On May 20, 2011, the State Administration of Foreign Exchange ("SAFE") issued the Circular of the SAFE on Operating Rules Concerning Financing and Round-Trip Investment Undertaken by Domestic Residents through Overseas Special-Purpose Vehicles (1)( "Circular 19" or "New Operating Rules"), which took effect on July 1, 2011. This Circular provides new operating rules for the foreign exchange registration with the SAFE of round-trip investments made through special-purpose vehicles ("SPV") and non-SPVs.
The SAFE has issued a series of circulars concerning round-tripping investments by SPVs since 2005. On October 21, 2005, the SAFE issued the Circular of the SAFE on Relevant Issues Concerning Foreign Exchange Administration for Financing and Round-Trip Investment Undertaken by Domestic Residents Through Overseas Special-Purpose Vehicles(2)("Circular 75"). Then, the General Affairs Department of the SAFE issued a number of circulars in 2005, 2007 and 2009 respectively, including the Circular of the General Affairs Department of the SAFE on Issuing the Operating Rules of the "Circular of the SAFE Concerning Improvement of Administration of Foreign Debt" and the "Circular of the SAFE on the Relevant Issues Concerning Foreign Exchange Administration for Financing and Round-Tripping Investment Undertaken by Domestic Residents through Overseas Special-Purpose Vehicles"(3)("Circular 124"),the Circular of the General Affairs Department of the SAFE on Printing and Distributing the Operating Rules of the "Circular of the SAFE on Relevant Issues Concerning Foreign Exchange Administration for Financing and Round-Tripping Investment Undertaken by Domestic Residents through Overseas Special-Purpose Vehicles" (4)( "Circular 106") and the Circular of the General Affairs Department of the SAFE on Printing and Distributing the Operating Rules of the "Circular of the SAFE on Foreign Exchange Administration for Capital Account 2009"(5) ("Circular 77"，with Circular 124 and Circular 106 collectively referred to as the "Old Operating Rules"). At present, foreign exchange regulations concerning financing and round-tripping investments undertaken by domestic residents through offshore SPVs are mainly governed by Circular 77.
The newly-published Circular 19 is an update and expansion of Circular 75 and the Old Operating Rules. It states that if any conflict arises between Circular 19 and the existing effective Circular 77, Circular 19 shall prevail. Circular 19, to a certain extent, reflects the trend of the SAFE gradually opening up and simplifying procedures for the foreign exchange administration of capital accounts.
This article aims to explore the trends in foreign exchange administration and regulatory guidelines provided by Circular 19 on dealing with issues arising under Circular 75, by comparing the New Operating Rules and the Old Operating Rules. Our analysis will draw on our previous experiences of dealing with the Sichuan Branch of the SAFE (Local SAFE).
II. Main Differences Between the New Operating Rules and Old Operating Rules
A. Foreign Exchange Registration for the Establishment of SPVs
a. Approval process and standards
According to Circular 77, when setting up an SPV, a letter of business plan regarding offshore financing must be submitted to the SAFE. The letter must include seven elements: (a) basic introduction to the actual controller and management; (b) legal arrangement and feasibility analysis for the procedure, control methods and follow-up financing for transferring the domestic assets of a domestic resident to the control of SPVs, illustrating the investment relationship between the domestic resident, domestic enterprise controlled by the resident and the proposed SPVs; (c) shareholding proportion of each domestic resident in the SPV (staff shareholding plan and management option incentive plan shall be disclosed, if any); (d) basic introduction to the planned financing methods, financing amount and offshore financing institutions, illustrating financing intention and memorandum of agreement with offshore financing institutions; (e) illustration of the plan to use offshore financing funds; (f) the development history of the industry of the domestic enterprise, the most recent 3 years financial status (the financial status since the establishment of the domestic enterprise shall be illustrated if such domestic enterprise has not been established for a full 3 years); (g) market prospects, market development strategies, development planning, financial forecast, and market risk analysis of the domestic enterprise.
The approval process of the SAFE is intended to focus on the reasonableness, feasibility and consistency of the financing methods, scale, conditions, capital repatriation arrangement and method mentioned in the letter of business plan regarding offshore financing. Under Circular 77, the approval process concerning the establishment of SPVs undertaken by the SAFE is substantive, and our previous relevant experience is consistent with this.
According to Circular 19, a resolution of the board of the domestic enterprise or a written statement by an individual which approves the offshore financing must be submitted to the SAFE for the establishment of a SPV. However, the letter of business plan regarding offshore financing and the items required to be listed in the aforementioned letter under Circular 77 are no longer required in Circular 19. Furthermore, examination of the commercial reasonability and feasibility is also no longer required under Circular 19. We tend to believe that, Circular 19 has simplified the SAFE approval process for the establishment of SPVs.
