The Supreme People’s Court of the PRC (“SPC”) confirms the validity of intercompany loans
On 6 August 2015, the SPC promulgated Provisions of the Supreme People’s Court on Several Issues Concerning the Application of Law in the Trial of Private Lending Cases (最高人民法院关于审理民间借贷案件适用法律若干问题的规定), effective as of 1 September 2015 (“SPCProvisions”).
This is the first time that the SPC confirmed intercompany loan contracts to be valid, a welcome change in the jurisdiction of the court which will facilitate the financing of businesses in China, including the financing of foreign-invested enterprises.
Until recently, Chinese courts had banned intercompany lending in China. Shareholder loans granted by foreign shareholders to their subsidiary companies in China within the so-called “borrowing gap” (difference between approved total investment and registered capital) were a notable exception.
This restrictive court practice went back a long way. It was based on a rather extensive interpretation of financial regulations providing, in essence, that financial services may only be carried out by licensed banks and financial institutions. In 1996, the SPC still stated in its Reply to the Question of How to Treat the Case Where the Borrower Fails to Repay Intercompany Loans Due for Repayment (最高人民法院关于对企业间借贷合同借款方逾期不归还借款的应如何处理的批复) that “Intercompany loans shall be invalid as they violate certain financial regulations.”
Enterprises in China developed two ways to remedy the effects of this restrictive court practice:
When one enterprise (lender) was willing to grant a loan to another enterprise (borrower), it could deposit the loan amount with a bank. The bank would then, upon the instruction of the lender, extend the deposited funds to the borrower. This so-called “entrustment loan” is regulated under the General Rules. Since entrustment loans are expensive and rather complicated, many Chinese enterprises turned to direct intercompany financing, often without legal protection.
Now, the SPC Provisions expressly confirmed that intercompany loan contracts for the purpose of production or business operations shall in principle be held valid by the people’s courts. However, intercompany loan contracts shall be held invalid if any of the following exceptions apply:
- if an enterprise fraudulently obtains credit funds from a financial institution and lends such funds to the borrower for higher interests, and the borrower knows in advance or should have known about the situation;
- if an enterprise takes a loan from another enterprise or raises funds from its employees and extends the funds so obtained to another enterprise as a loan for making profits, and the borrower knows in advance or should have known about the situation;
- if the lender knows in advance or should have known that the borrower will use the loan for illegal and criminal activities and still provides the loan;
- if the loan violates the public order and good customs; or
- if the loan violates effective and mandatory provisions of laws and administrative regulations.
Items no. 1 and 2 above are a product of the jurisprudence of the SPC especially made for determining the validity of intercompany lending contracts, while items no. 3 to 5 above are identical with the provisions of Article 52 of the PRC Contract Law (中华人民共和国合同法), effective as of 1 October 1999.
In simple words, intercompany loans shall be held valid provided they are used for production or (other) business operations and as long as none of the five defined circumstances apply which would render the contract invalid.
As in other countries, China’s financial services industry is subject to strict regulation. Enterprises providing loans to other enterprises on a frequent basis should bear in mind that a banking license is required for the provision of financial services to the public. The courts will have to define criteria to determine which lending activities between enterprises will be viewed as “private lending” and which will be viewed as the provision of financial services requiring a banking license. It is recommended to obtain legal advice before engaging in such business activity.