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At the Joint Ministerial Council meeting in London, Cayman Islands Premier Alden McLaughlin, Chinese Ambassador to the United Kingdom Liu Xiaoming, Bermuda Premier Michael Dunkley, and British Virgin Islands Premier Orlando Smith are pictured from left with Bermuda Premier Michael Dunkley and British Virgin Islands Premier Orlando Smith. (Picture Courtesy of Cayman Compass)

One of the first things that entrepreneurs considering doing business in China should consider is whether a company from the contemplated jurisdiction of incorporation would be eligible for listing on the Hong Kong Stock Exchange, as the Hong Kong stock market may be the most appropriate initial public offering stock market for a China-related business. Only businesses from the United States, Bermuda, China, and Hong Kong have been authorized for listing on the Hong Kong Stock Exchange at this time. Companies from the British Virgin Islands or the United States are not permitted to operate.

Furthermore, when a purchase by a United States-based business is used as an exit plan, there is no difference in tax consequences between CI and Bermuda. An acquisition of a CI or Bermuda business by a U.S. corporation in a tax-free transaction may be accomplished in a variety of ways. (As explained further below, the use of an intermediate subsidiary may help to minimize the Chinese tax obligation incurred in the purchase of a Chinese subsidiary by another Chinese company.)

Other factors to consider when selecting a jurisdiction for incorporation include the expenses and length of time required for incorporation, the costs of ongoing governmental and legal services, the degree of regulation, and the availability of international financial services, among others. The incorporation of a CI business has historically taken just a day or two, while the incorporation of a Bermuda firm may take many weeks. In the CI, it takes less time to modify the charter papers for a preferred stock financing than it does in Bermuda, and the starting and recurring yearly government costs, as well as legal expenses, are greater in Bermuda than they are in the CI, as well as the cost of doing business in Bermuda.

Recent modifications to the CI, on the other hand, have at the very least reduced the CI time advantage.

Investors will buy stock in the business at the top of the structure, which is expected to become public in the near future, and workers will be given options to purchase shares in the company.

In recent years, several publicly traded companies in the United States have chosen Bermuda as their new offshore headquarters. Bermuda, like the CI, does not impose a corporation income tax on revenue derived from sources outside of the country. In addition to tax benefits, several public companies in the United States have selected Bermuda because of the country’s stringent anti-fraud and anti-money laundering regulations. A number of entrepreneurs have voiced reservations about the usage of Bermuda since Enron was founded there; nevertheless, the vast majority of Enron’s subsidiaries were CI companies.

Despite this, the cheaper expenses and usually shorter time required to incorporate and modify charter papers for the financing offer the CI a small edge for startups and early-stage companies seeking financing. These characteristics are especially essential during the early phases of a firm’s development, but they become less relevant as the company grows in size and sophistication.

Following the terrorist attacks of September 11th, 2001, and the Enron scandal, several members of Congress and others have characterised reincorporating offshore as disloyal. It has been suggested that eliminating eligibility for government contracts and imposing an outright ban on offshore reincorporations are two potential measures. On the other hand, lawfully reducing taxes in order to maintain global competitiveness is a legitimate corporate goal. It is possible that the worldwide rival is a former U.S. company that reincorporated overseas before the rules for doing so became more stringent. Government policymakers have not addressed what actions would be taken against former publicly-traded companies in the United States that had previously reincorporated offshore, or against businesses that incorporate offshore at the outset or reincorporated offshore near the start of their operations, long before becoming a publicly-traded company.


Tax Considerations in the United States

The majority of offshore company creations will not result in immediate tax savings in the United States. Ownership of the CI business by U.S. shareholders may result in tax implications for the CI company that are comparable to those of a U.S. corporation before to, and potentially after, the CI company’s initial public offering (IPO). As a result, when critics refer to a CI structure as being a “tax-free” method to do business, they are referring to the fact that there is no taxes on revenue derived from sources outside the CI.

A company’s tax planning in the United States is divided into two categories: the first is concerned with the transaction of forming or reorganising an offshore corporation, and the second is concerned with the company’s continuing federal income tax obligation. However, while starting with a California or Delaware corporation and then attempting to invert the structure by reincorporating in the CI, the transaction will be taxable to the shareholders, as opposed to a domestic reincorporation in which a California corporation reincorporates in Delaware prior to an initial public offering (IPO) of the company in question.

