China Law Insight : China Business and Intellectual Property Lawyers & Attorneys : King & Wood Law Firm : IP, Arbitration, Litigation, Securities, Foreign Investment

1 Foreign Investment More Welcomed in Certain Sectors

According to China's economic development needs and planning goals, foreign investment in high-end manufacturing, high-tech, modern services, new energy, energy efficiency, outsourcing, and environmental protection industries will be welcomed while polluting or energy-gorging projects and industries running at overcapacity will not be as welcome. Based on the above guidelines, the Foreign Investment Industrial Guidelines Catalogue issued in 2007 will be revised.

In addition, foreign-funded projects in the “encouraged” category of China's foreign investment catalogue will benefit from lower land prices which will be discounted 30%. These policies are intended to facilitate China's continued economic growth by targeting foreign investment in industries higher up in the economic value chain and permit environmentally sustainability.

2 New Policies With Geographic Focus

Foreign enterprises are encouraged to increase investment in China's central and western regions with a particular focus on environmentally sound and labor-intensive businesses. This will be accomplished through tax incentives, policy support and in the development of streamlined procedures for foreign companies that relocate operations from the coastal regions to the center. Incentives will include potential matching funds, technical support, improved administration and other favorable policies. Based on revisions to the Foreign Investment Industrial Guidelines Catalogue, the Foreign Investment Dominant Industrial Catalogue in Central and Western Regions will be further revised.

3 More Open Domestic Capital Markets

Foreign investors are encouraged to participate and acquire domestic enterprises through restructuring or M&A. In particular foreign strategic investors are invited to participate in domestically listed companies, which used to be restricted for foreign investors. Foreign companies will also enjoy standardized and streamlined rules for investment in domestic securities and in corporate M&A moves. M&A transactions between foreign parties should become more streamlined, but a national security examination mechanism will also be established to review foreign M&A operations in China. Qualified foreign invested companies will also soon be allowed to list and issue corporate bonds or medium term notes in China.

4 Improved and Streamlined Operational Incentives

Multi-national companies will be encouraged to establish regional headquarters, R&D centers, financial management centers, and other critical management and operational centers in China. Imports for scientific and technological development from qualified R&D centers will be exempt from tariffs, import VAT and goods and services tax by the end of 2010 under the guidelines.

The approval procedures for foreign investment will be streamlined and the scope of approval and authorization will be reduced. Examination and approval competency for foreign investment will also continue to devolve to lower governmental levels whereby encouraged investment below $300 million for encouraged and permitted projects will be examined by local authorities rather than national ones. The devolution of approval competency for most projects will simplify and speed up the approval process for foreign investors.

In addition, the procedures on settlement of foreign exchange capital funds for foreign investment companies will be simplified. With respect to foreign investment companies operating legally but unable to meet their capital contributions requirements as a result of a tight budget, their deadlines for capital contributions may be extended.

Through these new guidelines, China reiterates its support for foreign investment and could be a response to some complaints that China was reversing its foreign investment policies in the wake of several high-profile matters involving Google and Rio Tinto. These guidelines widen market access to foreign investors and better direct the inflow of foreign capital while also improving China's global competitiveness and promoting more efficient foreign investment into economically vital areas. Naturally detailed rules to implement these initiatives are still to come out.
 

Please note that this entry is provided for general information only and may not be used as a substitute for legal consultation.
 

According to Circular Hui Zong Fa [2008] 142 (“Circular 142”), unless otherwise provided for under law, the capital of a foreign invested enterprise (“FIE”) shall not be used for equity investment. If an FIE intends to act as a GP of a RMB PE fund, it will find it difficult to satisfy the GP’s RMB commitment (often 1% of the total commitment of the fund) because the FIE cannot convert its capital into RMB. This further effectively blocks the means by which an FIE is able to act as an LP because it is much more difficult for it to satisfy the LP’s RMB commitment, which is typically substantially higher than a GP’s commitment.

The Trial Plan is intended to establish a Qualified Foreign Limited Partner (“QFLP”) mechanism by adopting the approach similar to the QFII (Qualified Foreign Institutional Investor) system, and allows foreign funded GPs and LPs to convert foreign exchange capital into RMB. The aggregate quota for foreign exchange convertible into RMB shall not exceed 50% of the size of the fund, and the quota for a GP shall not exceed 5% of the fund size.

