Out-Law Guide | 10 May 2022 | 3:28 pm | 16 min. read
Among a raft of significant changes, the FIL repealed the laws governing the key traditional forms of FIE including wholly foreign-owned enterprises (WFOEs), Sino-foreign equity joint ventures (EJVs), Sino-foreign cooperative joint ventures (CJVs) and foreign invested partnership enterprises (FIPEs).
This is the second part of our three-part guide providing basic information on the legal framework for foreign investment and operations in China:
For more detail request a full version of the Pinsent Masons guide to doing business in China.
For new ventures, the choice of appropriate form of FIE depends on the category of the intended activity in the negative lists (see part 1 of this guide) as well as on the particular operational needs or objectives of the foreign investor(s). Given the inherent costs and risks of joint venturing, a JV is rarely chosen where a WFOE is otherwise both permissible and feasible. The issue is whether a PRC partner is either required by the negative list or simply desirable in order to gain access to distribution, local know-how, resources or other specialist expertise.
New foreign ventures, whether JVs or wholly foreign-owned, can now simply set up a standard LLC or partnership under China's Company Law or Partnership Law. Like their domestic counterparts, these entities only require registration with the relevant state Administration for Market Regulation (AMR) in the vast majority of cases where the Negative List or other standard pre-approval or pre-examination requirements do not apply.
In contrast to this simplification for new FIEs, there remains significant opportunity for confusion for existing FIEs formed under previous law. The repeal of the old FIE laws did not eliminate existing WFOEs, EJVs, CJVs and FIPEs - these entities still exist in their old forms, even though the laws governing them have been repealed. The continuation of these entities in the absence of their governing statutes creates obvious opportunities for legal confusion.
This is especially true for the tens of thousands of JVs, EJVs and CJVs, which simply don't fit within the Company Law in many respects. For example, the board of directors is the highest organ of authority of an EJV, not the shareholder meeting as for WFOEs and other LLCs. JVs in particular could therefore face significant complexity at key junctures, especially in the event of a shareholder dispute or with equity transfers or other changes of control.
In any event, the continuation of old forms of FIE is intended to be temporary. The FIL and related regulations set out a five-year "transitional period" during which legacy EJVs, CJVs and FIPEs should change their organisational forms and structures in line with the Company Law or Partnership Law. For the time being, they can file for a registration change or maintain their original organisational forms and structures. However, from 1 January 2025, the AMR will not handle registration matters for those FIEs if they fail to restructure. This is not likely to be as much of an issue for WFOEs, which are similar in structure to standard Company Law LLCs.
In addition to the different basic forms of FIE, special types of FIE also exist to carry out certain specific business activities.
Some notable examples include:
Where more limited activities are contemplated or limited liability is not required or permitted, foreign investors may establish a representative office or branch in China:
The FIL and related regulations set out a five-year "transitional period" during which legacy EJVs, CJVs and FIPEs should change their organisational forms and structures in line with the Company Law or Partnership Law
Over the years, China's restrictions on foreign investment in different sectors have not entirely prevented foreign investment in those sectors. The most common way around the restrictions has been the so-called variable interest entity (VIE) structure. This is a US accounting term for a subsidiary entity that is not controlled by voting rights but is subject to contractual controls functionally equivalent to voting rights that allow the subsidiary's accounts to be consolidated with the parent.
Under a typical VIE structure the domestic business restricted to foreign investment will be carried out by a purely domestic operating company, with only PRC shareholders; the foreign investors will set up a WFOE in a permitted sector, typically technical or management consulting; there will be a series of contracts between the WFOE, the operating company, and the operating company's shareholders, basically giving the WFOE and foreign investor the right to control and take the profits of the operating company. The structure will typically include management contracts, IP licenses, share pledges, share purchase options, nominee shareholder agreements and loan agreements. Typically the Chinese parties owning the domestic operating company will also own equity in the offshore group parent, and will also own equity in the offshore group parent, and will look to be compensated at that level.
Because the purpose and effect of the structure is to permit foreign investment in areas prohibited to foreign investment, VIE structures inhabit a grey area of PRC law. There are a number of risks to the VIE structure, and the risks are probably greater for companies that are ultimately owned by foreign investors.
Those risks include:
Because of these risks you should not enter in to a VIE lightly, and should consider whether there any viable alternatives; and if the structure is adopted, plan and document it carefully.
