Trends in Chinese Offshore Incorporation

In 2016, for example, Hong Kong, the Cayman Islands and the BVI ranked first (US$112 billion), third (US$13.5 billion) and fourth (US$12.4 billion) respectively as the largest recipients of Chinese OFDI flows (the US was in second place, but with locations like Delaware also being important at a sub-national level). As this official data suggests, the triad jurisdictions of Hong Kong, the BVI and the Cayman Islands stand out as among the most popular offshore destinations for Chinese OFDI (and by implication, Chinese owned foreign subsidiaries). Combined, they received over 70 per cent of Chinese OFDI flows in 2016, and aggregated stock flows reflect similar historical patterns. The implications of such investments for understanding Chinese MNEs (CMNEs), however, are not generally very well understood in the academic community. Our initial firm-level research, therefore, looked into these offshore CMNE corporate structures. We did so at the micro-level, in contrast to much academic research (which often relies on aggregated OFDI data), to figure out what the implications might be for understanding CMNE activity. Interestingly, but perhaps unsurprisingly, we did also find that offshore incorporation in these three jurisdictions, mirroring official FDI data, was indeed frequent. More surprisingly, it also found that many such businesses created at least one subsidiary in each jurisdiction, giving a clear triadic form and structure to Chinese offshore incorporation (see Sutherland and Anderson, 2015[i]).We also found that Chinese offshore companies have become important conduits for further investments, both in China, but increasingly elsewhere in the world.

Why has offshore incorporation in these jurisdictions, which seems incongruous in light of Communist Party ideologies, become so common?

Investing in the triad, of course, is usually only a first step in the journey of Chinese capital. Indeed, our research showed that much of it returns back home to China – often augmented with additional foreign capital. Historically, as links between Hong Kong and the mainland developed (particularly after its return to China in 1997), Chinese firms looked to exploit the offshore world primarily so as to benefit from lower domestic corporate tax rates. Until the introduction of China’s new enterprise income tax law in 2012, ‘foreign’ MNEs investing in China paid a 25 per cent corporation tax, instead of the 33 per cent levied on ‘domestic’ firms. Much OFDI to these jurisdictions, therefore, ‘round-tripped’ back to China, in the guise of ‘foreign’ investment, to avail of the lower taxes. Thus, ironically, Chinese policy-makers inadvertently created incentives for domestic business to become ‘foreign’ by using offshore investment holding companies. Nearby Hong Kong, a former British colony, which has historical links to the BVI and the Cayman Islands (UK crown dependencies, sharing similar institutional legacies), played an early pivotal role, with its well-developed legal and financial institutions.

It did not take long for Chinese businesses to realise the numerous other advantages of offshore incorporation. With weak domestic capital markets, biased towards state-owned firms, the opportunities for picking up international investment became increasingly important. This was particularly true for China’s private sector businesses, looking to continue their breakneck development. We found that many of China’s most successful private businesses, including some well-known tech companies, as well as lesser known successes such as Nine Dragons Paper (a world leader in paper and packaging), BYD Electronics (specialising in mobile phone batteries/components) and Shenzhou International (supplying Nike, Uniqlo etc.) are typically owned via a Cayman Islands parent firm (i.e. they are technically ‘foreign’, not Chinese businesses). Indeed, most Hong Kong listed firms established by Chinese entrepreneurs are incorporated in the Cayman Islands. Incorporation in this jurisdiction has allowed these businesses to circumvent the financial biases towards state-owned businesses found in Chinese capital markets (i.e. state-owned/controlled banks support state owned businesses, and stock market listings are also biased towards the state sector). The Cayman Islands has also proved a popular jurisdiction for domiciling ultimate ownership owing to its role as a major offshore financial centre (the fourth largest according to some estimates), with deep pools of capital, as well as favourable opportunities for listings on either US or Hong Kong stock markets (although the BVI is catching up in this regard). Of course, as well as the more advanced and less discriminatory financing options, offshore incorporation has greatly facilitated things like the management of complex property rights transactions and executive compensation schemes. In general, greater confidence is placed in offshore legal institutions. One interesting phenomenon we came across during our research, for example, was the frequent buying and selling of Chinese companies held via offshore investment holding companies. In short, Chinese businesses have become adept at tapping into the advanced legal and financial services found in the triad jurisdictions.

