Doing Business in China via the Cayman Islands (2006 Update)

Many companies doing business in China are using a structure that includes a company formed under the laws of the Cayman Islands (CI). Chinese technology and Internet companies listed on NASDAQ ' such as Actions Semiconductor, Baidu, CTrip, China Medical Technologies, Focus Media, Shanda, Suntech Power and Tom Online ' are actually CI companies. The primary business reasons for an offshore structure are flexibility in an exit strategy, whether in connection with an initial public offering (IPO) or an acquisition; the possibility of reducing U.S. taxes; and reducing the impact of China's currency exchange restrictions.

In the simplest form, the structure is a CI company with a China subsidiary. Investments are made in the CI company and the subsidiary is the operating company. The next simplest form is when the CI company is the parent company of two subsidiary corporations ' one in China and the other in the U.S. A U.S. corporation is needed only if the U.S. is a market for the business. The most complex structure is required when the China business is in a restricted industry such as an Internet business (see, “Investment and Operating in Restricted Industries in China,” www.fenwick.com/docstore/Publications/Corporate/Invest_Operating_In_China.pdf.) Other variations include delaying the formation of a U.S. subsidiary until or if U.S. operations are needed and adding a company from a jurisdiction having a tax treaty with China (such as Mauritius) between the CI and Chinese corporations. Global venture capitalists have become comfortable with these CI structures and many U.S. venture capitalists also understand and use these structures.

Why the Caymans?

While alternative jurisdictions have been carefully compared in previous versions of this memorandum, today a CI company is the clear choice for a China-related business. An important decision factor is that a CI company is eligible for listing on the Hong Kong Stock Exchange. Only CI, Bermuda, China and Hong Kong companies are currently approved for listing on the Hong Kong Stock Exchange. Neither the British Virgin Islands (BVI) nor U.S. companies are approved.

The Hong Kong exchange has become a major exchange for China-related IPOs, in part because of the Sarbanes-Oxley requirements for a U.S. public company. Post-IPO liquidity for stockholders, a prior weakness of this market, appears to have improved. While many Hong Kong IPOs to date have been the privatization of Chinese state-owned companies, this exchange appears to be well positioned to attract Internet, IT and other technology companies. The number and size of China-related NASDAQ listings have declined since 2004. The improvements in the liquidity in the Hong Kong market, the cost of complying with Sarbanes-Oxley and the company economic size needed for a NASDAQ offering are factors that are causing Chinese businesses to increasingly consider an IPO in Hong Kong rather than the U.S. The U.S. may have no relationship with the business itself. Hong Kong may be closer to the businesses primary market when, for example, it is an Internet business focusing on China. Chinese business people also can communicate more easily and effectively with investors, regulators and analysts in their own language in Hong Kong.

Other considerations in choosing a jurisdiction of incorporation include the costs of and time necessary for incorporation, the extent of regulation, and other factors. A CI company traditionally could be incorporated within a day or two while a Bermuda company could take several weeks to establish. Less time is required to amend the charter documents for a preferred stock financing in the CI, and the startup and recurring annual government fees and legal fees are higher in Bermuda than in the CI.

Investors will purchase shares and employees will be granted options in the CI company, the tentative IPO entity. A key consideration for investors is that a conventional security, such as preferred stock, be available for financing. For employees, stock options and other equity incentives need to look and feel the same as those of a U.S. corporation. Both the CI and Bermuda operate under versions of U.K. company and common law, and adequately accommodate these business needs. Neither countries' laws, however, protect shareholders to the same extent as U.S. laws.

The issue for a start-up is to balance the cost of creating too much infrastructure before the business is validated in the market against precluding alternatives that may become too expensive to implement later. Because of the cost of the various CI structures and the uncertainty of business success at the time of start-up, entrepreneurs have considered simpler and lower cost ways of starting a China related business. These include initially using a U.S. corporation, obtaining initial validation for the feasibility of the business, and then later reincorporating in the CI and expanding the structure. This latter scenario is sometimes referred to as a 'corporate inversion.' The tax cost of an inversion, however, can be extremely high as explained below. While the authors' general approach is to keep things simple until a business is validated in the market, some infrastructure may be needed at the outset to preserve alternatives.

The bottom line in comparing the jurisdiction selection factors is the track record of CI companies going public on NASDAQ and the growing importance of Hong Kong for an IPO exit.

