Company Registration in the Cayman Islands under the Foreign Investment Act
Release time：2016-09-12 11:23
The Cayman Islands is perhaps the best-known offshore destination for company registration around the globe, and its fame comes down to the Variable Interest Entity (VIE) structure. The VIE structure was originally created by the Chinese Internet company Sina, during a time when it was tough for the company to finance domestically. The state doesn't allow foreign capital to be directly invested into Internet companies in China, so Sina's investors registered a company in the Cayman Islands, through which it could indirectly maintain control. Relying on this miraculous legal structure, Sina successfully financed from outside of China and eventually got listed in the overseas capital markets.
Foreign investors choose the Cayman Islands not only because of its good supporting services, including information non-disclosure, efficient registration, tax-exemptions, and absence of foreign exchange regulations, but also because the registration of a company in Cayman has the appeal of facilitating a smooth financial process that allows enterprises to get listed in the U.S. or Hong Kong.
Since then, Alibaba, Baidu and several other large Internet firms have dealt with the difficulty of financing by adopting this VIE structure, and eventually got listed on the NASDAQ. It is said that, on average, over 4,300 Chinese enterprises are registered in Cayman per year, and in the past two decades, 44 of the 50 family enterprises successfully listed in Hong Kong were registered in the Cayman Islands. In 2015, Li Ka-Shing also changed his enterprises' domicile to the Cayman Islands. In terms of offshore company registration, the Cayman Islands is a god-like entity to entrepreneurs.
The Chinese government's announcement of the Foreign Investment Act (yet to be enacted), however, has to some extent implied the termination of the Cayman Islands' golden days for offshore registration.
The Foreign Investment Act is a law that allows China to regulate foreign investment. The context of its introduction is that a large number of Internet and telecommunication giants – including Sina, Alibaba and JD, with market capitalizations in the region of CNY 100 billion – were being controlled by foreigners, and fell beyond the scope of China’s regulation. Meanwhile, the opening of the Internet sector endangered state security and social stability in China. In particular, after a decade of high speed growth, China has powerful economic strength, therefore, it is unwilling to let foreign capital continue to invest in or control the Technology, Media and Telecommunications (TMT) sectors which concern state information security and big data.
The act strictly regulates foreign investment and the Chinese government expects to encourage Chinese enterprises to seek domestic financing channels by restraining foreign capital from entering core TMT sectors, thereby stimulating China's economic vitality and ensuring national economic security. Such an act is, to investors who register controlling companies in the Cayman Islands in order to invest domestically, a deadly strike, as it destroys the VIE structure of overseas financing and overseas listings. This will definitely inflict great losses on the Cayman Islands, significantly reducing the number of offshore company registrations. The number of offshore companies registered in BVI, Hong Kong and other offshore jurisdictions will dramatically decrease as well.
The provisions of the Foreign Investment Act state:" enterprises established under the laws of other states or regions" and "domestically-funded enterprises controlled by the subject of the foregoing clause" are all considered foreign investors, and the act requires a review of access of foreign investment. Once it enters into force, the act will cause the following effects on registration of offshore companies in the Cayman Islands:
1. The number of Chinese citizens and companies that transfers domestic capital to Cayman by establishing offshore companies, and then obtain preferential policies or tax preferences by way of inbound investment to the domestic TMT sector, will decrease. Because a company established in Cayman is considered a foreign investor in such a case, it will be subject to strict restrictions on investments to China's TMT and other sectors.
2. A person who is either naturally or legally foreign who registers offshore companies in Cayman and then invests in domestic companies by other supportive structures will also be subject to restrictions, as with certain sectors in which such investors invest. The sectors which affect state information security and domestic technology, for example, are the precise targets under the Foreign Investment Act's restrictions.
