China's foreign exchange regulator, the State Administration of Foreign Exchange ("SAFE"), recently issued the Circular on Further Improving and Adjusting Foreign Exchange Administration Policies on Direct Investment (国家外汇管理局关于进一步改 进和调整直接投资外汇管理政策的通知, Hui Fa  No. 59, "Circular 59"). Circular 59, which became effective on 17 December 2012, relaxes controls on cross-border foreign exchange flows in connection with foreign direct investments into China ("FDI"), as well as facilitating Chinese outbound investment.
To put this development into context, Circular 59 can be seen as a major overhaul of China's foreign exchange regime, which was established in the 1990s when China was hungry for foreign capital and had very low foreign exchange reserves. Fast forward through 20 years of rapid economic development, and China has now become the holder of the largest foreign exchange reserves in the world. China is also making determined efforts to 'internationalize' its currency, the Renminbi1. It was perhaps felt time for China, having handed our power to a new generation of leaders, to move away from the strict controls that were more suited to an earlier era and to focus more on facilitating inbound and outbound commerce and investment in a difficult international economic environment.
Traditionally, China has divided cross-border payments into two categories, one for 'current account' items which refer to trade and other recurring transactions, and the other for 'capital account' items which basically cover equity investments and loans/debts. Under the existing regime, China imposes strict restrictions on capital account transactions, which are subject to SAFE approval both for the opening of the account, as well as for fund movements within such an account. Current account items are liberalised and hence SAFE's pre-approval is generally not required; payment can normally be processed directly by a designated foreign exchange bank2 subject to performing checks to confirm that there is a genuine and lawful underlying transaction.
Circular 59 reflects SAFE's intention to gradually relax restrictions on capital account transactions, and more broadly the trend towards the type of lighter touch regulation applicable to current account transactions. For instance, Circular 59 abolishes the original requirement for SAFE approval under certain circumstances, streamlines the processes by reducing documentary requirements and shortening timelines, and eases restrictions on the use of capital for direct investment purposes. As will become clear from the analysis below, SAFE will primarily require the relevant transaction information to be registered with it rather than approval of the transaction, and commercial banks will play an increasingly important role in the process. It will be the banks, not SAFE that will review specific documents to ensure that the proposed flow of foreign exchange is necessary and justified. In addition, they will file details on the cases they handle in the uniform database system (the "SAFE System"), so that SAFE can oversee and use such information for statistical purposes. All in all, Circular 59 marks yet another important step on the road towards the long-term goal of liberalisation of conversion out of, or into, the RMB on the capital account, including for FDI and outbound investment transactions.
This article discusses certain changes brought about to China's foreign exchange control regime by Circular 59, and analyses in detail how they may facilitate both inbound investment to China and outbound investment from China.
I. Summary of Key Changes
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II. Asset Realization Accounts (资产变现账户"ARAs")
Circular 59 provides for two types of ARAs: one for realization of onshore assets (境内资产变现账户"Onshore Asset ARAs") and the other for realization of offshore assets (境外资产变现账户"Offshore Asset ARAs"). The opening of, changes to, cancellation of, or the remittance of foreign exchange funds into, an ARA no longer requires SAFE's pre-approval. Previously each of these items was subject to such pre-approval. For domestic sellers (whether a company or an individual) selling onshore or offshore assets to foreign investors, this means that a bank designated by SAFE to handle foreign exchange matters (a "Bank") can, based on the relevant information or form recorded in the SAFE System3, directly open, change or cancel an ARA, and accept remittances of foreign exchange funds into such account (subject to the inflow quota recorded in the SAFE System in the case of an Offshore Asset ARA).
For any given transaction for the transfer of onshore equity interests, a domestic seller can only open one ARA. SAFE no longer requires this ARA to be opened in the seller's locality. When the foreign investor remits the consideration from an offshore account into such ARA, the seller's Bank should, on the strength of the Equity Transfer Information Registration Form recorded in the SAFE System, accept the remittance and report the arrival of the remittance to the SAFE System, which will then automatically confirm the capital contribution made by the foreign investor in respect of the target equity interests ("Capital Contribution Confirmation"). The ARA funds cannot be used until the Capital Contribution Confirmation is issued.