It is unclear if foreign funded GPs and LPs refers to foreign investors only or both foreign investors and FIEs, which are Chinese entities partly or wholly owned by foreign investors. Also, as is known by veterans of the Chinese PE industry, a domestic partnership’s partners shall all be Chinese individuals or Chinese entities, which may include FIEs. This allows indirect foreign investment (with difficulties arising from foreign exchange conversion). On the other hand, a foreign invested partnership may directly accommodate a foreign GP or LP. Therefore, either a domestic partnership and a foreign invested partnership both allow the participation of foreign investment. However, it is unclear if the Trial Plan will apply to both domestic partnerships and foreign invested partnerships.

Though not crystal clear, a domestic partnership with indirect foreign investment is likely to be treated equally as other pure domestic funds in terms of portfolio investment, but a foreign invested partnership will be treated as a foreign investor and subject to industrial restrictions and cumbersome approvals. If the Trial Plan does apply to domestic partnerships, that will be a real breakthrough and Pudong will be better positioned to attract RMB PE funds than its competitors in China. Further details will be publicized in April.
 

Without the Measures, the existing Partnership Enterprise Law itself does not allow foreign investors to directly invest in partnerships due to a provision which says such circumstances will be subject to administrative measures to be issued by State Council. Though with such restrictions, international PE/VC firms still appear to prefer using limited partnership as the form of RMB fund, and try the approach of setting up a foreign invested company acting as the general partner and raising fund from domestic investors, which proves practicable in some areas of China. Nonetheless, due to the foreign exchange control in China, a limited partnership cannot receive substantial funding from foreign investors even in such an indirect way.

The Measures generally allow a foreign investor to act as a general partner or limited partner of a limited partnership, but it is still too early for PE/VC firms to celebrate the opening of door. The Measures indicates that for foreign enterprises or individuals setting up partnerships in China with the main business of investment, special laws or regulations in this regard could apply. According to the answers of the Legal Affairs Office of State Council explaining the Measures to journalists, the authorities has not figured out a clear position on partnerships with the main business of investment, such as venture capital enterprises and private equity funds etc., and thus the relevant wording in the Measures is flexible. As a general practice in China, the implementation of the Measures will require detailed rules, which may address this issue further.

The Ministry of Commerce and its local counterparts (“MOC”) has been the main approval authority for foreign invested enterprises for decades, but the Measures take a different approach for foreign invested partnerships (“FIP”). An Application for the establishment of an FIP shall be submitted to the local administration of industry and commerce as authorized by the Sate Administration of Industry and Commerce (“AIC”). MOC will only be notified of the registration information upon the establishment of an FIP. An FIP is still subject to foreign investment industrial policies, including the Foreign Investment Industry Catalogue, and the AIC will review an explanation on compliance with foreign investment industrial policies as part of the application process. We would like to put a question mark on the consistency between AIC and MOC in applying industrial policies to FIPs and other foreign invested enterprises respectively, and speculate that this could trigger the involvement of MOC in approving FIPs.

A. Ease of Approving Holding Companies

On March 6th 2009, MOFCOM issued the Notice on Delegating the Approval Authority for Foreign Invested Holding Companies to streamline the establishment of foreign investment holding companies.

 This notice provides:

 1. Proposed holding companies with a registered capital of USD 100,000,000 or less will be examined and approved by the competent MOFCOM counterparts at the provincial or vice-provincial city level. Previously, the establishment of a holding company required MOFCOM level approval regardless of scale.

 2. Any amendments to established holding companies (i.e. such as name change, revisions to business scope) can be approved by MOFCOM provincial level counterparts except for cases where a single capital injection increases its value by over USD 100,000,000 or where shareholders of holding companies change.

 3. Despite the positive developments, MOFCOM also reinforces in the Notice that holding companies cannot invest in areas that are restricted or forbidden to foreign investment, or in industries that are subject to macro-control by the government. Further, if required by relevant industry rules, investments by holding companies will still need approval from the industry authorities even if approved at the local MOFCOM level.

B. Delegation of Approval Authority for FIVCEs and FIVCE Management Firms

MOFCOM further issued, on March 5 the Notice on Approving Foreign Invested Venture Capital Enterprises and Foreign Invested Venture Capital Management Enterprises (the “No. 9 Notice”) which simplifies the approval process for FIVCEs and FIVCE Management Firms.

