Venture Capital and Private Equity Investment, Mergers and Acquisitions and Listings Significantly Impacted By New Regulations for the Ownership of Offshore Assets by PRC Residents
The offshore holding company structure widely used by Chinese entrepreneurs to obtain overseas venture capital and private equity investment, engage in cross-border trade sales, and undertake overseas initial public offerings has been significantly impacted by two new circulars from the State Administration of Foreign Exchange (SAFE).
Background
Many if not all venture capital and private equity investments into China rely upon a structure that consists of an offshore holding company incorporated in either the Cayman Islands or the British Virgin Islands by founders/owners of a business being operated in the PRC. The offshore company then establishes or acquires a wholly foreign-owned enterprise (WFOE), which in turn operates the business or acquires the assets needed to operate the business. For some time, this offshore holding company structure has been scrutinized but largely unregulated by the Ministry of Commerce (MOFCOM), SAFE and the State Administration of Tax (SAT), which have been concerned, respectively, about the regulation of foreign investment, cross-border flows of capital and taxable gains arising from offshore income by PRC residents. An initial attempt to address these issues took the form of the Interim Provisions on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors. In a further effort to address these issues and to develop a more robust infrastructure for regulating the movement of assets and control of domestic assets by foreign investors, SAFE recently issued two notices, commonly referred to as Circular 11 (promulgated on January 24, 2005) and Circular 29 (promulgated April 8, 2005), requiring registration, disclosure and approval of cross-border capital movement. While the intent of the regulations is to facilitate enforcement of fraudulent cross-border capital flows by PRC residents, the regulations have had a significant impact on the manner in which virtually all entrepreneur owned and operated enterprises in the PRC can obtain overseas venture capital and private equity investment, engage in cross-border trade sales, and undertake public offerings on NASDAQ and other overseas markets.
Circular 11
Circular 11 places restrictions on the investment activities of all individuals "residents" in the PRC, including non-Chinese citizens. The principal restrictions and obligations are outlined on the following page:
- SAFE approval required for any PRC resident to directly or indirectly establish or obtain control of a foreign company. Approvals of this type have only rarely been given by SAFE.
- SAFE approval required for any PRC resident to exchange domestic assets or equity for stock or assets of a foreign company. This is often a key feature of the restructuring process to set up an offshore structure for venture capital and private equity investment.
- Compliance with Circular 11 required before SAFE will issue the required enterprise foreign exchange registration certificate. As enterprise foreign exchange registrations certificates are needed for the China-based subsidiary of the offshore company to engage in key foreign currency transactions, SAFE has a formidable tool to use in enforcing Circular 11.
The effect of Circular 11 is to significantly proscribe the ability of PRC resident individuals to set up and hold shares in the offshore companies that form a key part of the venture capital and private equity investment structures.
Circular 29
Circular 29 was issued to further clarify ambiguous provisions and close potential loopholes in Circular 11. It also provides implementation provisions but also many cases go beyond the provisions of Circular 11, including the following:
- Retroactive applicability of all regulated transactions occurring prior to January 24, 2005 (the date Circular 11 was promulgated). While not requiring formal approval, all transactions covered by Circular 11 must now be retroactively reported to SAFE – prior transactions do not receive the benefit of a grandfather exemption as was thought to be the case when Circular 11 was first promulgated.
- Any change in the equity structure of an offshore company (including transfers of equity) in which a PRC resident holds an equity interest must be reported to SAFE. New issuances of shares related to financings and other equity transactions now trigger a filing obligation in the PRC of PRC resident shareholders.
- PRC-based subsidiaries of offshore companies must affirmatively declare that their offshore parents have no PRC resident shareholders (directly or indirectly). This declaration is to be made in connection with the application for and renewal of the enterprise foreign exchange registration certificate. The PRC-based subsidiary must provide SAFE with information about its ultimate beneficial owners and demonstrate compliance with the Circulars.
- The consulting, licensing and other contractual arrangements used by foreign investors to control PRC entities engaged in Internet, valued-added telecommunications, gaming and other foreign-restricted activities, now expressly trigger the SAFE registration requirements. The implementation of transactions intended to transfer control of a domestic PRC entity through contractual means will now be deemed a transfer of assets and will be subject to the regulations applying to the assets transferred offshore in exchange for offshore company shares.
- Offshore companies owned by PRC residents may not hold foreign currency income. All foreign currency income must be transferred into China within 30 days of receipt. An exception exists for Chinese enterprises publicly traded outside of China.
Circular 29 extends the requirements of Circular 11 to transactions retroactively, requires repatriation of funds held in offshore companies with foreign ownership and requires disclosure to SAFE of any PRC resident ownership (directly or indirectly) of offshore companies.
Implications
Whether inadvertent or not, Circular 11 and Circular 29 provide SAFE with the ability to approve the formation and operating activities of offshore holding companies with PRC resident stakeholders. A PRC founder must now register and obtain approval from SAFE prior to acquiring an equity interest in an offshore holding company. SAFE is able to enforce such restrictions by withholding the issuance of enterprise foreign exchange certificates and restricting the distribution of domestic assets to its offshore parent. Historically SAFE has been reluctant to approve outbound investments by corporate persons and now appears to be imposing the same reluctance on individual investors. Given the uncertainty as to the consistency and expediency in the registration and approval process, founders, potential investors and potential acquirors are struggling to quantify the risk associated with SAFE’s new regulations, which is necessary to make an investment decision. Because of the potential broad reach of the Circular 11 and Circular 29, foreign venture capital and private equity investors and companies looking for acquisitions in the PRC must be sensitive to the new issues posed by these regulations. PRC restructuring transactions and corresponding PRC legal opinions will need to be more carefully scrutinized to understand how the issues created by the Circulars are addressed. Given the retroactive effect of these regulations, existing investors in such enterprises must also consider the disclosures and certifications that will need to be made by their portfolio companies to renew their enterprise foreign exchange registration certificates.
Outlook
The Circulars have led to significant short-term uncertainty with respect to the implementation and enforcement of the regulations. MOFCOM, SAFE and the SAT continue to consider how to address the broader issues arising from M&A activity and, now, the impact of these Circulars on the foreign investment process. There is speculation that new regulations will be promulgated in the coming months to provide a more consistent approach and process to the issues addressed in part by the Circulars. It is important to note that the SAFE Circulars were not jointly issued with MOFCOM and SAT. As all three organizations have an interest in monitoring and regulating cross-border capital flows, these organizations are expected to work together to coordinate and their respective roles and policy objectives. In addition, SAFE has been receiving significant input from a variety of interested groups, including representatives of the active venture capital and private equity firms in the PRC, discussing the implications of the regulations on the ability of Chinese enterprises to obtain legitimate offshore investment, engage in cross-border sales, and undertaking overseas listing activities. As a result of such dialogues, market participants expect that SAFE will emphasize more of a disclosure-based, rather than an approval-based, regulatory infrastructure.