The funds held in an ARA can be used to make payments under current account transactions (subject to the Bank checking to confirm that the underlying transaction is lawful and genuine) as well as capital account transactions approved by, or registered with, SAFE. The foreign currency funds can also be converted into RMB. However, if the ARA owner is a company, conversion should follow the same rules as are applicable to conversion within foreign exchange capital accounts for Foreign Invested Enterprises ("FIEs"). Essentially, this means a corporate ARA owner needs to follow Circular 142 of 20084 for purposes of conversion: it must present payment instructions and documentary proof confirming use of proceeds (e.g., a purchase contract) when applying for conversion into RMB. If the account owner is an individual, however, conversion of foreign exchange into RMB only requires a tax clearance certificate.
In addition, Circular 59 also allows transfer of the funds in an ARA to the following types of accounts (without conversion into RMB) based on actual needs and premised on a genuine and lawful underlying transaction: special guarantee accounts for receiving remittances within China (境内划入保证金专用账户), domestic reinvestment special purpose accounts (境内再投资专 用账户), entrusted loan accounts (委托贷款账户), cash pooling accounts (资金集中管理专户), outbound lending special purpose accounts (境外放款专用账户), and principal-protected money management special accounts (保本型银行理财专户).
Compared with the previous rules regarding SAFE's control over asset realization accounts, Circular 59 has materially eased restrictions on the use of ARAs and delegated more power to Banks. Furthermore, it substantially streamlines the documentation required to be submitted to Banks or filed with SAFE, such that Banks will rely on the SAFE System more than ever. The SAFE System will save applicants time and avoid re-submission of the same documents for different pre-approvals at different stages. For example, under the previous rules, the opening of, change to, cancellation of, and remittance of funds into, a foreign exchange account were all subject to SAFE pre-approval. Each of these items could take up to 20 working days under the relevant rules. If the consideration for the target assets were paid in multiple instalments, the remittance of each instalment into the account would require a separate SAFE pre-approval, which would obviously prolong and delay the whole transaction completion process. Circular 59 repeal the requirement for SAFE pre-approval for each of these items.
Circular 59 also makes it easier for individual Chinese sellers to convert foreign exchange funds in an ARA. Prior to the promulgation of the SAFE Circular on Issues relevant to Further Clarification and Standardization of the Administration of Certain Foreign Exchange Matters regarding Capital Accounts (国家外汇管理局关于进一步明确和规范部分资本项目外汇业务管 理有关问题的通知, Hui Fa  No. 45, "Circular 45") on 9 November 2011, conversion of foreign exchange (whether owned by a domestic individual or a domestic capital company) was subject to the same rules as are applicable to conversion of foreign exchange in capital accounts of FIEs. The previous rules did not differentiate between company account owners and individual account owners, which made the conversion of funds in an ARA5 owned by an individual equally difficult.
Following Circular 142 of 2008, an individual seller would also be required to submit documentary proof confirming use of proceeds (e.g., a purchase contract) and justify each disbursement by official tax receipts issued by the goods or services vendor (Fapiao) in connection with its application to convert foreign exchange into RMB. As a result, if an individual seller did not have a specific plan on how to spend the converted RMB, he would not be allowed to convert his sales proceeds into RMB. Under Circular 45 and as confirmed by Circular 59, as long as the individual owner of an ARA has obtained the required foreign exchange registration form and a tax clearance certificate for the equity transfer, he or she may apply to the Bank for conversion of foreign exchange received in the ARA without having a specific plan on how to spend the RMB funds derived from the conversion. Under Circular 59, upon the Capital Contribution Confirmation and obtaining of the tax clearance certificate by the individual owner of an ARA, such owner may apply to the Bank for conversion of foreign exchange in the ARA without submitting any Fapiao. In other words, Circular 59 and related rules make it easier for individual sellers to convert sales proceeds and keep RMB as long as they have paid the requisite taxes.