The legal basis for setting up FIVCEs and FIVCE Management Firms are the Management Rules on Foreign Invested Venture Capital Emperies (the “FIVCE Rules”) promulgated by MOFCOM, the Ministry of Science and Technology, the State Administration for Commerce and Industry, the State Tax Administration, and the State Administration on Foreign Exchange on January 30, 2003. According to the FIVCE Rules, foreign investors are permitted to set up a FIVCE to invest in unlisted high-tech enterprises, provide management services to such enterprises and are also able to enjoy capital gains from such investments.

Pursuant to the FIVCE Rules, the establishment of a FIVCE adopts a multi tier approval process regardless of scale. A FIVCE requires preliminary examination at the MOFCOM provincial level with final approval from the central MOFCOM with the consent of the Ministry of Science and Technology. On the other hand the establishment of a FIVCE Management Firm only requires MOFCOM provincial level counterpart approval.

The No. 9 Notice simplifies the approval process in the following regards:

1. Proposed FIVCEs and FIVCE Management Firms with registered capital of no more than 100 million USD can be approved by MOFCOM counterparts at the provincial level (1), vice-provincial city level, or national economic development zone level. It is important to note that FIVCE Management Firms which were previously approved at the provincial level should now obtain approval from central MOFCOM in cases where its registered capital exceeds USD 100,000,000. Accordingly, the new policy is that establishment of a FIVCE can be approved locally except if the registered capital exceeds USD 100,000,000.

2. The provincial MOFCOM counterpart is required to complete the approval process and decide upon approval within 30 days after receiving the complete application documents. It is noteworthy that under FIVCE Rules, due to the two tier approval level regime, the mandatory approval timeframe is 60 days (15 days for preliminary review at the provincial level and 45 days for final approval by MOFCOM). Furthermore, following the delegation of approval authority in respect of FIVCEs, the No. 9 Notice requires that when establishing a FIVCE, the provincial approval authority shall request the opinion from the science and technology administration of the same level (i.e. the Ministry of Science and Technology provincial counterpart).

3. The basic rule has always been for amendments to the corporate structure for a FIVCE or FIVCE Management Firm to be approved by the original approval authority. The No.9 Notice changes this by allowing FIVCE or FIVCE Management Firms originally approved by MOFCOM to have subsequent commercial changes approved by MOFCOM's provincial counterparts except for capital increases where the increase exceeds USD 100,000,000 or the change of “requisite investors (2)” in the FIVCE.

It should be borne in mind that although the No. 9 Notice simplifies the approval process and shortens the approval timeframe considerably the substantial requirements provided in the FIVCE Rules will still need to be strictly followed in many cases. These requirements include the restrictions on the business scope of a FIVCE, notably a FIVCE being prohibited from (i) obtaining loans to finance venture capital investments, (ii) investing in areas prohibited to foreign investment, (iii) directly or indirectly investing in the real estate market, (iv) directly or indirectly investing in publicly traded stocks or bonds, except for shares of the invested enterprises held by the FIVCE which are publicly traded after listing.)

Summary

The devolution of approval competency for holding companies, FIVCEs and FIVCE Management Firms will simplify and speed up the approval process for foreign investors as well as lower the work burden on MOFCOM. In addition, the new policy will simplify the operations of existing holding companies, FIVCEs and FIVCE Management Firms in that many will be able to bypass central MOFCOM approval for operational actions such as capital increases less than USD 100,000,000.
Although, there is no apparent negative impact upon foreign investors in these notices, it should be also noted that MOFCOM and other approvals still remain in place under specific circumstances. Foreign investors will need to carefully check which approvals at which level will be required in order to have a valid establishment and which restrictions remain in place.
 

(1) Vice-provincial cities, as an administrative division in China, are not treated as a province from an administrative perspective, but are distinct from a financial perspective.

(2) According to the FIVCE Rules, one shareholder of the proposed FIVCE must be a requisite investor i.e. a investor that meets the following requirements or thresholds: (i) the business of the requisite investor is venture investment; (ii) the capital under its management is not less than USD 100 million in the last three years prior to the application and at least USD 50 million of which has been used for venture investment; (iii) the investor shall have at least three professional management personnel with not less than three years experience in venture investment business; (iv) the requisite investors shall not have been prohibited by the judicial authorities or other relevant regulatory authorities from engaging in venture investment or investment and consultancy business or punished due to any fraud; (v) the amount of capital contribution subscribed to and paid in by the requisite investors shall not be less than 30% of the total subscribed capital and 30% of the total paid in capital of the FIVCE respectively.