The introduction of the FIL does not appear to have materially increased the risks around VIEs, and may even decrease them. It does provide additional legal grounds for acting against VIEs, by providing a general definition of "foreign investment" that could include VIE contractual controls. However, the published law omits an important distinction between ultimate foreign and Chinese control, which appeared in earlier drafts. This would have allowed a selective crackdown on foreign-controlled VIEs, while sparing the many prominent foreign-listed VIEs under ultimate Chinese control.
Equity ownership in WFIEs and JVs is expressed as a percentage of 'registered capital'. Registered capital has the following features:
An FIE's registered capital can be stated in either foreign currency or Chinese currency (RMB).
It is generally quite easy to increase registered capital but this can be a time consuming process. The recommended approach to capital planning is that investors should fix initial total investment at an amount required to fund capital expenditures and working capital until the enterprise reaches operating break even.
However, it may be less easy to reduce registered capital, so any excess could become trapped in the company. The use of some amount of debt financing to satisfy total funding requirements helps avoid a cash trap for excess registered capital.
Registered capital can be contributed in the form of cash, capital equipment, land use rights, debt and share rights and intellectual property rights.
In general, title to contributed non-cash assets should pass to the enterprise. Accordingly, revocable licenses, future services and other such contingent interests are generally not permissible as contributions to registered capital. There is however an exception in the case of CJVs, where it is permitted to contribute "cooperative conditions" that may include contractual performance. Mortgaged assets may not be contributed to registered capital in any event.
Cash and in-kind contributions to registered capital should be verified by certified PRC accountant. The valuation of non-cash contributions must be confirmed by a licensed PRC appraiser.
In order to help ensure corporate financial strength, FIEs and domestic enterprises alike are limited in the amount of foreign exchange borrowing that they can undertake.
Traditionally, FIE borrowing was limited by certain statutory ratios of paid in capital to total investment. First in May 2016, and then with new regulations in January 2017, a new system was put in place nationally, whereby FIEs could opt to calculate debt ceilings based on a more flexible multi-factor test. The multi-factor test had previously been trialled in China's pilot free trade zones.
The ability to choose between the old or new system was made available only for a limited transitional period of one year, to January 2018. If an FIE made an election during that time, it must use the same method going forward. If not, it may elect to use either method.
Under the traditional debt ceiling regime, the debt-to-equity ratios of FIEs are limited by specifying minimum ratios of registered capital relative to "total investment", defined to include registered capital plus long-term borrowing by the enterprise over one year. In practice, only foreign exchange borrowing is counted. However, there are lifetime limits for the enterprise, so no more can be borrowed once the thresholds are exceeded even if earlier loans are paid down. The ratios of total investment to registered capital, and therefore the levels of permissible borrowing, increase with the scale of the enterprise, subject to additional rules governing special industries.
Under the new regime introduced from 2016, non-bank FIEs can borrow foreign debt up to a risk-weighted balance.
There is no specific time limit for completion of the full capital contribution. However, in practice, the AMRs in many areas may still require that a fixed contribution deadline be included in the company's articles of association. In practice, there is no longer any clear mechanism to require compliance with the articles of association payment deadlines. But because certain consequences can result from non-payment, such as inability to make forex loans, it is prudent to pay in the registered capital in accordance with the articles of association.
Because the amount of registered capital and the equity interests among LLC investors are items included in a company’s constitutional documents and registration particulars, any change in the amount or ownership of LLC registered capital must be filed or, for restricted projects, approved, and re-registered with the competent authorities. Co-investor consents are also required for different transactions.
Complex China Securities Regulatory Commission and MOFCOM approval requirements apply to major acquisitions and changes of control of listed companies.
Rather than establishing a new wholly-owned or JV company in China, foreign investors may wish to acquire the equity or assets of an existing company. As in other jurisdictions, acquiring the equity of a company will normally mean acquiring it with all of its liabilities, whereas in an assets acquisition there is generally a choice whether or not to acquire any of the target company's liabilities.
Any acquisition of less than 100% of the equity of a domestic LLC will result in the target being converted into a JV which will be subject to the more conservative legal regime governing JVs.
Particular care is required in structuring JVs with individual shareholders continuing post-acquisition. The JV regulations assume that a JV will have only a few corporate entities as investors. For instance, each party normally has the right to terminate the JV under certain circumstances, and to appoint board members. This will not be appropriate in situations where there are multiple individual shareholders. Special care is required to balance the investors' rights and interests in these circumstances.
