MOC Promulgated New Regulations on Capital Contribution by Equity Interests

This fall the Ministry of Commerce (the “MOC”) promulgated the Interim Provisions on Capital Contribution by Equity Interests to Foreign Invested Enterprises (the “Interim Provisions”). The Interim Provisions tool effect on October 22, 2012.

1. The Interim Provisions allow foreign investors and Chinese enterprises (regardless whether they are foreign invested or domestically funded) (collectively the “Equity Contributor”) to make capital contributions in kind in the form of their equity interests in companies within the territory of the PRC (the “Chinese Subsidiaries”) for the following transactions:

• the establishment of a new foreign invested enterprise (“FIE”);
• the capital increase of a non-FIE and transformation of such non-FIE into an FIE; and
• the capital increase of an FIE.

Before the effectiveness of the Interim Provisions, in general only domestically funded enterprises could make capital contributions in kind in the form of their equity interests in Chinese Subsidiaries. For foreign investors, there was only one exception that they were allowed to subscribe for the registered capital of a foreign invested holding company in China by contribution of equity interests in Chinese Subsidiaries.

2. For capital contributions, the equity interests used for capital contribution shall be clear in ownership, attached with all the rights and transferable according to law. Under the Interim Provisions, the following equity interests cannot be used by the investors:

a) the registered capital of Chinese Subsidiary has not yet been fully paid in;
b) the equity interests have been pledged or frozen according to laws;
c) the equity interests may not transferred pursuant to the Articles of Association or the contract of the Chinese Subsidiary or in accordance with the laws and regulations;
d) the Chinese Subsidiary did not participate or failed to pass the annual inspection if it is a foreign invested enterprise; or
e) the Equity Interest is in a real estate enterprise, foreign-invested holding enterprise or foreign-invested venture capital (or equity investment) enterprise.

The Interim Provisions also provide that the aggregate amount of all non-cash contributions (including contribution in kind in the form of equity interests and other in-kind contributions) by all shareholders to an enterprise (the “Invested Enterprise”) must not exceed 70% of the registered capital of such enterprise. This provision complies with the PRC Company Law on the minimum percentage of cash contributions to a company.

In addition, all equity interests (regardless whether they are state-owned or not) used for capital contribution must be assessed by a qualified asset evaluation company in the PRC. However, the Equity Contributor(s) may still, on the basis of the evaluation result, negotiate with the shareholder(s) of the Invested Enterprise on the value of the concerned equity interests and the corresponding amount of registered capital of the Invested Enterprise to be contributed in the form of equity interests, unless state-owned equity interests are involved in the transaction.

3. The Interim Provisions set out the detailed procedures on approval of capital contribution in kind in the form of equity interests. In general, a preliminary approval from the examination and approval authority (the “COFTEC”) of the Invested Enterprise shall be first obtained. Upon approval the COFTEC will issue a Certificate of Approval of the Invested Enterprise stating that the equity contribution has been not yet made. Then, the Chinese Subsidiary shall go through the relevant approval and registration procedures for a share transfer in order to achieve that the Invested Enterprise becomes its shareholders. On the basis of the revised Business License of the Chinese Subsidiary, the competent COFTEC of the Invested Enterprise will then issue a Certificate of Approval stating that the equity contribution has been made in full.

4. Pursuant to the Interim Provisions, if the Invested Enterprise is a limited liability company, its total amount of investment shall be determined in accordance with its new registered capital after the capital contribution by equity interests is made. Such provision is different from the Circular Gong Shang Qi Wai Zi (1987) No.54 issued by the State Administration for Industry and Commerce in 1987, under which the increased total amount of investment shall be calculated standalone on the basis of the increased registered capital.

Under PRC law, an FIE may take out loans from abroad up to the balance between its total amount of investment and registered capital (the “Foreign Debt Quota”) and an FIE in an encouraged industry sector may also import self-used equipment free of customs duty within its total amount of investment (the “Import Tax-free Quota”). However, when determining the Foreign Debt Quota and the Import Tax-free Quota of the Invested Enterprise, the Interim Provisions provide that its total amount of investment corresponding to the registered capital contributed in kind in the form of equity interests shall not be taken into consideration.

5. There are also certain tax implications under the Interim Provisions which may enable foreign investors to avoid the 10% withholding tax for the gains from the share transfer. For details, please refer to our Tax Regulation Update of October 2012.

The Interim Provisions make foreign investment structures more flexible and give opportunities for tax savings. However, the company registration authority, i.e. the Administration for Industry and Commerce, also plays an important role to register the capital contributions in kind in the form of equity interests by foreign investors and FIEs. The Interim Provisions were only issued by the MOC and unfortunately not jointly with the State Administration for Industry and Commerce (the “SAIC”) so it remains to be seen whether the registration authorities will also implement them. It can be expected that the SAIC will issue corresponding rules for registration of equity contribution.