With the triad of the BVI, Cayman Islands & Hong Kong dominating outward foreign direct investment from China, Dylan Sutherland, Hinrich Voss & Peter J Buckley investigate the reasons behind this trend.
Emerging Markets, Tax Havens and Offshore Financial Centres
Comparatively little theoretical or empirical consideration has been given to the most prominent destination of emerging market outward foreign direct investment (OFDI), namely tax havens and offshore financial centres (THOFCs).
Brazil, Russia, India and China, all record very significant outward FDI to such destinations. By 2007, one half of Brazil’s OFDI stock was located in just three havens and by 2009, two thirds of Russia’s FDI stock was found in four. In 2008 and 2009, 40 per cent of Indian OFDI flows went to two havens and the majority of Chinese OFDI is also destined for several specific THOFCs, which accounted for 69–87 per cent of the annual outflow between 2003 and 2011. The stock of Chinese investments in these locations now stands at around 80 per cent of the total. In 2006, one tax haven alone, the Cayman Islands, had become the largest recipient of Chinese OFDI, with 44 per cent of officially recognised flows (and 18 per cent of its global OFDI stock). Subsequently Hong Kong became the lead recipient, ahead of the Cayman Islands and British Virgin Islands (BVI). As such, the triad of the Cayman Islands, BVI and Hong Kong are undoubtedly very important to understanding the characteristics, motivations and behaviour of Chinese MNEs.
A recent research project, published in the Journal of Economic Geography, attempted to get to the bottom of this very high geographical concentration of outward FDI from emerging markets, and specifically from China. How we account for investment flows through tax havens is an important question to address if we want to better understand emerging market MNEs and their FDI strategies.
As noted, the share of national outward FDI stock for these large emerging markets held in in havens is very high, considerably higher than that of the developed market economies. It is often suggested that tax-induced regulatory arbitrage is the main driver for investments into THOFCs and that such FDI does not constitute a productive activity. The notion that THOFCs are somehow ‘fictitious spaces’ created purely for tax related reasons does not, however, explain the geographic concentration of FDI in specific THOFCs or why the average national OFDI shares to these jurisdictions are higher for many large emerging than for developed economies.
An important historic explanation for the use of THOFCs in the Chinese case, of course, has been the preferential tax rates afforded to foreign invested enterprises in China, which has led to ‘round-tripping’, a form of tax-induced regulatory arbitrage that involves moving capital offshore only to bring it back onshore again in the guise of FDI to benefit from preferential tax treatment.
A variety of measures, however, have been introduced to restrict the registration of offshore holding companies by Chinese firms and discourage round-tripping. Since January 2008, for example, the new Enterprise Income Tax Law has harmonised tax rates for foreign invested enterprises and Chinese businesses. This law provides that enterprises established under the laws of foreign countries or regions but whose ‘de facto management body’ is located in the PRC actually be treated as a resident enterprises for PRC taxation purposes. As such the tax benefits of setting up offshore holding companies appear to have been eliminated. In addition, withholding taxes may now also be levied on dividends paid offshore. If round-tripping for lower taxes was the primary explanation for the use of THOFCs, we might expect to see a reduction in their use. Yet this has not been the case. Why?
Augmenting Capital Through IFCs: The Cayman Islands
Emerging market businesses are often forced to undertake a wide variety of innovative responses in an attempt to mitigate high transactions costs.
In emerging markets financial systems are considered to be quite inefficient and their capital markets are imperfect. The capital markets of the People’s Republic of China, for example, are generally considered not to be driven purely by market forces. State owned enterprises, particularly ‘national champion’ business groups, have privileged access to capital through the state banking sector at favourable rates and preferential access to capital markets owing to their embedded nature within the Communist Party system. Private firms, by comparison, generally face acute challenges in securing bank loans because of state control over lending within Chinese banks and control over domestic stock markets. Consequently, private firms tend to be crowded out of the domestic capital market. As access to domestic capital is limited by regulation, discrimination by lenders and by the restricted range of outside funders, private firms must search for alternative ways to augment their capital stock, sometimes outside of China. Accessing international capital markets, particularly through international listings, is an increasingly popular alternative for Chinese businesses.
The most successful THOFCs, by contrast to the Chinese domestic market, are recognised for their well-developed legal and financial systems. This is particularly so for those havens that also act as OFCs. The drive for offshore incorporation and the accompanying outward FDI flows we see may well be driven not only by domestic capital market imperfections and the needs of EM MNEs to augment their existing capital structure, but also by access to a more favourable institutional environment. Outward investors, after all, seek locations that minimise the cost of their activities so as to achieve optimality in location for the firm. Registering as a company in an IFC/offshore haven could enable Chinese companies to circumvent imperfections in the domestic Chinese capital market. In other words, this may drive what has been referred to as ‘institutional arbitrage’ in the academic literature, in which MNEs use THOFCs to internalise institutional and market differences between countries, with the strategic intent of guaranteeing their long term economic viability. As such, firm-level financing and institutional arbitrage decisions become an important determinant of where MNEs invest.