Both Circular 19 and Circular 77 provide that an SPV can be established prior to the initial registration with the SAFE. However, material changes on capital or equity by way of offshore financing, change of the shareholding structure or round-trip investment are not permitted prior to the completion of SAFE registration. In short, the application to the SAFE for registration must be made before any material change to capital or equity of the offshore SPVs is made. Rules concerning retrospective registration shall be applied if material capital or equity modifications are made before the initial application to register the SPV with the SAFE.
Pursuant to Circular 77, one precondition of the initial SAFE registration of SPVs is that the domestic enterprises and domestic natural persons must have definite financing intentions and have executed memoranda of offshore financing institutions. In our experience, the local SAFE may still accept applications for the initial registration of SPVs even if no memoranda on offshore financing are executed, or even if an offshore financing institution has not been ascertained, if the SAFE believes there is an urgent need for accepting the application. Under Circular 19, this precondition has been deleted.
We consider that, under Circular 19, an application of initial registration of SPVs could be accepted for the initial registration of an SPV prior to reaching definite financing intentions and execution of memoranda between the domestic enterprises and/or persons and offshore financing institutions. This change will enrich financing models and make offshore financing more flexible.
B. SAFE Registration of the Establishment of a SPV with Acquisition of a Domestic Enterprise
a. Injection of domestic assets
On August 8, 2006, six PRC governmental and regulatory authorities, including Ministry of Commerce ("MOFCOM") and SAFE, jointly promulgated the Regulations on the Acquisition of Domestic Enterprises by Foreign Investors ("Acquisition Regulation")(6). Under the Acquisition Regulation, MOFCOM approval is required if any domestic enterprise merges its affiliated domestic company in the name of a company legally established or controlled by the aforesaid party in a foreign country or region. In a situation where a domestic resident (including an enterprise or person) establishes under Circular 75 an offshore SPV and conducts a reverse acquisition of domestic companies owned by the domestic resident via the offshore SPV, the Acquisition Regulation shall govern. In short, the party shall obtain the MOFCOM approval.As we know, many domestic enterprises with plans to conduct an offshore IPO at that hoped to obtain an acquisition approval from the local MOFCOM branches before the Acquisition Regulation came into effect in order to avoid the uncertainty of obtaining the MOFCOM approval after the effectiveness of acquisition regulation. Therefore, the time when the domestic assets were injected into the offshore SPV became a key point. The governing Circular 124 did not provide clear provisions regarding the time of injection of domestic assets into an offshore SPV before the promulgation of Circular 106. Thus, prior to May 2007, the MOFCOM approval to the acquisition of an offshore company by a domestic company was generally deemed as a condition of recognizing the injection of domestic assets into the offshore SPV. However, Circular 106 and Circular 77 promulgated later stipulate the completion of SAFE registration of a domestic enterprise to be the time of asset injection.
Circular 19 is silent on the above issue. Whether the SAFE recognizes that the time of injection of domestic assets into an offshore SPV is the date of MOFCOM acquisition approval needs further clarification from the SAFE.
b. 3-year consecutive operation requirement
Both Circular 106 and Circular 77 provided that "… if a foreign investor which is an offshore enterprise, has completed the SAFE registration concerning overseas investment, but does not operate in compliance with the permitted business scope for three consecutive years, the application of such foreign investor for SAFE registration regarding its establishment or acquisition of domestic enterprises shall not be accepted." In our experience, when Circulars 106 and 77 were effective, the 3-year consecutive operation requirement was not strictly implemented by the local SAFE in practice and there is no provision in Circular 19 in this regard. We therefore consider that there is probably no longer a requirement to have maintained the business for three consecutive years.
c. SAFE registration of equity acquisition
Pursuant to the Acquisition Regulation, if the MOFCOM approves a foreign investor to acquire a domestic company by equity merger, the foreign exchange administrative authority shall issue a foreign exchange registration certificate to the domestic company which indicates that the certificate shall be "valid for eight months from its issuance". If the MOFCOM approves a special purpose company(7) to acquiring a domestic company by equity merger, the foreign exchange administrative authority’s certificate shall be "valid for fourteen months from its issuance".
