China’s New Regulations for Offshore Equity Financing

                                                                  Angela Yao

Red chip offshore listings, venture capital and private equity investment into China through offshore holding companies have experienced a slump during 2005.This is largely due to foreign exchange regulations issued earlier in 2005 which set forth strict approval-based investment requirements. After significant policy shifts in China’s foreign exchange control regime that took place later in 2005, offshore financing is poised to re-commence at a faster pace in the New Year 2006.

Overseas venture capital and private equity funds traditionally rely on the use of offshore holding companies as their China investment vehicles.These are typically located in tax efficient jurisdictions such as Bermuda, the Cayman Islands, or the British Virgin Islands. Rather than investing in a Chinese portfolio company directly, venture capital and private equity funds commonly make their investment into the offshore holding companies of their portfolio companies and then use the portfolio companies to establish a foreign-invested enterprise (‘FIE) in China to move ownership or control of PRC-based assets to the offshore holding companies and then go for offshore financing transaction.

On January 24, 2005, China State Administration of Foreign Exchange (“SAFE”) promulgated the Issues Relevant to Improving the Foreign Exchange Control on Merger and Acquisition with Foreign Investment Circular (referred to as “Circular No.11”), under which the establishment or control of overseas companies by domestic enterprises and the transfer of domestic assets or equity for exchange of equity or other property rights in overseas companies is subject to mandatory approval and registration. At the time, Circular No.11 was generally understood as the Chinese government’s attempt to clamp down on the practice known as “round-tripping” by some PRC individuals who would convert their RMB holdings to a convertible currency outside China, establish an offshore company, and then invest in the PRC as foreign investors to take advantage of, among other things, the preferential tax treatments available to foreign enterprises. It was not viewed as an attempt to regulate other legitimate uses of offshore holding structures for venture capital and private equity funds.

However on April 21, 2005, SAFE promulgated Issues Relevant to Registration of Overseas Investment by Individual Residents in China and Foreign Exchange Registration for Merger and Acquisition with Foreign Investment Circular (referred to as “Circular No.29”).This set forth additional clarifications and rules for the implementation of Circular No.11. Under Circular No.29, SAFE emphasized that if the establishment or control of overseas companies by domestic enterprises has not handled the foreign exchange registration of overseas investment, the outward remittance of profits and other amounts to overseas companies are then forbidden. SAFE’s intent was to prevent tax evasion, parking capital offshore and looting state-owned assets. However, an unexpected consequence of the broad wording of the two circulars is that many IPOs on offshore stock exchanges or private placement involving PRC assets and businesses were caught and put on hold. Circular No.11 and No.29 have created numerous concerns and confusion, and prompted much controversy among investors and financial professionals as to the effect and reach of these regulations.

Following the promulgation of the two circulars, officials from SAFE met with representatives from venture capital and private equity funds, investment banks, and law firms, to discuss the impact of the circulars. The representatives suggested that SAFE limit the application of the two Circulars to certain transactions, or to turn the approval-based requirement into a notice-based regulatory scheme.

With that, on October 21, 2005, SAFE promulgated a new Circular, entitled “Circular Concerning Relevant Issues in the Administration of Foreign Exchange Regarding Financing and Round-Trip Investment by Domestic Residents through Offshore Special Purpose Companies” (referred to as “Circular No.75”). This took effect on November 1, 2005, and completely replaced the two circulars mentioned above. Circular No.75 confirms that the use of offshore companies as holding companies for overseas equity financing is permitted as long as foreign exchange registrations are made with SAFE.

Under Circular No.75, (i) “special purpose companies” refer to the companies established by domestic residents (both enterprises and individuals) with holdings or equities based in China for the purposes of offshore equity financing; (ii) “round-trip investments” is defined to include but, “without limitation, purchasing or swapping for the equity of a Chinese owner or a domestic enterprise, establishing a FIE in China and using it to purchase or control domestic assets, purchasing domestic assets and using them to establish a FIE, or increasing the capital of a domestic enterprise”; (iii) “control” of a special purpose offshore company or domestic company is defined in great breadth and detail, and include “direct or indirect……rights to the benefits” from the company.

Circular No.75, among other things, has the following improvements compared with the former two circulars:

a、PRC residents (companies and individuals) are permitted to establish special purpose companies to engage in equity financing in the international capital market through means such as reverse mergers and acquisitions, equity conversion and convertible debts.

b、So long as PRC residents have completed their exchange registration requirements for overseas investment, their round-trip investment in China will be granted the foreign exchange registration status granted to FIEs.

c、After the foreign exchange registrations have been completed, the invested enterprises may distribute funds to offshore special purpose companies through dividends, liquidation, equity transfers, capital decreases and other means.

d、After completion of financing activities by the offshore special purpose companies, PRC residents may transfer back to China funds that should be used onshore, based on the capital use plan in their business plans or prospectuses.

e、Profits, dividends and other income distributed by overseas special purpose companies to the PRC residents are to be transferred back to China within 180 days of receipt to appropriate accounts depending on the nature of the income.

The most important development under Circular No.75 is the absence of approval requirements for PRC residents to engage in overseas financing through special purpose companies. However, Circular No.75 established a set of strict registration procedures and reporting obligations. The first registration procedure detailed by the Circular must be handled by a resident before “establishing or taking controls of a special purpose company abroad”. Submissions to the local SAFE office at this stage include the following:

a、a written application, with details of the domestics enterprise, special purpose company and overseas financing plans;

b、individual identification document or enterprise registration document;

c、offshore financing commercial plan;

d、(only for a residential legal person) official reply approving source of foreign exchange funds (or assets) and approval documents from MOFCOM or its local delegated department;

e、(for a resident individual) a signed and completed form, or (for a resident legal person) an Overseas Investment Related Foreign Exchange Registration Certificate; and

f、Other true explanatory/evidentiary materials.

In the second registration procedure detailed by the Circular, a somewhat different list of documents must be submitted either “(if) injecting a domestic enterprise’s assets or equity …...into a special purpose company” or (if) conducting an equity financing exercise abroad after injecting assets or equity into a special purpose company”. Submissions to the local SAFE office at these stages include the following:

a、a written application detailing changes in shareholders and equity structure, and the method of pricing the assets or equity, of the domestic enterprise and special purpose company;

b、(for a resident individual) completed and signed forms, or (for a resident legal person) an Overseas Investment Related Foreign Exchange Registration Certificate; and

c、The round-trip investment approval document from MOFCOM or its local delegated department;

d、If State-owned assets are involved, a document from the State-Owned Assets Supervision & Administration (SASAC) confirming the value of the domestic enterprise’s assets or equity;

e、Evidentiary documents of the special purpose company, such as its overseas registration, business license etc; and

f、Other evidentiary materials.

Although domestic residents are imposed with strict registration and reporting obligations as listed above, SAFE Circular No.75 officially permits venture capital and privately funded business through offshore holding companies for the first time, which will definitely encourage more and more venture capital business and overseas private equity investment and boost the number of PRC enterprises to seek offshore financing.