Recent merger and acquisition activity highlights the increasing use of “share swaps” as a way of structuring transactions. For example, last month Baidu sold its interest in Qunar, one of the People’s Republic of China’s (“PRC”) largest online travel companies, to Ctrip by swapping its shares in Qunar for ownership in Ctrip instead. This article will focus on how such share swaps can be used in the PRC to structure transactions (particularly from the perspective of foreign invested enterprises (“FIEs”)) and what application steps a foreign investor would be required to take to have such transaction structures approved.
A share swap is a way of structuring a transaction where the shareholders’ ownership of shares in one company are exchanged for shares in another company. Under Chinese laws and regulations, the following types of share swaps are permitted:
1.1 FIE incorporation
The foreign investor, who proposes to establish a new wholly foreign-owned enterprise (“WFOE”) in China, can inject capital into the WFOE by using the shares held in its existing FIE. Under the regulations, such WFOE shall be set up as a limited liability company rather than a joint-stock company.
In the event of joint venture enterprise (the “JVE”) incorporation, both domestic and foreign investors can consider to use the shares in their PRC domiciled company for the capital injection into the new joint venture company.
The relevant laws and regulations have removed the limitation on the percentage of non-monetary contribution that can be made into a company (this was previously limited at 70%), so that now the foreign investor can contribute any percentage amount of the registered capital of the company it wishes by way of a share swap.
There is no restriction under PRC law to the establishment of a foreign invested enterprise by using the shares of the foreign investor’s offshore company, however, it is extremely difficult to do in practice and has a complicated procedure to apply for the approval from the authority. Few investors will really think about it for these reasons.
1.2 Capital raise to domestic enterprise
Under Chinese law, a foreign investor is allowed to use the shares of its domestic FIE instead of a cash contribution in a foreign-funded capital raising programme of a domestic enterprise, irrespective of whether the target company is originally an FIE or not prior to the capital raising.
1.3 Acquisition of domestic enterprise
Foreign investors may use either its shares in a domestic PRC enterprise or an offshore enterprise as consideration for the acquisition of shares in other domestic enterprises.
Under PRC laws and regulations, the FIE being used by the foreign investor for the share swap shall not be a foreign-funded real estate enterprise, a foreign-funded investment enterprise, or a foreign-funded venture capital (equity) investment enterprise.
Although in theory, it is also possible for the foreign investor to use its shares in an offshore company as consideration for the acquisition of shares in a domestic company, such a transaction is rarely approved by the Ministry of Commerce (the “MoC”) and only applies where the offshore company is a listed company.
In practice, another feasible structure is an indirect acquisition by using the domestic FIE of the foreign investor as the acquiring company (in which case there is no need for MoC approval). Also, the FIE being used by the foreign investor for the share swap shall not be a foreign-funded real estate enterprise, a foreign-funded investment enterprise, or a foreign-funded venture capital (equity) investment enterprise.
It is worth noting that if the seller of the target company is a natural person of PRC nationality, the parties must check with the local MoC whether the seller would be permitted to be the shareholder in the foreign investor’s domestic FIE following the share swap. At the moment, it has been expressly confirmed that a natural person of PRC nationality is eligible to be a shareholder in a domestic FIE by the MoC of certain areas (e.g. Shanghai Pudong New District, Hunan Province and Hubei Province). However, there are other areas of the PRC which do not allow this.
2. Operational process
2.1 Capital contribution/consideration by shares in domestic enterprise
2.1.1 Primary confirmation of share-swap condition
If the foreign investor plans to make an investment via a share swap (whether for the establishment of a new FIE, any subscription of increased capital, or the acquisition of shares in a domestic enterprise), the shares used by the foreign investor for the share swap shall, amongst other matters, satisfy the following conditions:
- there shall be no mortgage or other charge over the shares;
- the shares must not be frozen by any court or bank order;
- there must be no limitation to such shares being transferred under the articles of association of the enterprise in question.
It is therefore important for the foreign investor, prior to the implementation of any share swap, to confirm that the shares of the domestic FIE to be used for the transaction comply with these conditions.
Interestingly, recent laws and regulations have approved the use of shares which have not been fully paid up (i.e. where an enterprise has not fully paid its registered capital), without any negative effect on the share swap transaction.
2.1.2 Legal opinion and evaluation of share-swap
In practice, the PRC regulatory authority typically requires the attorney of the foreign investor to provide a legal opinion confirming two key points as part of the transaction:
- the domestic FIE shares conform to the legal conditions set out above in section 2.1.1; and
- the share swap will not lead to any violation of the relevant China foreign investment access regulations by the foreign investor.
The regulatory authority also pays close attention to the real value of the shares used for the share-swap and the foreign investor is therefore required to appoint a professional institute to provide an evaluation report on the value of the shares used for the share swap. In our experience it can take up to 1-2 months for such a report to be prepared by the professional evaluation institute. To avoid any delay, the foreign investor should engage the professional evaluation institute as early as possible.
Both the legal opinion and the evaluation report would be submitted to the regulatory authority as part of application process.
