The Administration of Finance Leasing Companies Measures (the “CBRC Measures”) issued by the China Banking Regulatory Commission (“CBRC”) on 23 January 2007 became effective on 1 March 2007. In a June 2007 press release, the CBRC announced that it was currently reviewing applications by five commercial banks to establish finance leasing companies. There are currently two parallel regimes governing foreign direct investment in the PRC finance leasing industry:
- finance leasing companies established with the CBRC approval (“Financial Institution FLCs”) pursuant to the CBRC Measures; and
- foreign-invested finance leasing companies established with Ministry of Commerce (“MOFCOM”) approval (“MOFCOM FLCs”).
This article compares Financial Institutions FLCs and MOFCOM FLCs (collectively referred to as “FLCs”), and provides an overview of the effects forthcoming legal changes may have on the operations of FLCs.
Jurisdictional turf war or uncoordinated law-making?
The People’s Bank of China issued the first regulations on the establishment of FLCs on 30 June 2000 (“PBOC Regulations”). The PBOC Regulations did not expressly apply to foreign investors. In 2001, the MOFCOM‘s predecessor (the “MOFTEC”) issued regulations allowing foreign investors to establish FLCs. A few months after the issuance of these rules, the PBOC announced that foreign investors could apply to set up wholly foreign-owned or joint venture FLCs pursuant to the PBOC Regulations. However, no foreign-invested Financial Institution FLC has been established under the PBOC Regulations, and according to the CBRC, only six of the twelve FLCs established under the PBOC Regulations are still in operation. In contrast, more than 70 MOFCOM FLCs have been established so far, either under the previous MOFTEC Regulations or under the Administration of Foreign Investment in the Leasing Industry Measures (issued by the MOFCOM and effective since 5 March 2005, the “MOFCOM Measures”).
In April 2006, the National People’s Congress issued a second version of the Draft PRC Finance Leasing Law (the “Draft Law”) for comments. The Draft Law, which is expected to be promulgated by the end of 2007, contains rules on the establishment of FLCs and finance leasing contracts, which are largely borrowed from Article 2A of the US Uniform Commercial Code. The Draft Law would vest in the CBRC the power to approve FLCs. Shortly after this publication of the Draft Law, the MOFCOM expanded foreign investors’ ability to conduct finance leasing activities by issuing the Supplementary Regulation for Administration of Foreign Invested China Holding Companies (effective since 1 July 2006), according to which foreign-invested holding companies with “regional headquarter” status are no longer required to set up a finance leasing company to provide finance leasing business and are allowed to provide operating lease or finance lease products on their own account. Finally, the issuance of the CBRC Measures in January 2007 has cast serious doubt on the Draft Law eventually unifying the two parallel regimes.
A key difference between the CBRC and MOFCOM regimes is that the CBRC Measures mostly target large financial institutions instead of equipment manufacturers. Under the CBRC Measures, the main requirements are imposed on the company’s investors, which are either “Principal Investors” or “General Investors”, the former being subject to more stringent qualification requirements. Under the CBRC Measures, the Principal Investor must hold at least 50 per cent of the company’s registered capital. Only qualified domestic and foreign commercial banks, domestic and foreign leasing companies and “large enterprises registered in China and manufacturing goods suitable for financial leasing” can act as Principal Investor.
The reference to enterprises “registered in China” confirms that large manufacturing foreign-invested enterprises (“FIEs”) can act as Principal Investor under the CBRC regime. The removal of restrictions on inter-company investments by FIEs should allow large manufacturing FIEs to set up MOFCOM FLCs or act as Principal Investors of Financial Institution FLCs.
The CBRC Measures subject domestic and foreign commercial banks, leasing companies and large manufacturing enterprises seeking to act as the Principal Investor of a CBRC FLC to different qualification requirements. For acting as the Principal Investor of a CBRC FLC, a large manufacturer must comply with a number of conditions, including:
- having a business income of at least Rmb5 billion in the previous year;
- having been profitable for the last two years preceding the application; and
- having at least 80 per cent of its total business income deriving from sales activities.
It may take a few years before any of the foreign-invested banks recently approved (or to be approved) under the Foreign Invested Banks Regulations (issued by the State Council on 11 November 2006) can act as Principal Investor in a Financial Institution FLC. Under the CBRC Measures, banks seeking to act as Principal Investor must have been profitable in the last two consecutive years and must have assets of at least Rmb80 billion. In comparison, the requirements for establishing a MOFCOM FLC are more investor-friendly. These conditions include having total assets of at least US$5 million (app. Rmb38 million) and a minimum of three years experience in finance leasing.
Foreign Shareholding restrictions
The CBRC Measures and the MOFCOM Measures do not subject a foreign investor’s shareholding in an FLC to any cap. However, other provisions of PRC law will produce a similar effect. Take for instance the Civil Aircrafts Nationality Registration Provisions (issued on 21 October 1997), according to which an entity with a foreign equity interest exceeding 35 per cent cannot register an aircraft (and corresponding mortgages) on the PRC register. Likewise, a Chinese entity with a foreign equity interest exceeding 50 per cent cannot register vessels on the PRC register under the Vessels Registration Provisions (issued on 2 June 1994). A possible way to circumvent this restriction would consist in the foreign investor “splitting” its investment with one of its PRC subsidiaries.
Permitted business activities
The authorised business scope of each FLC vehicle is another key difference between the CBRC Measures and the MOFCOM Measures. Financial Institution FLCs have a much wider business scope than MOFCOM FLCs.
The CBRC Measures no longer allow Financial Institution FLCs to extend working capital loans to lessees or to provide guarantees. In the past, a number of Financial Institution FLCs established under the PBOC Regulations had their main business activities consisting in the extension of loans and the provision of guarantees, with limited financial leasing operations.
Another notable difference between the CBRC Measures and the PBOC Regulations is that the CBRC Measures no longer allow Financial Institution FLCs to pursue operating lease business activities. To some extent, this will not prevent FLCs providing products similar to operating leases. A carefully drafted hybrid lease presenting characteristics of both finance and operating leases could still fall under the ambit of finance lease in PRC law. MOFCOM FLCs can offer both operative and finance leases.
What is a PRC “finance lease”?
PRC law applies different standards for defining finance leases. For accounting purposes, finance lease in the “Enterprise Accounting Standard No.21 - Lease” (issued by the Ministry of Finance on 15 February 2006, “Standard No.21”) is the benchmark to be used for assessing whether a lease is a finance or an operating lease. Standard No.21 defines a finance lease as a lease under which all risks and rewards related to the ownership of the leased asset are transferred from the lessor to the lessee. Standard No.21 also provides that a lease will qualify as a finance lease in certain additional circumstances, such as:
- if the ownership of the asset is transferred at the expiry of the lease;
- if the finance lessee has the option to purchase the asset at the expiry of the lease;
- if the lease term covers most of the useful life of the asset; or
- if the total rents are approximately equal to the value of the leased asset.
Under Standard No.21, if the lease qualifies as a finance lease, the finance lessee will be allowed to enter the leased asset in its balance sheet and depreciate the leased asset as if it was the owner of such asset.
“Finance lease” is also defined in the CBRC Measures, the MOFCOM Measures, the PRC Contract Law (effective since 1 October 1999) and the Draft Law. Under the Draft Law, finance leasing is defined as a “business whereby a Lessor purchases property from a Supplier based on the Lessee’s selection (or approval) of Supplier and property, and, whereby the Lessor leases to the Lessee, pursuant to a finance lease, the right to possess and use the property in consideration of a lease payment for a minimum term of one year”. Generally, these definitions are less conclusive and clear than those of Article 2A of the US Uniform Commercial Code.
No accelerated depreciation
Accelerated depreciation, which allows more flexibility in matching repayments with the useful life of the asset, is expressly allowed under article 48 of the Draft Law. However, the Enterprise Income Tax Law (effective since 1 January 2008, “EIT Law”) does not allow accelerated depreciation. If accelerated depreciation is not allowed, the FLC will not be able to request a “balloon payment” (a higher rent early in the lease) mitigating its risk in the residual value of the leased asset. It will be interesting to see how the EIT Law restriction will dovetail with local rules. For instance, enterprises located in Tianjin are free to select the accelerated depreciation rate (up to 40 per cent the useful life of fixed assets except real estate property) and register their choice with the taxation authority.
Unpredictable regulatory environment
In addition to the CBRC Measures or the MOFCOM Measures, the FLC’s financial leasing operations will principally be governed by Chapter 14 of the PRC Contract Law, which governs the rights and obligations of lessors and lessees under financial leasing contracts. The Contract Law (and, when and if promulgated, the Draft Law) will apply to finance leasing operations conducted within China, with the exception of finance leasing of property to individuals or family units. Under PRC law, parties to a finance lease agreement involving a “foreign element” (for instance, a contract to which a foreign entity is a party) may choose the law applicable to the settlement of their contractual disputes. Parties to finance leases not governed by PRC law will have to consider PRC registration requirements if the leased property is located in or moves through China.
The Draft Law is expected to be promulgated before the end of 2007, although it is unclear whether it will take the form of a new law or an amendment to the PRC Contract Law. The Draft Law introduces new rules that will need to be considered in conjunction with the PRC Contract Law. In case of discrepancies between the Draft Law and the PRC Contract Law, it is unclear which one will prevail, since both will have been promulgated by the NPC.
Another example of regulatory uncertainty is the contradiction between the PRC Contract Law and the Draft Law on defaults under the finance lease. Under the Draft Law, if the Lessee fails to pay rent in accordance with the conditions of the finance lease agreement, the Lessee’s default must amount to 20 per cent of the total lease price for the Lessor to have the right to ask for the balance of lease rentals, or alternatively, terminate the finance lease agreement, repossess the leased property and ask the Lessee to compensate for losses suffered as a result of the late payment. This provision of the Draft Law conflicts with the PRC Contract Law, which does not impose conditions on the lessor’s right to ask for the entire lease payment. This provision also contradicts or cuts across standard “hell and high water clauses” whereby the Lessee must continue to pay the finance lessor whatever happens.
The CBRC and MOFCOM regimes serve different purposes, and there is room for them to coexist, at least for the time being. On one hand, foreign investors simply looking to complement their manufacturing capacity with leasing services will keep opting for the “road-tested” MOFCOM FLC vehicle. On the other hand, the CBRC regime has already gathered a lot of attention from large financial institutions looking to develop finance leasing in China. However, it may take time before the regime fully opens up to foreign investors. Despite the pressure exerted by the CBRC on China’s banks to establish Financial Institution FLCs, the CBRC referred to applications by these Chinese banks as pilot projects, and indicated that it would only consider new applications after these experiments are under way.
The entry of more FLCs on the Chinese market will have a positive effect on business. Clients of FLCs will be able to better manage cashlow, conserve capital expenditure and improve asset management. SMEs will have more finance options to upgrade assets, keep up with new technologies and maintain the upper hand against competitors. For large manufacturers relying on sales of equipment and advanced technologies, the FLC can act as a facilitator and a new revenue stream.
This is an abridged version of an article published by the authors in the July-August edition of China Law & Practice.