Just as so many foreign companies are realizing the importance/necessity of forming a China WFOE, China has made it nearly impossible for a WFOE to be formed without a full list of its owners. I first wrote about this issue in China’s New Foreign Investment Law: The “Actually Controlling Person” Requirement is Going to be Tough, where I predicted what has now transpired.
It has reached the point where my law firm’s China FDI lawyers make clear to our clients who hire us to form a China WFOE: either you reveal pretty much all owners of the WFOE-to-be (through the various layers of ownership) or the odds of your getting a WFOE are not good. Clients unwilling or unable to make the required ownership disclosure in the exact form required by the PRC government authorities cannot proceed. An Anti-Money Laundering Letter will be ignored and insisting on such a letter will only produce a hostile response. There are no exceptions to the rule.
This is a threshold issue and this issue must be resolved before it makes sense to incur the time and expense required for a WFOE formation application.
I provided the explanation for this in my earlier post:
China’s intent with this new [ownership disclosure] system is clear. The PRC government will no longer allow the use of special purpose vehicles and related entity structures to hide the actual ownership of the investors in PRC foreign-invested enterprises. And any attempt by a foreign investor to invoke a foreign law that allows secrecy with respect to ownership will [almost surely] be ignored. MOFCOM has plans to carefully audit all FIEs and that audit will include carefully reviewing their ownership structures. More important, however, is that a response that does not list out owners will simply not be accepted by the automated system. A response is therefore forced. A false response is a violation of law that can result in penalties and other legal/administrative action by the PRC government and its agencies.
Since I wrote that post, the we have seen the local MOFCOM authorities become even stricter about enforcing its WFOE ownership disclosure rules. The current trend is to require full disclosure all the way up the line of ownership. The only concession we have recently received is that some local governments will agree to end the disclosure at the level of what can be called a private equity or SICAR type fund. That is, some (not all) local MOFCOM offices will not require disclosing investors in private equity fund/SICAR type entities. However, other local MOFCOM offices DO require disclosure of private equity fund/SICAR investors.
There are though two levels of disclosure and getting past MOFCOM just means getting past the first level. The first disclosure is made in the information report provided to MOFCOM as part of the formation process. However, the new system includes an elaborate auditing process, so even if a local MOFCOM office allows for limited shareholder/ownership disclosure, an expanded disclosure may be required as a result of an audit. This is because the audit is done by a higher level office of MOFCOM. Such higher level offices are almost always stricter than the low-level offices.
So even if you are able to convince a local MOFCOM office to accept a limited disclosure of the shareholders of the investor, this is not a final decision. The initial MOFCOM decision can be overturned at any time and the demand for full disclosure can be made at any time. This demand would likely be made after your WFOE has started operations and if you then fail to comply with the demand your WFOE would be at great risk of being shut down.
Our European clients are usually the most taken aback by China’s new ownership disclosure requirements and we therefore often must spend extra time explaining the situation to those clients. Investor secrecy is at the heart of the European investment system. Most SICAR entities do not even disclose the identity of directors and officers. However, this form of secrecy has been rejected by the PRC government. For domestic companies that are not publicly listed entities, all shareholders are listed on publicly available websites. It is now possible to trace every PRC corporation up to the point of either a natural person shareholder or a public company shareholder. This is the system the PRC government intends to impose on foreign investors in China.
The investor disclosure requirement has become a fundamental policy in Chinese law. The PRC government fully understands that its policy of full investor disclosure is exactly opposite the investor secrecy systems standard in Europe and North America. Accordingly, any argument from a foreign investor that invokes European or international law is simply ignored as irrelevant. As noted above, as foreign entities have tried to resist fully disclosing their ownership, the PRC authorities have become more demanding, not less. We expect this trend to continue.
Note also that there are other disclosure risks, including the following:
- As part of the audit procedure, the PRC government may demand the tax returns of the disclosed shareholder(s) to confirm the accuracy of the reported information.
- It is nearly certain the PRC government will at some point require the WFOE provide three years of personal tax returns for each foreign individual employed by the WFOE.
