The Ministry of Commerce (“MOFCOM”) recently solicited comments for its proposed Measures on Capital Contributions with Equity Interests Involving Foreign-Invested Enterprises (the “Proposal”). The Proposal is intended to supplement the State Administration of Industry and Commerce’s implementing rules, which were promulgated in 2009 as a set of instructions on how the revised 2006 PRC Company Law should be implemented. Although the implementing rules and the revised Company Law expressly permitted equity contribution as a means of capitalizing domestically-owned companies, the prior legislation was silent as to whether such contribution was permitted in cases of foreign-invested enterprises (a “FIE”). MOFCOM’s latest Proposal directly addresses that omission.

The Proposal, as it is currently drafted, would permit the contribution of an unencumbered equity interest in a Chinese company held by foreign shareholders as a means of fulfilling a portion of the registered capital of the other Chinese company in which it wishes to invest (the “Target Company”). Such equity interest contribution can apply in the following three scenarios: establishing a new FIE; changing the ownership structure of an existing domestically-owned company to that of a FIE; or increasing the registered capital of an existing FIE. Note, however, the total amount of all non-cash contribution, including the equity interests, must not exceed 70% of the total registered capital of the Target Company. Thus partners looking to scale back cash commitments may need to do so on a pro-rata basis.  

The Proposal has certain benefits to foreign shareholders: It provides an alternative to using cash as a means of capitalizing onshore investments, thereby lowering the risk of overfunded capital accounts. By contributing shares from one entity to a parallel entity, the holding company can now consolidate its onshore operating companies. Thus dividends paid to the parent company can be used to offset the losses of the parent company.  

While the Proposal permits the share swap effecting the merger, it does carry the caveat that the appraisal value of the contributed shares may not exceed the value of the interest to be held in the Target Company. The excess portion must be contributed to the reserve account.  

The Proposal has certain additional limitations. The contribution is subject to MOFCOM’s approval on a discretionary basis. Approval risk aside, the most significant limitation is that the contributed equity is excluded from calculation of the FIE’s debt-equity ratio for purposes of both duty-free importation allowances and, perhaps more importantly, permitted leverage by way of offshore debt.