A major legal impediment to Chinese private equity investments appears to have been repealed, although it is not yet clear whether the new regulatory regime will in fact make it easier to actually implement such investments. Until early 2005 the use of offshore holding companies in a tax efficient jurisdiction (such as the Cayman Islands) to structure private equity investments in China was a well established practice, with the Chinese founders themselves setting up such special purpose vehicles ("SPVs").

On January 24, 2005 and April 21, 2005, the State Administration of Foreign Exchange (SAFE), a Chinese government agency whose role had been traditionally limited to managing foreign exchange activities, issued the two rulings regarding mergers and acquisitions by foreign investors, better known as "Notice 11" and "Notice 29" respectively.1

Under Notice 11, a "domestic resident" (not defined) became obligated to obtain prior approval from SAFE before setting up, or taking control of, an offshore company, or transferring domestic assets or equity in exchange for equity or other property rights in an offshore company. Under Notice 29, domestic resident individuals were forbidden to conduct any offshore investment (or outward remittance of profits to offshore holding companies) except with prior SAFE approval.

The Notices had the unintended but immediate effect of delaying many pending private equity transactions in China.

After months of uncertainty, SAFE repealed the two Notices and issued instead on October 21, 2005 the Circular on Issues Relevant to Foreign Exchange Control With Respect to the Round-Trip Investment of Funds Raised by Domestic Residents Through Offshore Special Purpose Companies, effective November 1, 2005 ("Notice 75").

Under Notice 75, SAFE now only requires a Domestic Resident (as defined) to "register" with SAFE (and only with its local branches, instead of the headquarters in Beijing) rather than obtain SAFE’s approval with respect to a Round Trip Investment (as defined).

The required registrations include:

  • Initial Foreign Exchange Registration: Prior to the establishment or acquisition of control of an offshore SPV (as defined), a Domestic Resident needs to fulfill certain foreign exchange registration obligations with a local SAFE branch. The SAFE branch will review the application materials and, having verified the authenticity of the transaction, approve the registration.
  • Amendment of the Registration: The foreign exchange registration needs to be amended whenever the Domestic Resident’s equity in the SPV changes. This usually happens when the Domestic Resident injects domestic assets or equity into the SPV or the SPV conducts an offshore financing.

Having cleared the registration/ amendment proceedings, the Domestic Resident may cause the PRC domestic entity to make distributions of profit, dividend or proceeds from liquidation, equity swap and capital decrease to the offshore SPV.

Notice 75 clarifies the meanings of certain important terminology:

  • The term "Domestic Resident(s)" refers to both legal person(s) and individual(s) and includes also foreign natural persons who for economic reasons "habitually" reside in China. No further details are given to this residence standard applicable to foreigners.
  • The term "SPV" refers to a company incorporated outside of China for the purpose of conducting an overseas equity financing (including convertible debt financing), which is directly established or indirectly controlled by a Domestic Resident (either a legal person or a natural person).
  • The term "Control" is broadly defined to include any right to influence operations, economic interests or decision-making processes that may arise from such status as a legal owner, beneficial owner or even (convertible) bond holder. This covers almost all offshore SPV structures typically used for private equity investments.
  • The term "Round-Trip Investments" is defined to include any "plain vanilla" foreign direct investments including both asset-based and equity-based acquisitions made by an offshore SPV in China.

However, certain ambiguities remain which may make Notice 75 difficult to implement and to understand. For example:

  • Notice 75 still does not specify the standards for SAFE’s review of the application and the length of the review period.
  • Literally speaking, it seems that Notice 75 would not apply to an SPV which is established other than for the purpose of conducting an offshore equity financing. But it is unclear whether this is indeed what SAFE intended.
  • Certain non-PRC citizens are included in the definition of "Domestic Resident(s)" and thus subject to Notice 75. The extent to which it is intended to, or could, apply to non-PRC citizens is unclear.
  • Notice 75 applies retroactively. Therefore, Domestic Residents who have established/controlled an SPV and have completed Round-Trip Investments before November 1, 2005, must go through the Notice 75-type registration proceedings no later than March 31, 2006. The lack of a cut-off date suggests that all prior round trip investments will be subject to Notice 75, regardless of how many years ago they were completed.
  • The term "overseas equity financing" is not defined. For instance, if a Domestic Resident wishes to grant an option to the management team of an offshore SPV and its domestic operating company, could this be construed as an overseas equity financing requiring SAFE registration?
  • Income from an offshore SPV may now be repatriated within 180 days from the date the income is obtained. However, it is unclear whether the 180-day period starts on the date of the auditor’s report or the date when the relevant dividend is declared.

While the new legislation certainly makes investors’ lives easier by requiring only foreign exchange registration locally instead of approval nationally, it is not yet clear how Notice 75 will impact private equity investments in China due to the remaining numerous ambiguities.


1. Circular on Issues Relevant to Improving the Foreign Exchange Administration Regarding Mergers and Acquisitions by Foreign Investors and the Circular on Issues Relevant to Registration Regarding Offshore Investments of Individual Domestic Residents and Foreign Exchange Registration in Respect of Mergers and Acquisitions by Foreign Investors.

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