A report in the Chinese press has outlined yet another instance of the government criticising VIEs and foreign influence in sensitive sectors.
While this might not sound as news it has two features that sets it apart from the average criticism. It is supposedly the opinions of some fairly senior people in the central government, and it outlines a potential course of action to bring current business practices more in line with official law and policy.
Although generally vague there are two features relating to the scrutiny of VIEs that offer some interesting insights into how enforcement around the issue could look. Something that should be of interest to investors seeking to understand risk exposure in the area.
- Talks about scrutinising all contracts between domestic and foreign companies in these restricted industries.
- Examining the suitability of the foreign partner in these contracts
The reason this is interesting is that it sets out a potential focus of enforcement that is different from what some thought it would be. For instance there’s no direct attack on the VIE concept, but rather a slower approach that starts with scrutinising the contracts involved and the companies that have signed them.
This is important as it shifts the focus from the structure as a whole into its individual parts, and as such opens up for treating different VIEs differently. This type of action looks a lot like trying to pick off some low hanging fruit in the industry, which in this case would likely mean some of the poorer constructed VIEs.
As I have mentioned before there are big differences between one VIE structure and another, ranging from how much of the assets are kept in the VIE to how they have formulated the contracts used to extract the money into the WFOE. These factors will take on a new importance if this type of action is implemented.
For instance, if the government was to start scrutinising the contracts used in VIE structures they will find that some of the technical services agreements have terms that can by no means be referred to as “at arms length”. Some of these agreements stipulate that the VIE is to pay all of its revenues as fees for services rendered by the WFOE, as well as any residual profit at the end of the year. While this contract might be good from a consolidation standpoint it is an absolute nightmare from a transfer pricing point of view, and leaves the company open to some very serious tax liabilities.
Increased scrutiny of the WFOE used in the deal offers another set of potential problems. With some of these companies holding virtually their entire operations in the VIE it could be hard to argue how the WFOE is providing services of enough value to receive all the profits from the VIE. Another potential issue that could arise is questions of whether the WFOE is acting outside its business scope, for instance when it provides loans to capitalise the VIE.
This type of enforcement, if enacted, is not so much an attack on VIEs as a tightening of the screws surrounding the structure. While well-constructed VIEs may walk away unscathed some lower quality arrangements could get in very real and costly trouble. Investing on this information will be all about being able to tell a good VIE from a bad one, which will require looking over the details of your investment structure before the Chinese government does.