3. How should foreign investors who previously registered companies in the Cayman Islands and invested in domestic sectors subject to prohibition or restrictions handle this? There is simply no way. Splitting the existing VIE structure to get listed in China or transferring equity interest to third parties legally eligible as a transferee is inevitable. In fact, the attractive valuation of A stocks has triggered the desire of the China-concept technology companies to get back into the A stock market. One example is Baofeng Technology, which is following this model of splitting a VIE structure and getting back into the A stock market. However, for those VIE enterprises already listed overseas, including Baidu, Alibaba and Tencent, it's incredibly risky to get back into the A stock market as it involves pricing transfers, tax-management, foreign exchange and many other barriers.
4. For start-ups with a VIE structure controlled by a domestic individual, this will affect their efforts to destroy their initial VIE structure. Although they can be directly identified as Chinese-invested enterprises, in the long run they will also lose opportunities to acquire capital injections by foreign VC investment agencies.
Besides all this, there is also a case that needs special attention. Chinese enterprises that are domestically invested would often, in order to strengthen control over the enterprises or resolve the issue of inheritance of family wealth, establish trust by registering offshore companies in the Cayman Islands before enterprises were listed (if ever) to resolve marriage property planning, control-strengthening over the enterprises, employee equity incentives, and family wealth inheritance. LongFor Estate achieved the aforementioned objectives by establishing complex structures in Cayman and elsewhere before listing, and Wu Yajun (owner of LongFor) and her husband Cai Yingkui divorced in a peaceful manner after the enterprise was listed because no split of the equity interest was required. Such a story wins praise from entrepreneurs.
But after the Foreign Investment Act enters into force, the complex structures of these kinds of registration in the Cayman Islands and other offshore jurisdictions will all be affected. They will not be feasible for sensitive or prohibited sectors that are restrained by the state, and even sectors that are not prohibited or restrained by the Foreign Investment Act will possibly be negatively affected too. Because the provisions regarding examination in the Foreign Investment Act are relatively general, it may result in unclear boundaries of the sectors subject to prohibition or restriction.
Based on the aforementioned negative effects caused by the Foreign Investment Act to the VIE structure of registration in the Cayman Islands, whether there will be professionals who can create new legal structures to avoid the restrictions and limitations of such an act is a question that will only be answered in time.
Due to the effects of the Foreign Investment Act, the number of China’s enterprises that register in the Cayman Islands is dramatically decreasing. What is the future of the Cayman Islands? We hope it can still be brilliant.
Foreign investors choose the Cayman Islands not only because of its good supporting services, including information non-disclosure, efficient registration, tax-exemptions, and absence of foreign exchange regulations, but also because the registration of a company in Cayman has the appeal of facilitating a smooth financial process that allows enterprises to get listed in the U.S. or Hong Kong.
Since then, Alibaba, Baidu and several other large Internet firms have dealt with the difficulty of financing by adopting this VIE structure, and eventually got listed on the NASDAQ. It is said that, on average, over 4,300 Chinese enterprises are registered in Cayman per year, and in the past two decades, 44 of the 50 family enterprises successfully listed in Hong Kong were registered in the Cayman Islands. In 2015, Li Ka-Shing also changed his enterprises' domicile to the Cayman Islands. In terms of offshore company registration, the Cayman Islands is a god-like entity to entrepreneurs.
The Chinese government's announcement of the Foreign Investment Act (yet to be enacted), however, has to some extent implied the termination of the Cayman Islands' golden days for offshore registration.
The Foreign Investment Act is a law that allows China to regulate foreign investment. The context of its introduction is that a large number of Internet and telecommunication giants – including Sina, Alibaba and JD, with market capitalizations in the region of CNY 100 billion – were being controlled by foreigners, and fell beyond the scope of China’s regulation. Meanwhile, the opening of the Internet sector endangered state security and social stability in China. In particular, after a decade of high speed growth, China has powerful economic strength, therefore, it is unwilling to let foreign capital continue to invest in or control the Technology, Media and Telecommunications (TMT) sectors which concern state information security and big data.
