Common Investment Vehicles in China

(I) Representative Office

The most basic form of foreign business presence in China is the Resident Representative Office (RO). A China Representative Office provides a permanent base from which its resident personnel may conduct local sales and purchasing activities. As a practical matter, it is desirable, and in most cases necessary, to establish a formal Representative Office for a foreign company to do the following in China:

– Open an office with company signage
– Print company business cards showing local contact information
– Open bank accounts
– Import office equipment and supplies
– Import personal effects of resident company representatives, and
– Hire Chinese employees.

Representative Offices are prohibited from engaging in “direct business operations” and violations may result in fines and the closure of the office. There is no precise definition of “direct business operations”. However, it is clear that the Representative Office may not directly enter into contracts with a view to making profits nor may it directly invest in the PRC with a view to making profits.

(II) Equity Joint Ventures

The Equity Joint Venture (“EJV”) is probably the most common of the foreign investment vehicles in China.

(a) Legal Form
EJVs are limited liability legal person entities. The concept of limited liability now appears to be both settled and respected in China and conforms substantially to international custom and practice.

(b) Capital Contributions
Capital contributions to an EJV (which are referred to as the “registered capital”) must be made in cash, patented and unpatented technology, materials and equipment and other property rights. However a recent circular released by State Administration of Foreign Exchange (“SAFE”) has loosened the restrictions to allow foreign parties to make capital contribution in assets other than those listed above, such as the proceeds of investments (released through liquidation, share transferring, capital reduction etc.) from FIEs it has previously invested in. The investors must share the profits and bear the losses of the EJV in proportion to their respective equity contribution percentages. The ratio of debt to equity and the timing of equity contributions must conform to applicable PRC legal requirements.

(c) Management and Operation
An EJV functions substantially as a corporation in Western jurisdictions, with a board of directors and a general management office operating under the supervision and direction of the board. However, an EJV also shares many characteristics of a partnership in that the directors are appointed by the parties in general proportion to the investors’ respective equity shares. There is no concept of a Shareholders meeting in an EJV (or any FIE) with power being concentrated at the board level. Also, equity interests can be transferred only with the consent of the other investors, and certain other fundamental activities require unanimous Board resolutions to be validly executed.

(III) Cooperative Joint Ventures

(a) Forms of Cooperative Joint Ventures (“CJVs”)
In the past, CJVs took one of two different forms: a “true” CJV which did not involve the creation of a legal person that was separate and distinct from the contracting parties; and a “legal person” CJV in which a separate business entity was established and the parties’ liability was generally limited to their capital contributions.

In the case of a “true” CJV, each party was responsible for making its own contributions to the venture, paying its own taxes on profit derived from the venture and bearing its own liability for risks and losses. In contrast, a “legal person” CJV, the more prevalent form today, shares more of the characteristics of an EJV. The “true” CJV is a rare animal in today’s market as few investors are willing to entertain the prospect of unlimited liability. For purposes of this overview, we will discuss only the “legal person” CJV structure.

(b) Parties’ Investments
The primary difference between a CJV and an EJV is that parties to a CJV, instead of or in addition to contributing to the registered capital, may provide “cooperative conditions” that may consist of access to or use of certain assets and/or rights that cannot be or are not assigned formally to the CJV, such as market access rights or undertakings to supply certain services or cooperation that will promote the business prospects of the CJV. In the most common scenario, the Chinese party provides such non-equity “cooperative conditions” in exchange for an agreed share of the profits, while the foreign party contributes most or all of the true registered capital in the form of cash or other permitted in-kind contributions.

(c) Distribution of Profit
The distribution of profits from a CJV does not have to conform rigidly to the ratio of the parties’ capital contributions. Consequently, CJVs are considerably more flexible than EJVs, permitting schemes whereby the profit sharing of the parties is not necessarily tied to the value of the contributions. Unlike EJVs, CJVs are expressly permitted to distribute dividend in kind as well as cash.

