After coming under pressure from tax authorities in China and elsewhere, offshore jurisdictions are fighting hard for China business. George W Russell reports
Offshore finance came under heavy scrutiny from tax authorities and other regulators in 2009 as the global financial crisis spread. The Organization for Economic Co-operation and Development updated its list of “uncooperative tax havens”, with the threat of sanctions enforced by the US, EU and other major markets.
The future of offshore finance looked uncertain. But two years on, the appetite for offshore legal structures and the lawyers able to advise on them shows no signs of diminishing. “The right blend of offshore and onshore expertise has proven vital to achieving favourable resolutions of insolvency and restructuring issues resulting from the global financial crisis, while international financial centre structures have greatly assisted global private equity houses in their recent efforts to build a stake in the burgeoning industry in China,” says Guy Locke, managing partner of the Hong Kong office of Walkers, a prominent offshore law firm.
According to Peter Cockhill, a Cayman Islands partner at Ogier, another offshore firm, “the competition for offshore business is increasing”. Cockhill is also a director of Cayman Finance, the promotional and lobbying agency for the islands’ financial services industry. The Cayman Islands, along with the British Virgin Islands (BVI), have emerged as a major destination for Chinese offshore investment.
Both Cayman and the BVI have had to deal with a recent hardening of attitudes by Chinese officialdom towards offshore jurisdictions. The new hard line manifested itself in two circulars from the State Administration of Taxation: Circular 698 and Circular 601. Both were designed to clamp down on tax evasion (see Paradise lost?, China Business Law Journal volume 1 issue 3).
As we reported last year, Circular 698, issued in December 2009, states that a foreign company can be taxed on the indirect transfer of an equity interest in a subsidiary in China. An indirect transfer occurs when the foreign company transfers the shares of a non-PRC subsidiary that in turn holds a subsidiary in China. If the subsidiary outside China whose shares are transferred is established in a low-tax jurisdiction, the seller must report the transaction to the local tax authorities in China where the Chinese subsidiary is located.
“Circular 698 is the PRC regulatory change that has had the greatest impact on corporate structuring for Chinese companies,” says Cockhill. “The PRC tax authorities look at these transactions to ensure that there is a reasonable business purpose for the transaction, although it is not yet clear how the authorities interpret that phrase.”
Cockhill notes that many companies using the Cayman Islands as an offshore base do not have bricks-and-mortar businesses located in China. “It is unsure how the interpretations will affect the use of Cayman holding companies and funds for Chinese investment, as Cayman is tax neutral and does not have capital gains, income, property or other direct taxation.”
Hong Kong lawyers concur that 698 could have wide-ranging effects. “From a structuring perspective, inbound investment has been affected by Circular 698,” says Nick Plowman, a partner at Ogier in Hong Kong. “In essence, Hong Kong companies have now been interposed within offshore investment structures, due to the favourable withholding-tax treatment afforded to them.”
Some lawyers insist that 698 has not had a huge impact. “Circular 698 results in a capital gains tax of 10% for a transfer of shares in an offshore holding company which is located in a jurisdiction which either has an effective tax rate below 12.5% or does not tax residents on overseas income,” says Arwel Lewis, a Hong Kong partner with Walkers. “Our clients have welcomed the certainty on this issue and have factored the additional costs into their financial models.”
Circular 698 was issued a month after Circular 601, which states that Chinese tax authorities might adopt the “substance over form” principle in deciding whether a non-tax-resident enterprise is a beneficial owner (and therefore subject to tax). Circular 601 covers dividends, royalties and interest. Under 601, a special purpose vehicle (SPV) established outside China will be disregarded for determining country of residence if the SPV has a limited function.
Lawyers advise that if companies want to avoid the “limited function” description, Chinese tax authorities must be able to identify “substantive business activities” in non-tax-resident enterprises. There are seven major identifiers: a physical office is located in that treaty jurisdiction; local employees and corporate directors are hired; a local bank account is opened and maintained; board meetings are held in that jurisdiction; corporate records are kept in the physical office; the office is registered with local tax authorities; and management decisions are made in that jurisdiction.
Lawyers also say the circulars are not meant to discourage the use of offshore jurisdictions, only their abuse. “There was concern about the misuse of offshore vehicles, especially by PRC nationals for round-tripping,” says Frances Woo, a Hong Kong partner at Appleby, an offshore firm.
While learning to adapt to a tougher regulatory environment, offshore firms appear to be building capacity. At the end of 2010, Harney Westwood & Riegels (Harneys) hired three lawyers – Cheng Cheng Tan, Kane Guo and Zhao Feifei. Their arrivals bring to eight the number of lawyers based in the firm´s Hong Kong office. Guo says his hiring by Harneys reflects the firm “expanding its focus on China”.