The act strictly regulates foreign investment and the Chinese government expects to encourage Chinese enterprises to seek domestic financing channels by restraining foreign capital from entering core TMT sectors, thereby stimulating China's economic vitality and ensuring national economic security. Such an act is, to investors who register controlling companies in the Cayman Islands in order to invest domestically, a deadly strike, as it destroys the VIE structure of overseas financing and overseas listings. This will definitely inflict great losses on the Cayman Islands, significantly reducing the number of offshore company registrations. The number of offshore companies registered in BVI, Hong Kong and other offshore jurisdictions will dramatically decrease as well.
The provisions of the Foreign Investment Act state:" enterprises established under the laws of other states or regions" and "domestically-funded enterprises controlled by the subject of the foregoing clause" are all considered foreign investors, and the act requires a review of access of foreign investment. Once it enters into force, the act will cause the following effects on registration of offshore companies in the Cayman Islands:
1. The number of Chinese citizens and companies that transfers domestic capital to Cayman by establishing offshore companies, and then obtain preferential policies or tax preferences by way of inbound investment to the domestic TMT sector, will decrease. Because a company established in Cayman is considered a foreign investor in such a case, it will be subject to strict restrictions on investments to China's TMT and other sectors.
2. A person who is either naturally or legally foreign who registers offshore companies in Cayman and then invests in domestic companies by other supportive structures will also be subject to restrictions, as with certain sectors in which such investors invest. The sectors which affect state information security and domestic technology, for example, are the precise targets under the Foreign Investment Act's restrictions.
3. How should foreign investors who previously registered companies in the Cayman Islands and invested in domestic sectors subject to prohibition or restrictions handle this? There is simply no way. Splitting the existing VIE structure to get listed in China or transferring equity interest to third parties legally eligible as a transferee is inevitable. In fact, the attractive valuation of A stocks has triggered the desire of the China-concept technology companies to get back into the A stock market. One example is Baofeng Technology, which is following this model of splitting a VIE structure and getting back into the A stock market. However, for those VIE enterprises already listed overseas, including Baidu, Alibaba and Tencent, it's incredibly risky to get back into the A stock market as it involves pricing transfers, tax-management, foreign exchange and many other barriers.
4. For start-ups with a VIE structure controlled by a domestic individual, this will affect their efforts to destroy their initial VIE structure. Although they can be directly identified as Chinese-invested enterprises, in the long run they will also lose opportunities to acquire capital injections by foreign VC investment agencies.
Besides all this, there is also a case that needs special attention. Chinese enterprises that are domestically invested would often, in order to strengthen control over the enterprises or resolve the issue of inheritance of family wealth, establish trust by registering offshore companies in the Cayman Islands before enterprises were listed (if ever) to resolve marriage property planning, control-strengthening over the enterprises, employee equity incentives, and family wealth inheritance. LongFor Estate achieved the aforementioned objectives by establishing complex structures in Cayman and elsewhere before listing, and Wu Yajun (owner of LongFor) and her husband Cai Yingkui divorced in a peaceful manner after the enterprise was listed because no split of the equity interest was required. Such a story wins praise from entrepreneurs.
But after the Foreign Investment Act enters into force, the complex structures of these kinds of registration in the Cayman Islands and other offshore jurisdictions will all be affected. They will not be feasible for sensitive or prohibited sectors that are restrained by the state, and even sectors that are not prohibited or restrained by the Foreign Investment Act will possibly be negatively affected too. Because the provisions regarding examination in the Foreign Investment Act are relatively general, it may result in unclear boundaries of the sectors subject to prohibition or restriction.
Based on the aforementioned negative effects caused by the Foreign Investment Act to the VIE structure of registration in the Cayman Islands, whether there will be professionals who can create new legal structures to avoid the restrictions and limitations of such an act is a question that will only be answered in time.
Due to the effects of the Foreign Investment Act, the number of China’s enterprises that register in the Cayman Islands is dramatically decreasing. What is the future of the Cayman Islands? We hope it can still be brilliant.
ByLi Meng
