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Welcomed development in foreign-invested venture capital holding structure in China

The developments in the Chinese venture capital industry since the country joined the World Trade Organisation have been the subject of much commentary among industry players. Here, Cassie Wong and Howard Yu give their assessment of how the new rules might affect China's venture capital landscape.

On 30 January 2003, a new set of regulations was issued to govern the establishment and management of foreign-invested venture capital enterprises (‘FIVCEs').  Ministry of Foreign Trade and Economic Cooperation (‘MOFTEC'), Ministry of Science and Technology, State Administration of Industry and Commerce (‘SAIC'), State Administration of Taxation (‘SAT') and State Administration of Foreign Exchange (‘SAFE') jointly issued the new regulation, the Administrative Rules of Foreign-Invested Venture Capital Enterprises (‘New Rules').  The New Rules took effect on 1 March 2003 and replace the previous regulation, Temporary Administrative Measures of Foreign-Invested Venture Capital Enterprises, which were viewed as inadequate to cater for the needs of foreign venture capital investors in China.
  
Why the old measures were inadequate?
When the old measures were promulgated in August 2001, they were considered as a genuine attempt by Chinese authorities to foster growth of China's budding high-tech industry using foreign venture capital funds.  However, upon close examination, it is generally believed that the old measures failed to address the needs of foreign venture capital investors and did not facilitate the set up of VC funds in China under conditions which are customary to more open economies.  Since the purpose of a VC fund is to channel and manage investments, investors would like to see more flexible features on profits flow-through, investment exits and capital repatriation with as little restrictions as possible. The minimum capital and pre-qualification requirements were also considered excessive leading many to believe that adopting a typical offshore VC fund structure in China is difficult. 
  
Major highlights of new rules
 The new rules retained some of the features of the old measures, but they are more sophisticated and less restrictive.  More importantly, the partnership concept and some of the attributes are enhanced.  The following points represent the major highlights of the New Rules and their respective implications to potential investors:

• FIVCEs are permitted either as legal persons (ie, corporate entity) or non-legal persons, are to be formed by two to 50 investors and their principal activity is to invest in unlisted high-tech oriented Chinese companies including those already with foreign investment.  The new rules, however, do not elaborate on what types of entity form are considered as non-legal person.  However, since the regulations were promulgated based on the framework of the regulations pertaining to equity joint venture (‘EJV'), co-operative joint venture (‘CJV'), and wholly foreign-owned enterprise (‘WFOE'), and the PRC Company Law, a non-legal person FIVCE seems to refer to a CJV formed without legal person status.
  
  
• Legal-person FIVCEs require minimum capital of $5m and non-legal person $10m.  Other than the requisite investor, each investor needs to contribute capital of at least $1m.  Requisite investor, if foreign, must have managed accumulated investment of at least $100m, of which at least $50m must have been invested.  In case the requisite investor is Chinese, these amounts are Rmb100m and Rmb50m, respectively.  Under the new rules, criteria for requisite investor can be looked through to the affiliated group, which is defined as group of entities having more than 50 per cent common control relationship.
  
  
• Capital call for non-legal person FIVCE can be based on investment needs and as prescribed in the FIVCE contract but should not exceed five years.  This is fairly flexible and can be tailored to fit the investment needs of the fund.  However, for legal person FIVCE, capital injection follows the rule applicable for the respective form of entity (ie, generally between one and three years and longer with consent of approval authority).  This may create certain cashflow inefficiencies if the FIVCE has no immediate investment but the investors are still obligated to contribute the capital.
  
  
• Distribution of investment gains can be determined internally by the investors in accordance with ‘international norms' and as set forth in the FIVCE contract.  For non-legal person FIVCE, proceeds from disposal of invested entities within the limit of the original capital investment may be distributed directly to the investors and be regarded as reduction of capital of the investors.  Other than the stated requirement in the new rules for the submission of distribution information to the approval and foreign exchange authorities for records, there is no specific reference to that the distribution is subject to approval.  SAFE is expected to issue specific guidelines on how this will be implemented.  This is a new and useful feature to investors as traditionally capital repatriation is very difficult.  However, treatment is not extended to legal person FIVCEs.
  
  
• FIVCEs should be taxed in accordance with relevant PRC tax laws and regulations.  Subject to approval of tax authorities, non-legal person FIVCEs may elect to have investors pay tax separately at the investor level or be taxed at the FIVCE level.  For a legal person corporate FIVCE, it should be subject to PRC tax on investment returns and gains, although dividends received from investees are currently tax exempt provided that both have foreign investment enterprise (‘FIE') status.  Further, foreign investors in a legal person FIVCE with FIE status should benefit from the current tax regime applicable to FIEs as after-tax dividends are generally not subject to further withholding tax.  For a non-legal person FIVCE, the option to pay tax at the investor level provides an opportunity for tax planning to investors, especially to the foreign investors.  Technically speaking, for a flow-through entity, income and expenses are allocated and taxed to the respective Chinese and foreign investors accordingly.  In the case of foreign partners, they will be taxed on their allocated share of income and expenses in China after considering the source and nature of the allocated items and whether the profits are regarded as arising from a permanent establishment in China.  There should be significant tax planning opportunity for foreign VC investors to mitigate China tax costs through proper use of the non-legal person FIVCE structure and appropriate tax treaty jurisdictions.   As the new rules specifies that SAT will promulgate regulations to address separately the tax treatment of non-legal person FIVCE, it will be interesting to see how the PRC tax authorities address some of these issues.

Observations
The new rules should mark another significant positive development in the PRC authorities' attitude towards modernising China's investment environment by introducing more flexible measures and features that are typical in a more developed economy.  In summary, as before, foreign investors will always have the option and many may still find it preferable to set up an offshore company to directly invest into PRC projects.  However, a non-legal person FIVCE potentially presents a good structuring option especially where a Chinese venture capital investor is involved.  However, some key areas, including taxation and foreign exchange matters, are still to be clarified as mentioned in the new rules.

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