New SAFE Guidelines on Registration of Financing by PRC Residents through Offshore Special Purpose Vehicles

07.10.2007

On May 29, 2007, the State Administration of Foreign Exchange of China (SAFE) issued new “operating procedures” (Operating Procedures)[1] further clarifying its earlier-released “Circular No. 75”—which relates to foreign exchange control on financing and round-trip investment by domestic residents through offshore special purpose vehicles (SPVs).[2]

The Operating Procedures impose new compliance burdens on venture capital and private equity firms involved in transactions with Chinese “round-trip” investors—that is, Chinese individuals and companies who set up offshore SPVs to invest back into China.[3]   The Operating Procedures are linked to the foreign exchange registration requirements that are set forth in both Circular No. 75 and the 2006 M&A Regulations.[4]  They provide a detailed roadmap of the documentation and intricate registration requirements for the multiple stages of SPV financing, including:

• setting up the offshore SPV;
• injecting offshore assets into the offshore SPV; 
• establishing, acquiring or investing in a PRC onshore target through the offshore SPV (i.e., round-trip investment); and
• changing or restructuring the offshore SPV. 

The Operating Procedures state that they will come into effect immediately, although they are not yet available on SAFE’s official website.  Most of the new rules, however, have been known for some time as “internal guidelines” among those in the China venture capital and private equity communities.  The highlights and implications of the Operating Procedures are set out below:

Expanded Definition of “Domestic Resident Natural Persons” Who Must Register SPV Financings

The Operating Procedures apply to the registration of SPVs established or controlled by a “domestic resident natural person” (individual) or a “legal person” (corporate entity).  Although Circular No. 75 provides vague guidance on the definition of a “domestic resident natural person” (which is different from a “PRC national” as commonly understood), the Operating Procedures elaborate and clarify that a qualified PRC resident individual can no longer escape the registration requirements by changing nationality or obtaining permanent resident status in the US, Hong Kong, Macau or other countries/regions outside of the mainland China.  Under the Operating Procedures, the following individuals are “domestic resident natural persons” for purposes of registration:

• an individual holding a PRC identification card or passport or other PRC identification documents;
• an individual who has a domicile inside China or who has a domicile inside China but has temporarily left China for certain reasons;  
• an individual who has an interest in a domestic enterprise; or
• an individual who has an interest in a foreign-invested enterprise converted from a domestic enterprise.

In practice, this expanded definition has been reflected in the undertaking forms prepared by certain PRC law firms, which require a signature by non-PRC residents in order for the PRC lawyers to issue a “clean” opinion.  

New Preconditions for Registrations

The Operating Procedures, for the first time, impose certain preconditions for the registrations required at different stages.  These include the following:

• In order to obtain a registration of incorporation or acquisition of, or investment in, the offshore SPV, the PRC onshore target company and the offshore SPV must have a common management and a common shareholding structure. This means that the SPV may not be able to carry out any financing activities before the registration is completed, because any front-loaded financing activities may lead to the SPV’s shareholding structure deviating from that of the PRC onshore target. The financing of the SPV may be significantly delayed as a result of the common shareholding requirement.
• The PRC onshore target company and the offshore financing institution must have signed a letter of intent and a private placement memorandum, and the contents of the business proposal must be adequate and complete.
• The Operating Procedures seem to indicate that, in order for the offshore SPV to obtain the registration for the round-trip investment, the SPV must have been in continuous operation in the approved scope of business for at least three years.  We anticipate additional guidance on this requirement in the coming months.

New Categories of Documentation Required For Registration

For the first time, the Operating Procedures require, among other things, that the following information be disclosed to and registered with SAFE:

• the financial reports of the PRC target company in the past three years;
• employee/management incentive plans;
• offshore financing agreements;
• private placement memorandums; and
• documents evidencing the legitimate sources of foreign exchanges over US$50,000 to be paid to set up the offshore SPV.

Also, for the first time, the Operating Procedures have imposed a clear confidentiality obligation on SAFE authorities.

Harsher Consequences for Non-Compliance

The Operating Procedures reinforce the registration requirements of Circular No. 75.  Failure to comply exposes both PRC residents and offshore SPVs (through their onshore subsidiaries) to onshore liability for foreign exchange evasion.  For instance, under the Operating Procedures, where an SPV has completed a round-trip investment (i.e., the PRC onshore target has become an onshore subsidiary of the SPV and thus obtained its foreign exchange certificate) before March 31, 2006 but failed to register with SAFE before such date, SAFE may impose foreign exchange evasion penalties for any funds paid by the onshore subsidiary to the SPV after April 21, 2005.  Such payments can take the form of dividends, profit distributions, proceeds of liquidation, share transfers, capital recoupments or capital reductions and/or loan repayments.[5]   In light of both the financial penalties and reputational risk, private equity and venture capital firms should make it a due diligence priority to confirm that the SPVs they intend to fund have complied with all requirements and have successfully obtained the SAFE registrations. 

The Way Forward

The implementation of Circular No. 75 has varied from place to place in China, and from one local SAFE authority to the next.  With the introduction of the Operating Procedures, these local practices will become increasingly standardized.  But aside from creating more transparent and uniform practices, the Chinese government appears to have issued the new rules for two important additional reasons. 

• First, to tighten up supervision over overseas listings and other equity transactions involving SPVs, where the principal business is located in China. 
• Second, to channel the flow of capital moving in and out of China, and to use the foreign-exchange administration requirements in Circular No. 75 (as well as the 2006 M & A Regulations) to strengthen the collection of taxes based on income derived from Chinese sources.[6]

Given the increased scrutiny and regulatory supervision of SPV financings involving “round trip” investors, venture capital and private equity investors may want to consider alternative structures.  For instance, China’s Company Law (2005) and the recently implemented Partnership Law conform to international standards.  Depending on the circumstances, these laws allow for alternative financing and investment structures such as PRC onshore limited partnerships, RMB funds, venture capital enterprises, onshore holding companies and  reinvestments of foreign invested enterprises.

As a practical matter, however, the two best ways to avoid pitfalls in structuring offshore private equity and venture capital deals are to (1) keep abreast of developments, such as the new Operating Procedures discussed here, with advice of experienced legal counsel, and (2) maintain good working relationships with SAFE authorities at both the national and the local levels—or work closely with advisors who do.

For More Information

If you have questions regarding these recent developments, please feel free to contact your main client contact at Heller Ehrman or the following Heller Ehrman lawyers:

Hong Kong
 

Simon Luk	+852 2292 2222	simon.luk@hellerehrman.com
Michael Phillips	+852 2292 2207	michael.phillips@hellerehrman.com

Silicon Valley
 

Mark Medearis	+1 (650) 233-8307	mark.medearis@hellerehrman.com
John Sellers	+1 (650) 233-8412	john.sellers@hellerehrman.com

Footnotes:

[1] Their full title is: “Operating Procedures Regarding Issues Concerning Foreign Exchange Control on Financing and Round-trip Investment Through Offshore Special Purpose Companies by Domestic Residents Circular.”

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