China regulation: Circular progress

Nearly 10 years ago, venture capital investment in China temporarily ground to a halt. This was a regulatory roadblock arising from the State Administration of Foreign Exchange's (SAFE) desire to establish a degree of control over the army of entrepreneurs raising money offshore.

Circulars 11 and 29, issued in early and mid 2005, mandated the registration of investment activities with SAFE, but the requirements and processes were not clearly set out. Spooked by the uncertainty, investors hung back. It wasn't until the end of the year, and the release of Circular 75, that confidence was restored.

Circular 75 was an improvement but not a panacea. It still imposed a heavier compliance burden on the VC community, requiring Chinese founders and foreign investors involved in setting up offshore entities for fundraising purposes to disclose the intended use of this capital to SAFE. Failure to do so could jeopardize a future IPO.

Now Circular 75 has itself been superseded. What does the new piece of legislation - Circular 37 - mean for the status quo?

"The Circular 37 is probably one of the most sophisticated clarification rules on the principle of PRC citizens and residents needing to register with SAFE," Rocky Lee, Asia managing partner at Cadwalader. He sees it as a substantial simplification of the registration process and a means of enhancing the use of variable interest entity (VIE) structures - a controversial but at times essential piece of the VC jigsaw.

However, other industry participants remain cautious. They note that the VIE situation has yet to be fully clarified, while measures taken to support Chinese companies making outbound investments - highlighted by SAFE as a key advantage of the revised approach - will only prove fruitful if investors know where they stand.

Offshore, onshore

The VIE structure was introduced so foreign investors could gain access to areas, such as the internet industry, where their direct participation is not permitted.

The normal practice is for start-ups seeking VC funding to register with SAFE and set up an offshore special purpose vehicle (SPV). A foreign investor injects capital into the SPV, which in turn acquires ownership of the onshore assets. The onshore entity becomes a wholly foreign-owned enterprise (WFOE) and distributes profits to its VC shareholders through dividend payments.

Assets to which foreign investors cannot have direct exposure are held outside of the WFOE in a parallel structure owned by one or more Chinese nationals, usually the company founder. The VIE is a series of contractual agreements between the WFOE and the parallel company to secure the former's interest in the latter.

Prior to the publication of Circular 37, Chinese companies had to comply with the Circular 75 requirement to disclose offshore investment proposals in order to get SPV registration approval. A VIE structure would have to be revealed as part of this process, but over the last few years it has been increasingly scrutinized.

In 2011, the China Securities Regulatory Commission (CSRC) asked the State Council to take action against the VIE structure. SAFE responded by refusing to accept foreign exchange registrations that included VIEs. Since then the regulator's stance appears to have softened somewhat, with some industry participants claiming that SAFE will approve a deal if VIE references are removed from proposals.

Circular 37 has liberalized the environment still further. The definition of an SPV and its purpose have been broadened, allowing offshore capital to flow more easily into China. This has been achieved by ditching two key Circular 75 requirements. First, rather than register the SPV (a red-chip structure) and every offshore subsidiary beneath it, SAFE only need known about the top-level SPV. Second, disclosure of offshore investment proposals - which would reveal the existence of any VIEs - is no longer necessary.

"The simplification of the registration process should streamline the SAFE registration process, if implemented in practice, and reduce delays in executing red-chip investments," says Thomas Chou, partner at Morrison & Foerster.

Cadwalader's Lee says his firm has already noticed positive changes. In the past, it would take 2-6 months for a Chinese company to get approval for registering an offshore SPV to receive foreign funding. Under the new circular, the waiting period is expected to fall to 10 days.

Lee adds that Circular 37 should be considered alongside Circular 36, which was issued one day after, to get a broader picture. Under Circular 36, SAFE is liberalizing capital account settlement for foreign-invested enterprises, allowing companies to covert foreign currency into renminbi.

"The two circulars help relax capital flow into China's venture-backed tech, media and telecom businesses," he explains. "The net result is that a VIE business structure will have better cash flow and that it is now much easier to register Chinese founders, employees, and investors when they own shares in a venture-backed business using a round-trip structure."

What it means in practical terms is that if a Chinese start-up raises $20 million from foreign VC investors, it will be much easier than before for the onshore WFOE to convert this capital into renminbi and put it to work in the business.

However, not everyone is so excited by the new rules, at least as far as VIEs are concerned. While SAFE hasn't outlawed the structures in the new circular, neither has it endorsed them.

"It would be dangerous to think that Circular 37 gives some kind of blessing to VIE structures," says Michael Chin, partner at Hogan Lovells. "Our experience has been that, when we applied for a registration under Circular 75, the authorities have asked for any express reference to ‘VIE' to be removed, even though a VIE structure was in place. We think the same scrutiny exists over VIE structures and Circular 37 doesn't change that."

Outbound initiatives

While SAFE remains officially silent on VIEs, it has been much more willing to trumpet the benefits Circular 37 brings to Chinese companies wanting to use an offshore SPV as a vessel for capital earmarked for international expansion. "In order to support the China ‘go out' policy and make full uses of onshore and offshore markets, we will further simplify the procedure to allow Chinese residents to raise funds and make investments through SPVs," SAFE noted in a statement.

The offshore SPV, which previously could only exist as a financing vehicle, can now be used to support acquisitions onshore and offshore. For onshore activities, it is free to engage in M&A under normal regulatory and foreign exchange rules, or to set up greenfield enterprises. "That type of investment in China wasn't explicitly permitted under Circular 75," says Christopher Xing, M&A tax partner at KPMG China.

Chinese founders have various options in terms of capitalizing the SPV, such as using onshore collateral to get loans overseas. But more importantly, that capital can accumulate offshore. Traditionally, companies have been obliged to repatriate the capital raised offshore to China within 180 days. In that context, those earnings would "immediately" become taxable.

"Now, SAFE has lifted this compulsory profit repatriation restriction and as long as the PRC-controlled foreign company rules do not apply and offshore earnings could be reasonably retained offshore, the SPV won't be subjected to immediate taxation in China," says Xing.

However, there is still some concern whether individuals can openly use SPVs to conduct outbound investment without approvals from other authorities, such as the National Development and Reform Commission (NDRC) and The Ministry of Commerce (MofCom).

"While Circular 37 in many ways liberalizes the registration and financing of SPVs, it was adopted solely by SAFE and therefore does not have the authority to supersede MofCom's jurisdiction over the acquisition of an affiliated PRC company. As the latter is an important component of red-chip restructurings, we look forward to further guidance from MofCom as to whether it will also liberalize its approval process with respect to such transactions," says Morrison & Foerster's Chou.

Progress may well be slow. Even though SAFE has issued guidelines, the fragmented nature of its physical presence and governance structure means they aren't yet being implemented nationwide. This is fairly typical of Chinese legislation where local authorities are reluctant to take action without further clarification.

"Circular 37 is still subject to a lot of interpretation by the local SAFE authorities," says Hogan Lovells' Chin. "Yes, it's further step in the right direction, but there are a number of matters that remain unclear."

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• Topics
• Regulation
• Greater China
• Venture
• Early-stage
• China
• Venture
• tax
• regulation
• Renminbi