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Study Times: China Must Pay Attention to Foreign Control of China’s Internet Companies

[Editor’s Note: Study Times, a weekly newspaper published by the Party School of the Central Committee of the Chinese Communist Party (CCP), published an article that a professor from the Chinese Academy of Social Sciences wrote, along with one of his students. The article warned that most of China’s Internet companies are controlled by foreign investment. This includes foreign companies, foreign investors, and companies that the Chinese have registered overseas. It held that the common practice for establishing an Internet company in China is to first register a controlling company overseas. This overseas company then either sets up a subsidiary company in China or finds an agent to register a company in China and then signs a contract to establish effective control over this China-registered company. Though Chinese own many of these overseas controlling companies, individual ownership is still different from state ownership. Also, it is easy for foreign capital to acquire these companies and thereby control China’s Internet business. The following are the main points of the article.] [1]

Chinese Internet companies operate in the following way: first, they are set up offshore and registered overseas; second, their main business is in China; third, their owners indirectly control the companies in China because they made a contractual arrangement with them; fourth, they went IPO overseas to raise capital. The above four characteristics determine the special organizational structure for Chinese Internet companies. Specifically, they consist of an overseas part and a domestic part, with direct ownership and a contractual relationship between the two. The overseas part is an overseas holding company or a registered subsidiary of such a holding company that is set up abroad; the domestic part consists of a wholly-owned subsidiary or joint venture of the overseas holding company, or an Internet company (in China) that the overseas holding company controls through a contractual arrangement. (Editor’s note: Throughout this article, the overseas part is called a “Chinese Internet company” and the domestic part is called “China’s domestic Internet company.”)

Most Chinese Internet companies were established overseas. Legally, they are considered foreign investments. Under current law, it is not possible to establish direct control over China’s domestic Internet services. The main way for an overseas company to control China’s domestic Internet service is through an indirect contractual business arrangement with an Internet company registered inside China. For international capital, the only way to control an Internet business in China is to take ownership control of the Chinese Internet company through direct capital investment or acquisition of its stock.

To effectively control China’s domestic Internet business, a Chinese Internet company usually takes the following approach: First, it finds a suitable Chinese citizen to be its agent in China. Second, the offshore company or its subsidiary provides interest-free loans to the suitable agent. Third, the agent receiving the loan incorporates a company in China to operate the Internet business. Fourth, the offshore company or its subsidiary enters into a series of contractual arrangements with the agent’s registered company, effectively transferring control over the Chinese company to the overseas company or its subsidiary. The Chinese company becomes the overseas company’s Variable Interest Entity (VIE) or subsidiary entity. In this way, the overseas company obtains actual control rights and income rights.

Based on the above research and analysis, we have the following observations.

1. When discussing China’s Internet companies, we should differentiate between China’s domestic Internet companies and overseas Internet companies operating in China.

2. When discussing foreign investment’s control over China’s Internet business, we should distinguish two kinds of control: first, international capital’s control over overseas Chinese Internet companies; second, overseas Internet companies’ control over China’s domestic internet business through contractual arrangements.

3. Similar to traditional industries, Chinese Internet companies secured their capital from international sources and thus the return on investment – their business’s profits – accrue to the international source of capital, while the maintenance of their business operation remains inside China. In a sense, the Chinese Internet company’s management becomes an agent of international capital in the field of the Internet business.

4. Almost all of China’s domestic Internet companies have become overseas Internet companies’ VIEs and overseas Internet companies have substantial control over them.

Therefore, of all China’s Internet companies that have gone IPO, only Shanda Interactive Technologies, which is listed on the Shenzhen Security Exchange, is a Chinese Internet company. All other overseas-listed Internet companies are foreign-funded enterprises. According to the industry standard, a company is considered relatively foreign controlled if foreign investment is more than 20% and absolutely foreign controlled if it surpasses 50%. Since international capital controls the vast majority of Chinese Internet companies, international capital effectively controls China’s Internet industry.

Based on this, we propose the following policy recommendations.

1. We should speed up financial reform, foster venture capital, and promote providing financial support to our nation’s innovative mechanisms. Through institutional innovation and financial industry development, we should make it possible for entrepreneurs to raise funds in China or obtain support from domestic venture capital, and thus keep the entrepreneurs and their companies in China.

2. Currently our legal system only regulates and supervises the capital structure. It should further monitor enterprises at the business operations level, such as related-party transactions and exclusive contractual arrangements between foreign companies and domestic companies that give substantial control of the domestic companies to foreign companies.

3. The Internet industry is a special, high-tech industry. The government should pay close attention to the situation and to the extent of foreign capital’s control because once capital is linked to the Internet, it will exert a strong control over society and have a substantial impact on politics and on the regime.

[1] Study Times, “Must Pay Attention to Foreign Control of China’s Internet Companies,” July 4, 2011.