McDermott Will & Emery has a strategic alliance with MWE China Law Offices, a separate law firm based in Shanghai. This China Law Alert was authored by MWE China Law Offices lawyers David Dai, Justin Cai and Mandy Yang.
The Chinese foreign exchange control authority recently adopted material changes to the regulatory framework on overseas financing and investment via special purpose vehicles undertaken by Chinese domestic residents and the corresponding round-trip investments that will facilitate the foreign exchange registration procedures for Chinese outbound financing and investment transactions.
On 14 July 2014, China’s State Administration of Foreign Exchange (SAFE), the foreign exchange control authority, released the Notice of the State Administration of Foreign Exchange on Relevant Issues Concerning Foreign Exchange Administration for Overseas Investment, Financing and Round Trip Investment Undertaken by Domestic Residents via Special Purpose Vehicles (Circular 37). The new regulation took effect 4 July 2014. At that time, the old regulation, the Notice of the State Administration of Foreign Exchange on Relevant Issues Concerning Foreign Exchange Administration for Financing and Round Trip Investment Undertaken by Domestic Residents via Overseas Special Purpose Vehicles (Circular 75), which was issued in 2005, was repealed.
Prior to being repealed, Circular 75 was an important SAFE regulation cited in almost all prospectuses for Chinese companies listed overseas through various overseas special purpose vehicles (SPVs) that required Chinese domestic residents to register their SPVs with local SAFE branches. Private equity investors usually set the Circular 75 registration by Chinese founders as a pre-condition to their pre-initial public offering (IPO) investment. The issuance of Circular 37 and simultaneous repeal of Circular 75 has triggered heated public discussion in China. This newsletter explores the major differences between Circular 37 and Circular 75, and their relevant implications.
Extended Definition of SPV
According to Circular 37, an SPV refers to an overseas enterprise directly established or indirectly controlled by a Chinese resident (including a Chinese institution or a Chinese individual) for the purpose of engaging in investment and financing by using the domestic or overseas assets or interests lawfully owned by such Chinese resident.
Compared with Circular 75, the definition of SPV in Circular 37 has two major differences:
The purpose of an SPV is no longer restricted only to overseas financing (mainly for IPO or debt financing), and it appears that such SPV may also carry out alternative investment activities like cross-border acquisitions (an SPV with the purpose of carrying out normal investment activities is hereinafter called a Non-Financing SPV)
A Chinese resident can use overseas assets or interests to set up an SPV
The first change above appears to benefit Chinese residents, particularly Chinese individuals who set up Non-Financing SPVs, and would be a significant liberalisation for Chinese individuals. Under Circular 75 and other related Chinese outbound investment regulations, Chinese individuals cannot set up Non-Financing SPVs directly unless they have specific overseas IPO or debt-financing plans. However, according to our informal inquiry with a local SAFE office, Chinese individual shareholders may still not be allowed by Circular 37 to inject capital or assets to such Non-Financing SPVs to fund their overseas investment activities. It is understood that the possible reason is that Chinese individuals are still not permitted by the National Development and Reform Committee (NDRC) and Ministry of Commerce (MOFCOM) to carry out outbound investment directly. In current practice, Chinese individuals will have to first set up a domestic entity, then use this domestic entity to obtain NDRC and MOFCOM approvals and SAFE registrations for outbound investments. Such a structure is generally tax inefficient and time-consuming. Whether this practice will be actually affected by Circular 37 remains to be seen, pending further official clarification from SAFE, NDRC or MOFCOM.
Meanwhile, the above amendments for the first time officially allow Chinese residents to use their overseas assets and interests to set up SPVs, which means if Chinese domestic residents use offshore assets or equities to carry out overseas financing activities, they also need to do so with Circular 37 registration. Further Clarification That SAFE Registration Does Not Legalize Improper Round-trip Investment
Article 4 of Circular 37 provides that registration by SAFE of an SPV and its round-trip investment does not mean that such SPV’s round-trip investment is legal in China. Article 4 appears to be targeting the business model of variable interest entities (VIE) commonly used in Chinese enterprises’ overseas listings.
“Round-trip investment” as defined in Circular 37 refers to direct investment activities carried out within China by a Chinese domestic resident directly or indirectly via an SPV. Compared to Circular 75, the term “direct investment activities” is further clarified in Circular 37 to include the activities of setting up a foreign-invested enterprise or project within China through new establishment, merger and acquisition or other ways, and obtaining ownership, control, operation and management rights, and other rights and interests in such projects. This broad definition apparently includes round-trip investments by way of VIE structures.