Other firms are also focusing on the region. “Asia is critical to our growth strategy and we have already made significant steps in this regard,” Nick Kershaw, chief executive of Ogier, said in announcing James Bergstrom’s appointment as managing partner of its Hong Kong office in January. “Our Hong Kong office is the fastest growing in the group,” he added.
One major reason for the staffing increase is the rising use of offshore legal centres by Chinese companies. Last October, Beijing-based Winsway Coking Coal Holdings became the first BVI-registered company to list on the Hong Kong stock exchange (HKSE). “There is certainly more attention on BVI companies’ ability to list on the HKSE now,” says Plowman.
Firms like Ogier are gearing up for a spate of new listings. “I am of the view that this interest will continue to grow,” Plowman adds. “More BVI companies will list on the HKSE, given the number of BVI companies in Asia and the relative ease with which existing holding structures can be prepared for listing without the need for a comprehensive restructuring to provide for a new listing vehicle.”
Some of the movement towards offshore centres may be due to dissatisfaction with major-market exchanges. In 2010, Xi’an-based West China Cement delisted from the London Stock Exchange and listed in Hong Kong, seeking a higher valuation. “The British don’t understand China and our stock has been severely undervalued,” chairman and chief executive officer Zhang Jimin said at the time. “I believe more enterprises will follow suit in the near future.”
Carey Olsen partner Guy Coltman, and associates Claire O’Boyle and David Allen, advised West China Cement on its Hong Kong listing, which used a Jersey vehicle. “This is a major listing for Jersey and an important milestone in our dealings with the domestic Chinese market,” Coltman noted when the deal was announced.
The listing, the first for a Jersey-incorporated company in Hong Kong, followed Carey Olsen’s advising of Jersey Finance – a non-profit, semi-official organization that aims to promote Jersey as an international financial centre – on its application to the HKSE for approval of the admission for listing of companies incorporated in Jersey.
Authorities in Jersey seem unworried by China’s apparent crackdown on offshore structures. “I believe that Circular 698, to some extent, enhances Jersey as an attractive jurisdiction to structure complex transactions … due to it being a well regulated jurisdiction of substance and reputation,” says Geoff Cook, chief executive of Jersey Finance.
Hong Kong faces competition from some offshore jurisdictions as a listing venue. NASDAQ Dubai – the Dubai International Finance Centre exchange that was rebranded in 2008 after NASDAQ OMX’s acquisition of a one-third stake – seeks to attract Chinese companies, among others, with the first overhaul of its rules since it was founded in 2005.
Proposals announced last year would ease Dubai’s market capitalization and credit rating requirements, and replace a complex sponsorship arrangement with a lead manager role. “As with the HKSE, NASDAQ Dubai is seeking to attract Chinese company listings to its exchange by allowing BVI-registered or other offshore-registered Chinese companies to be listed on the exchange,” says Eric Milne, a partner with Jones Day in Dubai.
A favourable tax regime in Dubai has also attracted interest from the Chinese. “Over the past year, Chinese companies have become more familiar with the double-taxation treaty (DTT) between China and the United Arab Emirates (UAE), as well as the increasingly wide spectrum of DTTs available when using a UAE structure [which are] able to justify a bona fide business activity in the jurisdiction,” says Yann Mrazek, managing partner in Dubai at Swiss law firm Cramer-Salamian.
In the wake of Circulars 698 and 601, China is expected to continue to hone its investment oversight. Recent legislation, including Assessment and Collection of Enterprise Income Tax on Non-resident Enterprise Administrative Measures (Guoshifa (Notice 19), February 2010) has implications for offshore vehicles. “Enterprises registered in the British Virgin Islands, Cayman Islands and Bermuda, which do not have a comprehensive DTT with China, are subject to enterprise income tax pursuant to Notice 19,” says Spark Shi, a senior lawyer at tax boutique Hwuason in Beijing.
Offshore financial centres say they’re ready to adjust to changing rules in China, the US, Europe and elsewhere. “We will work within this new regulatory framework,” says Sherri Ortiz, executive director of the BVI International Finance Centre in Road Town.
However, the improving global economy has taken the pressure off. “The hostility shown towards offshore jurisdictions by certain onshore jurisdictions has generally decreased as the effects of the global financial crisis have receded,” observes Richard Hall, a partner at Conyers Dill & Pearman in Hong Kong.
BVI officials, for example, display confidence. “Rather than being forced to react to legislation enacted elsewhere, we have been able to ensure that the new rules we enact here not only comply with international standards, but also improve our competitive position,” says Ortiz.