While the original motivation to incorporate offshore companies may have been strongly driven by ‘round-tripping’ (i.e. investing back in China), arguably a significant new impetus for offshore incorporation is now related to China’s ‘go global’ policy initiative, and more recently the ‘one belt, one road’ initiative. We found that offshore holding companies are now increasingly being established and used as vehicles for undertaking further international greenfield and acquisition FDI (what we refer to as ‘onward-journey’, in contrast to the original ‘round-trip’ investments that historically have been common). As Chinese outward FDI has risen exponentially in recent years, supported by government policy (although with a recent partial U-turn, owing to excessive speculative overseas investments by a few highly acquisitive diversified groups, like HNA Group), patterns of offshore incorporation have evolved accordingly. As well as facilitating the raising of capital for ‘round-trip’ investments, foreign incorporation of investment holding companies thus appears to now be more strongly motivated by the need to develop appropriate platforms for undertaking FDI in specific geographic regions (and industries). For example, in our firm-level research focusing on Chinese MNEs, we found that SPVs in Europe, including the Netherlands, Ireland, Luxembourg and Switzerland, have become relatively more common. This activity may also be partially reflected in the official Chinese OFDI data (with Luxembourg ranked as the 11th largest OFDI recipient, and the Netherlands 17th in 2016). While the triad structure (involving companies in Hong Kong, the Cayman Islands and the BVI) may have been suitable for ‘round-trip’ investments, it seems that Chinese companies are amenable to alternative structures if they can facilitate their further ‘onward-journey’ investment strategies. In this sense, Chinese MNEs may be maturing. Our impression is that the evolving geographical diversification of offshore incorporation is becoming more strongly driven by the international diversification strategies of Chinese business.

Moreover, a range of relatively recent regulatory changes may also be facilitating China’s ‘go global’ initiatives. This has arguably made offshore incorporation considerably easier to manage – further evidence and recognition that offshore structures are also vital tools in orchestrating international M&As and greenfield investments. Until July 2014, regulation of offshore incorporation had been controlled by China’s State Administration of Foreign Exchange (SAFE) and its somewhat restrictive Circular 75 (for more than a decade). The regulations related to this circular, however, were considered to have numerous constraints and ambiguities, making offshore investments more cumbersome than they need be. Some of these have been addressed in the new 2014, Circular 37. Circular 37, for example, now allows the creation of a SPV without any capital injection (or a nominal sum) before registration with SAFE. It is now only upon the contribution of capital that the application must be filed with SAFE, somewhat streamlining procedures. Perhaps more importantly, it relaxed the previous requirement that every layer of the offshore structure be disclosed. Now the focus is only upon disclosure in the first layer, or ultimate owner. Circular 37 also offers improvements on Circular 75 by allowing for the registration of employee stock option plans for key managers working in domestic enterprises directly or indirectly controlled by  non-listed overseas companies (previously this option was only available to listed SPVs). This allowed domestic employees to realise stock options (i.e. legal repatriation in RMB, for example). Furthermore, a number of previously unclear implementation procedures have now been clarified. In general, it is considered that the newer Circular 37 offers greater transparency and certainty regarding governmental procedures, facilitating and making offshore incorporation processes even more attractive.

In sum, the offshore world was made attractive to Chinese businesses partly by accident (Chinese corporate taxation policy favouring foreign businesses, and the nearby location and closer financial integration of Hong Kong with China after 1997), but also because of the evident requirement of Chinese business to avail of superior institutional environments (i.e. better functioning capital markets, markets for property rights, legal institutions etc.).  Many Chinese businesses have eagerly grabbed this opportunity, now facilitated by the easing of regulation and their strong push into global markets via FDI (i.e. acquisitions and greenfield investments). The further international expansion of Chinese MNEs, particularly some of the most dynamic private sector businesses, suggests that further geographical diversification in in offshore jurisdictions is likely to continue apace.

[1] (D. Sutherland & Ning, 2011; Dylan Sutherland & Anderson, 2015)

Sutherland, D., & Anderson, J. (2015). The Pitfalls of Using Foreign Direct Investment Data to Measure Chinese Multinational Enterprise Activity. The China Quarterly, 221, 21–48. https://doi.org/10.1017/S0305741014001490

Sutherland, D., & Ning, L. (2011). Exploring “onward-journey” ODI strategies in China’s private sector businesses. Journal of Chinese Economic and Business Studies, 9(1), 43–65. https://doi.org/10.1080/14765284.2011.542885

John Anderson
John Anderson Assistant Professor of Management at the University of Northern Iowa. He has presented his research on a global scale and has been nominated for numerous awards.

Dylan Sutherland
Dylan Sutherland is an Associate Professor in Management at Durham University Business School. His current research entails applying modern economic theory to emerging business groups.