Entity Form and Establishment

Non-Legal Person Entity Form

Similar to the 2001 Tentative Rules, the 2003 VC Regulation permits a VC Enterprise to be established as a non-legal person entity (a "Non-Legal Person VC Enterprise"), which is a form of foreign investment enterprise contemplated under the PRC's equity joint venture law, and further tailored under the 2003 VC Regulation to encompass the features of a limited partnership with which international venture investors are familiar. A Non-Legal Person VC Enterprise may elect to either have all investors bear joint and unlimited liability, or have one investor (the "Principal Investor") bear unlimited liability, with the other investors (similar to limited partners) bearing liability which is limited to the extent of their investment in the Non-Legal Person VC Enterprise.

Alternatively, the 2003 VC Regulation also allows a VC Enterprise to be established as a company (a "Company VC Enterprise"), [2] in which each investor's liability is limited to its capital contributions. Although the limited partnership form of entity is widely employed by VC funds overseas, its correspondent form in China - the Non-Legal Person VC Enterprise - is untested within the PRC legal framework. In contrast, the Company VC Enterprise's corporate form is well established in both conceptual and practical terms under PRC law and is more familiar to domestic investors as well as the regulatory authorities. Nevertheless, as discussed below, under the 2003 VC Regulation the Non-Legal Person VC Enterprise enjoys more flexibility than a Company VC Enterprise, which is also governed by the Company Law as well as the Sino-foreign joint venture laws and regulations.

Qualifications

Quantitative Requirements. The 2001 Tentative Rules set the minimum capitalization requirement for a VC Enterprise at a maximum of US$25 million. In addition, the 2001 Tentative Rules also required each foreign investor to invest at least US$10 million in any proposed VC Enterprise. In accounting for these capitalization requirements, the 2001 Tentative Rules did not distinguish between paid-in capital and committed capital.

In contrast, the 2003 VC Regulation makes clear distinctions between the committed capital and paid-in capital, and substantially reduces each investor's minimum capital requirement to as low as US$1,000,000, regardless of the nationality of the investor. The minimum aggregate capitalization requirement for a VC Enterprise is US$10,000,000. In addition, the 2003 VC Regulation also substantially reduces the minimum requirements for a Principal Investor's committed capital and paid-in capital as a percentage of total committed capital and paid-in capital of a Non-Legal Person VC Enterprise to 1% from 3% under the 2001 Tentative Rules. [3]

Lowering the entry threshold under the 2003 VC Regulation should give mid-to-small size domestic institutional investors and personal investors a greater ability to participate in VC fund activities in China.

Qualitative Requirements. Certain qualitative requirements relating to the creditworthiness and funding resources of the potential investors under the 2001 Tentative Rules in practice are either difficult to measure or conflict with the customary confidentiality requirements of VC funds. As a result of MOFTEC foreign advisors regarding overseas VC investor concerns in this area, the 2003 VC Regulation has eliminated these qualitative requirements for ordinary investors.

Another notable improvement in line with international practice under the 2003 VC Regulation, as compared to the 2001 Tentative Rules, is that the 2003 VC Regulation permits an investor whose affiliate meets the above quantitative requirements to quality as a Principal Investor if such investor meets the other requirements under the 2003 VC Regulation. The definition of the term "affiliate" substantially tracks Rule 405 under the U.S. Securities Act of 1933. However, the 2003 VC Regulation also requires that any investor relying on such affiliate qualification provide a guarantee issued by the affiliate. Foreign listed companies, in particular, Hong Kong listed companies, may be unwilling to provide such a guarantee.

A number of the qualitative requirements with respect to the Principal Investor remain under the 2003 VC Regulation. These include requirements that the Principal Investor (a) must have venture investment as its principal business, (b) must employ three or more professional venture investment personnel, and (c) must not, and its affiliates must not, have been prohibited from conducting venture capital or investment advisory activities, or penalized for fraud, by the governmental authorities of its jurisdiction of domicile.

Special Requirement relating to Company VC Enterprise. In contrast to the 1% committed capital and paid-in capital requirement, the 2003 VC Regulation requires a Principal Investor in a Company VC Enterprise to account for 30% or more of the total paid-in and committed capital of a Company VC Enterprise. It appears that this requirement is intended to address the fact that the investors of a Company VC Enterprise are liable to the obligations of the VC Enterprise only to the extent of their respective committed capital. By having an investor with a substantial equity interest in a Company VC Enterprise, the 2003 VC Regulation seeks to instill a sense of corporate responsibility on the VC Enterprise by, in effect, imposing greater liability on its lead investor. This approach will limit the flexibility desired by most international VC funds.

