TopicsinChineseLaw AN O'MELVENY & MYERS LLP RESEARCH REPORT. Managing Cash, Capital and Debt in the PRC. by Scott Silverman *

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1 TopicsinChineseLaw AN O'MELVENY & MYERS LLP RESEARCH REPORT July 2009 Managing Cash, Capital and Debt in the PRC by Scott Silverman * For foreign multinational corporations with operations in the People's Republic of China ("PRC"), foreign exchange and lending restrictions create challenges in financing and managing cash among their Chinese subsidiaries. As a result, their onshore subsidiaries often wind up cash-strapped when trying to meet operational or expansion plans. In addition, with the weakening of markets and tightening of credit resulting from the global financial crisis, many multinational corporations ("MNCs") are finding it necessary to unlock cash from their operating subsidiaries in the PRC. However, Chinese regulatory requirements often result in cash-traps that leave foreign investors unable to access available cash in China. Financing and managing cash among foreign invested enterprises in China is possible, but requires careful planning and utilization of the structural options, transactional approaches and banking services available to foreign investors to move cash where it is needed. This article will discuss these restrictions as well as methods for financing PRC investments through capital, debt, and related party transactions; managing cash among several foreign invested enterprises; and repatriating cash generated from PRC operations. It will also consider how recent policy developments of the State Administration of Foreign Exchange ("SAFE") are creating new restrictions on, as well as opportunities for, managing the funds of Chinese subsidiaries. Financing FIEs Financing FIEs through Capital Contributions and Increases of Registered Capital Capitalizing Chinese subsidiaries with cash or assets is the most common method of funding a foreign invested enterprise ("FIE") in China, which includes both wholly owned subsidiaries and joint ventures with Chinese investors. When applying to establish an FIE, the investors must specify, and the Chinese approval authority must approve, the registered capital and total investment of the FIE. Under Chinese law, the "registered capital" of a company represents the amount of the equity interest subscribed by all of the * Scott Silverman is a counsel in O'Melveny & Myers LLP's Beijing office.

2 shareholders and registered with the company registration authority. Investors must contribute the registered capital to the FIE using cash or assets. Any increases to the registered capital also require government approval. The "total investment" amount represents the aggregate amount of funds or assets intended to be invested in the FIE, either as equity or debt, over its life. The difference between the total investment amount and the registered capital is funded by debt, which can be funded by the investors or third-party lenders. An FIE must meet certain minimum registered capital levels, which vary depending on the total investment amount of the FIE. The total investment amount approved will therefore determine the minimum amount of registered capital that must be contributed. The specific leverage ratios are as follows: Once funds are contributed to an FIE as registered capital, it is very difficult for a foreign investor to get this money back, other than through the repatriation methods that are discussed below. Until they are used by the FIE, such funds earn little interest sitting in a Chinese bank account. For this reason, many foreign investors prefer to form an FIE using the minimum amount of registered capital required by law, and increase the capital later as operations require. However, such investors underestimate the time required to contribute additional registered capital to an FIE and/or the cash requirements of the FIE after it begins operations. As a result, such investors often find their newly formed FIE is cash-strapped very soon after formation or a sudden growth in business. 2 There are certain benefits to financing an FIE by use of registered capital and increases thereto. The FIE receives the funds tax-free, and a higher registered capital will increase the FIE's credibility and standing with Chinese suppliers and government officials. In addition, a higher registered capital increases the amount of foreign debt the FIE may borrow by raising the total investment amount of the FIE. However, there are several drawbacks to using registered capital to fund an FIE. For one, such funds offer little liquidity for the foreign investor. Chinese laws allow investors to contribute the registered capital in installments, with 15% paid within 90 days following approval, and the remainder within two years. Payment of capital in installments helps to reduce the costs of tying up the registered capital in a low-interest Chinese bank account while such funds are not needed by the FIE. However, they also increase administrative costs because each installment requires a separate capital verification report and filing with the company registration authorities.

