A New Channel of Foreign Re-investment (Capital Contribution in PRC Equity) Becoming Possible

On 4 May 2011, the Ministry of Commerce released the draft Measures for the Administration of Capital Contribution in the Form of Equity Involving Foreign-Invested Enterprises (《涉及外商投資企業股權出資的管理辦法》 征求意見稿) ("Draft Measures") for public consultation.

The Draft Measures, once finalised, would confirm the possibility of foreign re-investment in the PRC using existing equity investment in the PRC as contribution. It is expected that these Measures would be welcome by foreign investors as more innovative investment structures may be permitted in the way forward. The Measures, once finalised, would mark another milestone in the relaxation of foreign investment restrictions in the PRC.

It is also anticipated that the Measures would facilitate more Sino-foreign joint venture activities. The Measures would offer new structures for domestic and foreign companies to integrate their PRC investment and operations.

The Measures once taken effect will complement the Measures of Administration of Registration of Capital Contribution in the Form of Equity (《股權出資登記管理辦法》) ("SAIC Measures") promulgated by the State Administration of Industry and Commerce ("SAIC") on 14 January 2009 and the subsequent notices issued by SAIC. It is expected that the Measures would be finalised soon after the consultation period.

Below is an overview of the Draft Measures.

Scope of Measures

The Draft Measures signal a green light for a domestic or foreign company to make capital contribution to an investee company in the PRC (domestic company or Foreign-Invested Enterprise ("FIE")) by way of injecting equity interest of another PRC company. This would be applicable to the case of new establishment or capital increase.

The equity interest eligible for injection pursuant to the Measures could be equity interest of a domestic or an existing FIE ("PRC Equity Interest").

Capital contribution in equity is subject to discretionary approvals of the authorities and other requirements.

Qualifications

There are qualification requirements for the PRC Equity Interest.

The relevant PRC equity interest shall be free of encumbrances and transfer restrictions. Specifically, the PRC Equity Interest in the following circumstances shall not be contributed as capital:

(a) when the registered capital of the subject PRC company has not been paid up in full;

(b) when there are encumbrances or liens affecting the PRC Equity Interest;

(c) when the transfer of the PRC Equity Interest is prohibited according to the Articles of Association;

(d) if the annual inspection was not passed in the previous year;

(e) Equity interest of a Foreign-invested Investment Company, or Foreign-owned Venture Capital (Equity) Investment Enterprise will not be qualified;

(f) Additional approvals for equity transfer required as per laws, administrative regulations or State Council and such approvals have not been obtained; or

(g) Transfer of PRC Equity Interest subject to restrictions or prohibitions according to laws, administrative regulations or the State Council.

The relevant parties should check whether the PRC Equity Interest is caught by any of the above restrictions or prohibitions, in particular whether the transfer of the PRC Equity Interest is subject to any pre-emptive rights of other shareholders or any prior approval from any industry-specific regulatory authorities. Any such restrictions or approvals shall be cleared or obtained in accordance with relevant laws and regulations as well as the articles of association of the subject PRC Company.

Further, the Draft Measures do not permit contribution of equity interest which results in two companies cross-holding equity interest of each other.

Mandatory Valuation and Pricing

To contribute PRC Equity Interest as capital of another PRC company, the PRC Equity Interest shall be subject to valuation by a licensed valuation firm in the PRC. Based on the valuation result, the relevant investors and shareholders may agree on the "Consideration" of the PRC Equity Interest and the "Capital Contribution Amount" that it represents. The consideration of the PRC Equity Interest shall not be higher than the valuation. The "Capital Contribution Amount" represented by the PRC Equity Interest shall not exceed the "Consideration" of the PRC Equity Interest. Any difference between the "Consideration" and the "Capital Contribution Amount" may be regarded as capital reserve of the Investee Company.

Approval Requirements and Procedures

Capital contribution in equity shall be approved by the Ministry of Commerce, or its delegated authority at the provincial level ("Approval Authority") of the place of the investee company.

Precisely the level of authorities’ approvals required (central government or provincial level) would hinge on the total investment amount, size of registered capital of the investee company (depending on the form of corporate presence of the Investee Company), the transaction amount, the relevant business sector and whether there would be a change of control of the investee company.

Compliance with Foreign Investment Industry Policies and other Existing Regulations

As the Draft Measures apply to both domestic companies and FIEs, the equity contribution arrangements would possibly result in certain companies changing their domestic status to FIE status, and vice versa.

The Draft Measures emphasize that in any event, the compliance of existing regulations regarding foreign investment restrictions (including the Provisions Guiding Foreign Investment Direction ("Investment Direction") and Industry Guidance Catalogue for Foreign Investment ("Catalogue")) shall be paramount. The capital contribution in equity should not result in foreign companies holding any interests in prohibited or restricted sectors in violation of the Investment Direction and Catalogue.

In cases where the transaction involves listed companies, state-owned equity, Foreign-Invested Investment Company, merger or acquisition of a domestic company by a foreign investor, or circumstance which shall be subject to M&A security review, the relevant existing regulatory requirements should also be complied with.

Limit and Time Frame

As a form of in-kind capital contribution, the capital contribution in equity plus other forms of non-monetary capital contribution is subject to a cap of 70% of the total registered capital of the investee company.

The Draft Measures largely set out how capital contribution in equity may be effected. A formal application should be lodged by the investee company or its shareholders (in case of a new establishment). Discretionary approvals from the relevant authorities should be obtained. In the case of a new establishment or conversion of an existing domestic company into a FIE, the Draft Measures introduce a new concept of "conditional approval". In essence, the authorities would grant a conditional approval if it approves the transaction. The conditional approval is subject to the actual injection of PRC Equity Interest within one year from the date of issuance of the Business License and compliance of other relevant regulations and procedures.

According to the SAIC Measures, in case of capital contribution in equity for the purpose of capital increase of the Investee Company, the injection of the relevant equity interest should be completed before the issuance of the new Business License. There appears to be an inconsistency between the Draft Measures and existing regulations of the State Administration of Industry of Commerce. It remains to be clarified how the two measures and regulations may be reconciled in this respect.

No Multiplying Effect in Foreign Debts and Exemption of Import Duty

The Draft Measures also clarify, in the case of a capital contribution in equity, the investee company shall not be entitled to take out additional foreign debts, or enjoy additional import duty exemption based on the additional registered capital which is contributed in equity.

Conclusion

The release of the Draft Measures is definitely a welcoming step for foreign investors. Certain respects of the Measures and the precise processes in various situations have yet to be clarified. It is worth keeping a close eye on the further development of the Draft Measures and the authorities’ interpretation when the Measures are implemented.