Offshore to China

Chinese authorities are monitoring the use of offshore special purpose vehicles, which have afforded many advantages to private equity investors in the region. By Albert McLelland and Jiannan Zhang

To better understand the implications of China's new policy on offshore investment vehicles announced on January 24th and further detailed on April 8th (Circulars No. 11 and 29, respectively), it is worthwhile to briefly review the regulations in the context of the investment environment in China.

After a slowdown in foreign investment due, in large part, to the Severe Acute Respiratory (SARS) epidemic, foreign direct investment (FDI) in China reached a record US$64 billion (€53 billion) in 2004.

Although investments through free-ports such as the British Virgin Islands, the Cayman Islands and Western Samoa have long been utilized by foreign investors, these jurisdictions have become a growing source of FDI for China. Indeed, the increase in investments from these freeports corresponds closely with the decline in investments from Hong Kong beginning in 2003 and accounted for approximately 15. 5 percent of total new FDI invested in China in 2004. Although the country of origin for the freeport FDI is not tracked, market sources attribute the origin of these investments primarily to the OECD countries ? Taiwan and, most importantly, China itself. In fact, it is believed that a significant portion of the monies invested through freeports (a recent US Department of State Report suggests up to one-third) is derived from PRC investors seeking to capitalize on incentives and avoid domestic taxes.

Depending on the sector, investment regulations in China can be complex. However, in sectors where investment is not prohibited or restricted, most foreign invested enterprises (FIEs) have taken the form of wholly foreign-owned enterprises (WFOEs). In fact, in 2004, over 70 percent of approved projects took the form of a WFOE. Other common ownership forms that have evolved since the 1980's include equity joint ventures (EJVs), cooperative (or contractual) joint ventures (CJVs), or foreign-invested companies limited by shares (FICLS).

Other, more specialized, investment vehicles are also available. For example, branches are permitted in certain sectors of financial services and representative offices have been used by law firms (representative offices of accounting firms and law firms are allowed to conduct profit-generating business through this vehicle). With the amendment of China's Ministry of Commerce regulations in February of 2004, some believe that holding companies will become more popular with strategic investors that have several large investments to manage.

In March of 2003, a new regulation took effect that replaced previous provisional regulations for the formation of foreign invested venture capital firms (which can be in the form of a WFOE). The new regulations offered a number of advantages including lowered capital requirements, organizational forms similar to limited partnerships and, even the ability of firms to manage funds invested directly from overseas. However, like other foreign enterprise ownership structures, they are cumbersome and inadequate from the perspective of many, if not most, private equity firms due to limits on corporate structures, difficulties associated with share issuances and transfers as well as exit mechanisms.

In particular, even if you invested in an enterprise that was fortunate enough to qualify for listing in China, it does not-mean that the fund's shares would also be listed; listing in China is only a partial listing (i. e. only those shares issued at IPO will be listed on the stock exchange). The PRC Company Law (1994) states that only companies limited by shares can issue shares to the public and that there is a lock-up period of three years for the promoters. Thus, only the shares subscribed by the investing public are floated. Further, trade sales are not permitted during the lock-up period.

Thus, the only alternative for a fund is to attempt a private sale, which normally involves a steep discount due to the illiquidity of their shares. Further, even if the fund is able to identify a buyer willing to pay an acceptable price, the fund will face additional potential remittance problems. To remit the sale proceeds out of China, the remittance bank will require a tax clearance certificate (much as it does in the case of dividends). The issue is that China has not yet implemented regulations for capital gains taxes. If the fund is willing to pay higher ordinary income tax, there is no particular difficulty in obtaining the necessary tax certificate. However, if the fund would prefer to pay lower capital gains taxes, the fund will need to convince the tax authorities that the transaction represents a capital gain and, therefore, should not be subject to ordinary income tax. This can obviously be a difficult proposition and, as discussed below, many private equity funds have chosen to avoid issues with the tax authorities by listing outside of China.

Leading foreign private equity firms have often utilized investment holding companies established in freeports to implement their investment activities in China. These structures offer a number of significant advantages to private equity funds. Four that seem of particular relevance to a discussion of offshore investment vehicles are:

Qualifications criteria. As mentioned above, FDI actually accounts for a relatively small amount of China's fixed asset investment. Consequently, investment dollars are not viewed equally and there is a distinct preference for industry expertise in conjunction with investments. Thus, China's regulators have set up qualification requirements in selected industries such as elements of the financial sector, advertising, telecoms and broadcasting companies. To meet these criteria, funds have teamed with industry players to establish offshore companies to meet the regulatory requirements.

Acquisition financing. Foreign funds are quite accustomed to leveraging investments in target companies. However, the General Principles of Loans from the Bank of China prohibits PRC banks from financing equity investments (a new draft of the General Principles of Loans would seem to open the window further for PRC banks to finance equity investments but the new regulations have yet to be adopted). Further, there are several structures involving domestic Trust and Guarantee companies that, in practice, can ameliorate this obstacle.

Nonetheless, a number of funds have relied on offshore lenders to achieve the desired leveraged investments. This is commonly accomplished by providing security in the assets of target companies in China, which can take the form of a pledge of shares (which requires approval of the Ministry of Commerce or its local counterparts) or through a pledge of assets (which depending on the type of assetmay require approval from the State Administration of Foreign Exchange (SAFE), local real estate registration authorities and/or the local State Administration of Industry and Commerce).

Structural flexibility. Significant additional benefits of offshore vehicles are a wider variety of choices for investment structures (such as preferred stock and convertible securities) as well as easier transfers of equity ownership.

