notices, each Chinese founder (or other Chinese shareholder) must complete his or her SAFE 75 Registration prior to the establishment of an offshore holding company.  A Chinese founder’s (or other Chinese shareholder’s) failure to complete the SAFE 75 Registration creates a flawed VIE Structure that prevents an offshore company from repatriating profits generated by the onshore operating entity, and consequentially, prevents such offshore company from successfully listing offshore.   

6. What is the rationale of the VIE Structure?

Despite the risks as mentioned above, the VIE Structure does not go without rationale.  The most conspicuous rationale is that an VIE does not directly engage in business that Chinese government prohibits non-PRC companies or individuals from engaging in.  Therefore, the VIE Structure itself presents a bona fide evidence that Chinese law is not violated.  It is not groundless that Chinese government turns a blind eye to the VIE Structure.  For the same reason, it is not groundless for a Chinese lawyer to issue the following legal opinion about the viability of the legal arrangements surrounding the VIE structure:

In the opinion of [a law firm], our PRC legal counsel:

• the ownership structures of Meidiya Investment and Yihe Investment, their subsidiaries and our subsidiaries in China comply with all existing PRC laws and regulations;

• the contractual arrangements among our PRC subsidiaries, Meidiya Investment, Yihe Investment, their shareholders and their subsidiaries governed by PRC law are valid, binding and enforceable, and will not result in any violation of PRC laws or regulations currently in effect; and

• the business operations of our PRC subsidiaries, Meidiya Investment and Yihe Investment and their subsidiaries comply in all material respects with existing PRC laws and regulations.”

Please note that the legal opinions are usually qualified as follows:

“We have been advised by our PRC legal counsel, however, that there are substantial uncertainties regarding the interpretation and application of current and future PRC laws and regulations. Accordingly, the PRC regulatory authorities may in the future take a view that is contrary to the above opinion of our PRC legal counsel. We have been further advised by our PRC counsel that if the PRC government finds that the agreements that establish the structure for operating our PRC insurance intermediary businesses do not comply with PRC government restrictions on foreign investment in the insurance intermediary industry, we could be subject to severe penalties including being prohibited from continuing operation.”

7. Did Chinese government suggest to illegalize the VIE Structure?

7.1. Reuters reported yes.

Reuters reports that the China Securities Regulatory Commission (“CSRC”) is calling for action against variable interest entities (VIEs).  In the story of September 18, 2011 China company structure under threat, Reuters writes that:

China’s securities regulator is asking the government to clamp down on the controversial corporate structure used by companies such as Sina (SINA.O) and Baidu (BIDU.O) to list overseas, and employed in thousands of other investments by foreigners into domestic Chinese companies, four legal sources told Reuters.

Lawyers at four different firms in China and Hong Kong said they have seen an internal report, dated August 17, said to come from the China Securities Regulatory Commission (CSRC) which asks China’s State Council, or cabinet, to take action against the structures known as Variable Interest Entities (VIEs).

The CSRC did not respond to a Reuters request to confirm whether or not the report is genuine. But lawyers say they are taking it seriously and that if the government were to accept the CSRC’s view it could jeopardize the way in which Chinese companies list overseas or receive foreign investment…

“If the PRC government did clamp down on the use of VIEs for overseas listings, it would leave few options for many of these companies to list outside of China, or even to take on foreign investment of any kind,” said Alan Seem, a partner at Shearman & Sterling in Beijing who has not seen the internal document.

“I don’t think U.S. investors would be that excited to be investing directly into a Chinese entity, and there is a question whether the CSRC would approve these companies for foreign listing even disregarding the VIE issue.”

The move by the CSRC is apparently driven in response to the raft of fraud cases seen recently at Chinese companies listed in North America, many of which used the VIE structure. The CSRC has repeatedly stated that it often has no jurisdiction over these companies, which tend to be incorporated offshore, but the wider impact of the scandals on investor sentiment to China is putting them under pressure to act.

7.2. Some well-informed professionals said no.

After the Reuters story appeared Xie Wen, a longtime senior executive at various Chinese Internet companies, wrote on his Sina Weibo account that Vice Premier Wang Qishan has written a directive about the VIE Structure to the effect that existing ones should be grandfathered in and acknowledged as legitimate.  Xie also said that Ministry of Commerce has issued a document in accordance with Wang Qishan’s instructions – please see the screen print-out of Xie Wen’s blog as follows:

If Xie’s information is accurate then this is great news for companies with existing VIEs, including all the Chinese Internet firms listed in the U.S.  Wang’s directive, if it exists, make this a non-issue for all but the firms who have yet to establish VIEs.

7.3. Too many to fail

There is a Chinese proverb: if there are too many people in violation of law, these people would be too many to punish.  Take the Internet industry for instance, the remarkable feature of the Internet industry is that it requires a large amount of capital investment in the early stage to attract users, which is commonly known as “burning money”.  Profitability is only possible when the user scale reaches a pretty large number.     However, the relevant law stipulates that enterprises want to be listed on the domestic mainboard must guarantee a net profit of more than RMB 30 million in three fiscal years.  Even in the Growth Enterprise Market (GEM) with relatively loose conditions, a continuous profit of more than RMB 10 million in the last two fiscal years is also a must.

Requirements on the amount of profits alone can shut out the 100 billion-dollar Internet tycoon like Jingdong, let alone other private Internet companies.  As such,  the urgent need for overseas listing through VIE framework seems inevitable.

