On July 14, 2014, the State Administration of Foreign Exchange (“SAFE”) published on its website the Circular on Relevant Issues Relating to Domestic Residents’ Investment and Financing and Roundtrip Investment through Special Purpose Vehicles (Hui Fa  No. 37) (“Circular 37”) and its appendixes, including the Operating Rules for Businesses with respect to the Regulation of Foreign Exchange in Roundtrip Investments (the “Operating Rules”) and the Form of Application for Foreign Exchange Businesses with respect to Direct Investments under the Capital Account. According to Circular 37, Circular 75, which significantly impacted offshore investments, financings and listings that used the variable interest entity (“VIE”) structure, is repealed and superseded by Circular 37 with immediate effect. In addition, the operating instructions for foreign exchange in roundtrip investments in Circular 59, are repealed and superseded by the Operating Rules with immediate effect.
Circular 37 explicitly states that its purpose is to “support the implementation of the ‘Going Out’ strategy, to fully utilize onshore and offshore resources and markets and to further simplify and facilitate cross-border capital transactions arising from domestic residents’ involvement in investment and financing via offshore special purpose vehicles.” Compared to Circular 75, Circular
37 contains many material adjustments that are expected to pave the way for and have a significantly positive and practical effect on, offshore investment and financing and roundtrip investment by domestic residents.
Compared to Circular 75, Circular 37 contains material amendments to the following: i) definitions,
ii) scope of special purpose vehicles (“SPV”), iii) offshore investments, financings and roundtrip investments by domestic residents, iv) registration of employee stock option plans (“ESOP”), and v) procedures for registration, and the basis for and content of punishments.
Material Adjustments of Definitions
Circular 37 materially adjust the definitions of “SPV”, “Roundtrip Investment”, and “Domestic Resident”. Under Circular 37,
“SPVs” means offshore enterprises directly established or indirectly controlled by domestic residents (including domestic institutions and domestic individuals) for the purposes of offshore investment and financing with their legally owned assets or interests in domestic enterprises, or their legally owned offshore assets or interests. Compared to Circular 75, under Circular 37, (a) the purpose for establishing SPVs is not limited to offshore financings, but has been broadened to
include both financings and investments and (b) domestic residents can form SPVs not only with their assets or interests in the domestic enterprise, but also with their legally owned offshore assets or interests.
“Roundtrip Investment” means direct investment carried out within the territory of China by domestic residents directly or indirectly via SPVs (i.e., establishing a wholly foreign owned enterprise or project (“WFOE”) in the PRC by forming a new entity, through merger or acquisition or other ways, and obtaining ownership, control, operation and management and other rights and interests in a domestic PRC entity). Compared to Circular 75, Circular 37 simplifies and defines what constitutes direct investment.
“Domestic Residents” means domestic institutions and domestic individuals. A domestic individual means either a Chinese citizen with a Chinese ID card, military ID card or armed police ID card or a foreign individual, who, while not having any legal identity within the territory of China, nevertheless habitually resides within the territory of China due to business interests / relations.
Broadening the Scope of “SPVs”
Circular 37 broadens the scope of “SPVs” in the following ways:
SPVs are not onl y for financing purposes, but also for investment purposes.
According to Circular 75, the purpose of a SPV is limited to offshore financings. However, according to Circular 37 the purpose of a SPV is not onl y for offshore equity financing purposes, but also for offshore investment purposes.
This minor wording adjustment materially alters what qualifies as a SPV, and establishes the principles by which a domestic resident, especially a domestic individual, is permitted to invest offshore via SPVs for the reasons stated below.
The definition of outbound "investment" by domestic institutions is already provided for in the Measures for the Administration of Overseas Investments by the Ministry of Commerce in 2009 and other related regulations. However, prior to Circular 37, except for those regulations under Circular 75 and the principle provisions of the Administrative Measures for Personal Foreign Exchange and its implementing rules, there were no specific and practical rules for outbound “investment” by domestic individuals. Therefore, it was uncertain for a long time whether such investments were permitted, and to the extent that they were, the scope of such permitted outbound investment. The definition of SPV and other related provisions in Circular 37 may provide a formal legal avenue for domestic individuals to make outbound investments for the purposes of implementing China’s "Going Out" strategy." Still, the specific effect of Circular 37 in this regard requires further examination and clarification.
