Hong Kong: Issues arising from the reorganisation of a People's Republic of China state own

Last Updated: 26 September 1995
This article is intended to provide a general guide to the subject matter. Specific advice should be sought about individual circumstances. Further information or advice may be obtained from Linklaters & Paines, Hong Kong office, 14th Floor, Alexandra House, Chater Road, Hong Kong; telephone: (852) 2842 4888; fax: (852) 2810 8133; contact David Mullarkey or Jeremy Parr.

The following article examines the issues arising with regard to the reorganisation of a PRC state owned enterprise into a private company.

1. Introduction

Very often, as part of its preparation for listing on a stock exchange or investment by independent third parties, a state owned PRC enterprise will go through a reorganisation of its corporate structure. The enterprise may decide to hive off only the profitable parts of its business into the new company ("Newco"). The less profitable parts of the business or operations unconnected to its principal business (such as hospitals, schools, utilities and social welfare units) may be left to the original enterprise which will remain state owned ("Holding Co."). Holding Co. may continue to provide services to Newco in respect of the non-profit making units by way of service agreements.

Often, Holding Co. would also hold a substantial shareholding, which would represent the PRC government stake, in Newco.

2. Transfer of assets

Under the new Companies Law, the transfer or division of assets, rights and liabilities is not specifically provided for, and does not happen automatically. Care must be taken to ensure that Newco has the intended assets, rights and liabilities, and that investors, as well as creditors, are not prejudiced by the reorganisation. The transfer is usually achieved by an asset transfer or division agreement between Holding Co. and Newco.

It is important that the company and its professional advisers draw up a reorganisation plan comprehensively, identifying which assets which will go into Newco and Holding Co. respectively. This is because, if certain assets have been accidentally left out of Newco, subsequent asset transfers between Newco and Holding Co. may be difficult as the appropriate approvals from the PRC authorities may have to be obtained. This is also important because of the asset valuation process which will fix the capital of Newco and which will determine the number of state shares to be issued by Newco to Holding Co.. Any subsequent changes to this may be inconvenient.

3. Valuation

The purpose of a valuation is to assess the net asset value of Newco. Not only are all the assets (including trademarks and other intangible property) valued, but also the debts and liabilities of the enterprise to be listed. Typically, this is performed by the valuers (both foreign and PRC), with input by the auditors and reporting accountants.

The valuation process may take months to complete. Often, if Newco will be listed subsequently on a stock exchange, the valuation may influence the decision as to which assets will go to Newco and which will go to Holding Co.. This is because (especially when market conditions are not so favourable) Newco may wish to avoid having a net asset value which is too high, which may consequently affect the pricing of its shares, which in turn may make the marketing of its shares difficult. The issue of whether to include particular assets in Newco is particularly pertinent in respect of land, where it may not matter whether the land is being transferred to Newco, or whether the land will remain with Holding Co., which in turn leases the land to Newco.

The valuation must then be submitted to the State Assets Administration Bureau for verification and confirmation. Only then may the capitalisation of Newco be determined, which is an essential condition to its establishment. The valuation process is therefore a particularly important factor in the reorganisation timetable.

4. Trademarks

Usually, these would be transferred to Newco, since the trademark may be important to its operational business. However, in certain cases, Holding Co. may wish to share the use of these trademarks. As a result, there may be an arrangement whereby Holding Co. retains the trademark and licenses its use to Newco, or vice versa.

Another problem which may arise may be that the trademark may be of a disproportionately high value. Under the Company Law of the PRC, not more than 20% of the registered capital of a company may be contributed by way of industrial property and non-patented technology. In the case of the listing of Tsingtao Breweries on the Hong Kong Stock Exchange, the high value of the world-famous "Tsingtao Beer" trademark presented problems in this respect. The structure whereby Holding Co. licenses the trademark to Newco may not always be thought to be a satisfactory solution to this problem by potential investors, since they may take the view that a trademark of such significance to Newco's business should be owned by Newco itself.

5. Novation of contracts and other rights/liabilities

As part of the rights and liabilities to be transferred to Newco, contracts previously entered in the name of the original PRC enterprise (or Holding Co., as the case may be) will have to be novated to Newco.

Third party consents usually will have to be obtained for this. Identifying all these contracts and obtaining the consents from the third parties may be a tedious and time-consuming process. As a precaution, Holding Co. and Newco may enter into an agreement whereby Holding Co. will hold in trust for Newco all the benefits in contracts previously entered into by Holding Co. and which have not been novated to Newco. In turn, Newco will agree to indemnify Holding Co. against expenses which Holding Co. may incur in carrying out the obligations under the contracts as trustee for Newco.

6. Accounting Adjustments

The reorganisation may give rise to the need to make accounting adjustments for a number of reasons. It may be that the original entity, prior to its reorganisation, may have been buying some of its raw materials or utilities at a price subsidised by the government. If the subsidised pricing is to be discontinued, it may be necessary to have the profit figures for the appropriate track record period restated. This adjustment will take into account what the market price for the goods and services would have been during the period. Such restatement may be appropriate in order that the investors may know how the profits in the past years would have been affected, if the company had paid the higher market prices during that period. In this way investors will be able to get a more accurate picture of the company's trend of profits.

The accounts may also have to be restated for the track record period, on account of adjustments made in respect of the service fees to be paid by Newco to Holding Co.. That is to say, a notional amount representing such fees per year may be deducted from the yearly profits of the company during that period. This is to ensure that the trend of profits shown in the accounts fairly reflects that of the corporate structure of Newco. Whether or not such adjustments will be made will depend on the view taken by the accountants as to whether the adjustments involved are material to the overall turnover and profits of the company.

Further information or advice may be obtained from Linklaters & Paines, Hong Kong office, 14th Floor, Alexandra House, Chater Road, Hong Kong; telephone: (852) 2842 4888; fax: (852) 2810 8133; contact David Mullarkey or Jeremy Parr, or enter text search 'Linklaters & Paines' and 'Business Monitor'.

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