3 A main drawback of capital financing is the length of time required to fund the FIE. An increase in the registered capital of an FIE requires the approval of the FIE's approval authority, completion of a capital verification report, and registration updates with the foreign exchange and other authorities. Completing these procedural requirements can easily take two or three months before the FIE can receive the capital payment from the foreign investor. The procedures required to convert or "settle" the foreign currency capital add to the time required before the FIE can use these funds in most cases. In order to avoid cash-strapping an FIE as a result of these lengthy procedures and enable the FIE to pay start-up expenses, such as rent, salaries, equipment purchase, etc. immediately upon, or even before, the FIE's formation, a foreign investor planning to establish an FIE should apply to SAFE to open an onshore temporary capital account. The foreign currency deposited in the temporary account may be used for expenses, procurement and guarantees to onshore entities. Payments made from the account are credited as contributions to the FIE's registered capital. An application to SAFE must be made each time funds from the account are settled. In addition, in some locations, it can take 20 days for SAFE to approve establishment of the account or a settlement. It is therefore advisable for foreign investors who plan to use such an account to start taking steps to open one early in the process of establishing an FIE. Financing by way of capital contributions also presents certain foreign currency risks that are often the subject of negotiations between the investors in a Sino-foreign joint venture where the Chinese party contributes Renminbi Yuan ("RMB") to the FIE's registered capital. Chinese laws permit the registered capital of an FIE to be denoted in either RMB or foreign currency. Because relevant approval requirements for establishment of the FIE can often require several months between the time the investors execute the corporate documents setting forth the registered capital and the time the capital is actually paid, the foreign currency value of the RMB will have changed when the investors contribute the capital. Denoting the registered capital in RMB allocates the currency fluctuation risk to the foreign investor, while denoting it in foreign currency places such risk on the Chinese investor. For the foreign investor, it is usually preferable to denote the registered capital in foreign currency, so that the amount they are required to contribute to the FIE remains constant. The FIE itself is also subject to currency fluctuations because PRC foreign exchange regulations limit the amounts of registered capital that the FIE can convert into RMB at any one time. As a result, the RMB value of the foreign currency funds that sit in the FIE's registered capital bank account fluctuates. In certain cases, MNCs and other foreign investors with existing FIEs that generate RMB profits are able to avoid this risk by capitalizing a new FIE with RMB profits of existing FIEs. Settlement of Capital While China has been gradually loosening restrictions on the convertibility of the current account, the capital account is still tightly controlled. This results in significant red tape and delays when an FIE converts its registered capital into RMB and uses it to fund operations. A contribution of registered capital to an FIE requires that the FIE open a foreign currency capital account with a 3

4 4 bank in China after obtaining relevant SAFE approvals. In addition, the FIE must open a RMB operating account with a local bank, which requires an approval from the People's Bank of China. After the investor contributes the registered capital to the registered capital account, the FIE must complete certain procedures in order to convert, or "settle", such foreign currency into RMB for use by the FIE. SAFE regulations limit the amount of registered capital that can be settled at any one time and the purposes for which it may be settled. Consequently, an FIE cannot convert and transfer the balance of its registered capital to its RMB operating account, but must convert its registered capital into RMB on an "as needed" basis. In 2008, prior to the onset of the current economic crisis, China had been experiencing large amounts of "hot money" foreign currency coming into the country to take advantage of the growth in the Chinese property and securities markets, as well as the rapid and steady increase in the value of the RMB. In response to concerns over growing foreign exchange reserves and an overheating economy, SAFE issued numerous regulations in 2008 to tighten controls on foreign currency inflows. One such regulation, the Notice on the Relevant Operating Issues concerning the Improvement of the Administration of Payment and Settlement of Foreign Currency Capital of Foreign-funded Enterprises ("SAFE Notice No. 142"), imposes stricter requirements and limits on settlement of foreign currency held in FIE registered capital accounts. By requiring an FIE to complete and submit a capital verification report prior to settling registered capital, it increases the documentation and time required before an FIE can access its registered capital to pay rent, employee salaries and other operating costs and capital expenses. Furthermore, it requires the banks to review the FIE's use of funds and authorizes them not to carry out settlement if the bank believes the use does not fall within the FIE's business scope. The settled RMB must be paid directly to a third party payee and may not be deposited to the FIE's operating account except in cases where the settled funds are used for operating reserves and employee wages and bonuses. SAFE Notice No. 142 explicitly prohibits the settlement of registered capital for property investments (other than property purchased for the FIE's own use) and equity investments. The restriction on equity investments is noteworthy because since changes to the PRC Company Law in 2006, it has become common place for foreign investors to use a WFOE (often a small consulting WFOE) to acquire interests in PRC companies or establish subsidiaries which are not subject to foreign investment approvals. SAFE Notice No. 142 effectively curtails that practice, and foreign investors must now establish investment companies to hold multiple FIEs onshore and have existing FIEs that generate RMB profits to form domestic subsidiaries that are not subject to FIE approvals and governance requirements. Although the recent economic crisis has stemmed hot money inflows and raised concerns among regulators of capital outflows, there has been no indication that SAFE will loosen the more restrictive requirements put in place by SAFE Notice No Because of the delays and red tape involved in contributing foreign currency as registered capital and converting it into RMB, multinationals and other foreign investors with existing China operations that generate RMB profits should consider using such RMB to fund new and existing ventures, thereby eliminating the

