A frequently asked due diligence question for private equity or strategic investors in a China transaction is whether the Chinese shareholders of the target company have properly complied with applicable foreign exchange control regulations in connection with the target’s offshore corporate structure. Chinese foreign exchange authorities recently released a new rule which provides more specifics in respect of the required registration for Chinese residents or individuals to establish offshore holding companies.

On July 14, 2014, the State Administration of Foreign Exchange (“SAFE”) of the People’s Republic of China (“PRC” or “China”) released Circular No.[2014]37 dated July 4, 2014 on Issues Relating to the Administration of Foreign Exchange in Respect of Offshore Investments, Financings and Return Investments by Domestic Residents through Special Purpose Vehicles (“Circular 37”), which superseded and repealed Circular No.[2005]75 on Issues Relating to the Administration of Foreign Exchange in Respect of Financings and Return Investments by Domestic Residents through Offshore Special Purpose Vehicles (“Circular 75”) which was previously issued by SAFE in October 2005.

The adoption of Circular 37 is viewed by many as a significant development in SAFE’s evolving oversight of Chinese residents’ overseas and round trip investments - reflecting SAFE’s efforts to support China’s “going global” strategy and further facilitate cross-border capital transactions. Circular 37 re-defines certain key terms used in Circular 75, expands the registration scope, and simplifies certain registration procedures, as more specifically described below.

Certain Key Changes and Expansion of Registration Scope

Special Purpose Vehicle (SPV)

Circular 37 redefine SPV as “the offshore enterprise directly established or indirectly controlled for the purpose of investment or financing by domestic residents (including domestic institutions and domestic resident individuals) with assets or interests in domestic enterprises legally held thereby, or with overseas assets or interests legally held thereby.” Unlike Circular 75, which more narrowly defined SPVs to focus on offshore financings for domestically- owned assets, Circular 37 expands the scope of SPV to cover both return investments and overseas investments and financings. Whereas Circular 75 was less clear on this issue, Circular 37 seems to provide greater certainty that individuals will be able to set up an SPV for overseas investment and financing purposes, and not only for return investment purposes. Additionally, under Circular 37, a domestic resident forming an SPV will be entitled to use legally held overseas assets and interests to capitalize such SPV, which also is a new development as compared to what was permitted under Circular 75. On the other hand, such changes to the SPV definition in effect expand the scope of foreign exchange registration, so that domestic residents (whether institution or individual) need to make the corresponding foreign exchange registration for setting up a SPV by utilizing either their onshore or offshore assets or interests, and whether the purpose of the SPV is for overseas investment, financing or return investment.

Domestic Residents 

Circular 37 applies to “domestic residents” which  expressly includes “domestic institutions” and  “domestic resident individuals”. Moreover,  “domestic resident individuals” refers to “Chinese  citizens holding mainland identity card, military  identity documents or identity documents for  Chinese armed police force, as well as overseas  individuals who do not hold any mainland legal  identity document, but have habitual residences  within the territory of China due to economic  interests.” The implementation guideline attached  to Circular 37 further notes that an individual  holding both PRC and overseas (including Hong  Kong, Macau and Taiwan) legal identity documents  will be treated as an overseas individual for the  purpose of foreign exchange registration.

Return (or Round-Trip) Investment

Circular 37 has revised the definition of “Return (or  Round-Trip) Investment” as “the direct investment  activities directly or indirectly carried out onshore  by domestic residents through SPVs, namely the  activities whereby domestic residents establish  foreign-invested enterprises or projects onshore by way of new establishment, merger and acquisition,  etc., and obtain the ownership, controlling power,  operation and management rights and other  interests thereof.” Such new definition of such  investment activities is more broadly worded than  the definition in Circular 75, and captures not only  offshore financings of existing onshore interests, but  also new onshore green-field investments.

While Circular 37 omits the express reference to  contractual control, it still describes control in a  very broad manner. As such, the broad definition  should capture contractual control arrangements  (as commonly seen in VIE investment structures used for certain restricted industries). However,  Article 4 of Circular 37 expressly notes that “the  registration of an overseas SPV is not indicative of  the compliance of its investment and financing  activities with the requirements of competent  industry departments.” 

A More Streamlined and Simplified Registration System 

In addition to the changes to defined terms, Circular  37 (and its implementing guidelines) clarifies and  simplifies certain of the SAFE registration  requirements – focusing primarily on the foreign  exchange related issues which are more  administrative in nature.

Initial Registration. Pursuant to Article 3 and the  accompanying procedural guidelines, initial SAFE  registration by the domestic resident will be  required prior to the making of any capital  contributions into the SPV. We note that that the  implementation guideline has removed the  prohibition on any offshore financing, equity change  and return investment prior to the completion of  SAFE registration. Rather, the domestic residents  cannot make capital contribution to the SPV prior to  completing SAFE registration. Additionally, Circular  37 only requires SAFE registration in respect of the  top-level SPV established or controlled by the  domestic resident, as opposed to any of the  intermediate or subsidiary SPVs that may fall below such top-level SPV.

