On July 14, 2014, China's State Administration of Foreign
Exchange ("SAFE") issued the Notice on Relevant
Issues concerning Foreign Exchange Administration for Domestic
Residents Engaging in Overseas Financing and Investing through
Round-Trip Investment via Special Purpose Companies
("Circular 37"), together with its two
appendices—the Operational Guidance for Relevant Practice
for Round-Trip Investment ("Guidance") and the
Application Form for Foreign Exchange Practice for Capital
Direct Investment ("Application Form," collective,
the "New Rule"), which became effective on the same date.
The New Rule supersedes the previous Notice on Relevant Issues
concerning Foreign Exchange Administration for Domestic Residents
Engaging in Overseas Financing through Round-Trip Investment via
Special Purpose Companies promulgated by SAFE on November 1,
2005, commonly known as the "Circular 75," which had been
the main regulation governing foreign exchange administration of a
Chinese investor's "round-trip" investment (further
defined below).
The New Rule is intended to simplify and facilitate cross-border
transactions conducted by domestic residents and to better serve
the development of the Chinese economy in order to enhance the
convertibility of capital in cross-border transactions.
This Commentary summarizes the key changes made under the
New Rule and also compares these changes to Circular 75. We also
analyze the possible impact on Chinese investors, which are the
intended targets of this new rule, after the publication of
Circular 37.
Major Changes
Definition of "Special Purpose
Company." The first notable difference between
Circular 37 and Circular 75 is the change of the definition of
"Special Purpose Company" ("SPC"). According to
Circular 75, an SPC is any overseas entity directly established or
indirectly controlled by a domestic resident (either a business
entity or a natural person) for the purposes of overseas equity
financing using any domestic enterprise's assets or equity
interests held by the resident. Circular 37 defined "SPC"
as a foreign enterprise directly established by or indirectly
controlled by a domestic resident, including a domestic entity and
a domestic individual (collectively, "Domestic Resident")
through any domestic enterprise's assets, rights or interests,
or through any overseas assets, rights or interests legally held by
such domestic resident for the purpose of investing or
financing.
Compared to the definition under Circular 75, the definition of
"SPC" under Circular 37 expands the purposes of
establishment of such SPC to include "investment" in
addition to "financing." Previously, Circular 75,
together with the Notice on Further Improving and Adjusting
Foreign Exchange Administration Policies for Direct Investment
("Circular 59") issued on November 21, 2012, set up the
legal regime that domestic individuals who make direct investments
in China via overseas entities did not fall into the definition of
"SPC" under Circular 75 and therefore were not subject to
SAFE SPC registration. This created a confusion as to whether such
overseas investment via an SPC is permitted under Circular 75. From
SAFE's perspective, such investment activities were considered
"Chinese Individual's non-SPC Round-Trip Investment"
in terms of SAFE's statistics system. Now, under Circular 37,
it becomes feasible for a Domestic Resident to set up an overseas
entity for investment purposes and use this overseas entity as the
shareholder of a new Chinese company. This means that an SPC may
now be accepted by SAFE for registration for the broader
"investment" purposes even without any future plan to
make further overseas investment, be listed in an overseas stock
exchange, or be used as the vehicle for any other financing
plan.
Furthermore, overseas enterprises set up by using "overseas
assets, rights, or interests," as opposed to "domestic
enterprise's assets, rights, or interests," legally held
by Domestic Residents will also be regarded as SPCs and will be
subject to the regulation of Circular 37. Such expansion of
definition means that many overseas enterprises, which in the past
may not have been considered as SPCs, will now be covered under the
regulation of the current Circular 37.
Definition of "Round-Trip Investment."
Circular 37 defines "round-trip investment" as
"direct domestic investment activities conducted by Domestic
Resident directly or indirectly through a SPC, i.e., through
setting up foreign invested enterprise or project ("FIE")
through greenfield investment or merger and acquisition to obtain
relevant ownership, right of control or right of management or
administration, etc." In comparison to Circular 75, Circular
37 recognizes that establishment of a FIE through greenfield
investment will also fall within the scope of the round-trip
investment. Being able to register with SAFE for such structure
means more clarity for Chinese founders when they put together a
structure involving a "round-trip investment" and having
a structure approved for foreign private equity investors to invest
in the SPC that controls the Chinese asset/investment via a
FIE.
Scope of "Individual Domestic
Resident." The Guidance of Circular 37 further
clarifies the definition of "individual Domestic
Resident" and provides that individuals who legally hold both
Chinese and foreign identity documents will be considered as
foreign individuals, and thus are not subject to registration
obligation under Circular 37 when investing in SPCs with overseas
capital or interests. Therefore, it has removed the registration
obligation of some domestic individuals who have foreign
passports.