III. Foreign Exchange Accounts for Upfront Expenses ("Expense Accounts")
Foreign investors are allowed to open an Expense Account (前期费用外汇账户) in China to cover upfront costs before they set up an FIE. According to Circular 59, an Expense Account is used to deposit a foreign investor's money to fund all types of upfront expenses in relation to direct investment activities in China. Under Circular 59, as long as a foreign investor files a Foreign Direct Investment Foreign Exchange Registration Form (外商直接投资外汇登记业务申请表) with SAFE, together with the FIE name reservation approval, and is granted a quota on the inflow of upfront expenses (in foreign currency) by SAFE, the following items will no longer require any SAFE pre-approval: the opening of, changes to and cancellation of an Expense Account, and payments into such account.
Compared with the previous rules, Circular 59 also relaxes SAFE controls on the use of foreign exchange funds in an Expense Account from the following two angles: (i) conversion of funds no longer requires SAFE pre-approval (in the past, such preapproval was required and only granted on a case-by-case basis), rather, the Bank can directly carry out the conversion applying the same rules as are applicable to the conversion of foreign exchange in capital accounts of FIEs; and (ii) transfer of such funds into the foreign exchange capital account of an FIE established by the same foreign investor no longer requires SAFE pre-approval (in the past, such pre-approval was required and only granted on a case-by-case basis), rather, the Bank can directly transfer the funds after carrying out a review of the documentation. This will facilitate the capitalization of expenses incurred by foreign investors prior to incorporation of an FIE.
Furthermore, for any FDI project, Circular 59 has generally increased the inflow quota of upfront expenses from USD 100,000 (or 5% of the contemplated total investment amount) to USD 300,000, and allows local SAFE to further increase the quota on a case-by-case basis. In line with prior practice, upfront expense funds which have been remitted in and spent can be capitalized when the FIE is established. However, foreign investors were always concerned about the requirement for SAFE's pre-approval each time conversion or transfer of funds in upfront expenses accounts was needed. Many foreign investors wanted to capitalise their upfront expenses, but abandoned the idea due to the time-consuming SAFE approval procedures. Now, Circular 59 grants more authority to Banks to carry out conversion and transfer of funds into Expense Accounts more efficiently on the one hand, and substantially streamlines the SAFE procedures on the other hand. It can be anticipated that foreign investors will now find it much easier to capitalize upfront expenses than before.
IV. Re-investment in China
Overall, regulation on re-investment of proceeds from existing FDI projects is significantly relaxed under Circular 59.
- Re-investment by Foreign Investor
SAFE approval for re-investment by a foreign investor using its returns on an earlier investment is no longer required. Under Circular 59, if a foreign investor wants to re-invest its returns derived from an FIE (such as capital reserve, surplus reserve, and undistributed profits) back into such FIE, it should go through the following steps:
- Registration of re-investment with SAFE;
The FIE registers the relevant information about the proposed re-investment by the foreign investor (which has been approved by the Ministry of Commerce or its local authorised organ with SAFE;
- Opening of Domestic Re-Investment Special Account
The FIE proceeds to open a Domestic Re-Investment Special Account (境内再投资专用账户) with the Bank, and the Bank opens such account (only one such account can be opened) based on the information previously registered with SAFE;
- Transfer of re-investment amount
The Bank transfers (划转) the re-investment amount (which has been pre-registered with SAFE) from the FIE's Capital Account (资本金账户) to its Domestic Re-Investment Special Account (境内再投资专用账户);
- Verification of re-investment
The accounting firm in China engaged by the foreign investor verifies the above re-investment by the foreign investor after checking with SAFE and the Bank, and issues an Investment Verification Report (验资报告), which attests to the fact that the foreign investor has indeed contributed the re-investment amount to the FIE.
This new procedure under Circular 59 is much more straightforward as compared to the original SAFE approval process. In the past, the FIE would have to obtain approval (rather than mere registration mentioned in Step (i) above) from SAFE for the proposed re-investment by the foreign investor. This is a significant change, in that while the approval process is relatively complex, registration is fairly straightforward.
