Pre-IPO Corporate Restructuring: Designing a VIE Structure That Meets US Listing Standards

The number of Chinese companies filing confidential registration statements with the US Securities and Exchange Commission (SEC) for an initial public offering (IPO) on the NYSE or Nasdaq has risen sharply in the first half of 2025, driven by a perceived stabilisation in the regulatory relationship between Beijing and Washington. Data from the China Securities Regulatory Commission (CSRC) shows it received 42 new filings for overseas listings in Q1 2025, a 55.6% increase year-on-year from 27 in Q1 2024. This resurgence, however, is occurring under a significantly more stringent framework. The CSRC’s Trial Administrative Measures of Overseas Securities Offerings and Listings by Domestic Companies, effective from 31 March 2023, now mandates that any issuer with a Variable Interest Entity (VIE) structure must explicitly disclose the associated risks and confirm the structure complies with PRC laws. Concurrently, the Public Company Accounting Oversight Board (PCAOB) in the US continues to maintain full access to audit working papers in mainland China and Hong Kong, a status confirmed in its December 2024 report. For pre-IPO companies, the window is open, but the path is narrower. The central challenge is no longer whether to use a VIE, but how to design a VIE structure that simultaneously satisfies SEC disclosure requirements, CSRC filing obligations, and the operational demands of a PRC-restricted industry. A poorly structured VIE is now a direct barrier to listing, not merely a tax efficiency issue.

The Regulatory Trilemma: SEC, CSRC, and PRC Sectoral Laws

The VIE structure exists to solve a specific legal problem: foreign ownership restrictions in PRC industries such as telecommunications, internet content provision, education, and media. The SEC’s Division of Corporation Finance, via its April 2021 statement and subsequent amendments to the Foreign Issuer Reporting Enhancements Act (the Holding Foreign Companies Accountable Act, or HFCAA), now requires complete transparency on the contractual arrangements that constitute the VIE. This creates a trilemma for issuers: the SEC demands granular detail, the CSRC demands compliance with PRC law, and the PRC sectoral regulator demands that the foreign owner does not actually control the licensed entity.

SEC Disclosure Requirements Under the HFCAA Framework

The SEC’s position, codified in amendments to Regulation S-K, is that a VIE is a material risk. The issuer must file a prospectus (F-1 or F-4) that includes a clear statement that it is not a Chinese operating company but a Cayman Islands holding company with contractual arrangements. The SEC explicitly requires the issuer to quantify the financial impact of the VIE structure. Specifically, Item 5.D of Form 20-F and Item 3 of Form F-1 mandate a tabular disclosure of: (i) the percentage of total assets held by the VIE, (ii) the percentage of total revenue generated by the VIE, and (iii) the percentage of total net income attributable to the VIE. For a 2025 filing, these numbers must be precise to the nearest integer. The SEC’s Division of Corporation Finance staff will issue comment letters if the VIE’s contribution to the consolidated financial statements is not clearly separated from the holding company’s own assets and liabilities.

CSRC Filing Obligations and the 31 March 2023 Measures

The CSRC’s filing regime, established under the Trial Administrative Measures, requires the issuer to submit a filing within three business days of the SEC’s confidential submission. The filing must include the VIE agreement, a legal opinion from a PRC law firm confirming the structure’s legality under current regulations, and a risk disclosure document. The CSRC’s key concern is that the VIE does not circumvent PRC foreign investment restrictions. The CSRC has the power to require the issuer to restructure or abandon the VIE if it deems the contractual arrangements to be a disguised form of foreign ownership. As of May 2025, the CSRC has issued 17 formal inquiries to companies with VIE structures, with the most common question being whether the VIE’s control over the licensed entity is “substantive” or “formal.” The CSRC’s guidance, published in its Q&A document of February 2024, states that a VIE must demonstrate that the contractual arrangements are necessary because direct equity ownership is prohibited by sectoral laws, not merely inconvenient.

PRC Sectoral Regulator Veto Power

The most overlooked risk is the veto power of the PRC industry regulator. For an internet company, this is the Cyberspace Administration of China (CAC). For an education company, it is the Ministry of Education. For a financial technology company, it is the People’s Bank of China (PBOC) and the National Financial Regulatory Administration (NFRA). These regulators have the authority to disapprove the VIE structure if they determine it violates the Catalogue of Industries for Guiding Foreign Investment (2024 edition). The 2024 catalogue tightened restrictions in several categories, including “value-added telecommunications services” and “online data processing and transaction processing services.” A pre-IPO company must secure a written confirmation from its sectoral regulator that the VIE structure is permissible. This is a non-delegable step. Without it, the CSRC will not accept the filing, effectively blocking the US listing.