(d) Management and Operation
A CJV must either have a board of directors or a joint management office. In practice “legal person” CJVs typically adopt the board of directors’ model. The CJV law also permits the management of a CJV to be delegated to a third party with government approval. This arrangement has been the standard mode of operation for the hotel industry but could be utilised in other industries as well, although this is not so common.

(e) Recoupment of Investment
It is permitted in CJV contracts, subject to approval, to provide that the foreign party may recoup its equity investment prior to the expiration of the term provided that if the foreign party has already recovered its investment, all of the fixed assets of the joint venture will revert to the Chinese party upon termination of the CJV. In other cases, liquidation will be handled with reference to the procedures applicable to EJVs.

(IV) Wholly Foreign-Owned Enterprises

(a) Permitted Industries
In connection with China’s re-entry into the WTO, certain previous requirements that a Wholly Foreign Owned Enterprises (WFOE) be a high-technology or export-oriented (with more than 50% of products exported) production (but not service) enterprise have now been relaxed, and WFOEs are permitted in a broader range of categories. However, where the Catalogue or other PRC laws and regulations specifically refers to a joint venture requirement, WFOEs may not be possible.

(b) Parties Involved
The foreign investor in a WFOE does not need to negotiate with a Chinese enterprise matters such as the scope of operation, number of workers, percentage of exports and changes in control or ownership of the business. A WFOE will therefore be easier to establish and exit from than an EJV or CJV. In fact, in the past few years, the WFOE has become the foreign investment vehicle of choice, accounting now for more than half of all foreign investment in China.

(c) Management and Operation
Responsibility for the daily operations of a WFOE lies solely with its own management, although financial reports must be filed regularly with the PRC tax and financial authorities. However, such filings are for regulatory purposes only, and PRC law prohibits interference in operation and management activities of a WFOE pursuant to its approved articles of association (“AA”).

(d) Approval and Capitalization
Outline of Basic Legal Issues in Respect of the Establishment of Sino-Foreign Joint Ventures relating to permitted industry sectors (Section 2.1), government approvals (Section 2.2) preferential treatment for FIEs (Section 2.3), scope of business (Section 2.4), capitalization (Section 3.2) and term of operation and operating licenses (Section 3.5) also apply generally to WFOEs.

More information on Wholly Foreign Owned Enterprises (WFOE)

(V) Holding Companies

(a) Scope of Holding Company Operations
For a foreign company with many investments in China, a holding company structure can provide many advantages such as centralised management, employment, marketing and distribution. Upon approval by the relevant authority, a holding company may also balance foreign exchange within the group and hold other group companies’ interests in other Chinese investments. In recent years, the scope of permitted holding company activities has been expanded to include R&D, buy-sell distribution and systems integration, technical training, test marketing and holding shares in companies limited by shares, in each case subject to certain consents and approvals.

(b) Qualifications
To establish a holding company the regulations set out high threshold tests. The registered capital of the proposed holding company must be at least US$30 million and must be used for new investments (i.e. you cannot use it to buy-in the interest in FIEs brought under its mantle). For a wholly-foreign owned holding company, the applicant foreign company must have (i) had total assets in the year prior to application of not less than US$400 million, (ii) already established FIEs in China with paid-up capital of more than US$10 million and (iii) secured approval for at least three more projects or, alternatively established more than ten FIEs each with a paid up capital of more than US$10 million.

(VI) Alternative Investment Structures

(a) Acquisition of Equity Share in Existing FIE
As an alternative to establishment of a new FIE or as part of an overall acquisition transaction involving entities in China, it is possible to acquire the registered capital in an existing FIE held by a domestic or foreign investor. The other party(ies) to an EJV or CJV have a pre-emptive right to acquire the equity share of the proposed transferor, and have absolute consent rights to any transfer generally. All transfers of registered capital in any FIE additionally require amendment to the AA of the FIE, unanimous approval of the FIEs board of directors and approval of the local COFTEC (or in some cases, MOFCOM). Consequently, the transfer of registered capital in any FIE, including a WFOE, is more complex than a simple transfer of shares in an off-shore corporate entity generally, and the transfer of registered capital in an EJV or CJV is even more complex as it invites a possible renegotiation of the AA as a condition to the transfer. Tax and other related issues in respect of the sale of an equity interest in an FIE are discussed in Section 5.1 below.