- Other intrusive requests for what you likely will consider very private personal information may also be required during the life of the WFOE.
If you are not willing to provide the required information you should not move forward in trying to form a China WFOE because there is no way around these requirements. The PRC laws in this area are clear and the fact that those laws conflict with the laws and norms of Europe and North America is simply not relevant. What is relevant is that if you are not willing to comply with China’s ownership disclosure laws, you will not be permitted to set up and operate a WFOE in China.
This “actual controlling person” requirement does not make legal sense under modern corporation structures, but the PRC government simply ignores this fundamental point. Thus, even after we do a full disclosure of all shareholders and thereby PROVE there is no single actually controlling person, the response of MOFCOM is to say: “You must identify the actual controlling person or we will not approve the investment.” Most local MOFCOM offices accept the name of the Chairman/CEO of the first level shareholder as the “actual controlling person.” Even that result though is not certain and there are two other possibilities:
- The CEO/Chairman/Managing Director of the majority owning private equity fund or SICAR, no matter how far up the chain of ownership.
- Endless requests for the name of the actual controlling person, when in fact there is no such person, making a response to the request impossible.
We have encountered all three of the above in our work on WFOEs during the period after the actual controlling person requirement was imposed. To date, there has been no consistency in the requirements.
Consider a typical private equity fund/venture capital type of ownership structure. The investor in the WFOE is Operating Company A. The owner of Operating Company A is a Holding Company B. Holding Company B is in turn owned by three private equity funds: Equity Funds C, D and E. The largest of the funds is owned by Equity Fund Z. As you can see, there are four layers of ownership.
For the MOFCOM information report, it is certain we will be required to disclose the following:
- Operating Company A as the investor. This will require disclosing the officers and directors of Operating Company A.
- Holding Company B is a 100% shareholder of Operating Company A. This will require we disclose Holding Company B, together with its officers and directors. We usually argue that Holding Company B is a “private equity fund”, and for that reason, we should not be required to disclose the shareholders of Holding Company B. Some MOFCOM offices will accept this argument. Some will not. Even if the local MOFCOM accepts, the higher level MOFCOM that does the later audit may not accept and then require all shareholders of Holding Company B be disclosed.
- The local MOFCOM office may require disclosing the three shareholders of Holding Company B. If MOFCOM makes this demand, it will also require disclosing the directors and officers of Holding Company B. For the past several months, most MOFCOM offices have required this level of disclosure and foreign investors should plan on this disclosure being required.
The big question is whether MOFCOM will require moving up the chain to mandate disclosing the shareholders of the three shareholders in Holding Company B (Equity Funds C, D and E). We have in the last few months been asked by various MOFCOMs for this level of disclosure, but we have so far been able to convince them that this should not be necessary. In one instance, we provided MOFCOM with an organization chart showing nearly 75 owners of an LLC (including many private equity funds) but ended up convincing it not to require our client disclose the names of these nearly 75 owners, as originally requested. When MOFCOM requests/requires this sort of disclosure, we normally argue that the C, D and E entities are “private equity funds” and disclosure of their ownership should not be required for the same reasons public company investors are not required to disclose their shareholders. Several local MOFCOM offices have recently tentatively accepted this argument, but this decision is not binding and the higher level of MOFCOM could demand more disclosure, either as part of the initial WFOE formation process or later as a result of their audit.
China has rejected shareholder secrecy and its requirement of full shareholder disclosure imposed on foreign investors is simply the consistent application of PRC law to all legal persons. The shareholder disclosure requirement is contrary to European and North American legal principles and on that basis many shareholders will refuse to consent to disclosure. However, under PRC law, there is no exemption. PRC local governments and MOFCOM offices are authorized to require even more sensitive private documents, such as the shareholders’ tax returns and tax returns of the WFOE’s foreign employees.
Bottom Line: If you are unwilling or even legally unable to comply with China’s ownership disclosure requirements you cannot proceed with a China WFOE formation. It is that simple and resistance is futile.