ACQUISITIONS IN CHINA : ASSET OR SHARE DEAL?

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1 The opportunities offered to foreign investors by the Chinese mergers and acquisitions market are increasing every year: in 2010, transactions involving foreign companies came to 60.1 billion euros, an increase of 21.2% compared with Seen from the West, where markets are declining, all sectors of the Chinese economy seem to be undergoing promising development and the statistics indicate that the Middle Empire will be a lasting springboard for growth. In China, companies are still manufacturing and building, but they are also selling more. In China, even more so than in Russia, Brazil or India, industry is developing and consumers purchasing power is growing every day. Foreign enterprises often succumb to the lure of China or, if not, then they are conscious of the need for a presence in China. However, the difficulties of setting up directly in one s own name in a country that is so astonishingly different from our own often prompts informed foreign companies to consider an alternative: acquisition. Obtaining a foothold in China by means of an acquisition means acquiring brands, a reputation and knowledge of the Chinese market as well as production and/or distribution networks. However, the acquisition of a Chinese company can also hold surprises (underestimated taxes and social contributions, absence of certain permits or non-observance of applicable regulations, imperfect real estate deeds, etc). The question that then arises is what form the acquisition should take, and some investors prefer to acquire the assets of one of their subcontractors, suppliers, partners or competitors. Ultimately, the question is often whether to acquire an interest or assets. I- ACQUISITION VIA A CAPITAL INTEREST Foreign investors may acquire the Chinese target company directly or indirectly via a holding company based in Hong Kong owing to the many advantages offered by Hong Kong, through which one-third of all foreign investment in China 1 transits. Acquisition of an interest via a company in Hong Kong Hong Kong is an ideal platform for carrying out mergers and acquisitions because of the flexibility of its legal and tax rules 2. In addition, the Hong Kong dollar is fully convertible and there are no exchange control measures or restrictions to complicate cross-border acquisitions. The acquisition of shares in a Hong Kong-based company may form part of various investment strategies but meets the same objective: to penetrate the Chinese market and repatriate profits generated in China 3 while guaranteeing minimum taxation of financial flows. Some investors therefore choose to acquire a holding company based in Hong Kong because the latter already holds a subsidiary in mainland China, others because they want to set up, using the Hong Kong holding company, a foreign invested enterprise or a representative office in China. Using Hong Kong as a platform for investment in China also makes it possible to benefit, after a certain time, from the privileged status of a Hong Kong investor, which guarantees access to sectors of activity that, in theory, are closed off to foreign investors (financial services, legal advice, auditing, advertising). Finally, the tax treaties that exist between China, Hong Kong and France often make it possible to repatriate a profit generated in China at a lower tax cost than direct repatriation to France. (1) Thanks, in particular, to the Closer Economic Partnership Agreement, which provides for a preferential opening of the Chinese market for Hong Kong-based investors in 18 economic sub-sectors as well as the lifting of customs tariffs for 273 categories of products originating in Hong Kong. (2) There is no capital gains tax on the sale of securities. (3) All inbound or outbound transfers of funds are supervised by the State Administration of Foreign Exchange. The latter can refuse to transfer these funds to the recipient saccount.

2 However, because of the many abuses, the Chinese tax authorities have introduced taxation on foreign holding companies (including holding companies based in Hong Kong) the sole purpose of which is to keep holdings in subsidiaries located in mainland China. In practice, it is very easy to acquire shares of unlisted Hong Kong companies: Hong Kong law merely requires, under pain of invalidity, that the transfer be formalized in an «instrument of transfer» that is signed by the two parties and that is subject to stamp duty. Of course, the entire arsenal of guarantees, price adjustment and other such measures may be provided for by contract with no limit except the parties imagination. Moreover, there is no anti-competitive legislation that makes it possible to prevent concentrations and monopolies. This simplicity contrasts with the rules that apply in mainland China. Acquisition of a holding directly in a company based in mainland China Acquisitions are a recent phenomenon in China, which began in the early 2000s. Before that, foreign investments mainly involved the creation of a new joint venture (greenfield joint venture) with a Chinese partner. The few acquisition deals that were struck were concluded within an uncertain legal framework, which only began to get clearer in 2003 with the publication of rather vague interim measures. This legal framework has since been clarified and reinforced. A precise but not very flexible legal framework Overall, mainland China s law of contract and company law do not offer the flexibility which they offer in Hong Kong. As mentioned in an earlier newsletter, many obstacles exist, particularly if one wants to spread out or vary the payment of the price. When a foreign investor acquires equity interest in a domestic company, the latter is, in fact, converted into a foreign invested enterprise. This may change many things and in particular may call into question the advantages obtained from authorities such as the Chinese customs or tax departments. What is more, foreign investors may acquire equity interest only in sectors in which foreign invested enterprises are authorized to carry on an activity in China. In addition, these transactions are subject to certain conditions and restrictions, including: Administrative approvals One of the first points a European reader should bear in mind is that the acquisition of a company in China cannot be carried out freely: it is subject to extensive administrative controls and cannot be carried out, even when the acquisition contracts have been signed, until the approval of the relevant authorities has been obtained. These authorities are the local or regional branches of the Ministry of Commerce, or this ministry itself, depending on the size of the acquisition. In addition, the Anti-monopoly Law of the People s Republic of China 4, which came into force in 2008, now requires, in the case of a planned acquisition that involves a big foreign company and a medium-sized Chinese company, that a prior check be carried out to determine whether the transaction comes within the framework of this law. The sales figures, both worldwide and in China, of the companies concerned by the transaction must be verified. If necessary, the impact of the transaction (for example, in terms of the concentration of market shares) on the Chinese internal market will have to be analyzed. (4) Published on August 30th, 2007 by the Standing Committee of the National People s Congress, and which came into effect on August 1st, 2008.