Chinese outward FDI to the Cayman Islands is a case in point. It offers zero rates of tax on income and capital gains and may have certain secrecy regulations, which are advantages that might be exploited through the use of complex transfer pricing mechanisms and intra-corporate loan strategies. But it also offers firms an opportunity for Chinese MNEs to minimise their costs of raising capital. The Cayman Islands, after all, is the world’s fifth largest financial centre by asset size and has become an important adjunct to the North American capital markets. The most recent comparisons show it had 464 offshore banks, compared with nine in the BVI, 30 in Cyprus and 77 in Guernsey. As an OFC it also specialises in business related cross-border financial services, particularly in banking. It held total banking assets of US$1.7 trillion in 2009 and has become jurisdiction to 75 per cent of the world’s hedge funds and nearly half of the estimated US$1 trillion assets under management.
Most importantly of all, however, by vertically locating a listing vehicle within the Cayman Islands, IPOs may be undertaken on multiple stock exchanges, including both Hong Kong and US stock exchanges. Historically, no other havens have provided this facility (although we believe the BVI has recently acquired this status). Thus, the Cayman Islands has historically been the jurisdiction of choice for listing vehicles for Chinese MNEs with a view to raising capital. As such, many finance, accounting and legal professionals have argued that the use of a Cayman vehicle is not wholly or mainly for tax planning purposes. This is not, of course, to say zero tax rates are unimportant, rather simply that many other jurisdictions also offer such incentives. So taxation alone does not seem like a good enough explanation for the high concentration of Chinese FDI in this particular haven.
In our research on the use of THOFCs by Chinese firms, we found that 72 firms raised estimated gross IPO proceeds of US$11 billion and net proceeds of US$9.8 billion through listings in the USA. The vast majority of them did so by creating listing vehicles in Cayman Islands. This is also the case for Chinese MNEs that list in Hong Kong.
Suntech Power is a representative example, illustrating the sequence whereby Chinese businesses develop their offshore corporate structures. Suntech was originally incorporated in Wuxi (Jiangsu province), China as Suntech China. It designs, develops and manufactures a variety of photovoltaic cells and modules and is one of the world’s largest producers. Suntech raised net IPO proceeds of US$321.8mn on the New York Stock Exchange (NYSE) in 2005 via the use of an offshore holding company structure involving a company incorporated in the Cayman Islands as the ultimate controlling shareholder.
Once in place, these offshore structures allow Chinese companies to raise further capital. In 2009, for example, Suntech closed a follow-on offering on the NYSE with net proceeds of US$277 million and received through corporate bond offerings of US$1.1 billion. Following its IPO, access to short term bank borrowing dramatically improved, its net proceeds from short-term bank borrowing increased from US$15.3 million in 2005 to US$305.8 million by 2008. Suntech was able to realise net proceeds of US$294.1 million in longer term bank loans by 2009. Both Chinese and international banks lent to Suntech. The capital raised allowed Suntech to expand its production capacity, exploit its China based low-cost manufacturing model and to allow it to undertake a series of international acquisitions and investments.
Exploiting Institutional Differences: The role of the BVI
THOFCs also may provide institutional support for the restructuring of operations back in China. The market for property rights of Chinese businesses was late in its development and the domestic transactions costs are reportedly high. OFDI to THOFCs allows Chinese firms to reduce costs arising from various types of institutional misalignments. Chinese firms, moreover, avail of administrative and professional institutions and advanced business services, and engage in a form of arbitrage whereby they exploit the comparatively superior institutions of foreign markets.
It was also notable in our sample of Chinese MNEs (see methodology box) that many important transactions involving the buying and selling of mainland Chinese businesses took place via the use of investment holding companies held in these offshore jurisdictions, particularly the BVI. We found that 22 firms have acquired fully or partially one or more other China-based companies that were themselves held through offshore holding companies, supporting the idea that havens offer a supportive institutional environment for organisational restructuring.
Chinese firms may, of course, also benefit from foreign banking and financial expertise, which can add value to the Chinese capital, as well as more sophisticated and stable legal institutions. This allows businesses to undertake significant restructuring of their mainland operations via THOFCs and reduce their exposure to, and negotiation with, Chinese institutions in this process.
