reviver

China's State Administration of Foreign Exchange (SAFE) has announced reforms to its foreign exchange administration in order to make it easier for Chinese individuals and companies to invest abroad.

A new Decree

SAFE's Notice on Certain Issues Relating to Foreign Exchange Administration for Overseas Investment and Financing as well as Roundtrip Investment by Domestic Residents through Special Purpose Companies (Decree 37) reflects the growing popularity of China’s "going abroad" strategy, with more Chinese enterprises and individuals using "special purpose vehicles" (SPV) for overseas financing and investment.

It repeals and replaces SAFE's Notice on Certain Issues Relating to Foreign Exchange Administration for Financing and Roundtrip Investment by Domestic Residents through Overseas Special Purpose Companies (Decree 75) under which foreign exchange registration was one of the key steps for establishing a valid roundtrip investment structure.

SPVs are widely used by Chinese companies and individuals for overseas direct investments, private placements or for getting listed on overseas exchanges. The new regulations recognise the legality of SPVs and simplify the process of foreign exchange registration during their establishment and operation.

Loosening the rules for "going abroad"

Decree 37 appears to be particularly significant for PRC individuals. SAFE already has a series of rules for regulating PRC companies’ investments under its "going abroad" regulation, but until now Decree 75 was the only rule allowing PRC individuals to set up offshore SPVs (but only for roundtrip investment into China).

Decree 37 seems to be the first rule allowing PRC individuals to make foreign exchange registration when they establish offshore SPVs for direct overseas investments, not only round-tripping into China but also to other countries through SPVs. Under Decree 37, PRC individuals can invest overseas by setting up offshore SPVs or by participating in an offshore SPV’s employee stock ownership plan (ESOP).

Decree 37 also allows SPVs’ foreign exchange incomes from overseas financing or investments to remain abroad, and PRC residents to fund SPVs from domestic sources. This is a step further reflecting SAFE's loosening control over foreign exchange, consistent with China's changing policy on the administration of foreign exchange, which seems to be driven by China's huge and still growing foreign exchange reserves.

An analysis of the key provisions of Decree 37 are provided below.

Scope of SPV expanded

Under Decree 37, SPVs are offshore entities established directly or controlled indirectly by PRC residents (including PRC companies and individuals) with their legally held domestic or overseas assets or interests for the purposes of financing and/or investment, whereas under Decree 75, SPVs only include offshore entities established directly or controlled indirectly by Chinese investors for the sole purpose of making roundtrip investment and seeking offshore equity financing. It should be noted that under Decree 75, if SPVs are not established for roundtrip investment, SAFE will not accept foreign exchange registration for the relevant PRC residents, and the PRC residents will therefore face difficulty in converting and remitting foreign exchanges abroad for investment.

In addition, since an SPV may be established by a PRC individual for offshore investment, Decree 37 seems to be the first SAFE regulation that permits PRC individuals to make overseas investment through a SPV.

Streamlined registration procedures

• Decree 37 no longer requires SAFE registration or registration amendment for the establishment of a SPV and during the offshore financing process. Instead, Decree 37 merely requires SAFE registration before the PRC residents make capital contribution into the SPV with their domestic or offshore assets or interests (including but not limited to cash, exchangeable securities, intellectual properties or technologies, equity interest, creditor's right, etc). In addition, only when changes occur to PRC residents’ interests in the SPV, such as capital increase or decrease, share transfer or swap, consolidation or separation, will the PRC residents be required to apply for SAFE registration amendment with the relevant counterparts of SAFE.
• Decree 37 makes it clear that to set up SPVs for overseas financing and/or investment or roundtrip investment, PRC companies (as opposed to individuals) should carry out SAFE registration pursuant to relevant existing SAFE rules. No repetitive registration under Decree 37 is necessary.

Employee Stock Ownership Plan (ESOP) registration

Often, a PRC company with an offshore private (unlisted) SPV structure would provide incentives to its senior management or employees by way of giving them stock options for shares in the SPV. This is often included in the employee stock ownership plan (ESOP). Before Decree 37, the managers in the ESOP regularly faced difficulties with SAFE when it was time for them to exercise their stock options, as they could not remit money outwards without a prior SAFE registration.

With the issuance of Decree 37, for the first time, the participants of a private SPV’s ESOP are allowed to register with SAFE prior to the exercise of their options. Although Decree 37 does not expressly state so, it indicates that upon the registration, the ESOP participants would be able to legally convert and remit foreign exchanges for the exercise of their share options, and for holding and disposing of the private SPV’s shares.

Profits of SPVs can remain outside China

Under Decree 75, profits and dividends distributed by a SPV and gains from the transfer of a SPV’s shares must be repatriated into China and converted into RMB within 180 days from the date the relevant PRC resident is entitled to receive them. Decree 37 removes this time limit, which means that income from SPVs may be retained abroad. This will facilitate SPVs’ further investment outside China.

Funds can now flow from domestic sources to offshore SPV

Other than direct capital contribution, which is subject to the SAFE registration under Decree 37, two other routes are now available for PRC residents to fund SPVs:

• Article 10 of Decree 37 allows PRC enterprises that are controlled directly or indirectly by a PRC resident to fund the SPV that is registered under the name of the PRC resident. It is believed that the most common route of funding would be extending foreign exchange debt by a PRC enterprise to the SPV.
• Article 11 of Decree 37 allows PRC residents to convert and remit foreign exchanges to fund the establishment, share redemption or delisting of the relevant SPV. Where funds are provided for the establishment of a SPV, only the registration fees of the SPV is allowed to be paid by PRC residents prior to the SAFE registration under Decree 37, either with RMB converted or with legally held foreign exchange. All other funding for the establishment will be considered as capital contribution and shall be subject to SAFE registration under Decree 37.

Even though the above routes of funding from domestic sources to the SPV are still subject to SAFE approvals and registrations, it seems that the foreign exchange control over the SPV is loosened compared with the previous regulation. Under Decree 75, SPV’s only source of funding seemed to be offshore financing, and PRC residents are not allowed to provide any funds to the SPV.

Obstacles remain for roundtrip M&A

In terms of the roundtrip investment, Decree 37 fails to resolve the problem caused by Article 11 of the so-called Decree 10 of the Ministry of Commerce (MOFCOM) (the Provisions on Foreign Investors' Merger with and Acquisition of Domestic Enterprises), under which all mergers and acquisitions of PRC enterprises by affiliated offshore SPVs are subject to the approval of MOFCOM. This Article 11 remains the number one obstacle that bars most of the roundtrip mergers and acquisitions by SPVs set up by Chinese individuals or companies. To date, there is no clear indication if MOFCOM will issue new regulations to resolve this issue.