An offshore reincorporation is handled in the same way as if the shareholders had sold their shares in the original U.S. corporation. According on the value of the company at the time of re-incorporation, the real effect on the shareholders may differ. For example, the widely publicised proposed reincorporation in Bermuda of Connecticut toolmaker Stanley Works — which was ultimately forced to abandon its reincorporation plans in the face of widespread public opposition and threats of congressional action — would have resulted in approximately $150 million in capital gains taxes being paid to the company’s shareholders. In order to prevent this negative tax effect, at the very least the offshore parent company and the U.S. subsidiary corporation should be established from the beginning.

Over the years, Congress has developed a variety of strategies to combat tax evasion via the use of offshore corporations. These tax regulations are very complex, and what follows is a highly simplified description of them. The tax laws are complicated and maybe a trap for those who are not careful. It is possible for a foreign business to be classified as a controlled foreign corporation (“CFC”), a foreign personal holding company (“FPHC”), or a passive foreign investment company (“PFIC”). The tax legislation that applies to CFCs and FPHCs basically mandates that the company’s revenue be reported on the personal tax returns of the owners in the United States. Tax ramifications and filing requirements for taxpayers in the United States may be significant, and should not be underestimated.

It is a CFC when the total ownership of U.S. shareholders holding at least 10% of the business (the “Ten Percent Shareholders”) reaches 50% in a foreign corporation that is incorporated in another country. Even if no cash is given to the Ten-Percent Shareholders, they are taxed as if dividends had been paid to them by the corporation. They are subject to taxation on their share of the foreign company’s “Subpart F Revenue,” regardless of whether the income is paid to them. Revenue from Subpart F includes some interest, dividends, rents, royalties, and business income, but only if the CFC’s business is performed completely inside the nation in which the CFC is established is the income included.

As a CI business closes several rounds of financing including foreign investors, it may be able to escape CFC classification in the future due to the decrease of U.S. ownership in the company’s stock. Consider the following scenario: If a foreign person owns 50 percent or more of a business, no combination of individuals from the United States may control “more than 50 percent” of the foreign company. One foreign shareholder owns 30% of a foreign business and 10 individuals in the United States each possess 7%, the company is not a CFC since none of the individuals in the United States is a Ten Percent Shareholder.

The term “U.S. stockholder,” on the other hand, is extremely wide. Various principles of attribution and constructive ownership may result in a conflict.

For tax reasons, a shareholder in the United States will be regarded as holding more shares than he really owns in his name. The term “attribution” refers to the fact that a taxpayer is considered to own the shares of certain other connected taxpayers, such as a spouse, child, or parent since the law presumes that these individuals have a shared interest in the business. Constructive ownership is the same as attribution, except it is usually applied to entities in which the taxpayer has some control or beneficial interest, while attribution is generally applied to individuals.

In other instances, such as in the case of the PFIC regulations, the proportion of U.S. ownership is not the most essential consideration to consider. The proportion of passive income (interest, dividends, rents, and royalties) and the percentage of assets kept for the purpose of generating passive income are the most important variables to consider.

Considerations Regarding the Exchange of Chinese Currency

For foreign investors in China, one of the most challenging aspects is the repatriation of any profits made on their investments. Investments in Chinese companies and cash transfers out of the country are strictly regulated by the Chinese government, which generally requires permission before either can be made or cash can be moved out of the country. The Chinese subsidiary is usually funded on a monthly basis by the CI company, ensuring that the majority of the investment profits stay outside of China until required. Furthermore, business transactions may be arranged such that non-Chinese consumers pay the CI parent firm for the goods and services that they get from the CI. This has no effect on financial statement reporting, but it does provide for more flexibility in terms of cash availability.

Taxation in China: Aspects to Consider

Businesses can consider lowering their prospective Chinese tax liabilities by taking advantage of tax treaties, which may be achieved via the formation of a new intermediate company in a nation that has a tax treaty with China. This new business would be a subsidiary of the CI company as well as the parent company of the Chinese company, according to the plan. It is possible that this structure will reduce the potential Chinese tax liability associated with an acquisition of the business by a Chinese acquirer, among other things because a Chinese acquirer would most likely acquire the Chinese subsidiary rather than the CI parent company in order to reduce unnecessary complexity in its own corporate structure and to avoid certain regulatory obstacles. This transaction would result in the transfer of intellectual property from the Chinese subsidiary to the CI company, with ownership of the intellectual property initially concentrated in the CI company (as described in more detail below). It is anticipated that payment for the purchase of the Chinese company would be paid to the intermediate subsidiary, which would benefit from the reduced capital gains tax rate set by the tax treaty between China and the relevant jurisdiction. As an example, if the intermediate subsidiary is established in Mauritius, the capital gains tax rate would be nil.

