Recent interim provisions clarify the process and qualifications for investors to inject equity as the registered capital of a foreign-invested enterprise (“FIE”).

The guidance is provided by the PRC Ministry of Commerce (“MOFCOM”) in the Interim Provisions regarding Capital Contribution to Foreign-invested Enterprises in the Form of Equity (“Interim Provisions”), which became effective on 22 October 2012. The Interim Provisions were first circulated for public comment in May 2011.

  1. Background

In theory, the Company Law permitted capital contributions in the form of equity interest from 1 January 2006. However, the practice did not become nationwide until after the Sate Administration for Industry and Commerce’s implementing rules (“AIC Measures”) became effective on 1 March 2009. The problem for FIEs was that the AIC Measures did not expressly state that they applied to capital contributions made to FIEs.

The Interim Provisions are intended to clarify the requirements and procedures for making equity contributions to FIEs. The Interim Provisions should also unify the various practices in different localities.

  1. Types of transactions

The Interim Provisions permit, subject to approval from MOFCOM or its provincial-level branch, foreign and domestic investors to contribute certain equity interests for the purpose of:

  • Establishing a new FIE
  • Increasing the registered capital of a domestic enterprise and thereby converting it into an FIE
  • Increasing the registered capital of an FIE and thereby changing the shareholding structure of the FIE

The provisions of the Interim Provisions also apply, by reference, to the acquisition by a foreign investor of an equity interest in a Chinese company using equity held by it in another Chinese company as consideration.

  1. Qualified equity interest

According to the Interim Provisions, only equity interests in another Chinese company (“Equity Company”), including limited liability companies and companies limited by shares, may be contributed as registered capital of FIEs. The equity interest being contributed must be legally transferable, free from encumbrances, and fully owned by the party contributing the equity. Under the Interim Provisions, equity interests cannot be contributed if:

  • The registered capital of the Equity Company is not fully paid up
  • The equity interests have been pledged or frozen
  • The equity interests are not transferable according to the articles of association or shareholders’ agreement of the Equity Company
  • The Equity Company, if an FIE, failed to participate in or pass the FIE joint annual inspection of the preceding year
  • It is equity of a real estate company, foreign-invested holding company or foreign-invested venture capital enterprise
  • Regulatory approvals required for equity transfers have not been obtained
  • The transfer of the equity interests is prohibited pursuant to relevant laws and regulations

In addition, the equity contribution to an FIE will not be approved if it would result in a violation of the Foreign Investment Industrial Guidance Catalogue and other foreign investment policies by the Equity Company, the FIE or the enterprises in which the Equity Company or the FIE has direct or indirect shareholdings.

A legal opinion issued by a PRC law firm to verify the transferability and qualification of the equity interest must be submitted as part of the application materials.

  1. Valuation of equity interest

The Interim Provisions require the equity being contributed to be valued by a qualified valuation institution in China. The Interim Provisions also require the current and potential shareholders of the target FIE to negotiate and determine the value of the equity interest (“Deemed Value”) and the amount to be contributed to the target FIE’s registered capital (“Contribution Value”).

The Interim Provisions differ from the previously circulated draft of the regulation in stating that:

  • The Deemed Value must be based on the valued amount (without being capped at such amount); and
  • The Contribution Value may not exceed the valued amount.

Contributed equity, together with any other non-monetary capital contribution, may not exceed 70% of the target FIE’s registered capital post-completion.

By way of example, consider that an investor wants to become a shareholder in an existing FIE by way of capital contribution in the form of equity. The current registered capital of the target FIE is RMB10 million. The investor holds 100% equity in another Chinese company (Equity Company), which is valued at RMB6 million, and the parties agree a valuation of RMB5 million (Deemed Value). By contributing the 100% equity in the Equity Company at RMB5 million to the target FIE, the investor will hold approximately 33.3% equity in the target FIE after completion.

The charts below illustrate the above scenario:

Click here to view charts.

Before the issuance of the Interim Provisions, one of the key practical hurdles was how the value of the equity being contributed should be determined, i.e., whether it should be determined based on the registered capital of the Equity Company or the valued amount or a negotiated amount agreed upon by the parties. In practice, different authorities held very different views, which caused considerable uncertainty to the approval process. With the clarifications provided by the Interim Provisions, we expect more certainty from the authorities in the approval process.

  1. Timing of contribution

The Interim Provisions do not provide for any contribution time limit, but the AIC Measures require that the investors of a newly-established FIE would have up to one year from issuance of the target FIE’s new business licence to complete the contribution of the equity interest.

For increases of registered capital under the AIC Measures, the equity contribution must be completed prior to an application for registration of the registered capital increase.

One practical issue which the Interim Provisions have not addressed is, in cases such as the one illustrated above, whether parties should apply for approval of capital increase in the Target FIE or that of the equity transfer of the Equity Company first. Ideally, the two approvals can be obtained simultaneously but this will only be possible if the Target FIE and Equity Company are subject to the jurisdiction of the same approval authority. At the moment, authorities in different locations appear to have different practices. Parties will therefore have to consider the practical implications given the potential time gap between the two approvals required in the transaction.

  1. Foreign debt limitation

One significant limitation on the contribution of equity as registered capital is that the Interim Provisions exclude the contributed equity when calculating foreign debt quotas based on registered capital and total investment. This could severely limit the ability of an FIE to borrow money from overseas if it has been established with a significant portion of its registered capital being contributed in the form of equity. Moreover, equity contributed as registered capital will also be disregarded when calculating an FIE’s quota for duty-free importation of equipment.

For more information on the relationship between registered capital, total investment and foreign debt, please see Section 18 of the Herbert Smith Freehills China investment guide.

  1. Looking forward

The Interim Provisions offer welcome clarification of the contribution of equity as registered capital of an FIE. In the meantime, while the contribution of equity may relieve an investor’s cash flow burden, the appraisal requirement may increase the complexity of and lengthen the time required for the contribution of equity as registered capital in another FIE.