Structural Mechanics: Designing the VIE for Durability

A VIE is not a single contract but a bundle of at least five distinct agreements. The durability of the structure depends on the enforceability of these agreements under PRC law and their ability to survive a change-of-control event or a regulatory challenge. The standard structure involves a Cayman Islands holding company (the listed entity), a Hong Kong intermediate holding company (the WFOE, or Wholly Foreign-Owned Enterprise), and a PRC domestic company (the OPCO, or Operating Company) that holds the necessary licenses.

The Five Core Agreements and Their Enforcement Mechanisms

The five agreements are: (i) the Exclusive Call Option Agreement, (ii) the Equity Pledge Agreement, (iii) the Exclusive Business Cooperation Agreement, (iv) the Power of Attorney, and (v) the Spousal Consent Letter. The critical weakness is the Power of Attorney. Under PRC civil procedure, a power of attorney must be specific and revocable. A blanket, irrevocable power of attorney granted by the PRC shareholder to the WFOE is vulnerable to challenge in a PRC court. A 2023 decision by the Shanghai Pudong New Area People’s Court (Case No. 2023-0112) held that a VIE’s power of attorney was void because it granted the foreign entity “unrestricted control” over the PRC shareholder’s voting rights, which the court deemed a violation of the PRC Civil Code Article 165 on the scope of agency. To mitigate this, the VIE should limit the power of attorney to specific actions (e.g., voting on a merger, sale of assets, or liquidation) and include a sunset clause that requires re-execution every two years.

The Equity Pledge Agreement and Perfection of Security

The Equity Pledge Agreement is the primary security mechanism. It allows the WFOE to take control of the OPCO’s equity if the PRC shareholder defaults. Under the PRC Property Rights Law (Article 226), a pledge over equity in a limited liability company must be perfected by registration with the State Administration for Market Regulation (SAMR). Unregistered pledges are unenforceable against third parties. A pre-IPO audit must confirm that all equity pledges have been properly registered. The SEC’s staff will request a copy of the SAMR registration certificate. If the pledge is not registered, the SEC will require a legal opinion stating that the unregistered pledge is still enforceable as a contractual obligation, which is a materially weaker position. The standard practice is to register the pledge at the SAMR office in the OPCO’s jurisdiction of incorporation at least 90 days before the F-1 filing.

The Exclusive Business Cooperation Agreement and Transfer Pricing

This agreement is the mechanism by which the WFOE extracts profits from the OPCO. It typically takes the form of a technical services agreement, a consulting agreement, or a software licensing agreement. The PRC tax authorities, specifically the State Taxation Administration (STA), scrutinise these agreements under the Transfer Pricing Documentation and Compliance Guidelines (2023 revision). The STA requires that the fees charged by the WFOE to the OPCO be at arm’s length. If the fee is set as a percentage of revenue (e.g., 95% of net profit), the STA may recharacterise it as a dividend distribution, subject to a 10% withholding tax (reduced to 5% under the Hong Kong-Mainland China Double Tax Arrangement if the WFOE is the beneficial owner). A 2024 STA audit of a Cayman-Hong Kong-PRC VIE structure resulted in a retroactive tax assessment of RMB 42 million for transfer pricing violations. The solution is to commission a transfer pricing study from a Big Four firm that benchmarks the fee against comparable transactions between unrelated parties.

Risk Mitigation: Addressing the SEC’s and PCAOB’s Core Concerns

The SEC’s review process for VIE issuers has become more rigorous since the PCAOB’s December 2022 report on its inspection of PRC audit firms. While the PCAOB confirmed in its 2024 report that it can inspect all audit files, the SEC remains concerned about the enforceability of the VIE structure in a liquidation scenario.

The “Empty Shell” Risk and the SEC’s Focus on Asset Separation

The SEC’s primary concern is that the Cayman holding company is an empty shell with no direct claim on the assets of the OPCO. In a liquidation, the WFOE’s claim is as a creditor under the Exclusive Business Cooperation Agreement, not as an equity holder. This means the WFOE is an unsecured creditor. The SEC requires the issuer to disclose this risk explicitly in the prospectus risk factors. The SEC’s staff have issued comment letters requiring issuers to include a statement that “in the event of the OPCO’s bankruptcy, the WFOE’s claim is subordinate to the claims of secured creditors and may be subordinate to the claims of other unsecured creditors.” The issuer should also disclose the estimated recovery rate in a hypothetical liquidation scenario, based on a liquidation analysis prepared by a valuation firm. This analysis must be filed as an exhibit to the F-1.

