Tax issues when exiting a company adopting a VIE structure

Avariable interest entity (VIE) structure is an arrangement where an offshore holding company is jointly established between Chinese founders and foreign investors under which they establish a wholly foreign-owned enterprise (WFOE) in China. That WFOE then controls a domestic enterprise via a series of contractual agreements. Through these agreements, the holding company can consolidate the financial statements of the domestic company into the group’s overall financial statements.

VIE structures have been commonplace for emerging industries where foreign investment is restricted or prohibited such as online technologies or the operation of medical institutions. The holding company being acquired or merged into another firm, or the holding company going public tends to be the exit mechanism for investors and founders. In the case of merger and acquisition transactions, it is important to be mindful of the tax risks and take effort to reduce them.

The exit methods for investors and founders are many and complex, e.g. going public, dividend distribution, share transfers, buy-backs. Further, the parties involved may arrange different approaches per the type of transaction to optimize their taxes.

This article will primarily focus on potential tax issues in transactions wherein shares of a holding company, e.g. a Cayman Island company, are indirectly transferred between a foreign institutional investor and the domestic individual founder.

Amy Deng Hua is an attorney at law of PacGate Law Group.