5 complexities of foreign exchange settlement on the capital account. As can be seen from the above, while financing an FIE by way of registered capital is necessary, it requires advanced planning and significant time to complete, due to the approvals required to make increases to the registered capital. Funds are also tied up in the registered account until the FIE is able to use them, and the procedures required for settlement can create delays and administrative costs. For these reasons, the prudent foreign investor should also consider alternative means of financing their FIEs, such as use of loans and interparty transactions, which are discussed below. Financing FIEs through Lending There are several borrowing options for FIEs that foreign investors may utilize in funding and managing their operations in China. These options include foreign debt from the shareholder or an offshore lender, RMB loans from onshore banks, and RMB loans from affiliated onshore enterprises. Borrowing offers several advantages including the ability for the foreign investor to repatriate profits from the FIE in the form of principal and interest payments on shareholder loans, tax deductions for the FIE, and, in the case of RMB debt, the avoidance of foreign exchange settlement and payment restrictions and procedures. Foreign Debt One advantage an FIE has over a company established by domestic, Chinese investors is the ability to incur foreign debt (i.e. foreign currency debt from the foreign shareholder or other offshore lender). Nonetheless, foreign debt is considered a capital account transaction and subject to relatively strict monitoring by SAFE and local banks. All foreign currency loans to an FIE must be registered with SAFE within 15 days after execution in order for the loan to be effective, and local banks require a copy of the SAFE registration in order to remit the interest and principal abroad. SAFE will not register a foreign currency loan amount that exceeds the difference between the FIE's approved total investment and registered capital. For purposes of calculating how much of the FIE's foreign debt quota is available, SAFE will add the balance of outstanding short-term debt (i.e. one year or less) and the cumulative mid- and longterm debt. As a result, short-term debt may be re-borrowed once it is paid, while mid- and long-term debt cannot. SAFE authorities in some locations may scrutinize the purpose of the foreign debt and require certain mandatory clauses in the loan agreement. In addition to registering the loan with SAFE, the FIE must obtain SAFE approval to open a foreign currency loan account with the FIE's bank, which can take up to 20 days in some locations. Once the FIE has received the foreign debt into its loan account, the FIE must also obtain SAFE approval to settle the funds each time the FIE draws on the loan proceeds. This can take up to 20 days in some locations. If the amount of settled loan proceeds exceeds US$20, 000, the bank will only remit the funds to the third party payee, while amounts under US$20,000 may be deposited into the FIE's RMB account. In addition to the above procedural requirements, there are other restrictions and requirements that may or may not be actively enforced by local SAFE officials and banks. For one, loan proceeds can only be settled for purposes specified in the loan contract, and the use of the loan must be related to the company's business scope. Settlement may also be restricted depending on the term of the loan. Short-term foreign debt is supposed to be used mainly as working 5

