Hong Kong: MOFCOM Proposed FIE Equity Capital Contribution Measures: Another Stepping Stone To Grope For While Crossing The River?

Last Updated: 5 September 2011
Article by Hannah C. L. Ha

Originally published August 30, 2011

Keywords: MOFCOM, equity interest, FIE equity capital contribution measures

On 4 May 2011, the Ministry of Commerce (MOFCOM) released a discussion draft of the Administrative Measures on Using Equity Interest as Capital Contributions to Foreign-Invested Enterprises (the "Draft Measures").1

Background

The PRC Company Law, as amended in 2005, permits investors to make capital contributions in cash, in kind or in such intangible property rights as intellectual property rights, land use rights or other transferable non-cash properties with appraisable values. As shares and equity interests in a company satisfy the requirements for such non-cash properties, pilot schemes for using equity interest as capital contribution were launched in 2006 in certain provinces in the PRC and any shares/equity interest so contributed may now be registered with the State Administration of Industry and Commerce ("SAIC") or its local counterparts under the SAIC rules of 1 March 2009.

Implications

The Draft Measures permit capital contribution by foreign and/or domestic investors using equity interests they hold in a limited liability company ("LLC") or shares in a company limited by shares ("CLS") in the PRC ("Equity Company"), whether being a foreign-invested enterprise ("FIE") or a non-FIE company, into an FIE ("Investee") in the following situations:

Excluded Equity Interests For Capital Contribution

The Draft Measures disqualify the following equity interests of an LLC or shares in a CLS (collectively "equity interests") as capital contribution:

  • equity interests of an Equity Company whose registered capital has not been paid up in full;
  • equity interests that are subject to a pledge;
  • equity interests that have been legally frozen;
  • equity interests whose transfers are prevented under the constitutional documents of the Equity Company;
  • equity interests of an Equity Company which failed to apply for, or failed to pass, the annual review in the preceding year;
  • equity interests of an FIE investment holding company or of an FIE venture capital company;
  • equity interests whose transfers are subject to, but whose transferor(s) fail(s) to obtain, governmental approvals under PRC law, regulations or administrative decisions; and
  • equity interests that may not otherwise be transferable under PRC laws, regulations or administrative decisions.

Other Key Points

  • No cross shareholding

The Draft Measures expressly prohibit cross shareholdings between an Investee and an Equity Company as a result of the equity capital contribution but are silent on whether indirect cross shareholdings are permitted and how to enforce such blanket ban on cross shareholdings.

  • 70% cap on non-cash capital contribution

The Draft Measures reaffirm the limitation imposed by the PRC Company Law on non-cash capital contribution to the maximum of 70% of the registered capital of an Investee.

  • No unauthorised entry to restricted or prohibited industries

The business scope of an Investee, an Equity Company and their direct or indirect subsidiaries shall meet the requirements under the relevant foreign investment guidelines in respect of restricted or prohibited industries. As such, if an Equity Company engages in a project in an industry or sector where foreign investment is restricted or prohibited, the investor may not invest its shares/equity interests of such Equity Company in an Investee without required government approval.

  • Transaction value of equity capital Contribution

The "transaction value" of an equity interest for capital contribution must be jointly agreed among the Investee, the Equity Company's shareholders and the investor based on the "appraised value" of the equity interest, and the appraisal must be done by a PRC-qualified appraiser. The transaction value must be equal to or below the appraised value.

  • Approvals

In general, an equity capital contribution is subject to the approval by MOFCOM's counterpart of the province where the Investee's registered office is located (the "Provincial MOFCOM") unless the Provincial MOFCOM's approval authority is exceeded under certain specific circumstances or where relevant approval power is specifically reserved by MOFCOM.

Issues and Uncertainties

In essence, the capital contribution to an Investee using an equity interest of an Equity Company constitutes a transfer by the latter of its equity interest to the former so that the Investee becomes a share/equity interest holder of the Equity Company. This inevitably involves approvals on the part of the Equity Company, particularly where the Equity Company is an FIE. While the Draft Measures make painstaking attempts to comb out any mismatches or inconsistencies between the approvals required on both sides of the transfer, uncertainties remain in the following respects:

  • Uncertainties arising from coordination between different approval authorities: If the Equity Company is an FIE and its establishment was initially approved by a MOFCOM's local counterpart, the transfer of equity interest in the Equity Company to the Investee would need to be approved by such local counterpart of MOFCOM. As capital contribution to the Investee by using equity interest would also have to be approved by the Provincial MOFCOM, it will be necessary for the two approval authorities to coordinate the approval process, thus creating another layer of uncertainty. In addition to the uncertainties created by coordination between MOFCOM's local counterparts at different levels, uncertainties will also likely arise if the Equity Company and the Investee are respectively registered in different provinces.
  • Timing uncertainties: The constitutional documents of an Investee usually specify the capital contribution schedule for its investors to follow in order to avoid any liability for default caused by late capital contributions. Whether an investor wishing to use its equity interest in an Equity Company as capital contribution can meet the capital contribution schedule will be uncertain given a likely lengthy time span needed to complete the equity value appraisal, to obtain approval by the MOFCOM local counterpart in respect of the Equity Company's equity transfer and finally to obtain the Provincial MOFCOM's approval under the Draft Measures.
  • Uncertainties about Possible Rewinding Process: If the parties, for whatever reasons, failed to obtain any approvals, complete any filings or complete the equity interest transfer from an Equity Company to an Investee in compliance with relevant legal requirements subsequent to Provincial MOFCOM's approval, which are required under other applicable rules, including the Provisional Rules on FIE Domestic Investments, the Provisional Rules on FIE Investor Equity Variations, the Administrative Measures on Foreign Investors with Strategic Investments in Listed Companies and the State Council's Circular on Establishment of System for National Security Review of Foreign Investor's Mergers and Acquisitions of Domestic Enterprises, it would be a nightmare for the parties involved as they have to work out how to reinstate them to their original positions.

Conclusion

Although the consultation period for the Draft Measures had expired for more than three months, the Draft Measures in their final form have not yet been released. If the final version of MOFCOM's measures on equity capital contribution does not substantially differ from the Draft Measures, these Measures will provide useful guidance to investors who wish to use their capital invested in the mainland to set up new ventures or increase their capital commitments or vary their shareholding structures in other existing ventures. Although there might be some uncertainties as to how the Draft Measures will interact with the existing FIE-related laws and regulations in respect of various approvals and filing requirements, it would be better to have another stepping stone for the investors to grope for when crossing the river - investing in the PRC.

Footnotes

1 The submission of comments on the Draft Measures was closed on 20 May 2011.

2 Mayer Brown JSM | MOFCOM Proposed FIE Equity Capital Contribution Measures: Another Stepping Stone to Grope for While Crossing the River.

3 Mayer Brown JSM | MOFCOM Proposed FIE Equity Capital Contribution Measures: Another Stepping Stone to Grope for While Crossing the River?

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This article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein. Please also read the JSM legal publications Disclaimer.

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