Red-chip arrangements have served as a route for Chinese companies to tap international capital markets and bring in foreign capital. With the improvement in China’s onshore capital market framework and an evolving cross-border regulatory environment, the return of red-chip entities has become a trend in capital markets.
Classification
The term “red-chip structure” refers to a corporate arrangement in which a PRC resident enterprise or individual transfers ownership of onshore operating assets to an offshore holding entity, using that offshore vehicle as the financing platform. Such structures are classified as either direct equity structures or contractual control structures (or VIE, short for variable interest entity).
A direct equity structure involves the offshore holding company taking a direct or indirect equity stake in the onshore operating entity. The control chain under this model is transparent and is observed in industries without foreign ownership restrictions, including advanced manufacturing and consumer products. The VIE structure operates through a suite of contractual arrangements between a wholly foreign-owned enterprise (WFOE), the onshore operating company (the VIE or operating company [OPCO]), and its shareholders. These agreements enable the offshore holding company to consolidate the onshore entity’s financials and exercise control over it. The model is typically used in industries where foreign ownership is restricted, including value-added telecoms and education.
Dismantling
Partner
Commerce & Finance Law Offices
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The aim in dismantling a red-chip structure is the onshore repatriation of control and the controlling holding vehicle.
In the case of a direct equity structure, the dismantling method is a mirror image equity transfer: shareholders incorporate an onshore holding vehicle, which then purchases the onshore assets held, directly or indirectly, by the offshore holding entity, returning control onshore.
The case of MGI Tech illustrates the process. The controlling shareholder and other shareholders first formed an onshore holding platform; then the platform acquired the equity stake in the onshore operating company; and finally, the onshore operating company bought out the offshore holding company.
In the case of a VIE structure, the path to dismantling lies in entity selection and agreement termination – namely, choosing either the OPCO or the WFOE as the prospective listing vehicle and cancelling the control agreements. iSoftStone, for example, proceeded with the WFOE as its listing entity, while Bona Film Group chose the OPCO. In addition to the principal routes, further variations involve decisions on retaining elements of the offshore holding structure, exiting offshore investors, and winding up the WFOE.
Critical details
Tax consideration. Unwinding a red-chip structure triggers a chain of equity and/or asset transfers, each potentially giving rise to tax costs. To illustrate, buying back equity from investors at the offshore holding level can crystallise withholding tax on an indirect transfer, while the subsequent transfer of the onshore operating entity’s shares from the offshore holding company to the shareholders may attract direct-transfer corporate income tax (by way of withholding tax). MGI Tech’s red-chip unwinding, for example, incurred about RMB136 million (USD20 million) in income tax liabilities.
Liquidity and capital movement. Dismantling a red-chip structure often involves deploying sums to buy out offshore investors’ equity in the offshore holding company, and to discharge any loans taken on during privatisation (as illustrated by iSoftStone). The more funding rounds and the larger the amounts raised, the greater the capital outflow required at the dismantling stage.
Capital must flow through each leg of the transaction to demonstrate that every step has been completed, and that the entire unwinding process is free from disputes or uncertainty. Ideally, funding sources should be diversified, drawing on the company’s resources, shareholders’ capital, third-party bridge facilities, and injections from incoming investors.
Employee stock ownership plan (ESOP) rollover. As the red-chip structure is unwound, offshore employee share schemes must be transitioned into domestic shareholding vehicles that hold interests in the intended listing entity. This requires preserving the consistency of employee rights throughout the migration and properly accounting for any share-based payment expenses. The onshore entity seeking to list must also establish incentive arrangements and execute the relevant documentation. By way of example, RuanShi ZhiDong and RuanShi No.6 served as the onshore employee shareholding platforms when iSoftStone returned to the domestic market.
Foreign exchange compliance. Under red-chip arrangements, PRC resident individuals investing in offshore holding company shares through an overseas special purpose vehicle are required to comply with State Administration of Foreign Exchange rules, including the circular on foreign exchange administration of offshore investment, financing and return investment by PRC residents.
The controller of Highpower Technology, for instance, had filing defects at the setup stage, and when supplementary registrations were sought in 2013, each person received a RMB10,000 fine. Dismantling a red-chip structure also triggers an obligation for the relevant natural persons to cancel their foreign exchange registrations. At Haike New Energy, 44 natural persons applied for collective deregistration following the unwinding of the structure.
Regulatory focus
Regardless of whether the aim is an onshore or an offshore listing, any unwinding of a red-chip structure must be carried out in a lawful and compliant manner. Where a domestic listing is pursued, the regulatory review focuses with intensity on the dimensions set out below.
Transparent ownership structures. Undisclosed nominee shareholdings or trust arrangements in the entity to be listed must be eliminated (the iSoftStone case is instructive).
Stable control. The red-chip unwinding must be structured so that the ultimate controller does not change, as any such change would delay the listing process. Techking illustrates this approach: a restructuring framework agreement was executed to define the unwinding path and preserve control stability.
Fair value. All equity transfers forming part of the red-chip unwinding must be priced on a fair and reasonable basis. MGI Tech’s successive transfers were each supported by professional appraisal reports. Where prices diverge sharply within a single period, the company must demonstrate that the differences are justifiable.
Operational independence. Business restructuring often accompanies the dismantling process, and the entity to be listed must operate independently of any other businesses controlled by the controlling shareholder or ultimate controller. During its restructuring, iSoftStone absorbed the relevant personnel, core technical teams, contracts and assets of the separated entities to ensure that its business remained autonomous.
Compliance throughout the process. Regulators reviewing a listing will assess the lawfulness of every step in the red-chip structure’s lifecycle – both its creation and its unwinding – covering compliance with foreign investment, outbound investment, foreign exchange, and tax laws and regulations.
Vincent Shen is a partner at Commerce & Finance Law Offices. He can be contacted by phone at +86 21 6019 2659 and by email at shenjun@tongshang.com