Domestic residents can establish a SPV not onl y with their legally owned assets or interests in domestic enterprises, but also with their legally owned offshore assets or interests.
Under Circular 75, domestic residents could only establish a SPV with their legally owned assets or interests in domestic enterprises. Under Circular 37, domestic residents can also establish a SPV with their legally owned offshore assets or interests.
Under Circular 75, the SPV could only be established for offshore financing purposes, and the interests in domestic enterprises had to be injected into the SPV. Practically speaking, this meant that domestic residents were required to own assets or interests in domestic enterprises before establishing a SPV. Now, under Circular 37, SPVs can be established for the purposes of offshore investments without the need to inject any interests in domestic enterprises into the SPV. Therefore, we understand that a domestic resident can establish a SPV and complete registration under Circular 37 as long as he/she/it holds legal interests or assets offshore. In this case, the domestic resident does not need to establish a domestic enterprise or hold equities in a domestic enterprise in order to establish the SPV.
Compared with Circular 75, the definition of SPV and roundtrip investment under Circular 37 may therefore represent a breakthrough for the registration of SPVs who do not aim to secure financing and may efficiently address the SAFE registration issue for roundtrip investments made by "offshore companies for non-financing purposes." Still, the operational practices of Circular 37 in this regard require further examination and clarification.
Notwithstanding the above, given China’s long-standing control of foreign exchange, we will need explanations and statements from SAFE defining offshore assets and interests and its legality so we may further understand the scope of these reforms. In this regard, we will also need to sufficiently communicate and confirm these points with SAFE.
Domestic Residents Allowed to Fund SPVs
Under Circular 37, domestic residents are permitted to fund SPVs. Specifically, domestic residents can i) contribute capital to SPVs with legally owned onshore and offshore assets and interests; ii) advance loans to its registered SPVs via domestic enterprises controlled directly or indirectly by them based on real and reasonable demands in compliance with existing regulations; iii) purchase foreign exchange and remit the foreign exchange out of China for the purposes of establishing SPVs, for share repurchases or for delisting based on true and legitimate demands. If these provisions are implemented in accordance with their terms, it will significantly influence outbound investments made by domestic individuals.
Circular 37 solves the issue of SPVs’ demand for offshore funding by permitting such funding to occur in certain circumstances, more specifically in the following ways.
Allowing domestic individuals to directly contribute capital to SPVs
According to Circular 37, domestic individuals can contribute capital to SPVs with their legally owned onshore and offshore assets or interests (including but not limited to currency,
negotiable securities, intellectual property or techniques, equity and creditor's rights). These SPVs can then make offshore investments with funds remitted out of China. We need to communicate with SAFE to confirm the specifics of these directives and to understand how non-currency contributions are to be made.
Allowing domestic residents to advance loans to SPVs via the enterprises in China controlled by them
In addition to being able to directly contribute capital to SPVs, according to Circular 37, domestic individuals can also advance loans to its registered SPVs via domestic enterprises controlled directly or indirectly by them based on real and reasonable demands in accordance with the Circular of the State Administration of Foreign Exchange on Foreign Exchange Control Issues Concerning Overseas Lending by Domestic Enterprises and other relevant regulations.
Allowing domestic residents to purchase foreign exchange and remit the foreign exchange out of China for the purposes of establishing SPVs, for share repurchases or for delisting
According to Circular 37, domestic individuals can fund SPVs not only for outbound investments, but also for the purposes of establishing SPVs, for share repurchases or for delisting.
The provisions in Circular 37 permitting domestic individuals to fund SPVs represent a significant breakthrough and are of great significance. By removing the limitations set forth by Circular 75, these provisions in Circular 37 simplify the procedures for outbound investments made by domestic individuals.
