China: International Financing for Chinese Companies: An Update After SAFE Notice 106

Last Updated: 7 August 2007
Article by Thomas Shoesmith, David Tang and Julian Y. Zou

This summer, just when investors thought it was safe to go back in the water, the Chinese government leaked new internal guidelines affecting virtually all international financings of Chinese companies.

The new rules, known as "Implementation Notice 106," were generated by the Chinese State Administration for Foreign Exchange, or "SAFE." The foreign exchange authorities play an important role in transactions which provide international financings for Chinese companies because they must approve any reorganization of a Chinese company into an offshore holding company structure, as well as any acquisition by Chinese residents of any equity interest in that holding company.

This is not the first scare SAFE has thrown into the international financial community. Almost three years ago, SAFE brought international financing of Chinese companies to a virtual standstill by its Circulars 11 and 29. Investors were stymied by rules that made it almost impossible to structure international financing transactions. Then, in November 2005, perhaps responding to pressure from Chinese companies hungry for capital, SAFE replaced its earlier promulgations with the new Circular 75. Most investors viewed as a significant step forward, as it replaced rules that were impossible to follow with a relatively straightforward system requiring registration of offshore holdings by Chinese residents.

Almost a year later, in an unusual display of cooperation and coordination, six Chinese ministries, including SAFE, jointly promulgated comprehensive regulations dealing with international financing transactions for Chinese companies. The new rules became effective on September 8, 2006, and although they posed some new challenges for reverse mergers and other financings, they provided a clear roadmap that investors could follow.

Then, in late May 2007, SAFE released internal guidelines to all of its local offices dealing with the application of SAFE Circular 75. The rules leaked to the public in late June 2007. The initial reaction was dramatic, with some observers predicting, again, the end of international financing of Chinese companies. A closer examination of Notice 106 suggests that it will make it more difficult to execute some financing transactions, but it is hardly the end of foreign investments it in China.

In order to help our clients and friends understand SAFE's new Implementation Notice 106, we have prepared a comprehensive analysis and outline, including how it relates to and, in some cases, goes beyond both SAFE Circular 75 and the six-ministry rules from September 8, 2006. An executive summary of this analysis follows the links below.

Click here for our detailed outline and analysis of SAFE Notice 106. The text of Notice 106 in Chinese and English can be obtained by contacting any member of our China team.

What did Notice 106 do?

Confronted once again with complex and seemingly contradictory regulations in China, investors are asking, "What is the bottom line? What did Notice 106 do?"

Since the language of the notice is not crystal clear, and because it may be applied differently from one location to another, it is not possible to answer these questions with certainty. However, on the basis of the discussion above, the following requirements are probably in store for investors based on SAFE's most recent internal guidelines.

New Requirements for Central MOFCOM Approval

Maybe the most frightening early reaction to Notice 106 was the report that it would require approval from MOFCOM in Beijing for all international financings of Chinese companies. It is commonly believed that approvals from the central office of MOFCOM, as opposed to its local branches, would be difficult to obtain for middle-market international financing transactions.

We think this was an overreaction; it is not clear whether Notice 106 will result in an expanded requirement for central MOFCOM approvals. Except for the possibly anomalous situations created by Annex 4 (in which SAFE appears to insist on central approval for all establishments or acquisitions of new foreign-invested enterprises, or "FIEs"), Notice 106 should not give rise to new requirements for MOFCOM approval:

Notice 106, by definition, covers activities by special purpose companies, and, by definition, special purpose companies are formed to carry out offshore financings on the strength of domestic assets owned or controlled by their Chinese shareholders.

When such an offshore entity acquires the onshore company or assets (which, by definition, are related), Circular 10 already required central MOFCOM approval. Thus, references to MOFCOM approvals in Notice 106, in these circumstances, do not add anything to existing rules.

As a corollary, if the structure involved in a given situation does not include a special purpose company as defined by SAFE, then the entire notice is inapplicable.

