The foreign exchange control regime in China has been changing rapidly in recent years, and this has generally facilitated cross border financing arrangements. On May 12, 2014, the State Administration of Foreign Exchange (SAFE) issued the Provisions on Foreign Exchange Administration of Cross-border Security and its Operating Guidance (Circular 29) which is another step forward. Before Circular 29, the legal definition of “cross-border security” did not exist although similar concepts like outward security provisions are frequently touched upon by foreign debt related regulations. By clearly defining the scope of cross-border security and abolishing twelve existing regulations, Circular 29 provides more solid legal basis for cross-border security arrangements and largely streamlines foreign exchange control over such activities. Below is a snapshot of the key highlights which international operations should bear in mind.
Scope of Application
The scope of cross-border security arrangements as defined under Circular 29 is very broad. From a legal point of view, a security arrangement will normally involve three parties, namely the creditor, debtor and security provider. The debtor may sometimes be the security provider at the same time (e.g. mortgage or pledge of its own property). When the security is enforced, funds will first flow from the security provider to the creditor and the security provider will have recourse against the debtor. Now under Circular 29, a cross border security arrangement will be established if any of the aforesaid elements is located abroad which might finally result in cross-border flow of funds or cross-border transfer of asset ownerships.
On the basis of such a broad definition, Circular 29 provides for very detailed rules to regulate the two types of cross-border security arrangements below which are most common in practice
- Nei Bao Wai Dai: security provided by an onshore entity covering an offshore lending between the offshore borrower and the offshore lender;
- Wai Bao Nei Dai: security provided by an offshore entity covering an onshore lending between the borrower and lenders both onshore.
Nei Bao Wai Dai (NBWD)
In the past, the security part of a NBWD arrangement was regulated by rules regarding provision of outward security. For the Chinese subsidiary of a foreign company (i.e. the so-called WFOE), the conclusion of a contract to provide security for its foreign affiliates did not require approval of SAFE (but only post-signing filing). As of 2010, control in this regard was tightened and complicated formalities started to apply to each step of the transaction, including prior-approval as a precondition to effect security contract, security contract registration requirement, prior-approval before security enforcement, and registration of the outward claim resulted from enforcement of the security. The cumbersome rules made it difficult for a company in China to support financing of its overseas affiliates, in particular when the China operation is cash rich while the overseas operation is cash poor.
Circular 29 now substantially streamlines administrative procedures and formality requirements. As of June 1, 2014, for a NBWD deal, only filing procedures with SAFE remain for companies (excluding banks), which apply to conclusion of the security contract and the recourse of the onshore security provider against the offshore borrower resulted from a debt-default case. More importantly, failure to register the security contract in time does not necessarily make the contract invalid, which shows a very positive development in SAFE’s attitude towards transactional freedom. On the other hand, Circular 29 still stresses control over NBWD activities, which include
- use purpose of the loan under a NBWD arrangement is regulated. Generally speaking the loan is supposed to be for normal business operational use, and use purpose such as “speculation or arbitrage” is explicitly prohibited;
- if there is any materialization of the security due to default of the offshore borrower which is not yet settled, entering into a new NBWD arrangement by the onshore security provider shall require approval from SAFE.
Wai Bao Nei Dai (WBND)
WBND is not a new concept under Circular 29. Many international companies were already using similar concepts to provide financing support to its China operations, which were normally implemented with big banks having an international network whilst the security was provided by the foreign head office to the foreign branch of a Chinese bank. On May 13, 2013, SAFE issued the Administrative Measures for Foreign Debt Registration which further facilitated WBND arrangements by reducing formality requirements. For a foreign investment enterprise (FIE), the only required procedure is to register the claim of the offshore security provider against the onshore borrower when the security is materialized due to default of the onshore borrower.
Now, Circular 29 further relaxes control over WBND arrangements involving a FIE, in particular with regard to the so-called “foreign debt quota” exhaustion which has an impact on the FIE’s financing competence. In the past, whenever the security under a WBND arrangement was materialized, the foreign debt quota of a FIE would be exhausted. Such quota is the maximum a FIE may borrow from abroad and equates to the gap between its approved total amount of investment and its registered capital (“ToI/RC Gap”). This in return will reduce the room for the FIE to receive financing support from abroad (e.g. as shareholder loan from its mother company). Circular 29 now gives more buffering in this regard. If kept less than the FIE’s net asset value in the preceding year, the debt generated due to materialization of security under WBND (excluding interest part) will not count to exhaust the ToI/RC Gap. Since materialization of security is caused by breach of the borrowing arrangements under WBND, a certain impact still remains. i.e. before settlement between the FIE and the security provider under WBND, the FIE will not be permitted to further withdraw funds under the borrowing arrangement or to enter into new WBND arrangement, unless otherwise approved by SAFE.
Circular 29 shows another steady step of SAFE towards liberalization. For cross-border security arrangements, SAFE streamlines its control mechanism by considering the contingent nature of such arrangements. The focus is no longer on the establishment of such arrangement which does not necessarily result in flow of funds into or out of China, but instead on the later stage when the security is materialized creating cross border claims. This provides much more flexibility for international companies to structure financing arrangements for its operations in China. Although certain control still remains which needs to be considered, the whole foreign exchange control regime becomes much more transparent and easier to understand. Since there is still some distance to go before China fully opens up its capital account, rules and regulations in this area are expected to undergo quick and constant changes in the near future, in particular considering the general picture of further opening-up and reform of the country. Foreign companies operating in China will need to keep a close eye on related developments which might make new business models possible from time to time.