New Rules on Merger and Acquisitions Involving PRC Residents

China State Administration of Foreign Exchange ("SAFE") issued the "Circular on Issues Relevant to Improving the Foreign Exchange Administration Regarding Mergers & Acquisitions by Foreign Investors" ("January Circular") on 24 January 2005 and the "Circular on Issues Relevant to Registration Regarding Foreign Investment by Domestic Residents and Foreign Exchange Registration Regarding Mergers & Acquisitions by Foreign Investors" ("April Circular") on 21 April 2005. Under the January and April Circulars, outbound investments by domestic individual residents and foreign exchange registration of foreign invested enterprises ("FIEs") established through mergers and acquisitions are subject to stricter control.

The two Circulars have raised much concerns in the China investment market forcing many cross border transactions to be put on hold or restructured including IPOs of Chinese businesses and investments inbound into China as well as outbound from China.

According to Article 1 of the January and April Circulars, the purpose of the Circulars is "to maintain the balance of international payments and ensure the flow of cross-border capital in an orderly manner."

Under the January Circular, verification, approval and registration are required for the following transactions by PRC residents :-

1. overseas investments; and
2. cross-border swaps of company shares or other assets.

When carrying out foreign exchange registration regarding FIEs established through mergers and acquisitions by foreign investors which are set up or controlled by PRC residents, local SAFE branches are required to submit the foreign exchange registration applications to SAFE at national level for approval.

The April Circular further clarifies the application of the January Circular. According to the April Circular, the January Circular applies retrospectively. The April Circular also explains that "foreign exchange registration regarding FIEs established through mergers and acquisitions by foreign investors" in the January Circular and "foreign exchange registration regarding mergers and acquisitions by foreign investors" in the April Circular refer to the following circumstances :-

1. acquisition of equity interest by a foreign investor from a Chinese invested enterprise ("CIE") and the conversion of the CIE into a FIE;
2. acquisition of equity interest by a foreign investor from a PRC investor in a FIE;
3. increase of capital contribution by a foreign investor in a PRC enterprise;
4. a FIE established by a foreign investor acquires assets or operate such assets of a PRC enterprise;
5. acquisition of assets of a PRC enterprise by a foreign investor and the investment of such assets in the establishment of a FIE to operate such assets; or
6. control of the rights to proceeds and franchising rights of other enterprises or certain assets in the PRC by a FIE established by a foreign investor.

The April Circular sets out the following consequences in case of failure to comply with the foreign exchange requirements as stated in the January and April Circulars :-

1. If a PRC resident directly or indirectly or a PRC enterprise directly holds shares in an offshore company and fails to comply with the foreign exchange registration requirements, SAFE will not process the foreign exchange registration application which is required for FIEs by the relevant PRC enterprises; and
2. If a PRC resident or enterprise, directly or indirectly, holds shares in an offshore company and such offshore company fails to comply with the SAFE registration, PRC enterprises shall not be able to make any remittance to such offshore company.

Article 8 of the April Circular also states that apart from offshore listed enterprises, special purpose enterprises ("SPEs") are not allowed to retain any foreign exchange revenue. SPE means an offshore enterprise controlled, directly or indirectly, by a PRC resident for the purpose of raising funds outside China for the rights and interests of such PRC resident in a PRC enterprise controlled by him or her.

Foreign exchange registration requirement in the PRC is not new. However, the January and April Circulars put emphasis on identifying PRC residents who are in control of the offshore companies and require such PRC residents to obtain the same approval and registration from SAFE as PRC enterprises. The Circulars also put FIEs established through mergers and acquisitions involving PRC individuals as shareholders under stricter regulatory control. The resultant effect is that if a foreign investor is considering establishing an offshore company with PRC individuals as a means to mergers and acquisitions in PRC, they must be aware of the approval requirement which the PRC individuals are now subject.

Our China Practice Department regularly advise clients on cross border mergers and acquisitions and corporate restructuring. If you will like to have a copy of the above Circulars or have any questions in relation to other China related matters, please contact us.

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.