However, Annex 4 of Notice 106 appears to reach out to cover the foreign exchange registration of establishment by special purpose companies of new subsidiaries in China ("WFOEs") as well as joint ventures and acquisitions of unrelated companies, in situations where the domestic company will receive the proceeds of the offshore financing.

The anomalous situation created by Annex 4 raises the possibility of a "Catch-22." This is serious enough that many commentators have thought it will essentially end international financing of Chinese companies until subsequent regulation solves the problem. We are more optimistic.

  • When SAFE does not insist on central MOFCOM approval. In some situations, the local SAFE office may take a liberal view of Notice 106 and simply ask for the foreign investment certificate issued by whatever level of MOFCOM issued the certificate. Local COFTEC officials, however, are not always clear when central MOFCOM approval is required, and in the meantime, they are taking the "safe" route by insisting on central MOFCOM approval. In this situation, even when SAFE itself does require central MOFCOM approval, the local COFTEC office can, as a practical matter, do so.

  • When SAFE does insist on central MOFCOM approval. In other situations, the local SAFE office may take a more literal reading of SAFE 106 and require central MOFCOM approvals regardless of what the local COFTEC office says.

  • Catch-22. The problem is that MOFCOM in Beijing may well take the position that it is not required to, and it won't, get involved in the approval process unless mandated by Circular 10, which only requires central approval in the case of share swaps, material industries, renowned Chinese brands, national security, and acquisitions in which the target company is related to the acquirer or the investment amount reaches the level of MOFCOM's jurisdiction.

Thus, an investor might find itself being sent to Beijing by local officials, only to be turned away and sent back to the local offices, only to be sent back to Beijing again, and so forth.

Only the accumulation of practical experience in China will reveal whether this situation will actually create problems, or whether the authorities, as they often do, solve this by the application of common sense. We are optimistic in this regard.

Three-Year Waiting Period for All Offshore Holding Companies

Another early reaction to Notice 106 that frightened the international investment community was the belief that Annex 4 of Notice 106 was attempting to impose a three-year requirement on all special purpose companies that acquire existing domestic companies, whether or not related, or that establish a new WFOE or joint venture.2 This would, in effect, impose a three-year waiting period on any structures that are aimed at international financing of Chinese operations. The language of Annex 4 is unclear, however, and we do not think SAFE intends to impose a blanket three-year waiting period requirement.

However, Annex 3 imposes a new three-year requirement in situations where an offshore company was previously established as an operating company, and now plans to seek offshore financing on the strength of domestic assets, equity, or operations. In these cases, the offshore entity must have been engaged in the same line of business for at least three years. Audit reports and tax certificates must be submitted for the entire three-year period.

Two-Year Waiting Period in Some Situations

Annex 2 of Notice 106 imposes a new two-year requirement for situations in which a domestic resident uses offshore funds or assets to establish or acquire control over an offshore entity, converting it to a special purpose company. In this situation, before SAFE will register the company as a special purpose company, it must have been in operation in the same line of business for at least two years. Audit reports and tax certificates must be submitted for the two-year period. The period is shortened to one year for technology companies.

Coverage of "Triangular" Structures

Before the release of Notice 106, some investors employed "triangular" structures in various situations to permit foreign investment in the Chinese economy when direct ownership of certain PRC assets was restricted, for example, in the Internet, education, human resources, and public security sectors.

In these structures, an offshore entity would establish a WFOE (or a PRC joint venture), which would enter into a web of contractual relationships with a PRC company; the effect of the contracts was to shift the preponderance of the economic benefits and burdens relating to the PRC company's operations to the foreign-invested entity (FIE), as well as assets and other items in some cases. In most situations these contracts resulted in the FIE acquiring effective control over the PRC entity, whose financials were then consolidated with those of the FIE under FIN 46r.

Since no "acquisition" of an existing domestic company was involved in these cases,3 the situation was not captured by Article 11 of Circular 10, and therefore the parties did not feel obligated to seek central MOFCOM approval.4 Of course, local COFTEC approvals were required for the establishment of the FIEs.

