SHANGHAI – While perusing the list of China's most promising biopharmaceutical companies, a surprising fact emerges: Many are not registered in China as purely domestic firms, but operate here as wholly foreign-owned enterprises under a Cayman Islands holding company. Cayman Islands is a well-known business-friendly tax haven.

Beigene Ltd., of Beijing, the first company to list on Nasdaq this year (NASDAQ:BGNE), follows this structure. So does Shanghai-based Hutchison China Meditech Ltd., which started trading on Wednesday (NASDAQ:HCM). Other Cayman-domiciled companies with aspirations to be China champions, demonstrating China's innovative capabilities abroad, include Innovent Biologics Inc. and 3S Bio Inc.

The Cayman structure offers numerous advantages to Chinese entrepreneurs and came to light in a big way with the very successful U.S. public listing of the e-commerce platform, Alibaba.

Alibaba used a Cayman holding company, along with the controversial variable interest entity (VIE) structure to skirt China's rules barring foreign investment in sectors such as technology and education. But foreign investment in drug discovery and development are not on the prohibited list, (although stem cell research and genetic diagnostics are included). Yet while most biotechs have no need for a VIE structure, they still stick with a Cayman registration.

This begs the questions: What is the definition of a Chinese company? And why do biopharmas that are largely pre-profitable with little taxable income decide to go the Cayman route?

According to Cooley LLP partner, Christina Zhang, the definition of a Chinese company is best understood depending on the context or purpose of the definition and that often revolves around the application of China's restricted foreign investment categories. In this context, "a Chinese company is a legal entity established in China that is controlled by a Chinese national or Chinese corporation," explained Zhang. "If the China entity is a wholly foreign-owned entity, it is not domestic."

Yet it not always so cut and dried. If the context changes, and turns to tax, so does the definition. "If one sets up a directly owned, or an indirectly owned subsidiary in China, then that entity would be a Chinese entity. And that entity pays Chinese tax," said Wendy Pan, partner at Sidley Austin LLP.

Chinese companies that pursue a Cayman structure commonly set up a Cayman holding company before establishing a subsidiary in Hong Kong. The Hong Kong entity will then invest in China. The tax treaty between Hong Kong and China reduces the dividend tax from the typical 10 percent down to 5 percent. "That is the typical structure: Cayman-Hong Kong-China," said Pan.

Billionaire Li Kaishing, often referred to as Hong Kong's richest man, and the chairman of Hutchison Meditech parent company, stunned many when he shifted his business away from Hong Kong to the Caymans last year.

WHICH DO YOU PREFER?

But the main appeal of the Cayman registered structure for biopharmas is not really for tax reasons, but to appease investors, many of which are non-Chinese venture capitalists.

"When they invest, they want to invest U.S.-style," said Pan, referring to their interest in obtaining preferred shares and greater liquidation. These cannot be accommodated in a Chinese company where there is only one class of common shares. When founders of Chinese biopharmas accept venture financing, they may find they are being nudged in the direction of a Cayman holding company by their backers.

A Cayman registration is also a sign of what ambitions a company may have for an exit.

"The other benefits of Cayman registration is in terms of flexibility of the exit," said Zhang. "If you want to do an IPO, a Cayman entity can go public in Hong Kong or can go public in U.S." (Only domestic companies can list on the mainland exchanges, and companies must wind down the Cayman entity before doing so.)

"For biotech companies, I would say it is almost impossible to go IPO in China if they do not have revenues or profit history," said Pan. "So a U.S. IPO is often their primary objective. If they are considering a trade sell – selling the company to a multinational company – it is also desirable to have a Cayman structure."

The other aspect that is attractive is the registration of shareholders, as well as the articles of association, of a Cayman entity are not accessible to the public, and is kept confidential.

THE EYE OF THE BEHOLDER

Coming to a definition of what makes a company Chinese becomes more relevant when considering how the Chinese government perceives these firms and doles out certain perks and benefits.

On the one hand, there are numerous resources available for local biopharmas developing new drugs in the form of investment and free office space. While on the other, China's many hi-tech parks have the goal of attracting foreign direct investment into their parks as a key performance indicator. Staff are highly incentivized to attract foreign companies to invest in the parks. If the head of a biopharma is ethnically Chinese with strong Chinese roots, and a Cayman registered company, he or she may be able to work both sides of these benefits.

Few question the nationality of company founders. Many are returnee scientists who spent decades abroad and have returned to China only seeing family on regular business trips back and forth. Since China does not permit dual citizenship, these returnees may decide to keep foreign passports.

But, when it comes to CFDA review of new drugs, the regulators are less likely to be concerned about the legal status of the company or citizenship of the founder, than their ethnicity.

"The reason people perceive them to be Chinese is because the Cayman entity is controlled by a Chinese national," explained Zhang. "People seldom look into the citizenship; they just look at the nationality [ethnicity]. If they see a Chinese name, they will assume it is a Chinese company. If you look deeper, it might be the person holds a U.S. passport and is a U.S. citizen. That is considered private information and is not necessarily accessible to the public."