3 If the thresholds specified in the Anti-monopoly Law are exceeded, a special notice must be submitted to the agency especially created for that purpose, along with a complete file describing the expected impact of the transaction on competition within the Chinese market. If the transaction relates to a particular industry (banking, insurance, health, etc.) or a listed company, the approval of other specialized authorities will be required. This multiple-approval process, which must be taken into account very early, increases the timeline for the transaction and reduces the certainty that it will be finalized. The national security review New rules published on February 3rd, 2011 also introduce a national security control mechanism in connection with the acquisition of domestic companies by foreign investors 5. From now on, the acquisition of a majority stake by foreign investors in Chinese domestic companies (i.e. companies which are registered in China and in which a stake of less than 25% is held by foreign investors) in strategic sectors (defense, food, energy and resources, infrastructures, technology, transport industries, etc.) shall be subject to a specific review supervised by the Council of State, and carried out jointly by the Ministry of Commerce, the National Development and Reform Commission (NDRC) and other governmental agencies depending on the industries involved. It should be noted however that these new rules and this specific review will not apply to acquisitions of foreign invested enterprises in China (i.e. companies which are registered in China and in which a stake of more than 25% is held by foreign investors). These new rules are intended to control sensitive foreign investment in certain sectors that are vital to security and the Chinese economy. Another strategy employed by some foreign investors is to acquire certain assets of the target company only, such as production equipment. II- ACQUISITION VIA THE PURCHASE OF ASSETS Purschasing assets in mainland China This may be foreign investors preferred solution because of the tiny risk that it involves: unlike the acquirer of equity interest, who is liable for the obligations and debts of the Chinese target within the limit of its investment, the acquirer of assets does not assume the liabilities of the company. Chinese law 6 usually allows foreign investors to acquire the assets of a selling company according to one or other of the following options: (i) creation of a foreign invested enterprise followed by the acquisition of assets by this entity; or (ii) acquisition of the assets by the parent company which then transfers them by way of contribution in kind to the newly-created company or, if the company already exists, pursuant to a capital increase. Chinese law makes no distinction between the acquisition of the assets of a local company or of a foreign invested enterprise in China. On the other hand, the acquisition of assets of domestic companies by a foreign invested enterprise is subject to the conditions that apply to the latter (minimum capital, etc). (5) Notice Regarding the Establishment of National Security Review Mechanism for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, published by the State Council on February 3rd, (6) Acquisition of Domestic Enterprises by Foreign Investors Provisions [June 2009]; Administration of the Verification of Foreign-invested Project Tentative Procedure [October 2004]; PRC Contract Law; PRC Law on Property Rights.

4 The company selling the assets also has to inform its creditors of the deal and publicize the sale of the assets in a newspaper of provincial or greater scope at least fifteen days prior to the submission of the documents to the Chinese authorities. In addition, acquisitions of assets in China are subject to the review and approval of the Ministry of Commerce or one of its local branches, depending on the amount of the investment and the industry concerned. A comprehensive file has to be prepared that contains, in particular, proof of the consent of the target company as well as the documents proving the prior creation of, or failing this, the intention to create a foreign invested enterprise within the framework of the structuring of the acquisition. The Chinese authorities will also closely examine the purchase price of the assets: it is forbidden, in China, to sell assets or holdings at a price that is obviously lower than its assessed value (this value is to be determined by a Chinese firm). The date of the effective transfer of ownership differs according to the solution chosen (above solution: option (i) or (ii)). If a foreign invested enterprise was created in order to acquire assets, these assets will be effectively transferred when the company registration prerequisites are met. If the assets are acquired with the aim of contributing to the capital of the foreign invested enterprise to be set up, the investor will not be able to use these assets until the business license has been obtained 7. The special case of an acquisition of assets in Hong Kong Acquisitions of assets in Hong Kong are simple to carry out, since they benefit from a flexible and favorable regime: for this kind of transaction, a contract for the transfer of the assets concerned is drawn up, being specified that the purchaser can refuse to acquire the obligations and guarantees attaching to the transferred assets or may accept only part of them. Free in its form, it is however advisable to include in this contract the traditional representations and warranties. In addition, it is customary to append to the asset transfer agreement a declaration of the vendor attesting to the legal status of the transferred assets on the day of the transfer, along with the legal audit. It is important to note that there is a difference, in terms of formalities, between a simple transfer of assets and the transfer of a complete line of business. In order to protect creditors, Hong Kong law requires that one month s public notice be given prior to the transfer of a complete line of business. If this obligation is not fulfilled, the purchaser will be liable for the debts associated with the transferred activity. (7) Art. 23 of the Provisions on Foreign Investors Merger with and Acquisition of Domestic Enterprises [2009].

5 The authors Paul-Emmanuel Benachi Partner, in charge of Asia Tel. : Raphael Chantelot Partner, in charge of the China Desk in Paris rchantelot@lpalaw.com Tel.: +33 (0) Fanny Nguyen Tax advisor in charge of Shanghai office fnguyen@lpalaw.asia Tel. :