By Hai Huang | Ying Cui
On July 15, 2014, the State Administration of Foreign Exchange (the “SAFE”) promulgated the Circular on Relevant Issues Concerning the Pilot Reform of the Administration of the Conversion of Foreign Equity Capital of Foreign Invested Enterprises (“FIEs”) in Certain Areas (“Circular 36”). Circular 36 is one of the SAFE measures released in recent months to ease control on the administration of the foreign currency conversion on capital account transactions. Capital account refers to income derived from inflow and outflow of investment or debt activities, and current account refers to income that is of a recurring nature, such as income derived from international trade or provision of services.
China has been exerting a stringent foreign exchange control on the capital account transactions, and conversion of foreign equity capital into RMB requires complicated approval procedures. On August 29, 2008, the SAFE issued the Circular on the Relevant Implementing Issues Concerning the Improvement of the Administration of the Payment and Settlement of Foreign Equity Capital of Foreign-Invested Enterprises (“Circular 142”), which set forth very stringent requirements for the conversion of foreign equity capital and the subsequent use of the converted funds. Post Circular 36, Circular 142 shall still be applicable to the areas outside of the pilot zones as set forth in Circular 36. Circular 36, effective as of August 4, 2014, initiates a pilot program in 16 zones[Endnote 1], which breaks certain grounds in terms of currency conversion under the previous Circular 142. This article mainly discusses Circular 36’s implications on the non-investing foreign invested enterprises (“Non-investing FIEs”) and investing foreign invested enterprises (“Investing FIEs”) under Circular 36.
1. Non-investing FIEs
1.1 Foreign Equity Capital Converted At Will[Endnote 2]
In accordance with Circular 142, the conversion of foreign equity capital into RMB shall be subject to the rule of “convert-to-pay”, which means that the conversion shall be approved only when there is an underlying transaction and RMB payment is required for settlement. Banks handling the conversion are required to closely review the application documents, which may include, inter alia, documents evidencing the use of converted RMB funds (such as business contracts or payment notices issued by the vendors, the latest capital verification reports prepared by an accounting firm etc.). In addition, pursuant to SAFE’s subsequent notices, if 95% of the foreign equity capital of an FIE have been converted, the banks must first verify the authentication of the invoices and other documents used for the previous conversions before processing the conversion of the remaining 5% of the registered capital in foreign currency. Now, under the new Circular 36, FIEs established in the pilot zones are able to convert “at will” 100%[Endnote 3] of their paid-in foreign equity capital into RMB at any point of time they choose, provided that FIEs have completed the capital contribution confirmation registration with the local branch of the SAFE regarding their paid-in capital.
FIEs are exposed to fluctuations in exchange rates prior to the implementation of the pilot program under Circular 36. Now, by allowing an “at will” conversion of 100% of FIEs’ paid-in foreign equity capital into RMB, Circular 36 supposedly gives FIEs an opportunity to lock in a favorable exchange rate and avoid the exchange risk[Endnote 4].
1.2 Equity Investments Allowed with the Converted Capitals
Circular 142 provides that the RMB funds converted from foreign equity capital of an FIE shall only be used for purposes within its business scope approved by the competent registration authority, and unless provided otherwise, the converted RMB funds shall not be used to make equity investments. Circular 36 lifts the above restriction, and provides that FIEs established in the pilot zones are allowed to use the converted RMB funds to make equity investments in the PRC. Procedurally, the target entity to be invested shall go through a re-investment registration with the local branch of the SAFE and open a “settled-to-be-paid” account. After the foreign equity capital is converted into RMB funds by the FIE, the converted RMB funds shall be remitted directly to the target entity’s “settled-to-be-paid” account, which will be under the supervision by the banks.
While Circular 36 removes the restriction on the use of the converted funds for equity investments, it still adheres to the principle of being “truthful” and for ”self-use” when using such funds as set forth in Circular 142 (please refer to Section 1.3 below for details), which means that the converted RMB funds cannot be used for purposes outside of the FIEs’ business scope. If the Non-investing FIEs intend to invest the converted RMB funds in other entities, the questions would be: (i) should the business scope of the target entity be within the business scope of the Non-investing FIEs; and (ii) should “making invest” be included in the business scope of the Non-investing FIEs? Circular 36 remains silent on the above issues. One SAFE official with whom we spoke indicated that the target entity’s business scope does not need to be in consistence with the business scope of the Non-investing FIEs, but “making invest” should be included in the business scope of Non-investing FIEs. In practice, it is difficult to include “making invest” in the business scope of a Non-investing FIE, and if the SAFE does insist in seeing this in the business scope of a Non-investing FIE, equity investments by the Non-investing FIEs are expected to be greatly restricted.