6 6 capital and cannot be used for fixed asset investment. Medium/long-term foreign debt can only be used for the purpose specified in the loan contract, usually related to fixed asset investment. Another restriction is that the registered capital must be paid in by the investor before the FIE can register and settle a foreign debt. However, SAFE officials in some localities do not enforce this rule or interpret it differently, for example requiring only that the first installment of registered capital be paid in or allowing debt in an amount proportional to the amount of paid-in registered capital. In some locations, SAFE will require that the loan agreement contain provisions requiring registration of the loan as a condition to effectiveness and examination and approval for the repayment of the loan. Local SAFE officials may also comment on the exchange rate, but generally will allow a rate that is not higher than the prevailing market interest rate for a loan of the same tenor quoted in international financial markets. In practice, LIBOR plus a mark-up of one or two percentage points is usually accepted as reasonable. Finally, the loan agreement must have a provision permitting prepayment in order to remit foreign currency prepayments to the lender. Although the SAFE restrictions and procedures required for foreign debt are equivalent to those required to contribute and settle registered capital, foreign debt offers certain advantages over registered capital. For one, the interest payments create a deduction in China and dividends do not. A foreign investor can also repatriate funds from the FIE as loan interest and principal repayments without having to meet the conditions required to remit dividends or reduce registered capital (discussed in more detail below). While there is withholding tax on the loan interest paid to the lender, such tax is creditable for US tax purposes. RMB Debt from Local Banks Use of RMB debt from onshore banks presents another option for FIE financing that many foreign investors often overlook. Especially during the current economic crisis, where multinationals may be unable to tie up cash in their FIEs and credit is relative abundant in China given the relative health of Chinese banks, RMB debt offers certain advantages over foreign currency capital and debt, such as the avoidance of foreign currency restrictions and procedures. In theory, the "total investment" of an FIE refers to the total amount of investment in the FIE, as either equity or debt, and therefore would include RMB debt. In practice however, there is no effective regulatory limit on the amount of RMB debt an FIE may incur. Whereas SAFE registration is required in order to remit foreign currency debt repayments for a foreign debt, and a bank will not remit payments to a foreign lender without the relevant SAFE registration, there is no practical mechanism to limit the amount of RMB debt an FIE incurs. In practice, Chinese banks will rarely look at the total investment and registered capital of an FIE that applies for RMB financing. Rather, they will look at the security provided and the revenues of the project being financed to determine the level of risk the bank can support in line with its own risk management criterion. For working capital and cash requirements, RMB loans present an attractive option. There are no SAFE or special foreign currency requirements, so once a relationship with a local bank is established, an FIE should be able to obtain RMB funds rather quickly. While foreign debt cannot be used to repay RMB debt, an

7 FIE may convert its registered capital for purposes of repaying RMB debt provided it submits a statement that the loan has been used within the approved business scope. While it is possible to obtain RMB loans for fixed asset investment by an FIE, it is still difficult to use RMB debt for equity investments and M&A activities. Chinese laws governing lending activities have previously prohibited lending for the purpose of making equity investments. However, recent regulations issued by the China Banking Regulatory Commission in December, 2008 have opened the door to M&A lending. 1 The new rules allow "strong" commercial banks to loan money to companies for M&A activity. Currently, such loans are only accessible to strategic domestic investors where there is a correlation between the business of the target and the acquirer. While the use of RMB loans by FIEs for establishing domestic subsidiaries or acquiring interests in domestic companies is still rare, this may change as banks and FIEs take advantage of the new rules. Intra-Group Lending and Guarantees Under current Chinese laws, only banks and other entities approved by the People's Bank of China to engage in lending activity may lend money. As a result, a non-financial institution Chinese company may not directly lend money to an affiliated person or third party. To do so, it must entrust a qualified bank to lend the money on its behalf. This is commonly referred to as an "entrustment loan". The funds are placed with the entrusted bank, which then serves as an agent and lends the funds to a borrower nominated by the principal. The bank provides the entrustment loan on a commission basis (ranging from 0.1% to 0.3% in general) and does not take on any credit risks associated with the entrustment loan. In some cases, where an FIE needed funds from an offshore parent but was limited by its total investment amount or requires the funds quickly, the onshore subsidiaries of foreign banks have agreed to lend RMB to an FIE, while the FIE's parent provided security to the foreign bank parent offshore. This security structure creates foreign exchange and enforceability risks for the bank however, who may not agree in all cases. While it is possible for an FIE to secure an RMB loan from an onshore bank with a foreign currency guarantee from the FIE's parent in favor of the onshore bank, Chinese foreign exchange regulations treat the foreign currency guarantee as a foreign debt, and limit the amount to the FIE's total investment debt ceiling. In addition, the FIE must register the guarantee with SAFE within 15 days of the parent's performance of its obligations under the guarantee. Financing FIEs through Related Party Transactions A common method of funding an FIE is the use of related party transactions between the FIE and offshore parent. The FIE will provide goods, intellectual property or services to the parent at a markup, for which it can receive and settle foreign currency payments from the parent. Unlike contributions of registered capital and shareholder loans, which are capital account transactions, the export of goods, services and intangible property are treated as current account transactions. Consequently, the procedures required to receive and settle the foreign currency payments on the current account are faster and simpler. In most cases, to receive foreign currency payments on the current account for services or intangibles, the FIE need only submit the relevant documentation to its bank, who is authorized by SAFE to verify the transaction and handle receipt and settlement of the foreign currency 7

