Chinese crackdown on offshore firms gets the Caymans into trouble

In a move designed to prevent Chinese companies from expanding at “reckless speeds” abroad, Beijing is curbing the ability of Chinese tech firms – particularly those using a Variable Interest Entities (VIE) structure – to list on foreign stock exchanges. These restrictions are the result of a long fight against VIEs, whose foreign IPOs have come to be regarded as a threat to national security. No surprise that the new regulations also limit the ability of foreign investors to acquire stakes in firms deemed important for national security.

VIEs were created by Sina Corp. in the year 2000 as a means to circumvent China’s rules on foreign investment in sensitive sectors. Crucially, the increasing uptake of the structure in other companies over the years gave a massive boost to tax havens and registered trading places – primarily the Cayman Islands and the British Virgin Islands. The reason behind that is simple: the VIE structure enables a Chinese company to transfer its profits to an offshore special-purpose entity, which in turn can sell its shares to foreign investors.

The Cayman Islands are already a primary destination for the creation of shell companies, with Chinese firms having added an additional increase in value. Between the Caymans, the British Virgin Islands and Bermuda, the market value of Chinese companies with primary listings there is in excess of $3.7 trillion. However, it’s easy to see that the new Chinese law is promising to be painful to the Caymans’ bottom-line going forward, especially at a time when the island nation is already under closer scrutiny for being a hotspot of financial crime, such as money-laundering and complex corporate fraud.

One such case, arguably one of the most influential ones under litigation for its law-setting power on the Caymans, is that of the Kuwait Ports Authority (KPA) and the Kuwaiti Public Institution for Social Security (PIFSS) against the Port Fund (TPF), an international group registered in the Caymans. On 25 November, the Grand Court of the Cayman Islands ruled that the KPA and the PIFSS will be able to bring litigation against Mark Williams, the former effective manager of TPF who is accused of fraud and embezzlement of $200 million owed to TPF’s Kuwaiti investors.

It’s the first time that a Caymans court permitted investors to file claims against a fund’s management – on the very fund’s behalf. As such serves, the decision serves as a landmark for the jurisdiction’s legal landscape. While the specific impacts on the Caymans’ corporate law, particularly as regards beneficial ownership structures, still need to be fully assessed, it’s more than evident that the ruling will have far-reaching effects going forward.

While thus some of the legal structures will likely undergo an important evolution, the Caymans business model is also under threat from the recently announced international agreement to harmonize corporate tax rates. The OECD-backed agreement will come into effect in 2023, and has pharmaceutical companies incorporated on the Caymans in particular worried about the tax offsets for medical patents transferred there.

Critics of the agreement argue, not without justification, that tax havens will likely prevail by finding loopholes to maintain their status unscathed. That may well be so – but that possibility notwithstanding, it’s evident that between China’s crackdown on its own firms, unprecedented legal rulings and closer tax scrutiny, a storm is brewing for the Cayman Islands.

Image: Lee Shoal/Flickr