In addition, the offshore entities in these situations were not seen as "special purpose companies" because before Notice 106, the two definitions, in Circular 75 and Circular 10, both were phrased in terms of financings based on domestic assets or equity "held" or "owned" by the offshore entity or its shareholders.

Notice 106, for the first time, expanded its definition of "special purpose company" to include situations in which the offshore financing was based on domestic assets or equity "controlled" by the offshore entity or its shareholders.5 This opened the door for Notice 106 to assert that the offshore entities, which merely "controlled" PRC operating companies by way of contract still had to be registered as special purpose companies. But what is the effect of this? Most practitioners would have said that the domestic shareholders of the offshore entities in these cases should register under Circular 75 anyway. Annex 4 may be attempting to add an insistence on central MOFCOM approvals in these situations, but whether MOFCOM will agree is problematical. Without an acquisition, there is no need for central MOFCOM approvals under existing regulations (primarily, Circular 10).

As noted above, the language of Annex 4 also could be read as requiring a three-year waiting period for offshore companies engaging in triangular structures, but that language is not clear, and it will be necessary to wait and see how regulators apply these provisions.

Coverage of Legacy Structures

In a significant new development, Annexes 3 and 4 of Notice 106 add waiting-period requirements in cases wherein an existing offshore operating company plans to engage in an offshore financing based on the strength of domestic assets or equity.

Until now, so-called "legacy" situations6 have offered considerable comfort for investors in the reverse merger industry; legacy companies were not captured by Circular 10, and therefore the former regime of mainly local approvals applied.

The new requirements will mean that the younger legacy companies will have to mature for some period of time before they can engage in an offshore financing transaction. It is worth noting that almost one year has already passed since the effective date of Circular 10, when the last companies achieved "legacy" status.

New Compliance Obligations

Notice 106 adds some compliance obligations for the domestic company, as well as the offshore special purpose company,7 where previously only the domestic shareholders had the burden of compliance.8

Tightened Provisions Relating to Sources of Offshore Funds

Notice 106 tightens up somewhat on the source of offshore funds that might be used by domestic persons to fund offshore vehicles. The new provisions are addressed to domestic residents who use assets already offshore to fund special purpose companies in the run-up to an offshore financing, and include a requirement that the source and "legality" of more than US$50,000 in offshore currency must be explained.

Retroactive Registration

Notice 106 permits retroactive registration for domestic residents who missed the March 31, 2006 deadline for registering existing offshore holdings, but threatens penalties if the onshore company made any remittances offshore without proper foreign exchange approvals.9 The tone of Annex 6, which deals with this issue, is deeply skeptical.

Click here for our detailed outline and analysis of SAFE Notice 106. The text of Notice 106 in Chinese and English can be obtained by contacting any member of our China team.


1. The Ministry of Commerce (MOFCOM), SAFE, the State Administration of Taxation (SAT), the State Administration of Industry and Commerce (SAIC), the State-Owned Assets Supervision and Administration Commission of the State Council (SASAC), and the China Securities Regulatory Commission (CSRC).

2. Notice 106, Annex 4, Column 2, Item 2.

3. It is possible that regulators could view the FIE's acquisition of control over the PRC entity as a de facto acquisition, but these structures have an almost ten-year history in China and are clearly documented in filings with the US Securities and Exchange Commission. The Ministry of Information Industry specifically acknowledged the widespread use of this structure in the internet sector, in a 2006 release, although it did express some discomfort with it at the same time.

4. That article requires central MOFCOM approval when " …a Domestic Company, enterprise or natural person acquires, in the name of a foreign company established according to law or controlled by it, a Domestic Company with which it is connected."

5. Notice 106, Annex 1, Column 3, Item 2.

6. In other words, Chinese companies that reorganized themselves into offshore holding company structures before the effective date of Circular 10.

7. An offshore special purpose company has the obligation to apply for modifications to the offshore investment registration after material changes in its capital structure. These changes include acquisition of an onshore company as well as offshore financing. See Notice 106, Annex 5, Column 3, Item 2.

8. See Annex 5 for requirements applicable to an offshore special purpose company.

9. Notice 106, Annex 6.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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