8 8 payment. The documentation will need to include relevant registrations and/or licenses relating to trademark, software, technology and goods exports and licenses. Obtaining these registrations and licenses requires completing procedures with the relevant authorities when the export contract is signed. For exports of goods, registrations must be completed with the local SAFE and will require relevant Customs declarations forms. However, in its effort to stem hot money inflows, SAFE issued additional requirements for goods exports in 2008 that increase the procedures and time required to settle foreign exchange payments. 2 Exporters are now required to open foreign currency verification accounts into which foreign exchange payments received for goods exports must be remitted. The bank is required to verify the authenticity of relevant documents before the payment may be settled and released to the exporter's regular bank account. Many foreign investors have also used advanced and deferred trade payments between their FIEs and offshore entities as a means of managing liquidity between offshore and onshore entities. However, in an effort to curb hot money inflows, in 2008 SAFE introduced new registration and quota requirements for advanced and deferred trade payments exceeding 90 days which may limit the usefulness of trade financing as a liquidity management tool. 3 Although current account transactions may offer a faster and simpler means to remit foreign currency to an FIE in need of cash, the tax consequences are less favorable, as the FIE will incur corporate income tax and business or value added tax on the payments. In addition, the FIE will need to comply with new transfer pricing contemporaneous documentation and reporting requirements which were introduced in 2008 and significantly increase the associated administrative and compliance costs. Although controls on the current account are relatively light compared to capital account transactions, there nonetheless is a verification system in place. To the extent that an FIE's business does not include services or goods it can legitimately provide its offshore affiliates, it does not offer a dependable method for funding an FIE, as the bank may not permit the receipt and settlement of foreign exchange payments that appear inconsistent with the FIE's business or underlying transaction. Use of related party transactions to fund an FIE therefore work best for onshore R&D or processing centers that can operate on a cost-plus basis providing goods or services to an offshore parent. Centralizing Cash Management For multinational corporations and other foreign investors that have several FIE subsidiaries in China, managing cash among the entities presents challenges. Each entity may have its own bank accounts and lending arrangements, often with different banks. There may also be one entity that is cash rich and another that is in need of cash. However, due to restrictions on lending and related party transactions, there are difficulties and risks with moving money between the entities. Despite these structural and legal restrictions, there are tools and methods available for centralizing finance and treasury management among China entities that foreign investors can take advantage of with proper planning and structuring of their onshore investments and banking arrangements.

9 Use of Branches One approach to avoiding the inefficiencies that result from having many different legal entities is to consolidate various entities into branches of one company. This requires that the various entities engage in similar business because the business scope of the branch cannot differ from the parent company. To the extent separate legal entities have already been formed, such a consolidation will require restructuring, for which there may be significant administrative costs. However, a headquartersbranch approach can be useful in avoiding multiple, separate legal entities, where each entity uses a different bank and different facilities and services from each bank. Use of Holding Companies and RHQs For large multinationals with significant investment in China, use of an investment company (a "Holding Company") or regional headquarters ("RHQ") can offer advantages with respect to managing finances of onshore entities. A Holding Company and RHQ are each a type of limited liability FIE established under a separate set of regulations governing such entities. While these entities offer several advantages in terms of centralized management, their main drawback are the steep capitalization and other conditions for establishment. A Holding Company requires a minimum registered capital of US$30 million, while an RHQ requires US$100 million. The foreign investor must have total assets of US$400 million with US$10 million already invested in China or have 10 onshore FIEs with paid in capital of at least US$30 million. Holding Companies and RHQs are utilized primarily by MNCs with several subsidiaries and significant operations in China. The main purpose of a Holding Company is to hold investments in Chinese companies, and the minimum US$30 million registered capital must be used for this purpose. However, the business scopes of a Holding Company and RHQ also allow for additional, centralized financial management activities, subject to relevant approvals. A Holding Company for example may balance foreign currency among its onshore subsidiaries after obtaining relevant approval from SAFE, assist its subsidiaries with financing and provide guarantees, provide lease financing of machinery and office equipment to its subsidiaries, and engage in and act as the purchasing or sales agent of its subsidiaries. An RHQ, with approval from the China Banking Regulatory Commission, can establish a finance company to provide financial services to its onshore subsidiaries. In practice however, very few MNCs have pursued these additional approvals to enable their Holding Companies or RHQs to carry out foreign exchange balancing or financial services activities, the scope of which is still quite limited, although many MNCs will use a Holding Company or RHQ to centralize sales and purchasing activities among their onshore subsidiaries, thereby centralizing invoicing and banking arrangements. The business scopes of Holding Companies and RHQs also allow for them to provide a wide range of services to their onshore subsidiaries and offshore affiliates, thereby opening channels for intra-group funding via related party transactions and entrustment loan structures. Group Entrustment Loans and Other Bank Products The restrictions on lending discussed above make it difficult to manage cash among various entities in China. In practice, it is common for domestic Chinese companies to disregard the relevant legal restrictions and lend and transfer funds among affiliates without 9