Capital Payment and Change in Ownership Structure

Many restrictions in the 2001 Tentative Rules are attributable to the foreign investment regulatory regime of China that has been in place in China since the early 1980s. Recognizing that these restrictions are inherently incompatible with a VC fund's basic structure and practice, MOFTEC, in a joint effort with other promulgating authorities, has within its administrative power made certain important breakthroughs under the 2003 VC Regulation, particularly in connection with the capital payment, reduction, transfer and repatriation procedures in respect of a Non-Legal Person VC Enterprise.

Payment of Capital

Several points are worth noting here. First, the 2003 VC Regulation does not require that aggregate foreign investment exceed 25% of the total capital in a VC Enterprise, as is otherwise generally required under the Sino-foreign joint venture laws and regulations. To further accommodate the customary practice of international VC funds, the 2003 VC Regulation provides that investors in a Non-Legal Person VC Enterprise may pay in their respective committed capital into the VC Enterprise in installments on an as-need basis pursuant to the investors' agreement (including with respect to subsequent capital calls to fund portfolio company investments). However, investors must contribute their committed capital within five years (increased from three years under the 2001 Tentative Rules). The 2003 VC Regulation has also eliminated the requirement under the 2001 Tentative Rules that the investors pay at least 15% of the subscribed capital within three months after the issuance of the business license.

In addition, the flexibility on timing of capital payments is only available to investors in a Non-Legal Person VC Enterprise. Company VC Enterprise investors are subject to the Sino-foreign joint venture laws and regulations, which contain more rigid requirements, such as the obligation to pay 15% of the capital contribution within three months after the establishment of the joint venture.

Capital Reduction and Transfer

Capital Reduction. The 2003 VC Regulation explicitly permits reduction in an investor's committed capital subject to the approval of (1) investors contributing a majority of the capital, (2) the Principal Investor and (3) MOFTEC. This tracks the customary international VC fund practice, but, like the capital payment provisions described above, would not benefit Company VC Enterprise investors. The latter remain subject to more rigid corporate governance rules under the Company Law and Sino-foreign joint venture laws and regulations.

Principal Investor Transfers. Similar to the 2001 Tentative Rules, the 2003 VC Regulation in general prohibits Principal Investors in a Non-Legal Person VC Enterprise from transferring their investment interests in the VC Enterprise during its term. However, under special circumstances (on which the 2003 VC Regulation does not elaborate) and upon approval by investors contributing a majority of the capital and by MOFTEC, Principal Investors may transfer their investment interests to third parties who meet both quantitative and qualitative qualification requirements for Principal Investors under the 2003 VC Regulation.

Non-Principal Investor Transfers. Other investors may transfer their investment interests in accordance with the initial agreement among the investors, provided that the transferees meet the quantitative qualification requirements under the 2003 VC Regulation. The 2003 VC Regulation also allows the admission of additional investors to a Non-Legal Person VC Enterprise, subject to the initial agreement by all the investors and the consent of the Principal Investor. In what represents a substantial improvement from the approval requirements under the existing foreign investment laws and regulations, a non-Principal Investor's transfer of interest in a Non-Legal Person VC Enterprise and the admission of additional investors (regardless of whether the transferring or entering parties are PRC domestic or foreign) are subject only to notice filing with, instead of the approval by, MOFTEC.

Capital Repatriation Upon Disposition of Investment

The 2003 VC Regulation also gives guidance on distributions to investors when a Non-Legal Person VC Enterprise disposes of its portfolio investments. Under the 2003 VC Regulation, the distribution would constitute a reduction of the investors' paid-in capital in the Non-Legal Person VC Enterprise. Reflecting an effort on the part of MOFTEC to reform the current foreign investment regulation regime, the 2003 VC Regulation does not require the approval of MOFTEC in connection with such capital reduction and repatriation. Rather, only 30-day advance notice to MOFTEC and SAFE regarding the capital reduction and repatriation is required, so long as it can be demonstrated that the balance of the Non-Legal Person VC Enterprise's committed capital and paid-in capital combined would be sufficient to cover all the outstanding investment obligations. In addition, according to the 2003 VC Regulation, any such distribution may not be used as a defense against a VC Enterprise's failure to honor its obligation to invest in other portfolio companies.

Again, the notice filing procedure adopted by the 2003 VC Regulation in lieu of the conventional foreign investment approval procedure is not available a Company VC Enterprise.

Management and Operations

Management Enterprise

The 2003 VC Regulation provides that a Non-Legal Person VC Enterprise shall establish a joint management committee, and that a Company VC Enterprise shall establish a board of directors, to manage its affairs. Such joint management committee or board of directors shall establish an operational management organization to manage the day-to-day operations of the VC Enterprise. However, in an attempt to align itself with the normal practice of offshore venture funds and as a substantial improvement from the 2001 Tentative Rules, the 2003 VC Regulation also provides that in lieu of internal management, a VC Enterprise may contract out its operations to a venture capital management enterprise (the "Management Enterprise") or another VC Enterprise. Under the 2003 VC Regulation, a Management Enterprise can be a domestic enterprise, an FIE or an offshore entity.