The Indian experience with Mauritius may offer some insight into how the Chinese tax authorities may regard the employment of an intermediate subsidiary of this kind in their jurisdiction. A tax residency certificate issued by the government of Mauritius would be a required but not sufficient requirement for receiving the tax benefit. The question is whether the Chinese tax authorities will take the certificate without taking other variables into account, such as the group of businesses’ compliance with formalities, the sources of financing for the company, and the location of the subsidiary’s management. The answer is yes. In practise, it may be very difficult to appropriately incorporate the Mauritius subsidiary in transactions involving the group of entities that comprise the company. The extra time and complexity needed to route capital infusions via the Mauritius subsidiary may be incompatible with the pace with which business must be conducted in today’s globe. Since a result of the Indian experience, it is recommended that the subsidiary be controlled from a location other than China, as a Mauritian tax residency certificate may not be sufficient to preserve tax treaty status if the company is successfully managed from another country.

Intellectual Property

The distribution of intellectual property (“IP”) ownership among the group of companies must be meticulously arranged in advance. Instead of being spread across numerous companies, such ownership should usually be concentrated in the CI firm that will most likely be the IPO vehicle at the outset. IPO vehicles achieve this concentration mainly via research agreements, which stipulate that, regardless of where the research is conducted, the IPO vehicle pays for and controls the findings of the research conducted. This implies that in order to do business in the United States, the U.S. subsidiary firm may need an inter-company intellectual property licensing agreement with the CI company. When a business plans to license its intellectual property as an income stream, this ownership strategy is also compatible with tax minimization planning.

Nonetheless, if a company wants to engage in certain contracts with the Chinese government, it may be essential for all or a portion of the company’s intellectual property (IP) to be “located” in China. Because the criteria of various Chinese government organizations often change, there is no universally accepted definition of what it means for intellectual property to be situated in China. In its most stringent form, a Chinese governmental body may demand that the intellectual property be held by the group’s Chinese affiliate in order for it to be protected. In other cases, a license to the Chinese subsidiary to utilize intellectual property held by the CI parent company may be sufficient to meet regulatory requirements. Because of this, companies engaging in contracts with Chinese government entities must carefully examine the requirements of the relevant government body before proceeding with the transaction. Because it is uncertain whether it will be relying on Chinese government contracts in the future, a start-up company should initially concentrate its intellectual property in the CI company. It can later contribute all or part of its intellectual property to its Chinese subsidiary in order to comply with applicable regulations.


Implications for Business Operations

The operational connections between the many companies that make up this complicated structure must be meticulously recorded and checked on a regular basis in order to ensure that each company retains its own distinct legal identity within the group. Inter-company and other agreements must be in place between the businesses in order for the desired impact to be achieved in terms of taxation, liability, and other considerations. Consider a product business. A sales representative or distribution agreement, as well as another commercial channel agreement, will be required between the CI firm and each of its subsidiaries. Relationships inside the structure must be at arm’s length, and the Internal Revenue Service may examine transfer pricing among the companies within the structure, according to the IRS. Combining bank accounts and other assets, as well as combining activities and other business elements will detract from the value of the structure if the sloppiness of the structure results in the offshore company being subject to direct taxes in the United States.


Numerous China-focused entrepreneurs establish a parent company in Bermuda or the Caribbean Islands (CI) in order to maintain the possibility of launching an initial public offering in either Hong Kong or the United States, to provide comfort to investors, employees, and other stakeholders regarding the issuances of preferred stock and stock options, to minimise U.S. tax liability, and to maintain flexibility in light of Chinese currency restrictions. Bermuda’s advantages include a better legal framework and a growing reputation as the preferred destination for the offshore reincorporation of publicly traded businesses in the United States. CI, on the other hand, has an advantage over startups and early-stage businesses because of the cheaper expenses and shorter time it takes to incorporate and modify charter papers for financing. These characteristics are especially essential during the early phases of a firm’s development, but they become less relevant as the company grows in size and sophistication. By establishing an intermediary subsidiary in Mauritius, it is possible to reduce Chinese tax liabilities if the exit plan is to acquire the Chinese subsidiary from one or more additional Chinese entities. If the parent CI company intends to acquire a firm, its intellectual property should be held by the parent CI company, provided that such ownership is allowed under the contracts between the business and any Chinese governmental organizations. Finally, entrepreneurs should be mindful of the operational ramifications of maintaining a global corporate structure in their businesses. However, although it is advisable to avoid investing in infrastructure before a company has been proven, certain infrastructure may be required at the beginning in order to protect key alternatives.