10 10 any legal basis or documentation. However, this creates enforceability and compliance risks that are unacceptable to most foreign investors. To meet the cash management needs of MNCs with multiple onshore entities, most of the onshore branches of foreign banks have developed products to facilitate cash and treasury management. The bulk of these products utilize group entrustment loan structures. Based on the bilateral entrustment loan structure discussed above, group entrustment loans allow for funds to be moved where needed within an onshore group structure. The primary onshore entity entrusts the bank to loan funds to and from the various onshore entities as required by the use of drawdown notices for example, thereby effectively pooling cash among the group and reducing overall administrative costs. Subject to SAFE restrictions and approvals, an onshore entity may also lend foreign currency funds to its offshore affiliate through an entrustment structure, as described further below. Maximizing Cash Flows out of China China has withstood the current global economic downturn relatively well. Many multinational companies may find that their China operations continue to be profitable while operations elsewhere incur losses. As a result, they may want to maximize cash flows out of China. While recent policy developments have opened up new channels for repatriating funds from China, foreign investors still need to be aware of the limitations on, and methods available for, repatriating investments or profits out of China. Dividends The most common method of repatriating RMB profits out of China is through the distribution of dividends. However, dividend distributions have their limitations. An FIE may only distribute dividends after its registered capital has been paid in full, and distributions are limited to after-tax profits from the current account after making up for any losses and contributions to enterprise reserve, enterprise development and employee welfare funds. The contributions to the enterprise reserve fund alone must equal 10% of after-tax profits (until the cumulative amount equals 50% of the company's registered capital) and be used to make up for losses. It cannot be repatriated even if the company has no losses. An FIE can convert and remit its RMB profits to the foreign investor on the current account through its bank, and no SAFE approval is required. The company will need to submit audited reports and other documents showing that tax and fund payments have been made, and the bank will only approve remittance of dividends up to an amount of the company's after taxprofits shown in the audited reports. The after-tax profit limitation on dividend distributions creates a cash trap for many foreign investors in China. Because cash that is sheltered by depreciation cannot be distributed as after-tax profits, FIEs in capital intensive industries with depreciation expenses that cut significantly into their after-tax profits often build up sheltered cash. Furthermore, while there had previously been no Chinese withholding tax on dividend distributions to foreign investors, changes to China's corporate income tax law that took effect in 2008 included imposition of withholding tax on repatriated dividends. As a result, many foreign investors are revisiting less costly ways to repatriate funds from China, such as through the use of loan repayments and outbound loans.