Investment exit. As alluded to above, the offshore or red chip model remains the preferred choice for private equity funds to invest in China. Under this structure, private equity funds will generally invest in a freeport holding company that will, in turn, hold the assets of the target company. For those funds desiring the option of listing the target on a foreign stock exchange, this structure offers far fewer regulatory impediments related to PRC law.

Although venture capital investments represented less than 2 percent of total FDI, China reached new heights both in terms of transactions completed and amounts invested in 2004.

Further, according to Zero2IPO, total exit amounts reached almost four times those achieved in 2003. Trade sales were the most common method of exit at almost 50 percent but IPOs increased dramatically over 2003 and almost 70 percent of all proceeds were via overseas listings. These trends reversed dramatically as a result of the new SAFE policies on offshore investment vehicles.

Although media sources differ, according to the Asian Venture Capital Journal, the number of announced private equity deals fell from 31 in the first quarter of 2004 to 19 this year. This corresponded to a 31 percent drop in investments to $556 million. Moreover, market sources indicate that a number of IPOs have been put on hold as the legal community comes to grips with the potential impact of the announced policies. Part of the issue is that SAFE has yet to reveal the procedures investors must follow to comply with the proposed regulations and, further still, SAFE has not received official consent from the Ministry of Commerce, which oversees cross-border investments, on the proposed regulations. In short, uncertainty is anathema to investment and, according to senior directors of SAFE, the proposed regulations have had an unintended impact on foreign private equity investments and IPOs.

On May 31st, attorneys from Preston Gates & Ellis' offices in Beijing and Hong Kong met with senior directors of SAFE to discuss the circulars mentioned at the beginning of this article. During the meeting the SAFE officials confirmed that the intention of the circulars was to record and track PRC domestic entities' and/or individuals' foreign exchange transactions and tax obligations. As previously noted, as much as one-third of the funds derived from freeport investments are believed to be from PRC nationals. SAFE has had difficulty in keeping track of PRC entities' and individuals' activities, investments, shareholdings involving overseas entities (such as special purpose vehicles) for the purpose of tax and foreign exchange transactions. The ultimate goal of SAFE is to target and prohibit transactions that allow Chinese entities and nationals to avoid and/or circumvent Chinese tax and foreign exchange laws. This said, legal experts also believe that restructuring of PRC assets involving SPV's to gain preferential tax treatment in the PRC should be regarded as proper and in accordance with PRC laws.

Thus, in theory, PRC nationals and entities repurchasing their own assets domestically via an offshore SPV or even overseas listing are permitted provided that the arrangement used is transparent and such party legitimately obtained foreign currency overseas. Accordingly, in theory, in a relevant restructure exercise, loan arrangements to Chinese individuals and entities arranged overseas to acquire their own domestic assets are also allowed provided, first, the relevant fair asset value is paid; and, second the loan transaction is not a sham whereby foreign currency is settled overseas without SAFE approval.

Based on their discussions with the SAFE Officials, Preston Gates understand that establishment of an SPV to be held by a Chinese national/entity is allowed provided that there are no violations of foreign exchange laws and for purpose of tax avoidance in PRC. Thus, structures involving WFOEs, major or minor holdings by Chinese nationals in an offshore SPV, asset repurchases by PRC parties, etc., are all, generally, permitted provided that the domestic party can show that the foreign currency transaction involved in the restructure/transaction is legitimate and such party is filing proper tax in the PRC.

The SAFE officials also indicated that they were aware of all the negative sentiments and uncertainty surrounding the circulars. They reiterated that, broadly speaking, activities involving private equity and venture capital investments are both permitted and encouraged. Moreover, the SAFE Officials stated that the circulars were not intended to prevent foreign investment into or cross border transactions with China. It is their view that foreign investors are only aiding in the process to keep domestic parties honest. In that regard, all filings and approvals will need to be sent in by both overseas and domestic parties at the same time. Further, in order to enable SAFE to keep track, a foreign party along with its Chinese domestic party will need to (from time to time) report any changes in shareholding structures involving Chinese shareholders/beneficial owners.

Initially, the SAFE Officials indicated that a joint circular (between SAFE, Ministry of Finance, State Asset Investment Commission and the PRC Tax Bureau) would be issued by early July to clarify the situation and the regulations. The Joint Announcement was intended to clarify (in broad terms) that all relevant investment structures and overseas listings are to be permitted provided that one files and gains approval based on the relevant corporate structure. However, at the time of this article, the joint announcement has been delayed due to turf battles among the various responsible agencies.

Nonetheless, foreign investors can take some solace in the fact that virtually all the officials have stated repeatedly that the only transactions that will not be permitted are those whose transaction structures do not show or clearly identify how a Chinese entity/ individual obtained foreign currency overseas to acquire their holdings in an overseas company. So long as a Chinese entity/individual can show that the foreign exchange used to purchase or acquire overseas shares are legitimate under the laws of the PRC, approval will normally be granted.

With respect to the approval process, an approval and registration process should take no more than 20 (working) days in a normal case. The approval process is for transactions completed after 24 January this year. Any transactions occurring prior to that date will be a filing and report procedure to SAFE. Obviously, the discussions with the SAFE officials and promised joint announcement should ease concerns over both completed and anticipated transactions. However, the result of the circulars will ultimately be determined by the final language of the joint announcement and the implementation of the new procedures.

Albert McLelland is a Senior Managing Director of AmPac Strategic Capital LLC. AmPac is a boutique investment bank that specializes in assisting foreign strategic and financial investors to build their businesses in China. Reach him at

Jiannan Zhang is an attorney with the Beijing and San Francisco offices of Preston Gates Ellis LLP. Preston Gates is an international law firm with 11 offices in the United States and Asia. He can be contacted at