Utilising British Virgin Islands and Cayman Islands entities for Private Equity Investment into China

As offshore legal counsel based in Hong Kong, we commonly deal with the book ends of inbound private equity investment into the People's Republic of China ("PRC"), that being, the initial establishment of the offshore investment fund structure, typically structured as a limited partnership and domiciled in either the Cayman Islands or British Virgin Islands (the "PE Fund") at one end, and at the other, investments made by PE Fund's in certain offshore target entities ("Offshore Target"), indirectly holding strategic PRC assets which are subject to such acquisition. 1

Book end one: Establishment of certain offshore tax structures for PRC investment purposes

The following tax driven acquisition structures of PRC assets have arisen from recent changes to the tax laws in the PRC which took effect from 1 January 2008.

In scenario one, a minority investment has been made by a PE Fund in a PRC target. In this scenario, provided the Hong Kong Special Purpose Vehicle ("HK SPV") holds less than 25% of issued share capital of the PRC target entity, at the onshore PRC level there will be no withholding tax ("WHT") on any disposal of these shares by the HK SPV under the PRC-HK Double Taxation Arrangement which became effective on 1 January 2007, however there will be 10% WHT on dividends paid down by the PRC target to the HK SPV. At the Hong Kong level, stamp duty will be payable in the amount of 0.2% of any consideration paid for the sale of shares in the HK SPV by the British Virgin Islands SPV ("BVI SPV"). Any disposal thereafter shall not be subject to any tax at the BVI level.

In scenario two, the PE Fund is electing to indirectly enter into a joint venture ("JV") arrangement with a PRC JV partner through either a PRC equity joint venture ("EJV") or a PRC cooperative joint venture ("CJV"). In this scenario, provided the HK SPV holds greater than 25% of issued share capital of the PRC target entity, it will be subject to a reduced dividend WHT treatment of 5% (reduced from 10%). Provided the BVI SPV owns 100% of the HK SPV, no tax shall be paid on any distributions at the Hong Kong or BVI level. In this context, ultimately the preferred exit for the PE Fund would be the sale or disposition of the shares in the BVI SPV.

In scenario three, provided there is no round tripping of investment by the PRC founders (i.e. the classic "Red Chip" structure which now requires approval of the China's Ministry of Commerce ("MOFCOM") and registration with the State Administration of Foreign Exchange ("SAFE")), the PE Fund and the PRC founders will typically invest into the Offshore Target (typically a Cayman Islands exempt company for Hong Kong listing purposes), with the PRC founders holding ordinary shares and the PE Fund being issued Preference Shares (discussed below). If newly established, the Offshore Target will require MOFCOM approval as well as SAFE registration if it has PRC domestic investors. In order to avoid these regulatory hurdles, there have been more recent structures established whereby the Wholly Foreign Owned Enterprise ("WFOE") does not acquire equity interests in the PRC operations company, but rather relies on certain contractual arrangements between the PRC founders and the WFOE. The tax advantages to...

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