11 Current Account Transactions Foreign investors with cash trapped in China or who require more flexible access to onshore liquidity than dividend distributions permit can in many cases make use of current account transactions to repatriate funds out of China. This approach enables FIEs to repatriate funds regardless of profitability. Foreign exchange payments under the current account have been liberalized in China and therefore FIEs do not need to secure prior approvals from SAFE in order to receive or make payments for sales of goods or intangible properties or crossborder trade in services. However, all current account payments are required to be based on an authentic and lawful underlying transaction. SAFE requires that onshore banks examine and verify transaction documents to ensure that the foreign exchange payments are authentic and consistent with the underlying transaction. In many cases, the documentation required to verify the authenticity of a transaction can be substantial and require significant preparation, time and administrative resources. Imports of goods will require various customs declaration documents, while imports of intangibles may require technology import registration documentation for example. The tax costs of using current account transactions to repatriate onshore cash can be relatively high however. Customs duties and value added services taxes will apply to most good imports, while imports of intangibles and services may be subject to passive income withholding and business tax. Furthermore, China's new corporate income tax regime has introduced substantial transfer pricing documentation and disclosure requirements for related party transactions that significantly increase the planning and resources required to repatriate cash by means of current account transactions. Loan Repayments An additional advantage of using debt to finance an FIE's operations is that the FIE's repayment of loan principal and interest can create a channel to repatriate cash from onshore. Although SAFE approval is required for the FIE to convert RMB into foreign currency and remit loan repayments, cash can be repatriated more quickly and with more frequency than through the distribution of dividends, which can only be repatriated annually in most cases. However, RMB cannot be converted to foreign currency for purposes of prepaying a loan in advance. Tax will be withheld on the interest portion of the repayment, but in many cases, the total amount of tax on this amount will be less than the withholding on dividends, and the interest creates a deduction for the FIE in China. Outbound Loans As part of the Chinese government's recent efforts to encourage outbound investments, SAFE recently issued new rules that allow companies in China to make loans to offshore subsidiaries. Previously, only multinationals with a Holding Company or RHQ could provide foreign currency loans to offshore affiliates directly or through an entrustment loan. Pursuant to a notice issued in June, 2009, SAFE expanded eligible lenders to include all companies in China that meet the requirements under the notice. 4 Foreign investors who need cash offshore and whose FIEs onshore are cash-rich and meet the requirements can now borrow from the onshore FIE. The offshore borrower must be a wholly or partially owned subsidiary of the onshore lender. The lender may grant 11

12 12 loans directly, or by entrusting a designated foreign exchange bank or qualified group financial company. The permitted sources of loan funds include lender's forex reserves, forex purchased with RMB and forex pools approved by local SAFE. The lender must submit the relevant documents to the local SAFE for approval of the loan. Once the lender obtains its approved quota from the local SAFE, it may remit the funds in a lump sum payment or installments. The approved quota is good for two years, extendable at lenders' request. The amount the onshore company may lend is limited to 30% of its equity and the total, registered investment amount of the borrower committed by the Chinese party, although a lender may apply for an exemption from this limit through the local SAFE. The notice requires the lender and borrower to meet certain qualifications: (1) both lender and borrower are duly incorporated, with their registered capital fully paid in; (2) both lender and borrower have maintained sound business records, robust financial and internal control systems and have not breached foreign exchange regulations during the past three years; (3) all outbound direct investment projects of the lender have been approved by the Chinese and offshore investment authorities, registered with SAFE and rated class two or above in the latest annual joint review of outbound investments; and (4) there has been no default on lender's last outbound loan. Equity Transfers and Outbound Investment Another possibility for repatriating funds from an FIE is to sell equity or shares to the FIE. The foreign investor's transfer of equity of an onshore company (an FIE) to the cashrich FIE will require approval of the target FIE's approval authority and may result in the loss of FIE status for the target FIE. The other investors of the target FIE will also need to consent to the transfer. Once approved, the purchaser FIE can convert its RMB into foreign currency and remit to the seller after withholding relevant taxes. It is also possible for an FIE to purchase shares in an offshore entity. However, such outbound investments require approvals from the National Development and Reform Commission, Ministry of Commerce, and SAFE. New regulations from SAFE and Ministry of Commerce are expected to relax the restrictions and simplify the procedures required to make outbound investments, but it remains to be seen how the authorities will implement the procedures in practice. To date, there are few cases of FIEs holding shares in offshore entities. However, given the new policy and requirements of outbound loans discussed above, many foreign investors with cash-rich FIEs that want more options for repatriating funds may find it worthwhile to transfer shares of an offshore affiliate to the FIE in return for cash consideration and for purposes of enabling the FIE to loan funds to the offshore entity in the future. Early CJV Disinvestments As a method of repatriation, early disinvestment is available only to Sinoforeign cooperative joint ventures (a "CJV"). While the more common equity joint venture requires dividends be distributed in proportion to the proportion of registered capital held by an investor, a CJV may repay the principal amount of the foreign investor's investment on an accelerated basis, provided that the ownership of the fixed assets pass to the Chinese partner(s) at the end of the life of the CJV. This is effectively a statutory "build, operate and transfer" mechanism. Subject to prior approval by the PRC Ministry of Finance

