What You Need to Know About Chinese Stocks: Part 1

This article is part of our Rising Star Portfolios series.

Last week, I wrote about the Dada Portfolio's decision to purchase shares of China Yida (Nasdaq: CNYD  ) . Yida was a risky pick with a worrying track record of playing musical chairs with its auditors, yet I felt comfortable with the decision (which has so far netted us a more than 20% gain). But my comfort level with small-cap Chinese companies is going to be different from most people's -- and that's an opportunity.

With today's article, I want to transfer some of my comfort with Chinese investments to you. So let's start by taking a look at the holding structures of U.S.-listed Chinese companies. One of my responsibilities while I was an investment bank analyst in Beijing was to structure private equity deals so that a foreign investor could purchase Chinese assets. I never thought that particular skill would ever come in handy, yet, here we are.

Now that's what I call an org chart
While every company is going to be slightly different, all U.S.-listed Chinese companies have a corporate holding structure that follows a similar pattern (please note that "PRC" refers to People's Republic of China and is my preferred way of referring to mainland China):

The arrows indicate direct ownership and they flow downward, meaning that the company at the top of this chart ("U.S. Holding Co.") has equity ownership in all of the companies below it. However, keep in mind that income and cash actually flow upwards.

The "U.S. Holding Co." is a shell company with no actual operations. This is the entity that has its shares listed on a U.S. exchange like the NYSE or Nasdaq. If you are a Baidu (Nasdaq: BIDU  ) , Ctrip.com (Nasdaq: CTRP  ) , or even China Yida shareholder, what you actually own is shares of their "US Holding Co." analogue.

Despite not having any operations, the value of the "U.S. Holding Co." (and thus, the value of the shares that you own) comes from the entity's ownership of the "PRC Operating Companies" and the operating results they obtain. For the most part, the distinction is moot, and most people treat it that way. When someone talks about Sohu.com (Nasdaq: SOHU  ) , they aren't referring to the Delaware-incorporated shell company, they are in all likelihood referring to the company's PRC operating subsidiaries. But, not being cognizant of the distinction can be a huge risk.

How to save on taxes, Chinese-style
The "Tax Shelters" are intermediary holding entities that provide some sort of tax benefit to the company. The Cayman Islands, British Virgin Islands (BVI), or Bermuda are common tax havens that reduce the amount the U.S. government can levy on a company. "Tax Shelter 2" is often located in Hong Kong, which imposes no taxes on any dividends received from Chinese companies. One might say that this is needlessly complex, but a quick look at your average U.S.-listed Chinese company's effective tax rate shows that the effort often pays off:

Company

Effective Tax Rate in 2009

Average U.S. corporate tax rate

35.0%

China Yida

25.9%

Baidu

11.8%

Ctrip.com

16.5%

Sohu.com

16.1%

China Green Agriculture (NYSE: CGA  )

13.9%

Shanda Interactive (Nasdaq: SNDA  )

22.0%

It is only past these layers of tax shelters do we finally find a domestic PRC company. Depending on the ownership structure, the PRC holding company and its operating subsidiaries may either be WFOEs or JVs. WFOE stands for wholly foreign-owned enterprise, but if you're ever in China you'll hear it pronounced "wolfie" because it can also be abbreviated as WOFE, for wholly owned foreign enterprise (don't ask me about how Chinese people come up with English names -- I used to work with a vice president-level woman in her mid-30s named Ice, and the head of our finance team was named Mantic). What JV stands for is a bit more obvious: joint venture. But be aware, the "JV" title suggests more than just collaborative effort; it's an official legal designation governed by different rules and regulations than a WFOE or a wholly Chinese corporate entity.

Since most U.S.-listed Chinese companies have a "PRC Holding Co." analogue that is 100% owned by a "Tax Shelter" analogue, the majority of these onshore (inside the PRC) operating/holding companies are WFOEs. Even if a company does have a joint venture partner, typically the joint venture entities are established offshore (outside of the PRC) to avoid further PRC regulatory hassle.