1.3 Use of Converted Capitals are Subject to the Principle of being “Truthful” and for “Self-use”
Pursuant to Circular 36, RMB funds converted at will shall be deposited with a “settled-to-be-paid” account opened by FIEs. The intention for opening such an account is to put the converted funds under supervision to make sure that the funds are used for “truthful” and “self-use” purposes, which inherited from Circular 142. Banks are required to release the RMB funds deposited in the FIEs’ “settled-to-be-paid” account based on the principle of being “truthfully” and for “self-use”. Circular 36 reiterates the restrictions on use of the converted RMB funds as previously provided for in Circular 142: (i) the converted RMB funds shall not be used for business activities outside of FIEs’ business scope; (ii) except provided otherwise, the converted RMB funds shall not be used to make investment in securities (such as buying shares of a listed company), whether directly or indirectly; (iii) the converted RMB funds shall not be used to extend RMB loans (expect prescribed in FIEs’ business scope), repay corporate loans or repay bank loans on behalf of a third party, whether directly or indirectly; (iv) unless the account holder is an approved real estate company, the converted RMB funds shall not be used to purchase a real property other than for FIEs’ own use.
1.4 Influences on “Red-Chip” Structure
As Circular 142 does not allow the Non-investing FIEs to make equity investments with the converted RMB capitals, for the foreign-invested enterprises in a “red-chip” structure, the sources for funding an investment or acquiring a company are limited, and such FIEs will have to use revenues generated from its business operations to fund the re-investment activities[Endnote 5]. By contrast, Circular 36 widens the funding sources for the Non-investing FIEs to make equity investments, which is beneficial for the foreign-invested enterprises in the “red-chip” structure to convert the funds raised overseas into RMB for use in equity investments.
However, the pilot reform initiated by Circular 36 does not seem to address the currency conversion issues relating to the VIE structures. How to fund the operations of the domestic operating entities with foreign capital raised overseas is one of the tricky challenges to companies adopting a VIE structure. Given the restrictions on conversion of foreign equity capital under Circular 142, a common way to have foreign equity capital converted into RMB is that the WFOE (the foreign currency holder and the payer) in a VIE structure enters into business contracts with the domestic operating entities (the RMB “needer” and the payees), thereby enabling the WFOE to convert the foreign funds and pay the domestic operating companies in RMB for the business transactions contemplated in the contracts. Under such method of conversion, there shall be a “truthful” underlying business transaction, and inevitably, tax liabilities will incur. Hence, in order to avoid tax obligation and get more RMB funds, VIE companies have created a number of “alternative measures’, such as splitting the amount of foreign currency into multiple batches (easier to convert for smaller amount) or faking up business transactions.
Post Circular 36, it seems that the conversion challenges for VIE structures still exist. The converted RMB funds are still not allowed to be channeled to the domestic operating entities by way of, e.g., extending loans; also, as the domestic operating entities in a VIE structure mostly engage in the “restricted” or “prohibited” industries, the WFOE cannot remit the converted RMB funds into the domestic operating entities by way of equity investments.
2. Investing FIEs
2.1 Breaking Grounds on the Amount of Conversion under QFLP
Under the current laws and regulations, in addition to foreign direct investment and acquisitions, there are three primary ways for foreign investors to make equity investments in domestic Chinese companies: (i) through investment holding companies[Endnote 6]; (ii) through foreign-invested venture capital enterprises[Endnote 7]; or (iii) through foreign-invested equity investment enterprises. The first two forms require more stringent conditions on the foreign investors, and many foreign investors (particularly in the fund management industry) are interested in setting up foreign-invested equity investment enterprises (such as Qualified Foreign Limited Partnership, or QFLP) in China. However, no regulations on the national level provide guidance for the foreign invested equity investment enterprises. Rather, the establishment of the foreign-invested equity investment enterprises (such as QFLO) is regulated on a pilot basis in certain cities. According to some local QFLP measures, QFLPs meeting certain requirements can be granted a quota for the purpose of converting its foreign capitals into RMB to invest in Chinese entities.
According to the SAFE officials with whom we spoke, post Circular 36, the quota requirements on currency conversion under the relevant QFLP measures will be removed, and while reviewing the conversion applications, the banks shall focus on the principle of being “truthful” and “lawful”, not on conversion quotas.
