Against the backdrop of a huge amount of domestic liquidity from both state-owned and non-state enterprises, the launch of the long-awaited Growth Enterprise Market (GEM) in Shenzhen at the end of 2009 and the continued growth of private equity investment activity in China, China’s four major cities, Beijing, Shanghai, Shenzhen and Tianjin, continue to compete to become China’s hub for the formation of both domestic and foreign-invested equity investment fund enterprises (EIFEs) and equity investment management enterprises (EIMEs) with the promulgation of various local rules and incentive policies for the formation of EIFEs and EIMEs. This GT Alert discusses national and local rules regarding and incentives for the formation of EIFEs and EIMEs from a comparative perspective.
Formation of EIFEs and EIMEs
Permissible Entity Forms. In all four cities, EIFEs and EIMEs can be established either in partnership or in corporate form. Since March 2010, foreign fund sponsors may also set up RMB funds as “foreign-invested partnerships” (FIPs) pursuant to the FIP Registration Rules issued by the State Administration of Industry and Commerce (the FIP Rules). Carlyle and the Shanghai-based Fosun Group were the first to take advantage of the new FIP Rules to jointly establish a US$100 million equivalent RMB fund in Shanghai in the form of a general partnership. The foreign-invested venture capital enterprise (FIVCE) in the form of a contractual joint venture, the mainstream entity form for foreign-invested EIFEs before the advent of the FIP Rules, appears to be gradually fading away. Of the four cities, only the Tianjin rules still refer to the contractual form of EIFE in addition to the corporate, partnership and trust forms.
Capital Requirements. The four cities set different minimum capital requirements for EIFEs and EIMEs. Both Shanghai and Shenzhen require RMB 100 million for EIFEs and at least RMB 5 million for each shareholder/partner. In addition, Shenzhen requires the first installment of paid-in capital to be at least RMB 50 million. While the Beijing municipal rules are silent on the minimum capital requirement, EIFEs formed in Haidian District are required to have a registered capital of at least RMB 100 million. Of the four cities, Tianjin appears to have the lowest capital requirement for an EIFE, which is set at RMB 10 million for EIFEs in corporate form, and there is no minimum capital requirement for partnership funds. The capital requirements for EIMEs are the highest in Haidian District of Beijing (RMB 10 million for an EIME of any type), the second highest in Shenzhen (RMB 10 million for companies limited by shares, or CLBSs, and RMB 5 million for limited liability companies, or LLCs), and the lowest in Shanghai and Tianjin (RMB 5 million for CLBSs and RMB 1 million for LLCs).1
Name Requirements. The name requirements in the four cities are also somewhat different. In Beijing and Shenzhen, the fund names are allowed to contain ¡°fund¡± (¡°»ù½ð¡±) or ¡°investment fund¡± (¡°Í¶×Ê»ù½ð¡±). In Shanghai, the fund names are allowed to contain ¡°equity investment¡± (¡°¹ÉÈ¨Í¶×Ê¡±) without reference to ¡°fund.¡± In Tianjin, the fund names are allowed to contain ¡°equity investment funds¡± (¡°¹ÉÈ¨Í¶×Ê»ù½ð¡±) and ¡°equity investment fund management¡± (¡°¹ÉÈ¨Í¶×Ê»ù½ð¹ÜÀí¡±).
Foreign-invested Fund Management Enterprises
It is important to note that the municipal rules in all four cities, including the minimum capital requirements set forth above, generally apply to both purely domestic and foreign-invested EIFEs and EIMEs. However, Beijing and Shanghai have also issued a different set of trial rules for the formation of foreign-invested EIMEs in Zhongguancun District and Pudong District, respectively, both of which require a significantly higher minimum registered capital of US$2 million for foreign-invested EIMEs. One significant distinction between the two sets of trial rules on foreign-invested EIMEs is that under the Pudong trial rules, at least one shareholder of the foreigninvested EIME (or an affiliate thereof) is required to be engaged in equity investment or equity investment management business whereas such a requirement does not exist in the Zhongguancun trial rules. Another distinction between the Pudong and Zhongguancun trial rules is that the cooperation joint venture form is available in Pudong but not in Beijing. While technically the Pudong trial rules on foreign-invested EIME were set to expire on June 30, 2010, it is our understanding that the trial rules will continue to be in effect until they are replaced by new rules.
Tax Treatment of Partners in Partnership Funds
In China, partnerships are tax pass-through entities and the partners pay taxes on income allocated to them on an annual basis. According to Circular 159 of the State Taxation Administration issued in December 2008 and older tax regulations on sole proprietorships and partnership enterprises referenced therein, partners (limited partners and general partners) who are natural persons shall pay progressive income tax ranging from 5% to 35%, subject to certain deductions. The relevant tax rules in three of the four cities, however, provide differentiated tax treatment of partners depending on their status as limited partner (¡°LP¡±) or general partner (¡°GP¡±), which represents a deviation from Circular 159. In Shanghai and Shenzhen, individual GPs shall pay progressive income tax ranging from 5% to 35% on income from the fund, subject to certain deductions, and individual LP shall pay tax at a flat 20% rate on interest and dividend income from the fund (it is not clear if gain on the disposition of LP interests is also included).
In Tianjin, both individual LPs and individual GPs (with respect to their capital interests rather than profit interests in the fund) shall pay tax at a flat 20% rate on interest or dividend income or income from the disposition of their interests in the fund. In Beijing, both individual LPs and individual GPs pay tax at a flat 20% rate on all fund-related income (presumably including interest or dividend income or income from the disposition of interests in the fund), which represents the most radical deviation from Circular 159. While it can be argued that since individual income tax revenues belong to local governments as opposed to the central government, local governments have the authority to lower such tax in order to promote local private equity investment management business, the legality of such local rules is questionable because it involves the change of the type of the applicable tax rate (i.e., from a progressive rate of 5% to 25% to a flat 20% rate) rather than just lowering the tax rate.
Formation Rewards and Incentives Beijing, Shanghai, Shenzhen and Tianjin have promulgated various incentive policies and reward systems for locally formed EIFEs and EIMEs as set forth in the chart below.