Foreign Exchange Registration of ESOP Interests Made by Non-Listed SPVs to Directors, Supervisors, Senior Officers and Employees Allowed
According to Circular 37, when a non-listed SPV grants equity incentives to the directors, supervisors, senior officers and employees of enterprises in China that it controls, directly or indirectly, through equity or option holdings, these domestic individuals can apply for foreign exchange registration with respect to its interests in the SPV before they exercise their rights.
Circular 37 is the first law that specifies the procedures for and detailed implementation rules of foreign exchange registration of ESOP grants made by non-listed SPVs to directors, supervisors, senior officers and employees, which may reflect the fact that regulators have closely monitored the development of offshore financings and capital markets. Circular 37’s concrete provisions will assist in eliminating confusion over the registration and exercise of ESOP interests made by many non-listed SPVs who have a VIE structure. Chinese holders of ESOP interests in non-listed companies using the VIE structure no longer face uncertainty over whether offshore ESOP interests
can be exercised prior to the company’s listing. Instead, these employees will have the choice to hold interests in the non-listed SPV when appropriate. This reform, and the removal of prior uncertainty over ESOP grants made by non-listed SPVs to Chinese employees, may positively contribute to the ability of non-listed SPVs to retain and encourage its employees.
However, there are a number of implementation issues that will need to be addressed, given the complexity of ESOP administration and the fact that ESOP grants may be subject to amendment. First, SAFE may face more administrative burdens stemming from increases in the number of registrations. Second, enterprises have to consider when it would be appropriate to assist their employees in applying for the registration of their ESOP interests and how to handle equity interests that are exercised after employees depart. Third, option holders may have to assume some burdens with respect to the completion of the required SAFE registration for their ESOP interests.
It should be noted that Circular 37 does not specify that domestic residents who hold ESOP interests are required to apply for foreign registration, but rather that they may do so according to Circular 37. If we were to interpret this provision strictly, it would appear that the foreign exchange registration of an ESOP grants by a non-listed SPV is not a legal obligation of any one person or entity, but rather provides a choice for option holders or companies to complete the registration. We will require further communication and confirmation with SAFE with respect to the interpretation of these provisions.
Foreign Exchange Registration Procedures for SPVs Adjusted
Circular 37 and its Operating Rules materially adjust the foreign exchange registration procedures of SPVs in the following ways:
Adjustment of the Initial Registration
According to Circular 37 and its Operating Rules, domestic residents shall apply with SAFE for foreign exchange registration of their offshore investment of their legally owned onshore or offshore assets or interests into SPVs (the "Initial Registration"). Domestic individuals are permitted to establish SPVs before conducting the Initial Registration, but prior to the completion of the Initial Registration, they cannot fund the SPVs except for paying for registration costs.
Compared with Circular 75 and its operating rules, Circular 37 and its Operating Rules contain the following uncertainties: (a) Circular 37 and its Operating Rules do not specify whether offshore financings, equity transfers, roundtrip investments or other substantial adjustments of the SPV’s assets or equity are allowed to occur prior to the completion of the Initial Registration. Presently we do not know whether offshore financings or other assets or equity adjustments can be completed prior to the completion of Initial Registration. (b) Circular 37 and its Operating Rules specify that domestic individuals only have to apply for foreign exchange registration of the parent SPV established or controlled directly by them.
Presently, we do not know whether domestic individuals have to apply for foreign exchange registration of other SPVs apart from the parent SPVs established or controlled indirectly by them. For example, in a typical VIE structure; the offshore entities would consist of a financing vehicle in the Cayman Islands / British Virgin Islands, which is the 100% owner of a Hong Kong entity. In this scenario, would foreign exchange registration be required for both entities or only for the Cayman Islands / British Virgin Islands entity. We have to communicate and confirm with SAFE about how these rules are implemented in practice.
Adjustment of Amended Registrations
According to Circular 37 and its Operating Rules, domestic residents are required to amend their registrations with SAFE (a) when the domestic individual shareholder, the name, the operation period or other basic information of the registered SPV changes or (b) when the capital contributed by domestic individuals increases or is reduced, or when there is a share transfer or exchange, merger, division or other material event (the “Amended Registration”).
