In the poor-ried Caribbean, the Cayman Islands are a bit out of place to be rich. In 2021, the total population of the Cayman Islands was only about 68,100, but due to its huge offshore financial system, more than 100,000 companies were registered here, the number of companies exceeded the population, and the per capita GDP was as high as 86,000 US dollars, ranking first in the Caribbean.
More than just a world-famous destination, it's also one of the best places to register a company in the world. Here, foreign exchange is free to enter and exit, convenient for financing and listing, and the government does not levy any direct taxes, corporate profits, capital gains, personal income, inheritance do not need to pay taxes, almost completely "what you earn is what you get", and government departments are even tighter about investors' information.
According to the global "tax haven" ranking released by the UK research agency Justice Alliance in March 2021, the Cayman Islands, the British Virgin Islands and Bermuda all scored a perfect score of 100 on the "Corporate Tax Haven Index", ranking first in the world, and all three are overseas territories under the United Kingdom.
Registered in Cayman, listed in the United States, and physically operating in China are the common choices of many Chinese Internet companies in recent years. A recent study by Stanford University, Columbia University and Yale University in the United States found that in the past 10 or 15 years, China's share of the issued share of tax havens has increased significantly, and the Cayman Islands has quietly become the main channel for Chinese companies to sell shares to foreigners for financing Chinese.
For a long time, China's presence in the Cayman Islands was modest. A team of researchers from Stanford, Columbia and Yale University calculated that as of 2002, only 1.7 percent of the issued stakes in global tax havens had been issued by Chinese shell companies in the Cayman Islands.
However, the team found that by 2020, Chinese shell companies in the Cayman Islands accounted for 52.5% of all issued shares in all tax havens. In addition, Chinese companies issued 3.4% of shares in Bermuda and 0.5% in other tax havens.
Researchers say tax havens have become the main way for foreigners to invest in Chinese companies. The team published a study titled "China in Tax Havens" in January, which reads: "By the end of 2020, about 70% of foreign fund investments were made through the tax haven subsidiary of a Chinese company, with entities domiciled in the Cayman Islands accounting for the majority of this phenomenon. ”
One of the researchers, Matteo Maggiori of the Stanford Graduate School of Business, said even most people who track tax havens and Chinese stock issuance are unaware of the phenomenon. "When we presented this finding, people were shocked," he said. "When you mention who uses tax havens, you think of rich people and big corporations from developed countries. But things have changed a lot in the last 10 or 15 years. ”
In an era of increasing competition between the United States and China, this story is a bit offbeat. The U.S. government doesn't like what's going on, but the Chinese government doesn't seem happy either. Neither side wants Americans to take large stakes in Chinese companies.
For Americans, the biggest concern is investor protection. Shares issued by shell companies in the Cayman Islands, Bermuda and other tax havens do not represent direct ownership of Chinese companies. They are complex financial structures, known as variable interest entities, designed to circumvent the Chinese government's restrictions on foreign control of domestic companies. Worryingly, this structure does not give U.S. investors shareholder rights over the companies in question.
Senator Chris Van Holen, Democrat of Maryland, and Senator Rick Scott, Republican of Florida, said that in September, they announced they would introduce a bill to "protect U.S. investors from venture capital investments in variable-interest entities."
In addition to Maggiorie, the study authors include Christopher Clayton of the Yale School of Management, Antonio Coppola of the Stanford Graduate School of Business, and Amanda Dos Santos and Jesse Schleger of Columbia Business School.
As they explain in the research report, when you use a variable interest entity structure to buy shares in companies like Alibaba, Tencent, or Baidu, you don't own shares in the operating Chinese company, you own shares in a shell company, and even the shell company doesn't own a stake in the operating company. Instead, the shell company has a subsidiary in China known as a Wholly Foreign Owned Enterprise (WFOE). A WFOE has contracts with the operating company and its owners that give the WFOE the right to share in the company's profits and have a say in its operations. WFOEs can transfer dividends to shell companies in tax havens, which transfer dividends to investors in New York, London, and elsewhere (although most companies do not pay dividends).
The advantage of this Rube Goldberg-style arrangement (the use of complex methods to do simple things) is that under IAS, variable interest entity structures are considered equity for foreigners, while companies operating in China can report to local regulators that they are wholly owned by Chinese residents.
The risk of doing so, though, is that it may be a bit overly clever. The research team noted that when Insight Education (NASDAQ:JZ) listed on the NASDAQ last October using variable interest entities, Insight Education warned that the Chinese government might find that "these contractual arrangements do not comply with restrictions on FDI in relevant industries."
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Compared to the incorporation requirements in other parts of the world, the registration process for a "tax haven" offshore company is very simple and inexpensive, and there is no need to pay any income tax, capital gains tax, capital transfer tax, inheritance tax, inheritance tax or property tax, etc.
However, although these "tax havens" do not receive any income from corporate tax, they usually charge a registration fee for all newly formed business entities. In addition, companies are required to pay an annual renewal fee in order to continue to be recognized as an operating company.
In addition, depending on the type of business activity the company is engaged in, "tax havens" charge the company an additional fee. For example, banks, mutual funds, and other companies in the financial services business often require annual licenses to continue operating the industry, all of which create a strong recurring revenue stream for "tax haven" governments.
So how exactly is tax avoidance? For example, the general operating process is to register a Cayman company and then register a domestic subsidiary. The foreign customer signed a contract of 1 million yuan with the Cayman company, and the payment of 600,000 yuan from the Cayman company to the domestic subsidiary, and the domestic subsidiary sent 600,000 goods directly to the customer. So far, for Cayman companies: 400,000 profits, in Cayman companies do not need to pay tax. For domestic companies: the price of the goods is equivalent to the goods, and there is no tax on the non-profit. When a company is large enough, this method can avoid a lot of operating costs.
Of course, some companies are registered in the Cayman Islands to avoid taxes, while others are mainly for the convenience of listing. Since the threshold for listing in Chinese mainland is very high, many domestic companies will choose curve listing. As there is a popular saying in Cayman: "If you want to go to the NASDAQ to ring the bell, Cayman is the transit point." ”
If an enterprise wants to introduce foreign capital or has the need for overseas listing, it can complete the overseas financing of the domestic company by registering an overseas company in the Cayman Islands, acquiring 100% of the equity of the domestic company, and then submitting the Cayman company to the overseas exchange for listing.
For a long time, most of the main purposes of such offshore companies are to hold shares, have no economic substance, and have not applied for local tax residency, and information asymmetry has led to the offshore company neither paying taxes in the offshore region nor in the home country or the country where the ultimate beneficiary is located, which has caused dissatisfaction in the international community. In order to avoid being included in the "tax non-cooperation blacklist" by various countries, offshore financial centers have also "forced" to legislate to pass the Economic Substance Law in recent years.
Since 2019, the Cayman government has implemented the Economic Substance Act, and since then has successively passed three guiding documents, version 1.0, version 2.0 and version 3.0, requiring companies and partnerships incorporated locally to have sufficient commercial substance for companies and partnerships engaged in specific activities, otherwise face fines or even deregistration, which greatly increases the compliance costs of offshore enterprises, but does not have a substantial impact on the offshore structure.