A Management Enterprise, which can service multiple VC Enterprises, may be a company or a partnership. [4] It should be noted that, to establish a Management Enterprise as a foreign invested enterprise (a "FIE"), the entity must go through the normal FIE approval process. However, the 2003 VC Regulation has taken a significant step forward in allowing a purely offshore Management Enterprise to manage the operations of a VC Enterprise following government approval. In an unprecedented move, by allowing such offshore entity to conduct its investment management business directly in China without establishing an FIE (be it a wholly foreign-owned enterprise or a joint venture), the 2003 VC Regulation appears to exempt an offshore Management Enterprise from the requirements of the existing foreign investment legal framework. If the Management Enterprise is offshore, it may also enjoy certain tax benefits, but this point is subject to further clarification from the tax authorities.

Permitted and Prohibited Activities

The list of permitted activities for a VC Enterprise includes equity investment in portfolio companies, investment advisory services and provision of management advisory services to portfolio companies. The permission under the 2003 VC Regulation to allow a VC Enterprise to use all of its capital to invest in portfolio companies represents another important breakthrough from the existing legal framework in China. Currently under the Company Law, as well as the Sino-foreign joint venture laws, no entity is allowed to make any investment in any other entities if the aggregate amount of the investments of such entity exceeds 50% of its net assets. Pursuant to the 2003 VC Regulation, a VC Enterprise (even a Company VC Enterprise) would be exempted from such restrictions.

The list of prohibited activities for a VC Enterprise includes: (a) investment in industries prohibited under the Foreign Investment Industry Guidelines, (b) direct or indirect investment in publicly traded stock or corporate debt (excluding those of any portfolio company which has gone public), (c) direct or indirect investment in fixed assets not for its own use, (d) investment through loans (this would prohibit bridge loans), (e) investment using other than its own funds, and (f) provision of loans or guarantees of loans (investment in corporate bonds issued by a portfolio company with a maturity of one year or more or loans convertible into equity securities of a portfolio company is permitted).

Significantly, the legal status under the 2003 VC Regulation of convertible equity instruments such as options and warrants remains unclear.

Taxation

The tax implications -- both for a VC Enterprise and its investors -- in connection with the enterprise's investment activities within China was a major concern of the international VC community following the enactment of the 2001 Tentative Rules, which gave no guideline regarding the issue. Although definitive tax rules for VC Enterprises are still pending, the 2003 VC Regulation sets forth a number of general principles: the investors in the VC Enterprise may pay enterprise income taxes separately on an individual basis or, if requested by such investors and approved by the relevant authorities, may submit tax payments collectively. This approach essentially avoids double taxation. However, no tax breaks similar to reduced capital gains tax in the U.S. are mentioned in the 2003 VC Regulation, and it appears in all likelihood that the regular corporate income tax rate of 33% will apply to a VC Enterprise's disposition of a portfolio company investment. Specific tax collection procedures for Non-Legal Person VC Enterprises are subject to separate regulations to be issued by the State Administration of Taxation.

Conclusion

Overall, the 2003 VC Regulation represents a significant improvement from the 2001 Tentative Rules. While certain disadvantages remain in using a VC Enterprise as the vehicle for VC investment in China when compared to traditional offshore domiciles, the 2003 VC Regulation makes a number of important changes:

• First and foremost, it officially introduces the concept of a limited partnership operating model into China. Coupled with the Principal Investor concept, the regulation captures the two most important features of an offshore limited partnership: limited liability for investors as limited partners and pass-through tax status.
• Second, the 2003 VC Regulation substantially lowers quantitative requirements for both foreign and domestic investors in VC Enterprises as compared to the 2001 Tentative Rules.
• Third, the 2003 VC Regulation contains a number of unprecedented regulatory breakthroughs such as the adoption of the filing procedures in connection with certain investment interest transfers and capital reduction/repatriation, and permitting an offshore Management Enterprise to operate in China without first having to establish an entity under the PRC foreign investment laws.

At the same time, certain issues under the 2003 VC Regulation need further refinement and clarification. These include the requirements and procedures for disposition of investments through redemption by a portfolio company, and the lack of preferential tax treatment for distribution of capital gains from investments to VC Enterprise investors. Even though the 2003 VC Regulation is an overall improvement from the 2001 Tentative Rules, it is unlikely to have any significant impact on the inflow of foreign venture capital because the more systemic elements of the foreign investment legal regime, such as taxation, foreign exchange control and governmental approval rights as well as the rigidity and inadequacy of the Company Law (to which all portfolio companies are subject) remain unchanged. Until substantial changes are made in these fundamental areas, foreign venture capital will likely continue to use more proven offshore structures for investments in China.