Indeed, competition is expected to intensify as rival Caribbean locations such as Anguilla, a British dependency, and the Bahamas, an independent Commonwealth nation, seek to attract Chinese investment. “There is a strong and growing relationship between China and the Bahamas that extends to the areas of international cooperation and investment,” says Wendy Warren, chief executive officer and executive director of the Bahamas Financial Services Board in Nassau.
Competition comes not just from rival offshore centres but also from onshore markets that are hoping to grab a slice of the action. European jurisdictions such as Cyprus, Ireland, Liechtenstein, Luxembourg, Monaco, the Netherlands and Switzerland are also courting Chinese companies with tax breaks and hands-off regulation.
Lawyers in Cyprus point out that the island is also an approved jurisdiction for the HKSE. “Cyprus has an excellent reputation internationally and companies using Cyprus structures are much less likely to face increased scrutiny from their domestic tax authorities than companies with links to offshore centres,” says David Stokes, an attorney with Andreas Neocleous & Co in Limassol, which has applied to open an office in Beijing.
“Over the past few months we have continued to see a healthy level of work involving Chinese businesses,” Stokes adds. “Most involve Chinese companies using Cyprus as a base for expansion into Europe, but we have also been involved in one or two transactions where all the principals were based in Asia: for example, a loan from a Chinese bank and a Singaporean bank to a company listed in Singapore.”
Cyprus may face an uphill battle to draw business away from traditional offshore centres. “The BVI has long been popular as a corporate domicile for Chinese businesses as it offers efficiency and cost advantages over other offshore jurisdictions,” says Michalis Kyriakides, a partner with Harris Kyriakides in Larnaca. “Cyprus still remains an attractive location for Chinese offshore businesses as it provides a set of advantages unique to its location and tax regime.”
In Ireland, lawyers note that Irish SPVs owned by regulated Irish funds have been deemed to meet the requirements of a substantive business presence and have been permitted treaty access to China. “So while Circular 601 has cut down on companies in places like Barbados and Mauritius benefiting from treaty access in China, onshore jurisdictions such as Ireland remain well placed as part of the holding structure for Chinese investments,” says Caroline Devlin, a partner with Arthur Cox in Dublin.
Lawyers in Ireland also hope that the proposals whereby subsidiaries of Chinese fund management companies and brokerage firms may acquire RMB-denominated qualified foreign institutional investor (QFII) quotas for the purposes of investment into China may be extended to Irish-domiciled vehicles. “While the initial structures and proposals have revolved around the use of Hong Kong-regulated entities for the purposes of such investments, we are hopeful that as the scheme develops, there may be scope for eligible quota holders to use vehicles domiciled in Ireland,” says Shay Lydon, a partner with Matheson Ormsby Prentice in Dublin.
Caribbean offshore centres tend to dispute Irish claims that Ireland has eaten into their business. “Cayman continues to hold its ground as a market leader for offshore jurisdictions,” says Cockhill. “Claims that investment funds domiciled in Cayman have relocated to places such as Dublin are unsubstantiated by the statistics,” he adds.
Other Asian jurisdictions such as Singapore are also courting Chinese investment, presenting the Lion City as a more credible alternative to the offshore jurisdictions. “Singapore companies are perceived as more credible. Using them as SPVs for investment activities give comfort to the parties receiving these investment versus a direct investment from a Chinese company,” says Aloysius Wee, managing partner of Dacheng Central Chambers, a joint venture law firm between Beijing-based Dacheng Law Offices and Singapore’s Central Chambers Corporation.
Such intense rivalry among offshore firms indicates that China will be a lively battleground. Even the question of which jurisdiction to serve China-related clients from is a matter that divides opinion. Conyers Dill & Pearman handles China work through its Mauritius office, which opened in mid-2009, while Cayman Islands-based Walkers serves China out of its Singapore office, opened in February 2009, from which it also works on its significant India practice.
Meanwhile, Ogier established a practice in Hong Kong covering BVI, Cayman Islands, Guernsey and Jersey law. BVI-based Harneys has also opened a Hong Kong office, while Carey Olsen, with offices in Guernsey, Jersey and London, has so far resisted overseas expansion, given that Russia and Southeast Asia are just as important to the firm as China.
Some offshore law firms see a potentially profitable future in the formation of RMB funds – investment funds that have capital commitments and contributions denominated in China’s currency. Since 2009, the central and several municipal governments in China have enacted rules and regulations to enable the formation of RMB funds.
