Should a Special Purpose Vehicle Own Your China Subsidiary?

1. Who Should Own Your China Subsidiary?

One of the first tasks in forming a subsidiary company in China (often referred to as a WFOE or Wholly Foreign Owned Entity) is to determine what entity will be the shareholder of the subsidiary company. It is possible for an individual or individuals to own a China subsidiary company, but for various reasons, our China entity formation lawyers nearly always discourage that.

2. What About Having a Special Purpose Vehicle (SPV) Own Your Chinese Subsidiary Company

The basic analysis runs as follows:

1. Direct ownership of a Chinese subsidiary company by the foreign operating company parent company is most common for single owner Chinese subsidiary companies.

2. For clients that either do not want their company to be easily identified with the Chinese subsidiary company or for various other reasons do not want their company to own the subsidiary, forming or using a Special Purpose Vehicle (SPV) — a separate holding company not directly linked to the main company — is possible. When considering an SPV for owning a China subsidiary company, the following considerations can be important:

a. With the adoption of its new WFOE formation rules, the Chinese government now permits using SPVs.

b. In the past, investors often used an SPV to hide the true identity of the owners of the Chinese subsidiary company. Under China’s new company formation rules, the investor must provide an organizational chart that details ownership  and identifies the actual controlling person. Accordingly, SPVs are no longer useful to conceal actual ownership from the Chinese government.

c. SPVs continue to be used where there are several investors in the Chinese subsidiary company. Often these investors are resident in different jurisdictions. In that case, it is common to take all these investors into a single SPV. The SPV is then the single shareholder of the Chinese subsidiary company. Issues such as management, distribution of profits and purchase and sale of ownership interests are handled at the SPV level. In many cases, the SPV is formed in a tax haven jurisdiction such as Hong Kong or Singapore or the British Virgin Islands, to allow distribution of profits free of tax.

d. In terms of limiting upstream shareholder liability, there is little to no benefit in using an SPV since The Chinese subsidiary company will be a limited liability legal entity. The limitation of liability rules apply in China much as they do in the United States, Australia, Canada and the EU (including the UK). The financial liability of the Chinese subsidiary company is limited to the amount of the investment. Liability beyond the investment amount generally occurs only in the case of illegal acts. In China this liability would generally be as follows:

      • The shareholder will be liable if it does not contribute required capital to the China subsidiary company and that failure results in the subsidiary company not paying its taxes, employee salaries, or in a fraud against creditors.
      • A director of a Chinese subsidiary will be liable for instructing the subsidiary to commit an illegal act. Examples of illegal acts are tax fraud or commission of a significant safety violation.
      • Directors and shareholder will be liable if the subsidiary company terminates business and does not liquidate pursuant to Chinese company law. An improper Chinese company shutdown leads to both the investors and the directors being placed on a black list and prohibited from engaging in other investments or business in China. Individual directors should not travel to China since they may be detained. See Shutting Down a China WFOE: Don’t Go There.

The above three basis for liability are all real, but creating an SPV does not noticeably reduce any of these risks because most of the liability risk falls on the individual directors, not on the shareholders. Second, the Chinese government will use the org chart/actual controlling person information to “pierce the corporate veil” to assign liability to what the Chinese government determines in its own discretion is/are the actual party/parties in interest.

Other basis for liability arising from subsidiary operations are so rare they can in most instances be discounted. On the other hand, the three basis for liability set forth above are common and care must be taken to avoid these sorts of liability situations.

3. There are sometimes tax or other operational or accounting reasons for creating an SPV for China company ownership. In considering whether to do an SPV, a cost-benefit analysis makes sense. Most of our clients find using an SPV to own their China subsidiaries to be more trouble than it is worth. But each situation is different and there are definitely times where SPV ownership of a China subsidiary makes good sense.