Recent draft rules issued for public comment aim to clearly permit investors to inject equity as the registered capital of a foreign-invested enterprise ("FIE").

The recent draft rules circulated by the PRC Ministry of Commerce ("MOFCOM") are the Measures on the Administration of Capital Contribution with Equity Interests concerning Foreign-invested Enterprises (for public consultation) ("Draft Measures"). Comments must be received by MOFCOM by 20 May 2011.

Background

While the Company Law permitted capital contributions in the form of equity interests from 1 January 2006, it did not become a nationwide practice until after the State Administration of Industry and Commerce's implementing rules ("AIC Measures") became effective on 1 March 2009. The problem for FIEs, however, was that the AIC Measures did not expressly state that they applied to capital contributions made to FIEs.

The Draft Measures are intended to clarify the requirements and procedures for making equity contributions to FIEs. Once issued, the Draft Measures should also unify the various practices in different localities.

Three types of transactions

The Draft Measures would permit, subject to approval from MOFCOM or its provincial-level branch, foreign and domestic investors to contribute certain equity interests for the purpose of:

  • establishing a new FIE
  • increasing the registered capital of a domestic enterprise and thereby converting it into an FIE
  • increasing the registered capital of an FIE and thereby changing the shareholding structure of the FIE

Qualified equity interests

According to the Draft Measures, only equity interests in another Chinese company ("Equity Company"), including limited liability companies and companies limited by shares, may be contributed as registered capital of FIEs. The equity interest being contributed must be legally transferrable and free from encumbrances. The party contributing the equity must be the full beneficial owner.

Under the Draft Measures, equity interests cannot be contributed if:

  • the registered capital of the Equity Company is not fully paid up;
  • the equity interests have been pledged or frozen;
  • the equity interests are not transferrable according to the articles of association of the Equity Company;
  • the Equity Company, if an FIE, failed to participate or pass the FIE joint annual inspection of the preceding year;
  • it is equity of a foreign-invested holding company or foreign-invested venture capital enterprise;
  • regulatory approvals required for equity transfers have not been obtained; or
  • the transfer of the equity interests is prohibited pursuant to relevant laws and regulations.

In addition, the equity contribution to an FIE will not be approved if it would result in:

  • cross shareholdings between the Equity Company and the target FIE; or
  • a violation by the Equity Company, the target FIE or their subsidiaries of the Foreign Investment Industrial Guidance Catalogue and other foreign investment policies.

Foreign investors must submit, as part of the application materials, a legal opinion issued by a PRC law firm to verify the transferability and qualification of the equity interest.

Valuation of equity interests

The Draft Measures would require the equity being contributed to be valued by a qualified valuation institution in China. The Draft Measures would then require the current and potential shareholders of the target FIE to negotiate and determine:

  • the value of the equity interest ("Deemed Value"), based on and capped at the valued amount; and
  • the amount to be contributed to the target FIE's registered capital ("Contribution Value"), which should not exceed the Deemed Value.

That part of the Deemed Value which exceeds the Contribution Value can be allocated to capital reserves of the target FIE. Contributed equity, together with any other non-monetary capital contribution, should not exceed 70% of the target FIE's registered capital post-completion.

For example, consider that an investor wants to become a partner in an existing FIE. The parties agree that the new investor will contribute the entire equity in another FIE (the Equity Company) in exchange for a 50% interest in the target FIE. The new investor must contribute RMB8.5 million (Contribution Value) of registered capital for the 50% interest in the target FIE. The Equity Company is valued at RMB10 million, and the parties agree a valuation of RMB9 million (Deemed Value). Here the parties can either (i) increase the percentage ownership to be taken by the new investor to approximately 54%, (ii) agree for the new investor to contribute only 94.4% of the equity in the Equity Company, or (iii) agree for the new shareholder to contribute the full RMB9 million with the excess of RMB500,000 being allocated to the target FIE's capital reserves. In this third situation, the new investor may wish to seek compensation from the existing investor.

Timing of contributions

Under the Draft Measures, the investors of a newly-established FIE would have up to one year from issuance of the target FIE's new business licence to complete the contribution of the equity interest. This is the same rule as under the AIC Measures.

For increases of registered capital, however, the Draft Measures and the AIC Measures provide different timing. The Draft Measures again allow for up to one year from issuance of the target's business licence to complete the equity transfer. However, the AIC Measures require the equity contribution to be completed prior to an application for registration of the registered capital increase. It remains to be seen how these two Measures will apply to the cases where equity contribution is made to a domestic company for the purpose of converting it into an FIE.

Following the actual contribution, the Draft Measures would require various registrations to be adjusted.

Foreign debt limitations

One significant limitation on the contribution of equity as registered capital is that the Draft Measures seek to exclude the contributed equity when calculating foreign debt quotas based on registered capital and total investment. This could severely limit the ability of an FIE to borrow money from overseas if it has been established with a significant portion of its registered capital being contributed in the form of equity. Equity contributed as registered capital would also be disregarded when calculating an FIE's quota for duty-free importation of equipment.

For more information on the relationship between registered capital, total investment and foreign debt, please see Section 18 of the Herbert Smith China investment guide.

Looking Forward

Pending issuance of the final rules, the Draft Measures offer welcome clarification of the contribution of equity as registered capital of an FIE. In the meantime, while the contribution of equity may relieve an investor's cash flow burden, the process of contributing equity as registered capital in another FIE will continue to involve greater uncertainty and a lengthier approval process.