As to a foreign investor’s equity merger with a domestic company, Circulars 106 and 77 only generally state that the wording of the foreign exchange registration certificate given to the domestic company must be consistent with the wording of the approval certificate for the establishment of a foreign investment enterprise and its business license. Under Circular 19, the rules covering the SAFE registration of a foreign investor’s acquisition of a domestic company by equity merger are different from those governing an SPV’s acquisition of a domestic company by equity merger. Circular 19 contains a detailed distinction between these two kinds of mergers. For equity merger by foreign investors with a domestic company, Circular 19 provides that before a foreign exchange registration certificate is cancelled, the foreign exchange payments made by the domestic company will be restricted.For example, the domestic company shall not pay dividends, or provide security guarantees for its related companies or make any foreign exchange payments on capital account by equity transfer, capital reduction, liquidation.
The New Operating Rules are more consistent with the Acquisition Rules, and are clearer and more explicit to avoid any confusion.
C. Retrospective Registration of SPV’s Round-tripping Investment
a. Punishment before retrospective registration
Pursuant to Circular 106, a written application was required to be submitted for the retrospective registration of an SPV’s round-trip investment. The background information about the domestic enterprise and actual controller, the shareholding structure of offshore SPVs, the offshore financing and round-trip investment of the SPV must be clearly stated in the application. The SAFE was mainly concerned with whether the domestic enterprise had paid to the SPV any profits, dividends, liquidation dividends, transfers of equity, capital reduction proceeds, principal and interest on shareholder loans, etc ("Foreign Exchange Payment") when such application is examined. If a foreign exchange payment occurred, the retrospective registration will only be permitted after the foreign exchange evasion of the domestic enterprise and its actual controllers are investigated and dealt with. If the actual controller fraudulently obtained foreign exchange registration by providing false statement when an SPV merged with a domestic enterprise, then retrospective registration shall only be permitted after the fraudulent act is punished.
The principle of "punishment before retrospective registration" was firstly set out in Circular 106, but the later issued Circular 77 did not provide relevant operating rules concerning retrospective registration of SPVs. Therefore, during the intervening period between the promulgation of the Circular 77 and the Operating Guidance on the Circular of the SAFE on Relevant Issues concerning Strengthening the Administration of the Foreign Exchange Business(8)("Operating Guidance of Circular 59") on November 22, 2010 which restated the principle of punishment before retrospective registration, there was no unanimous view and practice among different levels of foreign exchange administrative authorities on the enforceability and operation of the retrospective registration of the SPV. The process of retrospective registration was filled with uncertainty.
Circular 19 reconfirms the principle of "punishment before retrospective registration". Furthermore, Circular 19 introduces two more examination elements in addition to the examination of the foreign exchange payment history of the domestic company required by Circular 106. The two new elements are: (1) whether there was a material change of capital or equity in the offshore SPV before the retrospective registration; and (2) whether there was a fraudulent act in the application for the foreign exchange registration conducted by the foreign-invested enterprise which was established through round-trip investment.
We think that Circular 19 confirms the feasibility of obtaining a retrospective registration, at the same time it strengthens the examination towards possible illegal conduct by the actual controllers in respect of compliance of the relevant foreign exchange laws and regulations. In addition, penalizing such conduct is emphasized.
b. Special audit report
Based on our previous experience, when Circular 106 was effective, during the process of granting retrospective registration, the investigation of the existence of offshore foreign exchange payments by the domestic enterprise existed was mainly dependent on the written undertaking of the domestic natural person. Pursuant to Operating Guidance of Circular 59, a special audit report issued by a professional audit institution shall be submitted. Circular 19 restates this requirement. We tend to believe that SAFE has enhanced the examination of offshore foreign exchange payments to check for foreign exchange evasion.
D. Round-trip Investment of Non-SPVs
a. Definition of a non-SPV
Compared with the Old Operating Rules, Circular 19 puts forward a new concept, namely, the non-SPV, but does not provide a definition of a non-SPV. Based on the definition of a SPV in Circular 75(9), we consider that a SPV should meet two requirements concurrently: first, it must conduct financing activity by equity transfer; second, the equity financing must be based upon the domestic assets or interests. In practice, it should be noted that, in practice, under the presently effective Circular 77, the local SAFE has a broader understanding of the definition of a SPV.In practice SPVs have often successfully obtained the foreign exchange registration even though they did not meet the strict definition of a SPV.
