China: When Love Comes To An End: Exiting A Joint Venture In China

Last Updated: 11 July 2016
Article by Betty Tam

While many foreign investors have entered the Chinese market by forming joint ventures with local partners, not all joint venture partners will live happily ever after. With complex legal, tax and operational issues involved, exiting a Chinese-foreign joint venture may prove to be more complicated than forming one.

At a recent seminar organised by Mayer Brown JSM, Betty Tam, Partner at Mayer Brown JSM, with guest speakers Peter Law (Partner – Tax Advisory, Mazars) and Jeff Shi (Vice President of Strategy, M&A, and Marketing, Asia at Tyco International), shared their insights and provided practical advice on exiting a joint venture in China.

The Trend

In China, historically, most foreign investors have formed joint ventures with local Chinese partners due to statutory restriction on foreign shareholding or otherwise because of practical needs, such as unfamiliarity with the local business environment and a lack of local network. However, with restrictions on foreign shareholding in most industries having been lifted in recent years, the regulatory reason for maintaining a Chinese-foreign joint venture has largely diminished. For joint ventures that were incorporated years ago, they may have reached a stage where investors begin to review their relationship with the joint venture partners. Ms. Tam commented that "We have seen more 'separation' in the last few years and the exit process could prove to be challenging to foreign investors."

Ways to Exit from a Joint Venture

There are basically three options to exit from a joint venture:

  1. buying out or selling to another joint venture party;
  2. selling the equity to a third party;
  3. or in more extreme cases, terminating the partnership and liquidating the joint venture.

In practice, buy-out of or sell-out to another joint venture party is the most typical path chosen. "In addition to business considerations, this is also due to a number of regulatory reasons," said Ms. Tam. According to Chinese law, a joint venture party is entitled to a pre-emptive right if another joint venture party sells its equity interest in a Chinese-foreign joint venture. Moreover, any equity transfer of a Chinese-foreign joint venture is subject to approval by the Ministry of Commerce or its local branches ("MOFCOM"), which will demand various supporting documents including the written consent of all non-selling parties as well as an unanimous board resolution of the joint venture supporting the transfer. This in practice means that any exit will not be possible without the co-operation of the non-selling parties. While in some cases the joint venture contract may incorporate a drag along or tag along clause, such a clause is in practice difficult to enforce due to the government approval requirements mentioned above.

"When considering exit options, time is also a critical issue," commented Mr. Shi, who explained that selling to a third party would usually involve a lengthier process due to the time required for the buyer to conduct due diligence and the need to obtain other shareholders' agreement.

Put/Call Option

To enable a joint venture party to buy from or sell to another joint venture party, joint venture contracts often include a put or call option. However, enforceability of a put or call option is problematic under Chinese law given the MOFCOM approval requirements for equity transfers. "Therefore, parties will almost always end up negotiating an exit even though there is a call or put option, instead of going to the court or arbitration tribunal to enforce the option," Ms. Tam said. Mr. Shi added that from the business perspective, companies would not want to initiate legal proceedings to enforce a call or put option given the time involved and the uncertainty of the result.

The process will be further complicated if the selling party is a Chinese state-owned enterprise. Selling equity held by a state-owned enterprise is subject to statutory listing procedures – the equity transfer needs to be conducted through open biddings at an equity exchange. In addition, it must also go through state-owned assets appraisal procedures and be approved by the State-owned assets administration authority. These requirements will create uncertainty of a transaction. However, both Ms. Tam and Mr. Shi agreed that the process was manageable despite a longer closing timeline.

"Notwithstanding the enforceability issue, parties may still want to include a put or call option in the joint venture contract," said Mr. Shi, "so that it can be used as a 'weapon' for negotiation with the joint venture partner."

Payment Issues

If the foreign investor is the selling party, then it should consider the payment risk and measures to mitigate the risk. Other than the usual counter-party risk, a foreign seller's risk is increased by the government approval requirements and foreign exchange regulations. "An equity transfer is effective upon MOFCOM approval but a Chinese buyer can only remit the purchase price out of China after MOFCOM approval and tax clearance, so there is always a time gap between the effectiveness of the transfer and payment," said Ms. Tam.

Mr. Law highlighted the tax bureau's recent change from a pre-approval system to one of record-filing in relation to tax payment for equity transfers. Mr. Law explained that under the new system, a Chinese buyer could remit the purchase price out of China without waiting for a substantive review by the tax bureau. However, Mr. Law cautioned that the tax bureau would conduct random checks on the applications and could recoup any tax which it considered should have been paid even though the purchase price had been remitted outside China. "Since this record-filing system is relatively new, practices of different tax bureaus may vary. It has yet to be determined how likely the tax bureau may recoup tax payment after the purchase price has been paid," Mr. Law said.

Ms. Tam said that to hedge the payment risk, a foreign investor should consider options such as opening an escrow account or asking the buyer to pay a deposit. She added that an escrow account would have to be opened with a bank in China, and similarly, a deposit could only be paid to a Chinese affiliate of the foreign seller since the purchase price could not be paid out of China before MOFCOM approval and tax filing. "However, these measures will significantly reduce the risk of the buyer defaulting," Ms. Tam said.

Termination and Liquidation

In extreme cases, parties may consider terminating the partnership and liquidating the joint venture company. Under Chinese laws, termination of a Chinese-foreign joint venture is subject to the unanimous consent of all joint venture partners and MOFCOM approval. MOFCOM will only accept a joint venture party's unilateral application for termination in case of serious breach by the other party, and provided that the applicant can produce a court judgment or arbitration award to prove the breach.

In relation to liquidation, one issue which often strikes foreign investors is the lengthy process of the final tax audit and clearance. Mr. Law explained that in a tax audit for liquidation, the tax bureau would usually focus their review on whether the company had paid up or would have the financial means to pay up its liabilities, and the verification of accounts and documents in this respect could be time-consuming. Mr. Law added that another area of focus by the tax bureau is the individual income tax of expatriates working for the joint venture, which might not be completely straightforward as the remuneration of expatriates were often paid both inside and outside China. "In some cases, the Chinese party and foreign party may have different approaches as to how the joint venture should keep its books – this may make the joint venture's accounting records rather messy and invites more questions from the tax bureau", said Mr. Law. To facilitate a smooth and quick process, Mr. Law suggested that joint venture parties should plan ahead and take actions to address potential tax audit issues before they initiate the liquidation process.

Originally published on 4 July 2016

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