Subject to the broad rules applicable to all foreign investments, foreign investors may acquire an existing domestic business through either asset or equity acquisition.
Under these broad rules acquisitions are subject to approval, are only possible in sectors open to foreign investment, and should result in at least 25% foreign equity in order for the target to be classified and treated as an FIE after the transaction is complete.
Equity acquisitions can be accomplished either by purchasing existing equity or subscribing to a capital increase.
Asset acquisitions can be accomplished by injecting the assets into an onshore vehicle, which will then operate them. In the latter case, the assets can either be purchased by the new company itself after establishment, or may be purchased by the investor of the newco and then contributed to the new registered capital of the newco.
Asset acquisitions are less common than equity acquisitions. This is in part because it is often difficult to transfer key assets free of encumbrances, and impossible to transfer key licences in heavily regulated industries. Also, from the perspective of the sellers, asset transfers may leave cash assets trapped in a predecessor company, rather than in the pockets of the controlling shareholders.
As with greenfield investments, the approval procedures for acquisitions have been simplified and streamlined in recent years. Additional or higher-level approvals may be required where the target is a state-owned enterprise or a listed company.
Central MOFCOM approval is required where the target company has traditional brands or a well-known trademark or is doing business in an industry key to national security and national economic security; or where shares are used as consideration. Use of shares is only permitted if the consideration shares are already listed on a stock market, or are those of an overseas special purpose vehicle to be used as a listing vehicle for the PRC target company's business.
Under the PCR Anti-Monopoly Law (AML), the parties must report and notify any acquisition or merger to the Anti-Monopoly Office of MOFCOM for merger review if the transaction meets certain thresholds relating to global and PRC revenue and presence.
A transaction that does not meet the thresholds may still be subject to review should the Anti-Monopoly Office consider that the transaction is likely to result in the, 'elimination or restriction of competition', though use of this approach has not been reported.
The Anti-Monopoly Office can stop the transaction or require divestitures, undertakings or other measures to address anti-competitive effects. It also imposes rules prohibiting a range of anti-competitive practices along lines similar to European competition law.
In addition to the standard approval regime, China also has in place a national security prior review requirement for foreign acquisitions of domestic companies' equity or assets. The requirement applies to any transaction targeting domestic military industrial enterprises and tertiary enterprises, enterprises located near major and sensitive military facilities, other entities related to national defence or security, or in other sectors related to national security such as major agricultural products, major energy and resources, infrastructure, transportation services, key technologies and key equipment manufacture. Proposed transactions may be ordered to be modified or prohibited as a result of the review.
Foreign investors can acquire the equity or assets of state-owned enterprises (SOEs) or their subsidiaries. However, the process is designed to ensure that state assets are not undervalued and to minimise the impact on employees. Therefore, the process is quite cumbersome and burdensome. It is administered primarily by the state-owned Assets Supervision and Administration Commission (SASAC) at central and lower levels.
In any transaction involving SOEs or state assets, it is critical to confirm that the seller has complied with the mandatory procedures for state asset transfers. These include use of a local state asset clearinghouse, internal approval and approval by the relevant SASAC, auditing, evaluation, publication of and invitation to bid, and undertaking a bidding process if two or more interested parties respond.
Only companies limited by shares established in China (not LLCs, and not foreign companies) can be listed on the Shanghai and Shenzhen Stock Exchanges. Foreign investors may purchase the shares of domestic listed companies in three principal ways:
Complex China Securities Regulatory Commission and MOFCOM approval requirements apply to major acquisitions and changes of control of listed companies. Particular care may be required to avoid the need to make a general tender offer when acquiring more than 30% of the shares of a listed company.
It is also possible for an onshore foreign invested enterprise(FIE) to undertake limited purchases of A shares for its own account provided that this does not constitute a significant component of its income and therefore causes it to exceed its approved scope of business.
Existing FIEs may engage in acquisitions of domestic companies operating in areas of business open to foreign investment, subject to conditions established at law and in the companies' articles of association.
For such onward investments, only registration with the AMR is required to record the change in shareholding of the target. Any subsidiaries of the target company should not be engaged in activities prohibited to foreign investment in the negative list.
Again, a domestic subsidiary of an existing FIE generally does not enjoy FIE treatment for foreign exchange and other purposes, except in the Central-Western region or for holding company investments.
There are certain restrictions on the permitted sources of funds for onward investments. For existing companies, the reinvestment of RMB retained profits requires SAFE prior approval.