Accordingly, we consider that, non-SPVs referred to in Circular 19 mean offshore companies which do not simultaneously satisfy the two requirements of SPVs. This understanding, however, does not rule out the possibility that different levels of foreign exchange administrative authorities will interpret it differently.
b. The approval process for round-trip investment of non-SPVs
Circular 19 does not require a non-SPV offshore enterprise to obtain foreign exchange registration for a round-trip investment as would be required by a SPV. The domestic enterprise controlled by such offshore enterprise will be identified as "round-trip investment of non-SPV" by local SAFE in the foreign exchange management information system directly and the compliance investigation will be carried out based on the following principles:
i. The domestic resident natural person shall provide evidence that in the formation of his offshore rights and interests does not involve any acts of foreign exchange evasion, illegal procurement, changing the use of foreign exchange without authorization and other acts that violate the foreign exchange administration regulations;
ii. The SAFE shall ensure that there is no false undertaking being made by the foreign-invested enterprise being set up via round-trip investment when applying for foreign exchange registration;
iii. Between November 1, 2005 and the date of application, whether the foreign invested enterprise established via round-trip investment made any offshore payments for profits, liquidation dividends, consideration of equity transfer, capital reduction proceeds, retrieved investment in advance, principle and interest of shareholder loan and other payments (including offshore payments of profits to be used for domestic re-investment and capital expansion).
Should any acts of violation be found, the principle of punishment before registration of round-trip investment shall be applied before the non-SPV is recorded with the SAFE. In short although registration is not required for round-trip investment of by a non-SPV, the SAFE imposes stringent supervision on non-SPVs as on SPVs.
c. Offshore investment by domestic natural persons
Applicable laws do not forbid offshore investments by domestic natural persons. However, in practice, since the relevant authorities, such as SAFE have not promulgated operating rules (except such operating rules concerning round-trip investment and employee incentive plans) in this regard, domestic natural persons often find it impossible to obtain foreign exchange registration for the purpose of offshore investments. As a result, the parties are unable to remit legitimate income obtained through such investments back to the country. Although the Circular 19 does not provide any specific provision regarding foreign exchange registration procedures for domestic natural persons investing overseas, it provides guidelines where offshore entities, directly or indirectly controlled by domestic natural persons, engage in domestic direct investments in China. Circular 19 provides that, under such circumstances, the legitimacy of the offshore rights and interests of the domestic natural persons shall be examined, furthermore, such investments shall be deemed and recorded as "round-trip investment of non-SPVs".
We are of the view that "round-trip investment of non-SPVs" provides a legitimate basis for the domestic natural persons to remit profits from offshore investments into China. Although the SAFE continues to restrict foreign exchange registration for domestic natural persons investing overseas, it has established procedure for foreign exchange registration, if it is evident that an offshore investment made by a domestic natural person into an offshore entity is conducted for the purpose of direct round-trip investment back to domestic enterprises. This provides a legitimate channel for profits obtained by domestic natural persons through offshore investments to be remitted back to China via "round-trip investment of non-SPVs."
E. Foreign Exchange Deregistration
Attachment 1.5 of Circular 19 sets out operating rules concerning deregistration of SPV’s round-trip investment. Deregistration of SPV’s round-trip investment is required when a domestic enterprise or natural person who has actual control over the SPV transfers the equity of the SPV to other domestic or offshore entities or offshore natural persons. Attachment 1.5, however, does not cover the circumstances when a domestic natural person takes over the SPV. We consider that this indicates foreign exchange registration for domestic natural persons in offshore investments can not be obtained currently, except for investments made through round-trip investments in SPVs or employee incentive plans. This is in line with the current practices of the SAFE.
The above is a brief analysis of the main differences between Circular 19 and Old Operating Rules. Because Circular 19 has only been promulgated for a short time, it is still vague regarding interpretation and application by different levels of foreign exchange administrative authorities in practice. Further study is needed when subsequent cases and opinions from the SAFE can be obtained.
1、Hui Fa  No.19, effective as of July 1, 2011.
2、Hui Fa  No.75, effective as of November 1,2005.
3、Hui Zong Fa  No. 124, effective as of November 24,2005.
4、Hui Zong Fa  No. 106, effective as of May 29, 2007.
5、Hui Zong Fa  No. 77, effective as of May 6, 2009.
6、Effective as of September 8, 2006.
7、The definition of a special purpose company is different from the definition of an SPV in the Circular 75. Pursuant to the Acquisition Regulation, a special purpose company refers to an offshore company directly or indirectly controlled by a domestic company or Chinese natural person realizing the interests of a domestic company actually owned by the aforesaid domestic company or Chinese natural person by means of offshore listing.
8、Hui Fa  No. 59, effective as of November 22, 2010.
9、Pursuit to Circular 75, a special purpose company refers to an offshore company directly established or indirectly controlled by a domestic company or Chinese natural person realizing the assets or interests of a domestic company holding by the aforesaid domestic company or Chinese natural person by means of equity financing(including convertible bond financing).