The irony of the WFOE is that from our perspective as non-PRC residents and investors, we think of Baidu, Yida, Ctrip, and so on as "Chinese" companies. But from the Chinese government's perspective, they're actually foreign companies that happen to have operations in China -- no different from McDonald's or Microsoft. This is super important! One must keep this subtle distinction in mind as it has the potential for serious ramifications for outside investors in these companies.

And next time ... the dangers
We've seen how this holding structure can be a significant boon, but there are some very real negative implications as well that not many investors are aware of, ones that could make you completely rethink any investment in a U.S.-listed Chinese company. In my next article for the Dada Portfolio, I plan on discussing and exploring these risks. In the meantime, check out our Foolsaurus page here and follow us on Twitter @TMFDada!

The Dada Portfolio is a part of the Rising Star series of real money portfolios. It is co-managed by Sean Sun and Ilan Moscovitz. If you're interested in learning more about the portfolio, click hereto join us on our discussion board.

Sean Sun doesn't own shares of any company mentioned. Microsoft is a Motley Fool Inside Value recommendation. Baidu, Shanda Interactive Entertainment, and Sohu.com are Motley Fool Rule Breakers selections. China Green Agriculture is a Motley Fool Global Gains pick. Ctrip.com International is a Motley Fool Hidden Gems selection. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of China Green Agriculture and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (42)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 08, 2010, at 4:24 PM, Fool wrote:

    Not sure if I am the only one with this problem, but the scrolling advertisements on the right-hand side of the page (beginning with "Today's Market") are cutting out half of the article. This is making it unreadable.

    I've read many a MF article and never had this problem before. To the editors: could you please correct this?

  • Report this Comment On November 08, 2010, at 4:30 PM, PatienceGrasshpr wrote:

    Internet Explorer is cutting off the right side of the article. Looks fine in Firefox.

  • Report this Comment On November 08, 2010, at 6:51 PM, rhallbick wrote:

    Thanks for the info! Very useful. RH

  • Report this Comment On November 08, 2010, at 7:02 PM, LDSGJA wrote:

    Very interesting article.

    So the US company owns shares in the Cayman Company which owns the HK company which owns the operations in PRC?

    PS, article looks fine in Chrome OS at 1280X720

  • Report this Comment On November 08, 2010, at 7:07 PM, TMFSun wrote:

    jdrumstik: Yes, that's typically how it goes. I'll look at some case studies in a follow-up article so we can see how it plays out for some real-life companies.

    I know we had some formatting issues earlier but I do believe they've been fixed. If not, please let us know. Thanks everyone for commenting and be sure to check out the Dada Portfolio discussion boards!

    -Sean

  • Report this Comment On November 25, 2010, at 6:10 AM, Soteriologist wrote:

    This article is wrong on several counts.

    1. Most US listed Chinese companies use a Cayman Islands company at the top, not a US company. It would be a mistake to use a US company because then it would be subject to US corporate tax. It would also be a domestic filer with the SEC which is much more rigorous than being a foreign private issuer. Most of the companies that have US companies at the top are reverse mergers, where the Chinese company got merged into a US shell. Bad idea, but so are most reverse mergers.

    2. The BVI companies are usually in the structure because they were cheaper to set up than Cayman Companies. When the lawyers got involved they fixed the structure by putting the BVI companies under the Cayman company.

    3. While the Cayman and BVI companies are in tax havens, few (if any) Chinese listings get any tax advantage from this. The reason for the lower tax rates is tax incentives granted by the Chinese government to foreign invested companies, and these are rapidly going away.

  • Report this Comment On July 09, 2011, at 11:55 AM, pmj98765 wrote:

    "While every company is going to be slightly different, all U.S.-listed Chinese companies have a corporate holding structure that follows a similar pattern"

    Is this due to a legal requirement? Are there any that do not have a holding structure? It sounds to me that if this is a US listing requirement its not helping us as it isolates us from the management.

    Rgds

    PMJ

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