A confluence of two events has the potential to curtail a type of US investment in China that may currently be flying under the radar. The first is a white paper recently released by a group of academics, which details the extent to which Chinese companies are raising capital from investors using offshore tax-advantaged jurisdictions. The second is the recent flurry of activity surrounding the potential for the US government to establish a new regulatory regime that would subject certain outbound investment to national security review.
The National Bureau of Economic Research's recent white paper "China in Tax Havens" describes how Chinese companies have been raising significant foreign capital in tax-advantaged locations—in particular, the Cayman Islands—by establishing offshore affiliates to issue equity and debt. The authors of the paper state that because of how standard international financial statistics are compiled, the recipient of such investment is classified as the offshore country, rather than China itself. For this reason, the full extent of foreign investment in China has not been widely recognized.
Moreover, Chinese companies’ use of offshore locations to raise capital has spiked. The white paper estimates that over the past 20 years, Chinese firms went from raising a trivial amount of capital through offshore jurisdictions to now accounting for well over half of equity issuance and about a fifth of global corporate bonds outstanding in such locations.
In addition to the obvious tax advantages, offshore companies have been widely used in variable interest entity (VIE) structures, designed to limit the reach of Chinese laws that curb foreign investment in Chinese companies operating in strategic sectors such as critical technology, information technology and services, and energy. In essence, the Chinese companies incorporate a shell entity in an offshore jurisdiction, and the shell entity is listed publicly on global stock exchanges. Because of how VIE structures enable the consolidation of the financials of the holding company and the onshore operating entities, these Chinese companies take the position that they are fully owned by Chinese residents.
In addition to the risk that such companies may wind up facing scrutiny from the Chinese government, the foreign investors also bear some risk because they have no equity or direct ownership interest in the Chinese companies and may lack legal recourse in the event of a dispute with the Chinese company. Reflecting this concern, a bill was introduced in the previous US Congress (S. 4757, 117th Congress) that would require the identification of consolidated VIEs on securities exchanges and would require brokers and dealers to warn investors in VIEs that the investors may lack legal recourse. This bill did not move forward, and it is unclear whether it will be resurrected in the new Congress.
What has not been widely examined, however, is the potential national security impact of such investment. Because the largest Chinese issuers in offshore tax-advantaged jurisdictions are technology companies, foreign investment—including from the United States and its allies—could end up providing capital to Chinese high-tech industries that goes on to strengthen the Chinese government in ways it can leverage for national security gain. The possibility for US and other foreign investment to undermine US national security is further heightened by China’s military-civil fusion strategy, which has the stated goal of leveraging even civilian innovation to advance China’s military capabilities.
As a result, in this particular area the US and the Chinese governments may have a rare instance of alignment, as both have reason to be concerned about the practice of using offshore companies to raise capital for Chinese enterprises. Those concerns may wind up being addressed, at least in part, by the likelihood that, in the near future, the US government will establish an outbound investment review regime. Most observers anticipate that President Joseph Biden will issue an executive order to put such a regime in place, and there is also significant congressional interest in regulating outbound investment.
Recent reports suggest that the scope of outbound investment regulation has been subject to extensive negotiation within the executive branch, and therefore an executive order may ultimately require government approval of US investment in only the most sensitive types of businesses—including businesses involved in semiconductors, quantum computing, and artificial intelligence. Although recent reporting indicates that other sensitive areas such as biotechnology will not be included, biotech would be an odd omission given the increased attention the Biden administration is giving to US competitiveness in life sciences, and the government’s increased scrutiny of biotech transactions that could result in technology transfer to China. Accordingly, even if an executive order does not subject US biotechnology and biomanufacturing investment in China to prior government approval, it might at least make such investment subject to a lesser notification requirement.
It seems likely that at least some of the outbound investment covered by an executive order—whether requiring approval or merely notification—would include investment in Chinese technology companies that are using offshore tax-advantaged jurisdictions to raise capital. It also seems likely that an outbound investment executive order would be crafted broadly enough to cover even indirect investment—similar to how the Committee on Foreign Investment in the United States (CFIUS) looks at the ultimate beneficial owner, and not just the direct acquirer, when conducting national security reviews of inbound investment from entities organized in locations such as the Cayman Islands.
For that reason, although US regulation of outbound investment would be primarily designed to counter China, the new regime could wind up at least in one respect working to the mutual benefit of both nations by reducing the ability of Chinese tech companies to raise capital from US investors using VIE structures.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following: