On May 27, 2011, China’s State Administration of Foreign Exchange (SAFE) published on its website Circular 19 (Circular 19), which will become effective on July 1, 2011.
Together with SAFE’s Circular 75 issued in 2005, Circular 106 issued in 2007 and Circular 77 issued in 2009, Circular 19 at a policy level signals a shift of SAFE’s focus from categorically trying to restrict Chinese residents from moving their shareholdings offshore, to its increasingly complex and difficult core mission of monitoring, calculating and regulating cross-border remittances, currency conversions and foreign (as compared to round-trip) investments.
Circular 19 removes some of the main obstacles that in the last six years have made it difficult for Chinese companies to "go offshore" to create "quasi red-chip" corporate structures for their businesses in China. As such, Circular 19 is highly relevant to companies seeking private equity investments from international investors or planning an initial public offering outside China, as well as to the international private equity and capital markets communities.
Key Effects of Circular 19
While we expect that as always, SAFE’s interpretation through verbal consultations and actual practice will be crucial to understanding various specifics in Circular 19, initially we observe that its text describes easier rectification, separated stages, increased focus and reduced duplication of SAFE’s role, as follows:
- Easier Rectification: Non-compliant round-trip transactions may now be brought into compliance upon imposition of penalties for certain previous illegalities, but without the previous deadline, vagueness and other difficulties that severely reduced the practical availability of rectification opportunities.
- Separated Stages: Round-trip investment will be permitted to be completed and registered without being dependent on (or close in time to) an offshore fund-raising transaction, and the related offshore enterprise will not be required to qualify as a fund-raising special purpose vehicle (SPV) as defined under Circular 75. Instead, such qualification and fund-raising can be deferred until later. In the mean time the round-trip investment can be registered by SAFE as being made by a "non-SPV" round-trip vehicle (which is a new and helpful category of foreign investor). When the group is ready to pursue offshore fund-raising, a supplemental application can be filed to qualify the offshore enterprise as an SPV under Circular 75.
- Focus Up; Duplication Down: Attachments to applications to SAFE (for non-SPV registration or for SPV qualification) will no longer need to contain documents such as a business plan, and an audit report (of the domestic enterprise). However, SAFE must still receive for review documentation of the shareholdings (along with other interests creating control) held by the ultimate controller of the domestic enterprise.
Circular 19 does not affect the regulation of round trip investments by China’s Ministry of Commerce (MOFCOM). Until MOFCOM takes a more permissive approach, we expect the more "asset light" domestic companies (rather than companies with high net asset value) to be in a position to benefit from Circular 19.
Changing Goals & Context
The main goals of both SAFE and most round-trip investors have evolved over the years. The China residents who participated in the early waves of round-trip investments sought to move their shareholdings offshore primarily in order to enjoy greater freedom and privacy of outbound investments, and to enjoy China’s tax preferences on inbound investments. Subsequently, China terminated tax preferences on inbound investments, while wealthy China residents found that some of the most profitable investment opportunities in the world were located inside China. Responding to these opportunities, and to take advantage of the appetite of offshore stock markets for China-related IPOs, China residents increased their use of quasi red-chip structures to facilitate such IPOs, and used the IPO proceeds mainly to expand their China investments and operations. The attractiveness of such funding has been increased by China’s tightening of bank lending in order to combat inflation (without a commensurate expansion of approvals of companies’ applications to issue shares on China’s domestic stock markets). But SAFE’s restrictions on conversion of foreign currency into Renminbi have been progressively tightened to the point that they are blocking many attempts to deploy foreign currency IPO proceeds into China.
SAFE’s priorities have also evolved – China needs to manage the progressive internationalization of the Renminbi, without exacerbating domestic inflation, and to understand what portion of inbound foreign direct investment is actually round-trip investments by China residents. These goals indicate some of the reasons why SAFE will focus more on restricting the remittance of offshore funds into China, while shifting to more of a monitoring role in respect of round-trip investments and other restructuring.