U.S. Tax Considerations

Many offshore business formations will not provide immediate U.S. tax minimization. Up to and possibly after an IPO, ownership of the CI company by U.S. shareholders may cause U.S. tax consequences for the CI company to be similar to those for a U.S. corporation. Thus, when commentators refer to a CI structure as being a 'tax-free' way to operate, they mean there is no taxation in the CI on income from sources outside the CI.

There are three important U.S. tax planning considerations:

1. The transaction of incorporating or reincorporating offshore,
2. Ongoing U.S. income tax liability of the U.S. shareholders of the foreign parent entity, and
3. Making sure the business operations of the foreign parent entity are not subject to taxation in the U.S.

While in the past, entrepreneurs had the flexibility of starting with a California or Delaware corporation, and then reincorporating the parent entity off-shore through an 'inversion' transaction once the business plan was validated, this alternative has become very expensive due to changes in the U.S. tax laws. Following the enactment of the 2004 Tax Act, the ability to reincorporate a U.S. parent company structure off-shore via an inversion transaction is severely limited. While not impossible, an inversion transaction today typically is not effective absent a significant capital infusion from new third-party investors or an unrelated foreign acquirer. In most cases, an inversion transaction will be disregarded for U.S. tax purposes, resulting in the new foreign parent company being characterized as a U.S. corporation for U.S. tax purposes. In addition, the new 'anti-inversion' rules can impose a substantial tax penalty with respect to the unexercised options of certain 'insiders' of the management team. These anti-inversion rules have proven to be very frustrating for a number of our clients seeking to pursue IPOs outside the U.S. As such, entrepreneurs must carefully consider whether an offshore parent structure should be formed at the outset.

Over the years, Congress has devised a number of ways to prevent tax avoidance (or U.S. tax 'deferral') by going offshore. The U.S. anti-deferral tax rules are very complicated and what follows is a very simplified summary. The tax rules are tricky and a trap for the unwary. A foreign company may be a controlled foreign corporation (CFC) or a passive foreign investment company (PFIC). The tax law applicable to CFC's essentially requires the U.S. shareholders of the CFC to report the company's income on their personal tax returns to the extent the foreign corporation has current year 'earnings and profits' (a concept that is somewhat similar to retained earnings). The earnings and profits limitation can be an important exception in the case of start-up operations that are not immediately profitable. The tax implications and filings for U.S. taxpayers that hold interests in CFCs can be significant and should not be underestimated.

A CFC is a foreign company in which the total ownership of U.S. shareholders owning at least 10% of the voting power of the company (Ten Percent Shareholders) exceeds 50% of the total voting power or value of the foreign corporation's outstanding shares. The Ten Percent Shareholders are taxed under the Subpart F rules of the Internal Revenue Code (IRC) as if dividends had been paid to them, even if no cash is actually distributed to them. They are taxed on their share of the foreign company's 'Subpart F Income' whether or not this income is distributed ' provided the foreign corporation has current year earnings and profits. Subpart F Income can include certain interest, dividends, rents, royalties, and certain business income.

As a CI company closes multiple rounds of financing involving foreign investors, it may eventually avoid CFC status because of the reduction of U.S. ownership. For example, if a foreign person owns 50% or more of both the voting power and value of the company, then no combination of U.S. persons can own 'more than 50%' of the foreign company. If one foreign shareholder owns 30% of a foreign company, and ten U.S. persons each own 7%, it is not a CFC, since none of the U.S. persons is a Ten Percent Shareholder.

U.S. shareholder, however, is defined very broadly. Various attribution and constructive ownership rules may cause a U.S. shareholder to be treated as owning more stock for tax purposes than he actually owns in his name. 'Attribution' means that a taxpayer is deemed to own the shares of certain other related taxpayers such as a spouse, child or parent, because the law presumes that these persons have a common interest. 'Constructive ownership' is the same as attribution but it is generally applied with respect to entities in which the taxpayer has some control or beneficial interest.

In other cases, such as with respect to the PFIC rules, the U.S. ownership percentage is not the most important issue. The key factors are the percentage of passive income (interest, dividends, rents, royalties) and the percentage of assets held for the production of passive income.

The third tax issue that must be carefully planned is making certain the business operations of the foreign parent company do not become taxable in the U.S. A foreign corporation is taxed at the full U.S. corporate tax rates with respect to any net income that is 'effectively connected income' (ECI) with a U.S. trade or business. An additional deemed U.S. withholding tax can apply with respect to ECI. This issue of ECI is of particular concern where the CI parent company, for example, is managed and controlled by individuals who are U.S. residents who perform certain business operations for the CI parent company within the U.S.'s borders.

Part Two will examine Chinese currency exchange and tax considerations, intellectual property issues and operational relationships.