2.2 Conversion Procedure for Investing FIEs’ Equity Investment Streamlined
Another highlight of Circular 36 is to facilitate the currency conversion for FIEs with primary scope of business of making equity investment (“Investing FIEs”). Unlike the Non-investing FIEs discussed in Section 1.2 above, Circular 36 allows the Investing FIEs to remit the converted RMB funds directly into the target entity’s regular account rather than into a specially supervised account, which significantly streamlines capital flows between an Investing FIE and its portfolio companies.
Prior to Circular 36, the target entity is required to register information relating to the proposed investment with the local branch of the SAFE and open a domestic re-investment special account with its bank. The foreign currency will be directly remitted to this re-investment special account, and the conversion of such received amount shall still be subject to scrutiny by banks under the rule of “convert-to-pay”. By contrast, under Circular 36, the foreign currency can be converted into RMB in the Investing FIEs’ bank account, and the capital remitted to the target company will no longer need to be under banks’ scrutiny in any special account.
3. Looking Forward
Following the implementation of “at will” conversion in Shanghai Free Trade Zone granted by the SAFE[Endnote 8], Circular 36 is another positive signal that Chinese regulators are adopting a pragmatic approach in facilitating foreign currency conversion for capital account transactions. As there are still many uncertainties with respect to how Circular 36 may be implemented, we will keep you posted with respect to any new development of this new circular.
Mr. Hai Huang is a Beijing-based partner with Global Law Office who specializes in merger & acquisition, private equity investment, venture capital investment, foreign direct investment, corporate financing, and corporate public offering and listing.（E-mail: hh@glo.com.cn）
Ms. Ying Cui is a Beijing-based associate with Global Law Office who specializes in merger & acquisition, private equity investment, venture capital investment, foreign direct investment, corporate financing, and corporate public offering and listing.（E-mail: cuiying@glo.com.cn）
Endnote 1:16 pilot zones includes (1) Tianjin Binhai New Zone (天津滨海新区); (2) Shenyang Economic Zone (沈阳经济区); (3) Suzhou Industrial Park (苏州工业园区); (4) East Lake National Innovation Zone (东湖国家自主创新示范区); (5) Guangzhou Nansha New District (广州南沙新区); (6) Hengqin New District (横琴新区); (7) Chengdu Hi-tech Park (成都市高新技术产业开发区); (8) Zhongguancun National Innovation Park (中关村国家自主创新示范区); (9) Chongqing Liangjiang New District (重庆两江新区); (10) Heilongjiang Reform Zone for Foreign Exchange (黑龙江沿边开发开放外汇管理改革试点地区); (11) Wenzhou Financial Reform Zone (温州市金融综合改革试验区); (12) Pingtan Reform Zone (平潭综合试验区); (13) China-Malaysia Qinzhou Industrial Park (中国-马来西亚钦州产业园区); (14) Guiyang Free Trade Zone (贵阳综合保税区); (15) Shenzhen Qianhai Port Modern Industry Zone (深圳前海深港现代服务业合作区); (16) Qingdao Pilot Area for Financial Reform (青岛市财富管理金融综合改革试验区)
Endnote 2:According to a SAFE official with whom we spoke, if the converted RMB funds are to be used for equity investment, for both the Non-investing FIEs and the Investing FIEs, “at will” conversion might not apply.
Endnote 3:Circular 36 indicates that the SAFE may lower the percentage depending on “China’s balance of international payments” from time to time.
Endnote 4:There still could be exchange risk if the FIE makes a wrong bet on the trend of the exchange rate change.
Endnote 5:In accordance with Guidance for Administration on Risk of Granting Acquisition Loans by Commercial Banks (effective as of December 6, 2008), the commercial banks are allowed to extend commercial loans to enterprises engaging in acquisition activities, which is applied under certain circumstances with strings.
Endnote 6:Legal Basis: Provisions on Establishment of Investment Companies by Ministry of Commerce (November 17, 2004) promulgated by the Ministry of Commerce
Endnote 7:Legal Basis: Provisions on Administration of Foreign-invested Venture Capital Enterprises, jointly promulgated by International Trade and Economic Bureau (Predecessor of the Ministry of Commerce), Technology and Technical Bureau, the State Administration for Industry, the State Administration of Taxation and the SAFE on January 30, 2003
Endnote 8:The Circular on Detailed Rules of Implementation on Providing Foreign Exchange Administration Support for the Development of the China (Shanghai) Pilot Free Trade Zone, promulgated by Shanghai Branch, the SAFE on February 28, 2014. The FIEs established in the free trade zone are able to convert their paid-in capital at will.