(b) Acquisition of Off-shore Vehicle
Many financial or strategic investors planning to do private placement capital raises in anticipation of an eventual public offering set up an off-shore special purpose vehicle (“SPV”) in a tax-efficient jurisdiction to be the named foreign investor in the FIE. Even many multinational strategic investors not planning for a potential exit from the investment may also utilize an off-shore SPV for their China investments for internal management purposes. Instead of selling its interests in the FIEs concerned, the foreign investor may sell its shares in the off-shore SPV which holds the FIE interests in China. Consents and approvals of such sale of off-shore SPV interest are not required, as PRC law is not directly applicable to such transaction.

However, since EJVs and CJVs operate in many respects as a partnership (and good partner relationships are the key to the success of any such EJV or CJV), and since the new investor may wish to negotiate amendments to the AA of the EJV or CJV in any event as a condition to the acquisition of the SPV shares (which will require board and COFTEC approvals), it is as a practical matter necessary and desirable for each new investor in the SPV to cultivate a positive working relationship with, and obtain at least tacit consent of, the other investors before concluding the investment.

Acquisition of the shares in an off-shore SPV holding all of the registered capital of a WFOE, of course, is much simpler. However, given the ease with which a new WFOE can be set up, the circumstances in which acquisition of the SPV’s indirect interest in an existing WFOE will, as a practical matter, be simpler may be limited.

(c) Branch Office
To establish a branch office of a foreign company in China, significant prerequisites have to be fulfilled. Among other requirements, the applicant must have had a Representative Office in China for over two (2) years and the minimum working capital of the branch office must exceed US$10 million. A branch office will not have legal person status and as such, as in the West, its parent company will be held liable for its activities. Certain branch office restrictions have recently been lifted in compliance with WTO provisions, which will allow foreign companies to establish liaison offices for a local parent company. However, approval of branch offices for other purposes is, at present, rarely given and then only in certain industries such as banking and insurance.

(d) Foreign Invested Company Limited by Shares (“FICLS”)
An FICLS essentially is a blend between an EJV and a Western stock company or public company. An FICLS is governed by a board of directors which is subordinate to the shareholders. For an FICLS, the board of directors must be established in addition to the supervisory board consisting of representatives of the shareholders and employees. Compared to EJVs, some of the advantages of an FICLS include having perpetual existence and no requirement of unanimous consent of “shareholders” as is required in EJVs. The foreign investor is required to hold more than 25% of the total shares of the FICLS to qualify as an FIE. An FICLS can be established by way of promotion with a minimum of US$30 million of paid up capital. However, if the FICLS is set up by way of public share offering the total investment will be substantially higher. Unlike FIEs, FICLS can, with approval, be listed on a recognised PRC stock exchange, or even offer shares overseas. Guidelines issued by MOFCOM indicate that promoters may be jointly and severally liable to pay for the shares of an FICLS in full.

(e) Acquisition of Shares in State-owned Companies (Direct Cross-Border M&A)
Corporate law in China generally did not contemplate direct cross-border merger and acquisition (“M&A”) investments until recently (below Section 2.6(f)). In addition, many foreign investors have been reluctant to take on the liabilities of existing state-owned enterprises (“SOEs”). Consequently, most FIE deals involving SOEs have taken the form of asset acquisitions, in which selected SOE assets have been contributed to or acquired by a new EJV or CJV.

However, in a landmark deal in 2002, Chinese authorities allowed a foreign investor to acquire a stake in a Chinese state-owned bank and relevant cross-border M&A rules for foreign purchase of equity interest or shares in SOEs were issued shortly afterwards by the State Economic and Trade Commission (“SETC”) (now merged into MOFCOM) and other authorities. Foreign investors may acquire a minimum of 10% (10-25% to qualify as an FIE, or more than 25% to be able to enjoy the preferential treatment afforded an FIE) of SOEs that do business in industries that are not prohibited to foreign investors either: (i) by acquiring certain state-owned equity interest or unlisted shareholdings, (ii) by becoming an additional investor in an SOE through a capital increase or issuance of new unlisted shares, (iii) by acquiring claims of SOE creditors by way of debt transfer, or (iv) by purchasing assets of an SOE to establish a new FIE. However, the multi-stage approval procedures are cumbersome and lack clarity, and thus take up remains low.