First, registration is a procedural rather than a substantive process. For the registration, SAFE will probably not review from a substantive perspective. Under the original approval procedure, SAFE would scrutinize an application based on its substance.
Second, the registration typically only involves submission of an application form. This contrasts to the relatively burdensome documentation requirements for approval. If approval were to be required, the FIE would have had to have submitted a considerable amount of documentation, such as an application letter, a board resolution of the FIE, the foreign investor's written confirmation of its intention to re-invest, the FIE's most recent annual audit report and capital verification report, and the tax clearance for the foreign investor for the purposes of making the re-investment.
More importantly, timing wise, registration generally only takes up to five business days for SAFE to process if the application package is complete. In contrast, SAFE would normally have taken 20 business days to process an application for approval.
- Re-investment by FIE Investment-type Companies
Another highlight of Circular 59 is the change in the rules for foreign invested holding companies (外商投资性公司), foreign invested venture capital investment enterprises (外商投资创业投资企业), foreign-invested equity investment enterprises (外商投 资股权投资企业), and other foreign invested companies whose main business is investment (together referred to as "Investment Companies" below). Circular 59 significantly facilitates capital flows between an Investment Company and its portfolio companies by abandoning the requirement for SAFE approval in certain situations.
For example, a portfolio company wholly owned by an Investment Company no longer needs to register with SAFE and obtain a foreign exchange IC card from SAFE, while previously it had to do so (like a typical FIE). Rather, to receive re-investment by the Investment Company, it only needs to register information relevant to the proposed investment with SAFE and then open a Domestic Re-Investment Special Account with the Bank (as discussed in Steps (i) and (ii) above). The simplified registration process will take up to five business days while the previous registration process could take as long as 20 business days. In this regard, the Investment Company is treated like a Chinese shareholder of the portfolio company, and the portfolio company is treated differently from a typical FIE which is directly owned an offshore investing entity.
In addition, certain capital flows between the Investment Company and the portfolio company no longer require SAFE approval. In contrast to the previous position, a Bank can now process (1) capital contributions by the Investment Company to the portfolio company; and (2) transfer of the returns on investment attributable to the Investment Company (e.g., profits, dividends, premiums) from the portfolio company to the Investment Company without SAFE approval.
Moreover, the accounting firm engaged by the Investment Company does not need to make enquiries with SAFE to verify the authenticity of the capital contribution from the Investment Company; instead, the accounting firm can simply undertake verification by checking the payment records with the Bank. By way of comparison, in the case of investment from a typical offshore investor, the accounting firm would need to enquire with both the Bank and confirm the outcome of those enquiries with SAFE in order to carry out verification of the offshore investor's capital contribution.
The de-regulation with respect to Investment Companies is welcome because it will make re-investment by Investment Companies in China less burdensome than before. It also means these types of companies will become more attractive as investment vehicles to foreign investors. Presumably the rationale behind such relaxation is that the capital inflows to an Investment Company have already been monitored in the first place when the foreign currency capital was originally remitted in from overseas to the Investment Company, so the Investment Company's subsequent use of money to invest into portfolio companies and receipt of returns from portfolio companies should not be subject to repeated scrutiny.
V. Outbound Investment
- Upfront Expenses for Outbound Investment
Circular 59 also simplifies the procedures for outbound investments by Chinese companies. Under Circular 59, SAFE approval is no longer required before a Chinese company can remit upfront expenses for its contemplated outbound investment. Instead, the Chinese company only needs to register limited information about the proposed outbound investment, purchase foreign currency from a Bank, and remit the foreign currency through the Bank to the investment destination country.
This significantly reduces the burden on a Chinese company planning an outbound investment by lifting the requirement for SAFE approval. As noted above, registration of SAFE and dealing with the Bank as contemplated under Circular 59 is a much easier procedure than the original procedure for obtaining SAFE approval.
First of all, registration with SAFE would be a procedural matter, while the original SAFE approval involves substantive review by SAFE.