As mentioned above, by the end of August of 2011, 96 of 213 (i.e., 45%) Chinese companies listed in New York Stock Exchange adopted VIE structure.  In 2010, there were 38 domestic entities listed by VIE Structure on foreign stock exchanges, including 34 on US Stock Exchanges and four in Hong Kong.  

From 2015 to 2017, there were 43 China-concepted companies listed in the U.S., 34 of which used VIE.  From 2000 to today, there were about 250 domestic Chinese companies getting listed by use of VIE.

There are too many VIEs to punish.

7.4. VIEs bring investments into China

As mentioned above, just in the Internet area, there are almost 40 Chinese VIE-related enterprises listed outside China (mainly in NASDAQ and NYSE), with total market capital of 160 billion dollar.  Hundreds of billions dollars should be a very persuasive argument for the Chinese government not to eradicate the VIE Structure completely.

8. What is the possible fate of the VIE Structure?

If the VIE Structure is grandfathered, what is the possible fate of the VIE Structure in the future?  The VIE Structure might be possibly snuffed on an industry by industry basis.  However, there will still be VIE-related IPOs continuously launched.

8.1. Snuffing on an industry by industry basis

For example, On September 28, 2009, the General Administration of Press and Publication (“GAPP”), the National Copyright Administration (“NCA”) and the National Anti-Pornography and Anti-Illegal Publications Working Group Office jointly issued the Circular on Consistent Implementation of “Stipulation on ‘Three Provisions’ of the State Council and the Relevant Interpretations of the State Commission for Public Sector Reform and the Further Strengthening of the Pre-approval of Online Games and the Approval and Examination of Imported Online Games” [Xin Chu Lian [2009] No. 13] (“Circular 13”), which prohibits foreign investors from directly or indirectly investing in China’s online game industry.

Circular 13 explicitly prohibits foreign investors from directly or indirectly engaging in online gaming business in China, including through the VIE Structure. 

1. Ban on Equity Ownership. Foreign investors are not allowed to invest in or provide online gaming services in China through wholly foreign-owned enterprises, equity joint ventures or cooperative joint ventures. 

2. Ban on VIE Structure. Foreign investors are not allowed to indirectly control or participate in PRC operating companies’ online gaming operations, whether: 

by establishing other joint ventures, entering into contractual arrangements or providing technical support for such operating companies; or 

in a disguised form such as by incorporating or directing user registration, user account management or game card consumption into online gaming platforms that are ultimately controlled or owned by foreign companies. 

Circular 13 further strengthens the government’s control over online gaming companies in China as well as the examination and approval of the import and publication of online games. It reiterates the position that GAPP is responsible for the examination and approval of the import and publication of online games and it clearly sets forth that downloading from the Internet is considered a publication activity, which is subject to GAPP’s approval. 

8.2. VIE not hopeless yet

Although Circular 13 repeats the long-standing de jure prohibition against the VIE Structure, absent enforcement actions against foreign-invested online gaming companies, we expect the market to continue using the VIE structure for foreign investments into restricted industries. Just this year, two Chinese online gaming companies with VIE Structures completed initial public offerings in the United States, and both were spin-offs of existing U.S.-listed public companies that also use the VIE Structure. 

8.3. National security – a key factor to scrutinize the VIE Structure

On February 3, 2011, the State Council promulgated the “Notice of the General Office of the State Council on Launching the Security Review Mechanism for Mergers and Acquisition of Domestic Enterprise by Foreign Investors”, which established the national security review system for merger and acquisition (M&A) transactions by foreign investors in China.  On August 25, 2011, after a trial implementation period of about six months of an interim regulation on the security review system, the Ministry of Commerce finalized and issued the “Regulation on Implementing of the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors”, which came into effect 1 September 2011.  The national security review system as established and specified under the notice and the regulation may have a broad impact on prospective M&A transactions by foreign investors in China. 

A center of focus has been the new requirement that foreign investors may not for any reason evade the security review process through entrustment, phased-in investment, leasing, loans and control agreements.  Therefore, the VIE Structure could fall under the scrutiny of the new regulation. 

9. Conclusions

--The VIEs will be grandfathered.

--The Chinese government will tighten up administration on the VIE Structure.

--However,  the Chinese government will not eradicate the VIE Structure completely. 

--The VIE Structure might be prohibited in relation to sensitive inbound M&A deals such as the deals that may trigger the concern on national security.

--VIEs might be used for some other uncommon purposes such as avoiding tax reporting under the Common Reporting System.

*Henry Chen, former AP Compliance Director of Ford, is licensed to practice law in China and New York State of the USA.  Henry provided policy analysis and legal services to to one of the world largest Internet search engine service providers on its autonomous driving projects, Henry also provided legal and compliance services to the largest automotive manufacturers in the world.  Henry's practice areas include risk management of compliance risks on monopoly, bribery, data privacy and security; PR and crisis management on governmental investigations; setting up compliance management system; conducting internal investigations on corporate frauds.  Henry is a member of Chinese delegation on ISO TC309 of the Organization of Governance regarding ISO19600 Compliance Management System, ISO37001 Anti-Bribery Management System and other international standards.  Henry is the author of the book Risk Management on Commercial Bribery in China.  

Henry is accessible via

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