2.1.3 Execution of the share swap document
After the foreign investor and domestic shareholder have agreed on the commercial and legal terms of the share swap, they should execute the relevant share swap agreement (which, if necessary, should be conditional on the regulatory approvals being obtained). Note that the value of the consideration payable by the share swap should not exceed the value of the shares as assessed by the professional institute in its evaluation report (see above). The signed agreement will be submitted to the regulatory authority as part of the application materials.
2.1.4 Preparation and submission of application material
In practice, the preparation of the application materials should start from the moment that the parties have decided to proceed via a share swap structure. Foreign investors will typically engage a law firm experienced in handling corporate transactions in China to assist with the preparation and submission of the application documents (as well as to provide the legal opinion and the drafting of the share swap agreement) to ensure that the correct documents are submitted to the relevant PRC regulatory authorities. In our experience, carrying out the steps set out below as early as possible in the application process will make a big difference to the transaction timeline in terms of the speed at which the applications can be processed:
- establishing early communication with the relevant department(s) of the MoC;
- identifying the hierarchy of administrative approvals needed;
- obtaining a checklist of application materials and gathering the necessary documents;
- identifying which application documents need notarization and embassy certification.
Some transactions may need to deal with the multi-regional departments of the MoC across the country. For example, where foreign investor A proposes, via its shares held in FIE B registered in Beijing, to invest and acquire the shares from FIE C, registered in Shanghai. This type of transaction will involve multiple regional authorities, each of which may have their own requirements and interpretation of the sequence of approvals needed. It is therefore important for the parties to establish early communication with the relevant local authorities in order to coordinate the approval sequence of the transaction and avoid any resulting delay to the share swap approval process.
In general, the application materials to be prepared by the parties include the following:
- the application form;
- the share-swap agreement;
- the evaluation report on the shares to be used for the share-swap; and
- the legal opinions.
However, the specific checklist of the application materials must always be confirmed with the MoC as well before proceeding as they may ask for other supporting documents.
When the application documents and any supporting documents have been prepared and submitted to the MoC, the approval procedure normally takes 1 month.
After obtaining the MoC’s approval, the parties should continue with other company approvals which may be necessary (for example, business licence applications, changes to shareholder name and articles, etc.) depending on the type of share swap transaction in question.
2.1.5 Indirect acquisition of domestic enterprise
It is worth noting separately that, in the event that the business of the target company belongs to the industries where the foreign investors are “allowed” or “encouraged” to participate in, a foreign investor who uses its domestic FIE as the acquiring company of the shares in the target domestic company does not require MoC approval anymore.
Clearly, using this transaction structure improves the transaction efficiency and simplifies the application process.
2.2 Capital contribution / consideration by the shares in offshore company
As noted earlier, with respect to whether a foreign investor is allowed to use its shares in an offshore company as consideration, the PRC law keeps silent on this issue except that a foreign investor is allowed to use shares in an offshore listed company in transaction that is structured as a “foreign-funded acquisition”. Examples of such foreign-funded acquisition are:
- the foreign investor purchases the shares from a non-FIE in China;
- the foreign investor prescribes the capital increment from a non-FIE in China;
- the foreign investor purchases and operates the assets from a non-FIE in China, via its domestic FIE;
- the foreign investor purchases the assets from a non-FIE in China and use such assets to establish a FIE for operation.
Generally, the following approvals are needed for a foreign-funded acquisition where shares in offshore listed company are used as consideration:
- foreign-funded acquisition approval
It is required that all the foreign-funded acquisition where shares in offshore listed company are used as consideration shall be approved by the national-level MoC, and the investors are required to engage a PRC-domiciled financial advisor to conduct due diligence, and issue due diligence report, against the offshore listed company.
- offshore investment approvals
If the acquisition is approve by MoC, since the target company is going to hold stake in an offshore company, the target company shall apply for the relevant outbound investment approvals (e.g. NDRC approval, MoC approval, and SAFE approval).
However, in practice, this kind of share swap transaction is rarely approved by the MoC and therefore foreign investors are unlikely to consider this as a viable transaction structure. So far, there have been only a couple of major state-owned enterprises obtaining the MoC’s approval for such a transaction, and their applications related to internal shareholding restructurings (i.e. the shares held by the state-owned enterprise in any listed offshore company undertake a share-swap with the shares held by the state-owned enterprise in its domestic funded company).
3. Special tax treatment
A transaction structured as a share swap will frequently lead to tax considerations, for example, in respect of the appreciation of the value of the shares used for the share swap.
With respect to this tax issue, a foreign investor may consult with its financial advisor, in particular, to confirm whether the relevant transaction satisfies all the conditions for “Special Tax Treatment”. If the “Special Tax Treatment” applies, the investor would be temporarily exempted from paying the related tax owing to the appreciation of the value of the shares used for the share swap.
It is worth noting that, the application of “Special Tax Treatment” shall be approved by the relevant local tax bureaus of both the target company and the company in which the shares are used as consideration, and in practice, even if all the criteria were met, it’s still possible that the tax bureau of the company in which the shares are used as consideration rejects to issue “Special Tax Treatment” approval due to the application of “Special Tax Treatment” would cause the reduction on the local tax revenue, especially for cross-province transactions.