A variable interest entity (VIE) is an investment structure that can be used by foreign investors (as well as Chinese companies that list on an overseas stock exchange or attain foreign financing) to circumvent Chinese government restrictions and prohibitions on foreign investment. More specifically, a VIE enables foreign investors and overseas listed Chinese companies to invest in industry sectors of China’s economy where, according to China’s Negative Lists and other sector-specific regulations, foreign investment is either “restricted” or “prohibited”.

Three entities (although sometimes more) are generally involved in a VIE: (1) an offshore holding company or special purpose vehicle (SPV), usually established in a tax haven such as the Cayman Islands; (2) a WFOE established in China; and (3) a domestic “Chinese-owned” company with the required business scope and licenses to operate in the industry sector(s) where foreign investment is either restricted or prohibited.

In its simplest form, the SPV owns 100 per cent of the WFOE, which in turn is linked to the Chinese-owned company (usually owned by a trusted Chinese employee or individual) through a complex set of contractual agreements, rather than through direct ownership of shares or equity. These contracts effectively give the WFOE and therefore the foreign investor(s) de facto ownership and control over the Chinese-owned company, but without the investor(s) owning any stock in such company.

The purpose of a VIE and the contractual arrangements that underpin it is to mimic the ownership and control that typically comes with stock ownership. This allows the investors to bypass Chinese laws and regulations restricting or prohibiting foreign ownership, and to transfer profits made by the Chinese-owned company to the WFOE, and if necessary back to the SPV and investors.

Despite the potential benefits of using a VIE, however, it should not be considered a risk-free structure. For example, foreign investors face regulatory risk in that the Chinese government may enact laws and regulations in the future explicitly prohibiting VIEs. Additionally, effective control and ownership over the Chinese-owned company largely depends on the contractual agreements, and whether Chinese courts are willing to uphold them as valid and enforceable. This is uncertain, as past cases demonstrate.

Nonetheless, VIEs in general have existed in China for around 20 years, with some existing for more than a decade. Many well-known Chinese companies listed on stock exchanges in the United States, including Sina, Alibaba, and New Oriental, use VIE structures. Indeed, if properly and meticulously set up, lucrative industry sectors normally off-limits (partly or fully) to foreign investors and overseas listed Chinese companies, including internet platforms, telecommunications, e-commerce, media, and education, are suddenly accessible. Therefore, VIE structures are likely to remain an important part of the foreign investment landscape in China for years to come, and should continue to be used by foreign investors and overseas listed Chinese companies alike to access restricted and prohibited industry sectors.

If you are considering a VIE structure as a market entry option, professional advice from a law firm with expertise in VIE structures should always be sought to assess the potential benefits and risks compared with other options (such as a JV if the industry sectors are restricted and not prohibited), which can only be based on an extensive analysis of the company’s specific circumstances.