Most recently, at the end of December last year, the Shanghai municipal government released the Work Carried Out in Pilot Projects of Foreign-funded Equity Investment Enterprises Implementing Measures. “The Shanghai RMB fund regulation should be welcome news for non-Chinese fund managers considering forming and operating a private equity fund in Shanghai,” Thomas Shoesmith, who leads the China practice at Pillsbury Winthrop Shaw Pittman from Silicon Valley, notes in a recent analysis.
“Anything relating to RMB financing is quite sexy these days,” says Woo at Appleby. “Many of our international private equity and hedge fund clients are looking very closely at the RMB fund market.”
While the tide of investment may ebb and flow between jurisdictions, it is safe to say that the use of offshore structures will continue. “There will always be a demand for the use of offshore structures for transactions for Chinese companies venturing overseas,” says Wee. “As long as China has a foreign exchange control policy and with the issue of the revaluation of the RMB still in question, offshore structures will still serve a commercial purpose.”
Some offshore deals and who helped them happen
Transactions involving Chinese entities and offshore components tend to fall into one of three categories: capital markets, mergers and acquisitions (M&A) and private equity deals.
China-related listings often have offshore components. Maples and Calder advised as Cayman Islands counsel on two Hong Kong listings in June last year. The first of these was China Liansu Group, a manufacturer of plastic pipes and fittings, along with Fried Frank Harris Shriver & Jacobson, Jun He Law Offices and Skadden Arps Slate Meagher & Flom. The second was Trauson Holdings, a maker of orthopaedic products, along with Ashurst, Jackson Woo & Associates and Latham & Watkins.
Walkers, meanwhile, acted as Cayman Islands counsel to underwriters Goldman Sachs and CLSA on the US$2.5 billion IPO of Sands China, a subsidiary of the New York-listed resort and casino operator Las Vegas Sands, on the Hong Kong stock exchange in December 2009. It was one of the largest recent IPOs involving an offshore entity.
Hong Kong-based corporate partner Denise Wong advised on the Sands listing. Davis Polk & Wardwell, Freshfields Bruckhaus Deringer, MWE China Law Office, Sidley Austin and Macau firms Advogados & Notários and Alves, Leonel Alberto,dr-Escritório also contributed advice.
Meanwhile, John Trehey led a Maples and Calder team acting as Cayman Islands and BVI counsel to China SCE Property Holdings for its issue of RMB2 billion (US$306 million) in US-dollar denominated senior notes. (Davis Polk & Wardwell and Paul Hastings Janofsky & Walker were also involved).
Conyers Dill & Pearman advised Sunac China, a property developer, on Cayman law in respect of its HK$2.6 billion (US$336 million) Hong Kong listing. (Jincheng Tongda & Neal, Jun He Law Offices and Norton Rose also took part). Another property company, Shijiazhuang-based Tian Shan Development, listed on the Hong Kong stock exchange in July last year with a HK$377 million offering with Appleby acting as Cayman Islands counsel.
Appleby, meanwhile, launched the first dual listing in Hong Kong and Singapore by an offshore company – BVI-incorporated China New Town Development. “The dual listing raises its credibility with investors and allows analysts to really follow the movement of the stocks,” says Frances Woo, a partner at Appleby in Hong Kong. Latham & Watkins advised the sponsor, Standard Chartered Securities.
After West China Cement used a Jersey vehicle to switch its listing from London to Hong Kong in 2010 in search of a higher valuation, partner Guy Coltman and his St Helier-based team at Carey Olsen advised the same company on the listing of US$400 million in senior notes on the Singapore exchange.
M&A transactions involving an offshore special purpose vehicle also require offshore legal help. Wong at Walkers advised Korea-based Lotte Shopping on its 2010 takeover of Times, a Chinese retailer. Herbert Smith and Norton Rose also worked on that deal.
Maples and Calder acted as BVI counsel to an institutional investor, a pension fund and a unit of CapitaMalls Asia in connection with their acquisition for S$759 million (US$589 million) of 55% of an offshore SPV involved in developing CapitaLand’s second Raffles City development in Shanghai. Commerce & Finance Law Offices, Rajah & Tann and WongPartnership also featured in the deal.
Some M&A deals involve the largest private equity players in the China market. In 2010 Carlyle Asia Pacific Buy-Out Fund II sold its 49% stake in Cayman Islands-incorporated China Yangzhou Chengde Steel Tube Company to Precision Castparts, a US steel company.
The Carlyle deal highlights the continuing need for China-specific expertise. “While the entity sold to Precision Castparts is a Hong Kong SPV controlled by a Cayman Islands company, the PRC’s foreign investment policy, governmental approvals, antitrust, tax and corporate governance matters drove the entire sale process,” says Greg Miao, who leads the China M&A and corporate practice at Skadden Arps Slate Meagher & Flom in Shanghai, and who led the representation of Carlyle.