Many companies doing business in China are using a structure that includes a company formed under the laws of the Cayman Islands (CI). Chinese technology and Internet companies listed on NASDAQ ' such as Actions Semiconductor, Baidu, CTrip, China Medical Technologies, Focus Media, Shanda, Suntech Power and Tom Online ' are actually CI companies. The primary business reasons for an offshore structure are flexibility in an exit strategy, whether in connection with an initial public offering (IPO) or an acquisition; the possibility of reducing U.S. taxes; and reducing the impact of China's currency exchange restrictions.

In the simplest form, the structure is a CI company with a China subsidiary. Investments are made in the CI company and the subsidiary is the operating company. The next simplest form is when the CI company is the parent company of two subsidiary corporations ' one in China and the other in the U.S. A U.S. corporation is needed only if the U.S. is a market for the business. The most complex structure is required when the China business is in a restricted industry such as an Internet business (see, “Investment and Operating in Restricted Industries in China,” www.fenwick.com/docstore/Publications/Corporate/Invest_Operating_In_China.pdf.) Other variations include delaying the formation of a U.S. subsidiary until or if U.S. operations are needed and adding a company from a jurisdiction having a tax treaty with China (such as Mauritius) between the CI and Chinese corporations. Global venture capitalists have become comfortable with these CI structures and many U.S. venture capitalists also understand and use these structures.

Why the Caymans?

While alternative jurisdictions have been carefully compared in previous versions of this memorandum, today a CI company is the clear choice for a China-related business. An important decision factor is that a CI company is eligible for listing on the Hong Kong Stock Exchange. Only CI, Bermuda, China and Hong Kong companies are currently approved for listing on the Hong Kong Stock Exchange. Neither the British Virgin Islands (BVI) nor U.S. companies are approved.

The Hong Kong exchange has become a major exchange for China-related IPOs, in part because of the Sarbanes-Oxley requirements for a U.S. public company. Post-IPO liquidity for stockholders, a prior weakness of this market, appears to have improved. While many Hong Kong IPOs to date have been the privatization of Chinese state-owned companies, this exchange appears to be well positioned to attract Internet, IT and other technology companies. The number and size of China-related NASDAQ listings have declined since 2004. The improvements in the liquidity in the Hong Kong market, the cost of complying with Sarbanes-Oxley and the company economic size needed for a NASDAQ offering are factors that are causing Chinese businesses to increasingly consider an IPO in Hong Kong rather than the U.S. The U.S. may have no relationship with the business itself. Hong Kong may be closer to the businesses primary market when, for example, it is an Internet business focusing on China. Chinese business people also can communicate more easily and effectively with investors, regulators and analysts in their own language in Hong Kong.

Other considerations in choosing a jurisdiction of incorporation include the costs of and time necessary for incorporation, the extent of regulation, and other factors. A CI company traditionally could be incorporated within a day or two while a Bermuda company could take several weeks to establish. Less time is required to amend the charter documents for a preferred stock financing in the CI, and the startup and recurring annual government fees and legal fees are higher in Bermuda than in the CI.

Investors will purchase shares and employees will be granted options in the CI company, the tentative IPO entity. A key consideration for investors is that a conventional security, such as preferred stock, be available for financing. For employees, stock options and other equity incentives need to look and feel the same as those of a U.S. corporation. Both the CI and Bermuda operate under versions of U.K. company and common law, and adequately accommodate these business needs. Neither countries' laws, however, protect shareholders to the same extent as U.S. laws.

The issue for a start-up is to balance the cost of creating too much infrastructure before the business is validated in the market against precluding alternatives that may become too expensive to implement later. Because of the cost of the various CI structures and the uncertainty of business success at the time of start-up, entrepreneurs have considered simpler and lower cost ways of starting a China related business. These include initially using a U.S. corporation, obtaining initial validation for the feasibility of the business, and then later reincorporating in the CI and expanding the structure. This latter scenario is sometimes referred to as a 'corporate inversion.' The tax cost of an inversion, however, can be extremely high as explained below. While the authors' general approach is to keep things simple until a business is validated in the market, some infrastructure may be needed at the outset to preserve alternatives.

The bottom line in comparing the jurisdiction selection factors is the track record of CI companies going public on NASDAQ and the growing importance of Hong Kong for an IPO exit.

U.S. Tax Considerations

Many offshore business formations will not provide immediate U.S. tax minimization. Up to and possibly after an IPO, ownership of the CI company by U.S. shareholders may cause U.S. tax consequences for the CI company to be similar to those for a U.S. corporation. Thus, when commentators refer to a CI structure as being a 'tax-free' way to operate, they mean there is no taxation in the CI on income from sources outside the CI.

