Explore foreign exchange registration routes for ESOPs of unlisted companies with red chip structure

First, it is common for overseas non-listed companies to take the employee as founder status along with the major shareholder for the registration of No. 37.

As Article 3 of No. 37 stipulates that "before a domestic resident contributes to a special purpose company with legal assets or interests inside or outside the country, he or she shall apply to SAFE for foreign exchange registration procedures for overseas investment". Therefore, if the registration is handled in this way, it is necessary to let the employees hold the equity of the domestic equity company at the domestic subject level before building the red-chip structure.  Subsequently, in the process of setting up the red chip structure, the registration of No. 37 is processed so that their domestic interests are reflected outside the country, i.e. to achieve domestic and overseas shareholding of employees.

However, in reality, many companies often plan ESOPs after the completion of the red chip structure, by which time employees do not hold domestic interests, so there are practical obstacles. And even if the aforementioned conditions and procedures are met (such as synchronizing the employees' interests in the domestic entity before the ESOP exercise), if there are too many foreign exchange registrants for the same project, they may still meet the same operational uncertainty, and banks may be reluctant to accept the registration.

Second, the founder hold shares on behalf of employees.

The founder can set up a separate BVI company, and the Cayman company issue a certain number of shares to that BVI company as a pool of employee options. Whenever an employee exercises his or her options, the founder signs a nominee holding agreement with the employee. Under this approach, the employees can circumvent the registration of Circular 37 due to the hidden nature of the nominee holding agreement, but we must draw attention to the possible compliance risks associated with such operations.

Third, employee equity incentive trusts.

Typically, employee equity incentive trusts are set up by companies to be listed or listed, the trustee is an overseas trust company and the beneficiaries are the incentivized employees. In addition, an equity incentive trust will often have an advisory committee acting as administrator, which is usually composed of the board of directors or members appointed by the board of directors to develop the equity incentive plan and instruct the trustee to implement such plan.

For employees, on the one hand, the proposed incentive equity or options injected into the trust exist independently of the company's and the employee's property and are not affected by relevant factors such as changes in the employee's own marital relationship or recourse to creditors. On the other hand, the trust mechanism enhances the employee's security and predictability. The founding team can instruct the trustee to exercise their voting rights, thus ensuring control of the business.

After the introduction of employee equity incentive trusts, do employees who are beneficiaries need to register for foreign exchange? According to the provisions of No. 37, domestic residents who acquire the operating rights, income rights or decision-making rights of a special purpose company through a trust are within the scope of foreign exchange registration.

In that case, how do employees who are beneficiaries apply for foreign exchange registration? In practice, due to the confidentiality of the trust and the changeable nature of the beneficiary, it is very difficult to apply for foreign exchange registration as the beneficiary of the employee's equity incentive trust. If the subject of the incentive meets the conditions of the general registration of No. 37, but is limited by the identity of the beneficiary of the trust and could not register, an offshore two-tier BVI company structure could solve the problem. 

The first layer of BVI company set up by the subject of the incentive shall register No. 37, and then the second layer will be a trust structure. This can maintain the effectiveness of the No. 37 registration, and allow for a smooth legal access to capital. However, if the incentive recipient itself does not meet the conditions for general registration of the No. 37 (e.g. not holding domestic interest), the registration cannot be applied.

According to our observation, most of the red-chip listed companies that have set up employee equity incentive trusts only disclose the registration status of their controllers or core shareholders, not the foreign exchange registration status of the beneficiaries of their employee equity incentive trusts. Most of the companies include the foreign exchange registration matters in the risk factors section of the prospectus, which shows that the foreign exchange compliance problem of employee equity incentive trusts under the red-chip structure is very common.

Conclusion

It is easy to see that it is the best solution to break the barrier of registration under Article 6 of No. 37, both in terms of legal compliance and tax planning. It can effectively solve the confusion of registration and exercise of ESOP for many unlisted red chip structured companies, so that the ESOP implemented by these companies will no longer be uncertain for most employees before listing. It may realize that employees hold shares directly offshore in due course, which is also a positive boost to the company's retention and motivation of its employees.

The policy design of Article 6 of No. 37 indicates that SAFE is aware of the need for registration of share incentive plans of overseas unlisted companies. But there are difficulties at the practical level due to the varying levels of understanding of the policy by local branch offices and local banks.

However, given our years of practical exploration in the field of cross-border investment and financing, red chip structuring and dismantling, we believe that the difficulties in registration can still be resolved with professional assistance.