Compared with Circular 75 and its operating rules, Circular 37 and its Operating Rules make the following adjustments: (a) not specifying financings or equity transfers relating to the SPV as events that trigger an Amended Registration, (b) abolishing the 30-day time period requirement to complete an Amended Registration, starting from the occurrence of the triggering event, and (c) abolishing the requirement that domestic residents’ profits, dividends and foreign exchange income from capital variation gains of SPVs be transferred back to China within 180 days following the acquisition of such profits, dividends and foreign exchange income.
Further specifying “Supplement Registrations”
Circular 37 provides that domestic residents who, prior to the effectiveness of Circular 37, funded SPVs with legally owned onshore or offshore assets or interests but who failed to appl y for foreign exchange registration of its offshore investment, shall issue a cover letter explaining such non-compliance to SAFE. SAFE will then provide a “Supplemental Registration” in accordance with law and reasonableness, while administrative punishments are imposed on the activities that breach prior SAFE provisions. Considering China’s “Going Out” policy, the “Supplemental Registration” may be effective to remedy legacy non-compliance issues at a time when such prior conduct is now legal.
Due to the operational issues surrounding foreign exchange registration procedures for SPVs, we need to communicate and confirm the details of these procedures with SAFE.
Concrete Bases for Punishment and Penalties
Unlike Circular 75, Circular 37 specifies the concrete bases for punishment and penalties, which target unlawful acts that arise in practice. Circular 37 incorporates provisions from the Regulations
on Foreign Exchange Control, as follows:
Domestic residents or enterprises directly or in directly controlled by them remit funds out of China into SPVs via false or fabricated transactions.
According to Article 39 of the Regulations on Foreign Exchange Control, SAFE shall order the offending party to repatriate the involved foreign exchange back to China within a specified time limit and shall impose a fine of not more than 30% of the involved foreign exchange. In serious cases, the SAFE shall impose a fine of more than 30% and not more than the total amount of involved foreign exchange. The offending party shall also be subject to criminal liability according to law if the act constitutes a criminal offence.
Domestic residents fail to apply for the required foreign exchange registrations, fail to truthfully disclose information on who actually controls the roundtrip investment enterprises or make fictitious promises.
According to Article 48, Paragraph 5 of the Regulations on Foreign Exchange Control, SAFE shall order the offending institution or individual to remediate the non-compliance, issue a warning, and impose a fine of not more than RMB 300,000 in the case of an institution or not more than RMB 50,000 in the case of an individual.
Funds are remitted out of China when domestic residents fail to apply for the required foreign exchange registrations, fail to truthfully disclose information on who actually controls the roundtrip investment enterprises or make fictitious promises.
According to Article 39 of the Regulations on Foreign Exchange Control, SAFE shall order the offending party to repatriate the involved foreign exchange back to China within a specified time limit and shall impose a fine of not more than 30% of the amount of the involved foreign exchange. In serious cases, the SAFE shall impose a fine of more than 30% and not more than the total amount of the involved foreign exchange. The offending party shall also be subject to criminal liability according to law if the act constitutes a criminal offence.
Funds are remitted into China or foreign exchange is settled when domestic residents fail to appl y for the required foreign exchange registrations, fail to truthfully disclose information on who actually controls the roundtrip investment enterprises or make fictitious promises.
According to Article 41 of the Regulations on Foreign Exchange Control, if anyone remits foreign exchange into China in violation of relevant law, SAFE shall order the offending party to remediate the non-compliance and shall impose a fine of not more than 30% of the illegal remittance amount. In serious cases, the SAFE shall impose a fine of more than 30% and not more than the total illegal remittance amount. If anyone illegally settles foreign exchange, SAFE shall order the offending party to convert the funds from the illegal settlement and shall impose a fine of not more than 30% of the illegal foreign exchange settlement amount.
W here cross-border balance of payments occurs between domestic residents and SPVs, domestic residents fail to declare the international receipts and payments or conduct statistics registration according to law.
According to Article 48, Paragraph 1 of the Regulations on Foreign Exchange Control, SAFE shall order the institution or individual to remediate the non-compliance, issue a warning and impose a fine of not more than RMB 300,000 in the case of an institution or not more than RMB 50,000 in the case of an individual.