(f) M&A Conversion of Domestic Enterprises
Under tentative rules jointly issued in March 2003 by MOFCOM and other authorities and which became effective in April 2003, a foreign investor may directly acquire an equity interest in an existing domestic enterprise (share deal), and if the resulting foreign ownership share is more than 25% and the investment otherwise complies with the other laws, rules and regulations applicable to FIEs, then the target domestic company can be converted into a new FIE. Alternatively, the foreign investor can also acquire assets of a domestic enterprise and inject these into an existing FIE or use such assets to establish a new FIE (asset deal). For the first time, these rules introduce criteria and thresholds under which a merger or acquisition is subject to anti-trust reporting, hearing and review procedures. Such reporting obligations also apply to offshore-only transactions that give rise to competitive effects in China. There remain many ambiguities in these rules which will not be resolved until new regulation is issued in this area.

The form of M&A discussed here, is a direct form of investment, as opposed to the typical quasi-M&A investment in which the domestic company contributes or sells its key assets to the new Sino-foreign joint venture but the joint venture does not assume the liabilities of the Chinese company (although typically the liabilities of the Chinese investor must be addressed, otherwise the Chinese party will not be able to make the investment). This is still a relatively new, untested and procedurally intensive investment structure (formerly only available in Beijing under rules issued in 1999 by the Beijing COFTEC) which requires substantial negotiation among the parties and consultations with the relevant government authorities.

It appears that these rules, which are applicable to all domestic companies that are not FIEs, are complementary to the above-mentioned M&A rules in regard to SOEs, although there is some overlap. The merger of SETC into MOFCOM has at least partially consolidated approval jurisdiction in this area. However, it remains to be seen if and how the disparate cluster of M&A related rules will be consolidated in the future.

(g) Qualified Foreign Institutional Investor (“QFII”) Scheme
Foreign portfolio investment in domestic PRC A shares is now possible under a set of new rules made effective in December 2002. Since China’s currency, the Renminbi (RMB), is not convertible on the capital account (see Section 3.3 below), the equity of PRC listed companies is split between RMB-denominated A shares and B shares (denominated in RMB but tradable in either US dollars or Hong Kong dollars). A shares account for most of the value of the PRC equity market but were previously off-limits to foreign investors. The new regulations permit foreign institutions from 16 jurisdictions to invest in A share, subject to some restrictions, and repatriate profits and principal without having to establish a PRC business vehicle.

Four different types of institutions are eligible to apply for a license for QFII status: fund managers with at least a five (5)-year track record and US$10 billion in assets under management; insurance and securities companies with thirty (30) years’ experience, US$$10 billion in assets under management and paid-in capital of at least US$1 billion; and commercial banks ranked within the top 100 banks globally in terms of assets and not less than US$10 billion in assets under management. In addition to these financial qualifications the applicant must satisfy other requirements such as having had no record of material regulatory sanctions in the last three (3) years.

Under the new regulations, the minimum investment quota is US$50 million, and the maximum is US$800 million. Portfolios can be managed by the QFII itself, or by a nominated securities house, but assets must be held via a custodian. A number of foreign invested banks are qualified to provide this service. All trades must be executed by a licensed PRC securities house and all settlements and offshore repatriations must be affected by the QFII custodian.

The regulations outline a somewhat restrictive liquidation mechanism devised to encourage longer term investments.

QFIIs who are closed-end fund managers are subject to a three (3) year lock-in period, whereas the lock-in period for other QFIIs is one (1) year. Repatriations of principal must be made in installments of not more than 20% of total invested principal and must be separated by a defined period of time.