There are three important U.S. tax planning considerations:

1. The transaction of incorporating or reincorporating offshore,
2. Ongoing U.S. income tax liability of the U.S. shareholders of the foreign parent entity, and
3. Making sure the business operations of the foreign parent entity are not subject to taxation in the U.S.

While in the past, entrepreneurs had the flexibility of starting with a California or Delaware corporation, and then reincorporating the parent entity off-shore through an 'inversion' transaction once the business plan was validated, this alternative has become very expensive due to changes in the U.S. tax laws. Following the enactment of the 2004 Tax Act, the ability to reincorporate a U.S. parent company structure off-shore via an inversion transaction is severely limited. While not impossible, an inversion transaction today typically is not effective absent a significant capital infusion from new third-party investors or an unrelated foreign acquirer. In most cases, an inversion transaction will be disregarded for U.S. tax purposes, resulting in the new foreign parent company being characterized as a U.S. corporation for U.S. tax purposes. In addition, the new 'anti-inversion' rules can impose a substantial tax penalty with respect to the unexercised options of certain 'insiders' of the management team. These anti-inversion rules have proven to be very frustrating for a number of our clients seeking to pursue IPOs outside the U.S. As such, entrepreneurs must carefully consider whether an offshore parent structure should be formed at the outset.

Over the years, Congress has devised a number of ways to prevent tax avoidance (or U.S. tax 'deferral') by going offshore. The U.S. anti-deferral tax rules are very complicated and what follows is a very simplified summary. The tax rules are tricky and a trap for the unwary. A foreign company may be a controlled foreign corporation (CFC) or a passive foreign investment company (PFIC). The tax law applicable to CFC's essentially requires the U.S. shareholders of the CFC to report the company's income on their personal tax returns to the extent the foreign corporation has current year 'earnings and profits' (a concept that is somewhat similar to retained earnings). The earnings and profits limitation can be an important exception in the case of start-up operations that are not immediately profitable. The tax implications and filings for U.S. taxpayers that hold interests in CFCs can be significant and should not be underestimated.

A CFC is a foreign company in which the total ownership of U.S. shareholders owning at least 10% of the voting power of the company (Ten Percent Shareholders) exceeds 50% of the total voting power or value of the foreign corporation's outstanding shares. The Ten Percent Shareholders are taxed under the Subpart F rules of the Internal Revenue Code (IRC) as if dividends had been paid to them, even if no cash is actually distributed to them. They are taxed on their share of the foreign company's 'Subpart F Income' whether or not this income is distributed ' provided the foreign corporation has current year earnings and profits. Subpart F Income can include certain interest, dividends, rents, royalties, and certain business income.

As a CI company closes multiple rounds of financing involving foreign investors, it may eventually avoid CFC status because of the reduction of U.S. ownership. For example, if a foreign person owns 50% or more of both the voting power and value of the company, then no combination of U.S. persons can own 'more than 50%' of the foreign company. If one foreign shareholder owns 30% of a foreign company, and ten U.S. persons each own 7%, it is not a CFC, since none of the U.S. persons is a Ten Percent Shareholder.

U.S. shareholder, however, is defined very broadly. Various attribution and constructive ownership rules may cause a U.S. shareholder to be treated as owning more stock for tax purposes than he actually owns in his name. 'Attribution' means that a taxpayer is deemed to own the shares of certain other related taxpayers such as a spouse, child or parent, because the law presumes that these persons have a common interest. 'Constructive ownership' is the same as attribution but it is generally applied with respect to entities in which the taxpayer has some control or beneficial interest.

In other cases, such as with respect to the PFIC rules, the U.S. ownership percentage is not the most important issue. The key factors are the percentage of passive income (interest, dividends, rents, royalties) and the percentage of assets held for the production of passive income.

The third tax issue that must be carefully planned is making certain the business operations of the foreign parent company do not become taxable in the U.S. A foreign corporation is taxed at the full U.S. corporate tax rates with respect to any net income that is 'effectively connected income' (ECI) with a U.S. trade or business. An additional deemed U.S. withholding tax can apply with respect to ECI. This issue of ECI is of particular concern where the CI parent company, for example, is managed and controlled by individuals who are U.S. residents who perform certain business operations for the CI parent company within the U.S.'s borders.

Part Two will examine Chinese currency exchange and tax considerations, intellectual property issues and operational relationships.