China in Tax Havens — a Cautionary Tale

China in Tax Havens — a Cautionary Tale

The following commentary/analysis is one I wrote in my capacity as a senior fellow at “the nation’s oldest consumer protection agency,” Consumers Research, where, among other things, I compile a weekly letter for public pension-fund managers.  I am sharing it here today because I thought it might be useful to some of you.


You Don’t Own A Damned Thing

Over the last several months, discussions about the case for (or against) ESG have largely focused on research papers – papers produced by prominent academics, prominent consulting firms, and prominent asset management think tanks – all of which have been employed historically to justify the use of ESG and the promulgation of regulations to enable that usage.  Thanks to scrupulous and dedicated researchers like Andrew King and Alex Edmans, however, many of these papers have been exposed as poorly designed with results that are irreplicable, leading King to label them and the analyses based on them “meaningless.”

Of all the finance-related research available, though, one paper stands out as exceptionally important and yet exceptionally underappreciated – at least as it relates to ESG.  That paper – a working paper published in January 2023 by a group of researchers from Stanford, Columbia, and Yale – is titled “China in Tax Havens” and documents the meteoric rise of Chinese use of tax havens such as the Cayman Islands to manage financial dealings with other nations.  The New York Times’s Peter Coy summarized the paper’s principal findings as follows in his March 8, 2023 economics newsletter:

As recently as 2002, only 1.7 percent of the outstanding equity issued in tax havens worldwide consisted of equity issued by Chinese shell companies in the Caymans, the researchers calculated.

By 2020, the team found, Chinese shell companies in the Caymans accounted for 52.5 percent of all outstanding equity issued in tax havens.

Why does this matter, you ask?  What on Gaia’s green earth do tax havens have to do with ESG?

Well…it’s complicated – which is sorta the whole point.

Although the researchers bill this as a story about China’s use of tax havens for financial purposes, this focus has the net effect of what we might call “burying the lede.”  China’s presence in the Cayman’s isn’t the real story, in other words.  It’s the purpose of that presence that really matters.  They write:

This investment into Cayman Islands based entities reflects the use of variable interest entity (VIE) structures by Chinese firms. Under Chinese law, foreign investors are restricted from owning equity in firms operating in strategic industries, including the tech industry. In order to abide by the letter of Chinese law and still attract foreign equity investment, some Chinese firms incorporate a shell company resident in the Cayman Islands that they list publicly on global stock exchanges such as the New York Stock Exchange. This Cayman Island resident shell, in turn, enters into a series of bilateral contracts, none of which are formally equity contracts, with the operating company and its Chinese owners. These contracts aim to replicate equity ownership by giving control and a claim to the residual profits of the operating company to shareholders of the offshore shell company. Under international accounting standards, these contracts are sufficient for the offshore shell company to claim them to be equivalent to equity and report on a consolidated worldwide group basis. At the same time, the operating firm in China takes the opposite view of these contracts and attests to local regulators that it is fully owned by Chinese residents.

Translating that into plain English, what we have is a description of the process by which the overwhelming majority of foreign investment in Chinese companies is conducted.  Foreign investors – which is to say American investors and the ETFs they buy – do not hold any equity in the Chinese companies they think they hold.  Instead, they hold equity in shell companies set up in the Caymans by the Chinese companies.  In most cases and at most times, the ownership of the shell company is the financial equivalent of ownership in the company on which the shell is based, but the bottom line is still that Americans DO NOT own what they think they do.

And it gets worse.  Even those who understand the shell company setup still might not know the extent to which their equity ownership is removed from the actual company it purportedly represents.  Peter Coy continues:

Even the shell doesn’t own shares in the operating company. Instead, the shell owns a unit in China called a wholly foreign-owned enterprise, or WFOE (pronounced “woofy”). The woofy — oops, WFOE — has contracts with the operating company and its owners. These contracts entitle the WFOE to a share of the company’s profits and a voice in its operations. The WFOE can funnel dividends to the tax haven shell, which passes them through to investors in New York, London and elsewhere (though most don’t pay dividends)….

For now, the Chinese government seems to tolerate variable interest entities because its companies need to raise money abroad. But if the Chinese government doesn’t recognize the foreign holders as true owners, it might not respect their interests if push comes to shove. The authors note that when Jianzhi Education used a variable interest entity to list on Nasdaq in October, Jianzhi warned that the Chinese government could find “these contractual arrangements noncompliant with the restrictions on direct foreign investment in the relevant industries.”

Let that sink in for a moment.  The “Chinese government could find ‘these contractual arrangements noncompliant with the restrictions on direct foreign investment in the relevant industries.’”

Again, translating into plain English: “You don’t own a damned thing.”  And at any moment, the Chinese government can declare the arrangements created by VIEs and WFOEs null and void, leaving investors with…well…not a damned thing.

Supporters of ESG have long insisted that the strategy is, at its heart, a “risk-assessment tool.”  Yet most of these supporters continue to pretend that investing in Chinese companies is not fundamentally different from investing in any other companies, American companies, for example.

For the record, this applies especially to the biggest, boldest, and brashest historical advocate of ESG, asset management giant BlackRock.  Four years ago, Larry Fink, the firm’s CEO, called China one of the biggest investment opportunities of his lifetime.  Three years ago, BlackRock’s internal think tank encouraged investors to triple their allocations to Chinese companies, saying that the PRC is “no longer an emerging nation.”  And, of course, BlackRock was one of the biggest American investors and biggest supporters of the Chinese “challenger to Starbucks,” Luckin Coffee, which turned out to be a wholly fraudulent enterprise.  Interestingly, Luckin Coffee makes an appearance in “China in Tax Havens,” as the authors note that “the company’s offshore registration in the Cayman Islands complicated the investigation and subsequent legal proceedings against it, highlighting concerns about the transparency and accountability of Chinese firms domiciled in tax havens.”

The case against investing in Chinese companies is long and sordid, and runs the gamut of associated problems, from the use of slave labor to the CCP’s insistence that corporations drop the Big Four as their auditors.  Inarguably, however, the biggest risk can be found not in Xinjiang Province or backrooms in Beijing, but much closer to home, in the Cayman Islands.  You don’t own what you think you own.  Indeed, you don’t own a damned thing.

Stephen Soukup
Stephen Soukup
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Steve Soukup is the Vice President and Publisher of The Political Forum, an “independent research provider” that delivers research and consulting services to the institutional investment community, with an emphasis on economic, social, political, and geopolitical events that are likely to have an impact on the financial markets in the United States and abroad.