Furthermore, the documentation burden is substantially reduced. More specifically, in order to receive SAFE approval under the previous position at law, the Chinese company had to submit quite a few documents with regard to the proposed transaction (e.g., a letter of intent, memorandum, or framework agreement with the foreign party, the Chinese company's written undertaking that the foreign currency to be remitted will indeed be used as upfront costs). These documents were sometimes difficult to obtain, especially when they were not yet in place. For example, if a Chinese investor needed money at a very early stage (e.g., negotiations, on-site visits), at which time even a preliminary document (e.g., letter of intent) between the parties was not yet in place, it was not possible to get approval.
Furthermore, the lead time for payment has been significantly reduced. The SAFE registration only takes up to five working days, but it would typically have taken up to 20 working days for SAFE to process an application for approval.
- Loans Extended by Domestic Entities to Their Affiliated Offshore Borrowers ("Outbound Loans")
Circular 59 eases SAFE controls on Outbound Loans. It allows a domestic Chinese corporate lender to use the foreign exchange loans contracted onshore to extend Outbound Loans to its offshore affiliates. It also allows an FIE to extend Outbound Loans to the FIE's offshore parent company, provided that the principal amount may not exceed the aggregate of the dividends declared but not yet remitted to the borrower and the undistributed dividends to which such borrower is entitled. This poses an interesting conundrum as to the underlying legality of this, given that lending between corporates in China where the lending party is not set up as a financial institution (i.e. with 'lending' in the lending party's business scope) is still prohibited. Presumably that is not seen by SAFE as a SAFE issue.
Circular 59 also repeals the requirement for SAFE pre-approval on payments into an Outbound Loan Special Account ("OLSA") and the remittance of OLSA funds to an offshore borrower. Once the lender completes the registration procedures with SAFE regarding the quota on Outbound Loans, it may apply to its Bank for opening an OLSA. Afterwards, the Bank may directly carry out the procedures for crediting the foreign exchange funds purchased by the lender for the purpose of extending Outbound Loans into this account, without requiring any SAFE pre-approval. When processing the remittance of OLSA funds to the offshore borrower, the lender's Bank will only look to the SAFE registration regarding the lender's quota on Outbound Loans and the lender's foreign exchange registration certificate. When the offshore borrower repays the Outbound Loan, the Bank will check whether the sum remitted back to the OLSA has exceeded the principal amount already extended plus agreed interest, without requiring any SAFE pre-approval.
In terms of the qualification for granting Outbound Loans, Circular 59 adopts the basic principles set forth in the Circular on Issues regarding the Administration of Foreign Exchange in Cross-Border Loans Granted by Domestic Enterprises (关于境内企业境外放款外汇管理有关问题的通知, Hui Fa  No. 24, "Circular 24") issued by SAFE on 9 June 2009 and effective as of 1 August 2009, except that Circular 24 requires the offshore borrower to be a subsidiary of the onshore lender.
In terms of the quota on Outbound Loans extended by an onshore lender to its offshore subsidiary, Circular 59 also follows Circular 24. Namely, the quota should not exceed (i) 30% of the equity interests held by the lender in the borrower or (ii) the registered outbound investment amount that the lender commits to contribute to the borrower. Circular 59 allows local SAFE to approve a quota over such limit on a case-by-case basis, while Circular 24 would have required the approval of central SAFE under such circumstances. Similar to the previous rules, a change to, or cancellation of, the quota still requires SAFE preapproval under Circular 59.
Compared with Circular 24, Circular 59 substantially streamlines the SAFE procedures in connection with extending Outbound Loans. SAFE control seems to be now shifting in the direction of regulating the approval of quotas on Outbound Loans, with actual remittance and payment matters being left to the Banks.