Under the prevailing VIE model, Chinese founders will set up an SPV in the Cayman Islands or other offshore jurisdictions for overseas listing purposes (and register it with local SAFE according to Circular 75), then use this SPV to make a round-trip investment in China by establishing a wholly foreign-owned enterprise (WFOE), which signs control documents with the domestic entities owned by the Chinese founders so that it will have actual control over the operation, management and profits of such domestic entities. This type of VIE model circumvents two Chinese statutory restrictions: (1) the acquisition of related domestic entities by an offshore SPV must be approved by the central MOFCOM and (2) the limitation on foreign investors’ shareholding percentage in certain sensitive industries, such as value-added telecommunication or internet services, because the contractual control relationship between the WFOE and the domestic entities does not appear to be a related-party acquisition on its surface, and the WFOE does not hold equity interests in the domestic entities.
As Chinese regulatory authorities gradually cast doubts on the validity of such VIE structures due to the above circumvention of law, it is understandable that SAFE wants to make its position clear that even if SAFE agrees to register the SPV and its round-trip investment (i.e., establishment of the WFOE), SAFE shall not be deemed to have verified the legality of such arrangement.
Broaden the Financing Channel for SPV
Pursuant to Circular 37, on the basis that there is a real and reasonable need, domestic enterprises directly or indirectly controlled by Chinese domestic residents could provide loans to the SPV duly registered by such Chinese residents. What’s more, the Chinese residents are also allowed to purchase foreign exchanges and remit them overseas for the purpose of setting up an SPV, sharing buybacks or delisting when there is a real and reasonable need.
Compared with Circular 75, Circular 37 provides SPVs with two new financing channels—in addition to overseas financing—from which SPVs could receive funds from the domestic side. To a certain extent, it could also help to improve the financing efficiency of an SPV and further encourage more Chinese residents to do overseas financing (IPO).
SAFE Registration of Domestic Employees’ Participation in ESOP of Unlisted SPV
Before the issuance of Circular 37, SAFE had only released relevant regulations about the administration over domestic employees’ participation in the employee stock ownership plan (ESOP) of overseas listed companies. But in Circular 37, the feasibility of SAFE registration for the participation in ESOP of an unlisted SPV has been officially confirmed.
As stipulated in Circular 37, the directors, supervisors and senior managers of the domestic enterprise directly or indirectly controlled by the unlisted SPV, and other relevant employees who have labor relationships with the enterprise, could apply for SAFE registration before they exercise their stock options granted by the unlisted SPV.
Funds to Be Retained Offshore
According to Circular 75, the profits, dividends and foreign exchange incomes from the changes in capital gained by the Chinese resident from the SPV should be transferred back to China within 180 days. However, the above requirement has been removed in Circular 37, which means relevant funds can now be retained offshore.
Adjusted Requirements on SAFE Registration
First, with respect to the initial registration, the requirement on when to apply to SAFE for registration has been changed. Under Circular 75, the Chinese resident had to apply to SAFE for registration prior to establishing or controlling an overseas SPV. But according to Circular 37, Chinese residents should apply for SAFE registration before they make capital contribution to the SPV.
Second, according to Circular 75, when the SPV carried out overseas financing, the Chinese resident had to apply to SAFE for change registration with respect to the change of the SPV’s net assets. When there were major changes to the capital of the SPV (such as an increase or decrease of capital, equity transfer or exchange, merger or division, long-term equity or debt investment, external guarantee, etc.), the Chinese resident also had to apply for change registration. But under Circular 37, the change registration is only required: (1) when the basic information of the SPV (including Chinese individual shareholder, name, term of business, etc.) changes or (2) when there is capital increase or decrease, equity transfer or exchange, merger or division, and other relevant important changes made by the Chinese individual. So compared with Circular 75, the scope of change registration in Circular 37 has been narrowed down to the basic information and capital changes related to the Chinese individual. Third, Circular 37 further sets out the procedure of how to apply for registration if a Chinese resident failed to complete it before the implementation of Circular 37.
Clarify Relevant Penalties for Violations
Compared with Circular 75, Circular 37 makes the penalties for relevant violations more explicit. Any Chinese resident that violates the provisions set forth in Circular 37 and commits other illegal activities against foreign exchange administration will be punished by SAFE in accordance with specific provisions of the Regulations of the People’s Republic of China on Foreign Exchange Administration.
As mentioned in the beginning of Circular 37, the issuance of this new regulation aims to support the implementation of the “going-out” strategy adopted by the Chinese government. Compared with Circular 75, Circular 37 reflects the trend of SAFE’s policy to gradually loosen the restrictions and simplify the procedures for overseas financing and investment by Chinese residents, so as to fully utilize the financial resources in domestic and overseas markets. However, as Circular 37 has only recently been issued, the actual interpretation and enforcement of the above changes by SAFE in practice remain to be seen.
Justin Cai and Mandy Yang also contributed to this article.