Registration Amendment. Pursuant to Article 5,  amendments to the initial SAFE registration shall be  promptly made when the registered SPV  experiences significant changes, including in  respect of its domestic resident individual  shareholder, its name, operating period or other  basic information, or increase or reduction of  contribution by the domestic resident individual, the  transfer or replacement of equity, or merger or  division. While there is no set deadline in respect of  such registration amendment, the domestic resident  may only engage in subsequent cross-border  business activities (e.g., repatriation of profit and  bonuses) in respect of such SPV following  completion of the amendment filing.

Registration Amendment and Deregistration. Article 9 requires amended SAFE registration or  deregistration when a domestic resident no longer  has interests in a registered SPV (whether due to  stock conversion, bankruptcy, dissolution,  liquidation, expiry of the operating period, identity  change or other reasons), or where a domestic  resident is no longer required to apply for the  registration of SPVs.

Supplemental Registration. Finally, Article 12  provides a domestic resident with the opportunity to  make up the registration if, prior to Circular 37’s effective date, such resident made a capital  contribution to an SPV with legitimate domestic and overseas assets or interests, but failed to apply for  the requisite SAFE registration. The supplemental  registration should follow the same procedures and  requirements as an initial registration, except that  the domestic resident should submit an explanatory  statement regarding its prior failure in completing the registration. In such event, SAFE will determine  whether to accept a SAFE registration from such  domestic resident and whether to assess any  administrative punishment.

While the new registration procedures in Circular 37  are more streamlined and simplified, it remains to  be seen how local SAFE authorities will actually  interpret and implement such registration  procedures. Based upon the streamlined guidelines,  we would expect less substantive review that could  vary from locality to locality, and we hope that such  rules will provide more predictability and certainty  regarding the SAFE registration procedures.

Other Key Developments of Circular 37

Registration by Domestic Employees in Respect  of Equity Incentive Awards of Non-listed SPVs

Prior to Circular 37, foreign exchange registration with SAFE has only been available in respect of  equity incentive awards that have been issued by a  publicly-listed company to domestic resident  employees. In this regard, the exercise by domestic employees of equity incentive awards issued by  non-listed overseas companies had not been  subject to any SAFE rules or regulations – leaving Chinese employees unable to properly exercise  such equity incentive awards due to foreign  exchange restrictions. Following the issuance of  Circular 37, a domestic resident individual who is a  director, supervisor, senior management personnel  or other employee of a domestic enterprise that is  under control of a non-listed SPV may now apply for registration with the SAFE prior to exercising  his/her equity incentive awards granted by the  non-listed SPV. As a result, while existing SAFE  rules continue to govern the exercise of awards  in overseas publicly-listed companies, Circular  37 provides a path for Chinese employees to  also exercise equity incentive awards of a non-listed  SPV.

Offshore Profits No Longer Required to be  Repatriated within 180 Days

Whereas Circular 75 previously required profits,  dividends or other proceeds obtained from disposal  of SPV interests to be repatriated onshore within  180 days of receipt, Circular 37 has removed such  180-day repatriation requirement. Rather, Circular  37 simply notes that any repatriation of such profits,  dividends or other proceeds shall comply with SAFE  provisions on current accounts or capital accounts, as applicable.

Allowing Cross-Border Capital Support to SPV

Circular 37 further liberalizes cross-border foreign  currency flow in relation to the SPV. Specifically, when there are real and reasonable needs, a  domestic enterprise that is directly or indirectly  controlled by a domestic resident may extend  loans to the registered SPV. Additionally, a domestic  resident is permitted to purchase and remit foreign exchanges overseas, on the basis of real and  reasonable needs of an SPV (including to fund its  establishment costs, a share repurchase, delisting, etc.)

Specific Penalties for Violations of Circular 37

Unlike Circular 75, which had more general  statements in respect of the consequences for  violations thereof, Circular 37 articulates specific  penalties for violation of its provisions. Specifically,  depending on the type of violations of Circular 37, domestic residents shall be subject to the relevant administrative or criminal (as the case maybe)  penalties pursuant to Article 39, 41 and 48,  respectively, of the PRC Foreign Exchange  Administration Regulations.

Final Observations

While Circular 37 expands the SAFE registration  scope, simplifies registration procedures and  provides more flexibility in respect of certain foreign  exchange related matters – all of which are  intended to facilitate China’s “going global” strategy  and promote the development of the China’ real  economy with both domestic and overseas  resources – how it actually will be implemented in  practice is yet to be widely tested. In this regard,  the local bureaus of SAFE throughout China may  interpret Circular 37 in different ways, pending  further guidance and feedback from SAFE.  Nevertheless, despite potential near-term  challenges, the adoption of Circular 37 to replace  Circular 75 should be welcomed as a positive  development in relation to SAFE’s evolving  oversight of Chinese residents’ cross-border  investments – whether for overseas or round-trip  purposes.