The ultimate purpose behind dismantling a red chip is to return shareholders’ equity in the offshore listed entity to the domestic listed entity. At its core is an adjustment of the equity structure of one or more companies, and the common means of doing so include equity transfers, capital increases, buybacks and share swaps.
An equity structure adjustment may involve ODI, FDI, capital increment of a foreign-invested enterprise, and equity transfer, among others. The crucial issue for evaluating the compliance of the dismantlement and the key point of an IPO review process is in both whether the required approval procedures have been fulfilled. In both scenarios, companies must ensure they handle these matters in a timely manner.
While ensuring compliance, the design of the legal procedures should take a back seat to commercial benefits. That is, the legal procedures should be appropriate to fulfilling the principle of maximising commercial benefits for the client – and this is the mindset under which a qualified commercial lawyer should be operating.
As dismantling a red chip does not bestow direct economic benefits on an enterprise, consideration of commercial benefits mainly means how costs are reasonably controlled. The main costs include funding, time, tax and tax base. Only by planning a reasonable fund flow track in light of the actual circumstances of the project, after balancing the above-mentioned costs, can the client’s benefits be maximised.
Funding costs. An enterprise is usually required to pay transaction consideration, making the cost of using funds one of the key factors to be considered. Lawyers should consider the enterprise’s financing capabilities and funding costs to reverse-adjust the plan design. If an enterprise has some funds that can be used in the dismantlement, this can reduce utilisation costs of the funds. For example, if proceeds from a previous fundraising exercise have not been used, these may go towards the payment of consideration and so contribute to the flow.
Time costs. If the enterprise does not have strict requirements in terms of the timetable, and provided that the fund flow constitutes a closed loop (its starting point and end point are the same, and the amounts are essentially matched), funding costs can be reduced by arranging for the funds to cycle multiple times. In contrast, if there is a strict timetable, it can shorten the time required for red-chip dismantlement by completing the fund flow in one go, which is usually only achievable with a large bridging loan of some sort.
Tax costs. The transaction taxes at each step are the core issues in the design of the plan. Transaction taxes are subject to numerous factors, such as net assets and historical transactions, which will mean transaction prices and tax costs vary under different plans. Thorough consideration needs to be given to these factors in each subsidiary of the enterprise to formulate a transaction plan and thus reduce the tax costs.
Tax base loss. For a private enterprise, when dismantling a red-chip structure, there are no mandatory laws or regulations that require it to have its equity valued when it is returned to China, or that it be valued at such a level should an evaluation take place. The enterprise is free to set its own prices for the transactions but the taxes on these need to be paid based on the valuation determined by the tax authority. There can be a discrepancy between the consideration paid and the valuation reported for tax purposes.
However, the issue that arises when a transaction is conducted at below market price is tax base loss, particularly because the valuation is usually higher when the investors enter at the last financing round, so that, if a transaction is then conducted at a low price, the investors are likely to suffer a large tax base loss and bear higher tax costs in the future when divesting.
Fund flow planning. As the execution of legal procedures for a dismantling of a red chip is not contingent on the completion of the fund flow, the legal procedures and the flow may be planned and implemented independently of one another.
The clearing of claims and liabilities also needs to be considered. After an enterprise has completed setting up of a red chip structure, if the proceeds raised by the offshore listed entity are lent to operating entities by loans from the offshore shareholders, consideration needs to be given to timely clearance of the relevant claims and liabilities at the time of cash flow planning. Failure to do so will mean the offshore entities will continue to have claims against the domestic operating entities – and cannot be written off and liquidated – after the red-chip structure is dismantled. This will also lead to the issue of remaining related-party transactions that have not been fully disposed of when the IPO application is made.
When designing a red-chip dismantling plan, it is necessary – taking the bending of the fund flow into a “closed loop” as the guidepost – to design a set of appropriate legal procedures and steps to allow the enterprise to make payment in multiple instalments or to flexibly select the currency for the bridging funds, so as to maximise the client’s benefits.
The design of a red-chip dismantling plan is the art of balancing legal compliance and commercial benefits. It involves a series of tasks, such as legal procedure design, fund flow planning, transaction pricing, tax cost estimation, claim and liability clearance. Each factor constrains and affects the others, such that changing one condition will result in a substantive change to the plan as a whole. Lawyers have to consider the specific characteristics of the project itself and, in terms of compliance, reducing tax costs, avoidance of tax base loss, reduction of funding pressures and assurance of the project timetable, seek a balance point that is in keeping with the client’s and investors’ interests and satisfies the timing demands of the application.
It should be noted that as state-owned enterprises must comply with regulations relating to state-owned assets, they have less flexibility than private enterprises in plan design. Special consideration is required and each project should be treated on a case-by-case basis.