13 or its local counterpart, this method may allow the foreign investor in a CJV to receive funds derived from depreciation of fixed assets and amortization of intangible assets, and withdraw its investment earlier than the expiration date of the CJV. In recent years, private equity investors investing directly onshore have used the CJV structure to mimic preferential dividends. Capital Reductions and Liquidation In theory, it is possible for an FIE to reduce its registered capital and remit the reduced amount to the foreign investor. A reduction of capital requires the approval of the company's approval authority, which in pratice is rarely forthcoming. In addition, the reduction will require the preparation of detailed balance sheets and asset inventories. The company must inform its creditors and the public, who will have a period to claim payment of debts owed by the company. The process can easily take several months, and due to the uncertainty of obtaining the requisite approval, few investors rely on this as a feasible method for repatriating cash that has built up in China. An exception exists for foreign invested venture capital enterprises, which are governed by separate regulations that permit the return of capital upon exiting portfolio companies or upon the approval of the approval authority and majority of other investors. Excess cash can be remitted to a foreign investor upon the expiration of the FIE's operating term or early liquidation of an FIE. Liquidation will require the FIE to form a liquidation committee and liquidation plan, notify its creditors, settle its debts and taxes, and complete its liquidation and deregistration procedures with various Chinese authorities. Funds that remain after paying off liquidation expenses, employee wages, social insurance premiums, outstanding taxes and the company's debts can be converted into foreign currency and remitted to the foreign investor upon obtaining SAFE approval. Liquidation of an FIE in China typically requires anywhere from six months to a year or more to complete. Use of Holding Companies and RHQs Holding Companies and RHQs offer certain advantages for repatriating excess cash generated in China. As described above, their business scopes allow for centralized procurement and distribution activities by which they can centralize invoicing, cash management and foreign exchange balancing. The FIEs of qualified MNCs may also purchase foreign exchange and reimburse offshore affiliates for certain expenses incurred on behalf of the onshore FIE, such as expatriate salaries and insurance, overseas travel and training expenses, and other corporate overhead upon SAFE approval. Conclusion In recent years, the Chinese government has relaxed controls on the current account significantly, and companies in China find it much easier to settle RMB or foreign exchange and remit funds across borders on the current account. Although the restrictions are few, the documentation requirements are considerable, and often require completing relevant filings with Chinese authorities before payments can be made. China still maintains strict controls over capital accounts. As a result, many foreign investors have difficulties efficiently funding their operations in China as well as repatriating profits and capital that accrue in China. With the rapid appreciation of the RMB following the elimination of the Yuan-Dollar peg in 2005, SAFE's priority had been the control of "hot 13

14 money" capital inflows and growth of China's foreign exchange reserves. Although the onset of the global economic crisis has not caused SAFE to repeal certain hot money controls put in place prior to the crisis, it appears to have caused SAFE to expedite the easing of restrictions on the capital account. While such developments are geared primarily to facilitating outbound investments by Chinese companies, foreign investors looking to repatriate funds they have built up in China can also benefit. China's foreign exchange controls are complex and constantly shifting and create challenges for foreign companies used to dealing in freely convertible currencies. They require that foreign investors have a clear understanding of the unique requirements and restrictions of China's regulatory system, plan in advance, and communicate frequently with their tax and legal advisors, banks and relevant Chinese government officials. With proper systems put in place by management and utilization of cash pooling and other account and treasury services offered by foreign and domestic banks, foreign investors can better manage cash flows, capital and debt among their Chinese subsidiaries. Endnotes: 1. The Guidelines on Risk Management of Acquisition Loans by Commercial Banks promulgated on December 9, See the Notice Measures for the Online Inspection of the Collection and Settlement of Foreign Exchange in Export issued by SAFE, the Ministry of Commerce and the Ministry of Customs on July 14, See the Circular on the Issues Concerning the Implementation of Registration of Foreign Debts under the Goods Trade of Enterprises issued by SAFE on July 14, See the Notice on the Administration of Cross-Border Loans Granted by Onshore Enterprises issued by SAFE on June 9,


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