The PCAOB’s Inspection Rights and Audit Committee Responsibilities

The PCAOB’s 2024 inspection report on the Hong Kong office of a major PRC audit firm identified deficiencies in the audit of VIE structures, specifically in the confirmation of the existence and control of the OPCO’s licenses. The PCAOB found that the audit firm had not independently verified that the OPCO held the necessary PRC operating licenses (e.g., the ICP license for internet companies). The issuer’s audit committee must now, as a matter of standard procedure, request that the auditor obtain a direct confirmation from the PRC sectoral regulator that the license is valid and in good standing. The audit committee should also review the auditor’s workpapers on the VIE structure. The SEC’s Audit Committee Standards (Rule 10A-3 under the Securities Exchange Act of 1934) require the audit committee to be directly responsible for the appointment, compensation, and oversight of the auditor. This responsibility extends to the VIE audit.

The Spousal Consent Letter and Marital Property Risk

A frequently overlooked risk is the PRC marital property regime. Under the PRC Civil Code Article 1062, equity in a company owned by one spouse is presumed to be marital property unless there is a prenuptial agreement. If the PRC shareholder of the OPCO is married, the spouse has a legal claim to 50% of the equity. This means the WFOE’s call option and equity pledge are only enforceable against the shareholder’s 50% share. The Spousal Consent Letter is a legal instrument in which the spouse explicitly waives their claim to the equity and consents to the VIE agreements. This letter must be notarised in the PRC. The SEC’s staff have requested copies of notarised spousal consent letters in multiple comment letters in 2024. Without it, a subsequent divorce or inheritance proceeding could invalidate the entire VIE structure.

The SPAC Alternative: VIE Structures in De-SPAC Transactions

The use of a Special Purpose Acquisition Company (SPAC) to list a Chinese company with a VIE structure has become more common since 2023, but it introduces additional complexity. The SPAC is a US-domiciled entity, not a Cayman holding company. The de-SPAC merger must be structured to preserve the VIE.

The SPAC as the Listed Entity and the VIE as the Target

In a de-SPAC transaction, the SPAC (a Delaware corporation) merges with the target company (a Cayman company). The surviving entity is the SPAC, which becomes the listed company. The target company’s VIE structure must be transferred into the SPAC’s corporate chain. This is typically done by having the SPAC acquire the Cayman holding company. The SEC requires that the proxy statement/prospectus (Form S-4 or F-4) include all the same VIE disclosures as a traditional IPO. The SEC’s Division of Corporation Finance has issued specific guidance for SPACs with VIE targets, requiring the issuer to disclose the SPAC’s ability to enforce the VIE agreements. The key difference is that the SPAC’s board of directors, which is US-based, must certify that it has conducted due diligence on the VIE structure. This certification is a personal liability risk for the SPAC directors.

The PCAOB’s Role in SPAC Audits

The PCAOB’s audit standards apply to the combined entity after the de-SPAC merger. The PCAOB has stated that it will inspect the audit of the VIE structure as part of its regular inspection cycle. The SPAC’s audit committee must ensure that the target company’s financial statements, including the VIE consolidation, are audited in accordance with PCAOB standards. The PCAOB’s 2024 inspection of a SPAC auditor found deficiencies in the audit of the VIE’s revenue recognition. The auditor had accepted the OPCO’s management representations without independent verification of the underlying contracts. The PCAOB’s sanction was a censure and a fine of USD 750,000. The lesson is that the audit of a VIE in a SPAC context is subject to the same scrutiny as a traditional IPO audit.

Actionable Takeaways

1. Commission a PRC legal opinion from a Tier-1 PRC law firm that specifically addresses the enforceability of the Power of Attorney and the Spousal Consent Letter under the PRC Civil Code Articles 165 and 1062, and file this opinion as an exhibit to the F-1.
2. Register all equity pledges under the VIE with the local SAMR office no later than 90 days before the SEC filing, and obtain the SAMR registration certificate for inclusion in the audit workpapers.
3. Engage a Big Four firm to prepare a transfer pricing study for the Exclusive Business Cooperation Agreement, benchmarking the fee against arm’s-length transactions, to pre-empt an STA audit.
4. Secure a written confirmation from the relevant PRC sectoral regulator (CAC, PBOC, or Ministry of Education) that the VIE structure does not violate the Catalogue of Industries for Guiding Foreign Investment (2024 edition).
5. For SPAC transactions, require the SPAC’s board of directors to pass a resolution explicitly certifying that it has conducted independent due diligence on the VIE structure, including a review of the PCAOB’s 2024 inspection findings.