VI. Round-Tripping Investments
Circular 59 and the SAFE operating rules issued thereunder substantially adopt the Operating Procedures concerning the Foreign Exchange Administration of Company Financings and Round-Tripping Investments by PRC Residents through Overseas Special Purpose Vehicles (境内居民通过境外特殊目的公司融资及返程投资外汇管理操作规程, Hui Fa  No. 19, "Circular 19") issued by SAFE on 20 May 2011 and effective as of 1 July 2011, except for the following main changes:
- Circular 59 no longer requires a separate "approval for the crediting of revenue generated through equity changes earned by a PRC individual resident from a special purpose vehicle ("SPV")" (境内居民个人从特殊目的公司获得的 资本变动收入入账核准) set forth in Circular 19. Rather, the PRC individual resident only needs to complete the foreign exchange amendment registration relating to the SPV established by him/her before the revenue can be remitted back to China. Once the foreign exchange amendment registration is done, the SAFE System will record the quota on revenue which can be remitted back to China, and the said individual can then apply to the Bank for opening an Offshore Asset ARA and crediting of such revenue within the approved quota;
- Circular 59 differentiates between "round-tripping investments made by a non-SPV of an institution" (机构非特殊目 的公司返程投资) and "round-tripping investments made by a non-SPV of an individual" (个人非特殊目的公司返程 投资), while Circular 19 generally uses "round-tripping investments by a non-SPV" without distinction (非特殊目的 公司返程投资);
- Circular 59 no longer requires separate foreign exchange registration relating to the establishment of PRC enterprises or mergers and acquisitions involving PRC enterprises by SPVs. Rather, this type of registration is now partially absorbed by the foreign exchange registration system for newly-established FIEs and partially absorbed by the foreign exchange registration of FIEs through mergers and acquisitions of domestic enterprises by foreign investors. Such separate registration was required for SPVs under the Acquistions of Domestic Enterprises by Foreign Investors Provisions (关于外国投资者并购境内企业的规定), as amended on 22 June 2013 ("M&A Rules") and the Notice on Relevant Issues concerning Foreign Exchange. Administration of Corporate Financing Through Offshore SPVs and Round-tripping Investments of Chinese Residents (关于境内居民通过境外 特殊目的公司融资及返程投资外汇管理有关问题的通知), issued by SAFE on 21 October 2005 ("Circular 75"); and
- Circular 59 reiterates the requirement for SAFE pre-approval on the purchase and payment of foreign currency by PRC individual residents when they need foreign currency to buy back shares of SPVs controlled by them and listed offshore or to privatize SPVs, as set forth in the Reply on Issues concerning Foreign Exchange Administration of Operations relating to the Singapore-listed CentraLand Limited's Privatization (关于新加坡上市公 司中部大观地产有限公司退市操作有关外汇管理问题的批复, Hui Zong Fu  No. 137) issued by the General Affairs Department of SAFE on 21 November 2011 and effective as of the same date. As a result, Circular 59 would not help companies that plan to achieve offshore listing by way of the so-called Slow Walk Arrangements ("SWA"), which are designed to circumvent registration required under Circular 75. Under a SWA structure, the PRC founders would transfer equity in their Chinese business to an offshore SPV owned by a third party, and then gradually acquire and increase their interest in such SPV, by way of a call option or other arrangement. This structure would arguably avoid being identified as a round-trip investment, as the PRC founders did not own the SPV at the time of transfer of equity in the domestic Chinese company to the SPV, thus not subject to the registration and approval requirements under Circular 75 and M&A Rules. As Circular 59 continues to require SAFE approval on the purchase and payment of foreign currency by PRC individuals to buy back shares of SPVs, this highlights the risks associated with the SWA structure.
Like Circular 19, Circular 59 and the SAFE operating rules issued thereunder cover foreign exchange registration of SPVs established by PRC individual residents, the amendment, cancellation and retrospective registration and other relevant issues.
Circular 59 marks another important milestone on the long road towards relaxing capital flows into and from China. It abolishes quite a few SAFE approval requirements, simplifies a number of formalities, and lifts some restrictions on the use of proceeds for direct investment purposes. In addition, it further delegates specific supervisory power to commercial banks and moves SAFE away from a less hands-on regulatory role scrutinizing every small step taken and more in the direction of an oversight role. It can reasonably be expected that going forward, Circular 59 will usher in further reforms in foreign exchange controls.