First-Level-Only Registration. Previously,
Circular 75 required registration for each level of overseas
entities established by the Domestic Resident. Under the Guidance
of Circular 37, only the top-level SPC that is directly established
by the Domestic Resident needs to be registered. In other words, a
Domestic Resident no longer needs to disclose to SAFE the other
levels of overseas entities set up underneath the umbrella of the
top-level entity. This simplifies the registration process and
removes certain registration burden from Domestic Residents, which
will result in time and cost saving for the Domestic Resident in
making such investments.
Change of Registration Timing. According to
Article 3 of Circular 37, a Domestic Resident must complete
registration for overseas investment before making contributions to
the overseas SPCs. This is different from Circular 75, which
requires registration before the establishment of the SPC. In other
words, Circular 37 permits the establishment of the SPC before
registration with foreign exchange authorities. However, before a
Domestic Resident may contribute any money into such SPC,
application for registration needs to be filed with SAFE. This is a
more practical approach since, unlike company incorporation in
China, the overseas SPCs can be established without any capital
injection (or with a minimum capital such as US$1.00).
Scope and Time Limit for Change of Registration and
Remitting Profits Onshore. Article 5 of Circular 37 sets
forth the requirement of change of registration when the Domestic
Resident increases or decreases its capital, transfers its shares,
merges, divides, makes long-term equity or debt investments, or
provides external guarantees, which differs from the relevant
provisions under Circular 75. Under Circular 75, the registration
obligation was triggered by any changes associated with the
SPCs.
For the purpose of providing simplicity and convenience for
Domestic Residents making cross-border capital transactions
relating to investment or financing activities via SPCs, Circular
37 removes the reporting and filing requirement for matters that do
not involve changes of Domestic Residents or cross-border movement
of capital. For example, no change of registration is required when
an overseas third party injects investment into the SPC.
Additionally, Circular 37 eliminates the requirement under
Circular 75 that the change of registration must be made
"within 30 days" of occurrence of the change and replaces
it with "timely," which may give the Domestic Resident
more time for registration. Circular 37 also eliminates the
requirement under Circular 75 that profits or dividends from the
SPCs must be transferred back in China within 180 days as long as
it complies with the relevant foreign exchange requirements, for
example, to be used in overseas investment.
Employee Stock Option Plans. Circular 37 for the
first time allows employee stock option plan ("ESOP")
registration for directors, supervisors, managers, and employees
working in domestic enterprises directly or indirectly controlled
by nonlisted overseas companies.
Before the promulgation of Circular 37, domestic employees could
register ESOPs only if such stock option was issued by an overseas
listed SPC. Domestic employees who had employee stock options in a
nonlisted foreign company were unable to properly realize such
rights and remit money relating to such option to overseas company,
nor could they legally exchange their income from selling the stock
option into RMB. The New Rule allowing employee stock options
issued by nonlisted companies will solve many existing registration
problems and will facilitate ESOPs to be more popular in nonlisted
foreign companies with Chinese employees.
Financing from Domestic Residents to SPCs.
Article 10 and Article 11 of Circular 37 permit Domestic Residents
to provide financing to SPCs with domestic or overseas capital or
interests lawfully held by them. Article 10 specifies that
financing by Domestic Residents can be made by domestic enterprises
directly or indirectly controlled by the Domestic Residents, and
Article 11 further specifies that such financing can be made for
the purpose of establishment, buyback, or delisting of the
SPCs.
Prior to the promulgation of Circular 37, the SPCs could not
obtain financing from Chinese domestic entities or individuals.
Circular 37 is a significant breakthrough that resolves to a great
extent the need for financing of overseas SPCs and substantially
simplifies the procedure for Domestic Residents investing
abroad.
Allowance for Remedial Registration. Article 12
of Circular 37 clarifies the procedure for remedial registration,
providing that Domestic Residents that failed to initially register
with SAFE for their round-trip investment at the time of the
investment can make a remedial registration so as to legalize those
round-trip investments under the New Rule. Having said this, the
New Rule also lists relevant applicable penalties that will be
imposed by SAFE when such remedial registration applications are
made.
Conclusion
Compared to Circular 75, Circular 37 embraces many of the gray areas that Circular 75 failed to address. Meanwhile, Circular 37 loosens the government's control over Domestic Residents, especially individuals, in making foreign investments. There are still gray areas yet to be clarified by Circular 37, however, which the Chinese government may address in future notices and regulations. For now, Circular 37 will give Chinese investors more flexibility in making foreign investments.
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