As with the high transactions costs incurred in domestic capital markets, transactions costs in the domestic market for property rights may force businesses to seek less costly and effective alternatives. More specifically, when transactions costs are high, firms investing in the havens follow strategies to reduce exposure to domestic institutional conditions.
Xinhua Sports & Entertainment Limited (XSEL) is a sports and media entertainment group that conducts all of its operations in mainland China. It has grown significantly since its inception, primarily through the acquisition of assets and businesses and development of its distribution channels. After XSEL secured access to international capital markets it has undertaken numerous acquisitions. The proceeds from the IPO were used to fully acquire at least seven privately held offshore holding companies that own (or control) other onshore Chinese media businesses. These companies in turn effectively control at least 29 mainland Chinese subsidiaries and a further eight offshore holding companies. Through its 2007 acquisition of East Alliance Limited, a BVI holding company, XSEL controls all of East Alliance’s wholly owned subsidiaries and variable interest entities collectively known as the M-Group, a mainland China-based mobile service provider.
Completing the Triad: What about Hong Kong?
As mentioned, as well as the Cayman Islands and BVI, Hong Kong is also another large recipient of Chinese FDI. Unsurprisingly, we also found that the incorporation of offshore Chinese investment holding companies in Hong Kong was common. Indeed, our investigation of a sample of Chinese MNEs found that it has been very popular for them to simultaneously incorporate offshore vehicles within the triad of Hong Kong, the BVI and Cayman Islands. There is, of course, a common shared past – related to the former British empire – linking these THOFCs. But what can explain the recent hike in FDI to Hong Kong from China?
Since 2006 new regulations imposed by the Chinese State Administration of Foreign Exchange, as well as the new enterprise income tax law of 2008, appear to have created incentives to hold Chinese mainland businesses via a Hong Kong incorporated investment holding company.
A common discussion we found in the financial statements of the Chinese MNEs filed with US SEC was the pending review of the tax status regarding the introduction of withholding taxes paid on dividends from mainland Chinese firms to offshore holding companies. Many of the sample firms clearly stated that all necessary measures would be taken to mitigate the adverse impacts of any possible rescinding of preferential taxation rates currently applied, and cite the use of Hong Kong holding companies as a possible solution. In effect, some disincentives to incorporate offshore (and round-trip) appear to have been put in place, with the use of Hong Kong investment holding companies considered as one possible solution.
In this light, it is of interest to note that many of our sample firms still looked to use offshore vehicles, even despite the introduction of taxes levied on dividends to offshore companies. Again, this would suggest that lower tax rates alone are unlikely to be the sole explanation for the extensive use of the specific THOFCs we identified, found in the triad of the Cayman Islands, BVI and Hong Kong.
We believe the very high levels of outward investment from China to the triad can in part be explained by Chinese MNEs wishing to exploit offshore capital markets and superior institutional environments. Chinese MNEs invest in specific THOFCs because it is these jurisdictions alone that allow them to access capital markets and institutions unavailable to them domestically.
Particular THOFCs, moreover, have different specialisations and are networked together in ways that provide unique and inimitable services. So even despite the increased regulation and higher costs associated with offshore incorporation, Chinese MNEs continue to undertake FDI to these THOFCs. And, of course, while many countries aspire to become tax havens, it is actually only those with the best governance and institutions that actually succeed. Low taxes, therefore, appear to be only one, albeit important, attraction of THOFCs.
In light of the above arguments it is also important to keep in mind the idea that finance is also a vital component of economic activity that cannot be considered in isolation from production. The capital raised offshore by our sample of Chinese MNEs has facilitated both further domestic and international expansion, illustrating its direct links to production and the need to further incorporate the role of the offshore world, particularly in explaining emerging market MNE behaviour.
Comparatively little academic research has been undertaken at the micro (firm)-level on the use of THOFCs. This is in part owing to the inherent secrecy of havens. This veil of secrecy makes it difficult to determine which firms have interests in THOFCs and what activities they engage in once offshore. One of the few windows through which to observe such behaviour is the publicly available data of firms that have raised capital on foreign stock markets. All businesses listed on stock markets in the USA, for example, must submit various formal documents to the US Securities Exchange Commission (SEC) (US SEC EDGAR database), including annual financial statements and reports. It is a requirement of the SEC that foreign private issuers complete a 20-F form annually. These submissions, owing to legal obligations, are generally candid in nature and provide detailed information on company accounts; capital raising activities and use of proceeds from such activities; information on the organisational structure; subsidiary information including the country in which any listing vehicle is incorporated and the use of offshore vehicles for such purposes.
Dylan Sutherland, Durham University Business School, University of Durham, Hinrich Voss, Centre for International Business, University of Leeds & Peter J Buckley, University of International Business and Economics, Beijing