Key Considerations for Foreign Equity Investment in China

Equity investment is one of the popular merger and acquisition (M&A) channels for foreign investors to gain access to the China market. During this process, in addition to tax considerations, there are a series of legal considerations for foreign investors to ensure the smooth progress of the project.

The ”foreign equity investment” discussed in this article refers to all equity investment involving foreign investors, which also includes entities established in Hong Kong, Macao, and Taiwan, and the foreign entities invested in or established by domestic investors.

In terms of activity, equity investment can be done through the purchase of equity or shares (hereinafter collectively referred to as the “Equity Transfer Method“) of a company already established in China (the “Target Company”), or through the purchase by foreign investors of newly increased registered capital or newly issued shares of the Target Company (hereinafter collectively referred to as the “Capital Increase Method“).

In this article, we provide in-depth analysis and practical advice for foreign investors to engage in foreign equity investment in China. In particular, we summarize key rules and regulations, best practices, and tips for foreign investors participating in equity investment in China.

Consideration 1: Foreign Investment Negative Lists

When making a foreign equity investment in China, the first and most fundamental question for foreign investors to consider is whether the investment is allowed by the Chinese government, or whether the investment will face restrictions, as provided in China’s Foreign Investment Negative Lists.

What are the Foreign Investment Negative Lists?

China’s Foreign Investment Negative Lists refer to two documents released by the National Development and Reform Commission (NDRC) and the Ministry of Commerce (MOFCOM) to specify fields that are restricted to foreign investment in China.

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The current effective Foreign Investment Negative Lists are the Special Administrative Measures (Negative List) for Foreign Investment Access (2021 Edition) (full list in Chinese available here and English translation available here) and the Special Administrative Measures (Negative List) for Foreign Investment Access in Pilot Free Trade Zones (2021 Edition) (full list in Chinese available here and English translation available here).

To be more specific, the Foreign Investment Negative Lists establish the fields where foreign investors are not allowed to invest in, and the fields that are restricted from foreign investment. To invest in these restricted fields, foreign investors must meet certain conditions required by the Foreign Investment Negative Lists, such as the cap on the share ratio of foreign investment, senior management qualifications, and so on. Re-investment by foreign-invested enterprises must also comply with the Foreign Investment Negative Lists.

How do the Foreign Investment Negative Lists impact equity structure?

Prohibited industries

For foreign investors who want to engage in sectors that are prohibited from foreign investment in China as provided in the Foreign Investment Negative Lists, one way that is often adopted in practice is to set up the variable interest entity (VIE) structure.

Under this model, foreign investors invest in a non-Chinese holding company and the holding company does not own any equity interests in the Chinese domestic operating company but retains control over the China domestic operating entities through a series of contractual arrangements.

That is to say, foreign investors under the VIE structure retain final control of their China investment based on contractual arrangements rather than direct shareholding. Consequently, there are risks that the investors’ control over the structure might be threatened by the intentional breach of the contractual arrangements.

Restricted industries

As mentioned above, for a foreign investor to invest in an industry that falls under the “restricted” category in the Foreign Investment Negative Lists, they must meet corresponding requirements in the foreign ownership cap, senior management qualifications, and so on.

For certain industries, foreign investors should also check if there are other laws and regulations stipulating additional investment conditions or requiring special approval from competent authorities.

For example, according to the Regulations for the Management of Human Genetic Resources, the use of Chinese human genetic resources by foreign institutions to carry out scientific research activities requires cooperation with a Chinese institution and approval and filing by the Ministry of Science and Technology.

Consideration 2: Foreign investment supervision

All foreign investment in China, including foreign equity investment, is supervised by multiple government authorities at different stages of investment. Below we list all relevant foreign investment supervision authorities in a table.

As there are many different authorities that have various supervisory functions in the foreign investment area, foreign investors are advised to consult legal professionals on specific projects to get a better understanding of practical procedures, such as approval, permissions, filing, registration, and more.

Consideration 3: Equity transfer process and requirements

“Deliver first, pay later”

Due to China’s foreign exchange control policy, the payment formalities for foreign equity investment projects can be quite difficult (except in the equity transfer mode where the transferor is an overseas entity or individual).

The foreign investor must first complete the shareholder amendment formalities with the local State Administration for Market Regulation (SAMR). Then, the target company must complete foreign direct investment (FDI) registration with the State Administration of Foreign Exchange (SAFE) via a bank and obtain the registration voucher issued by SAFE.

The process for receiving an equity transfer payment depends on the mode of investment:

• If the investment mode is a capital increase, then the Target Company must open a foreign exchange capital account in the bank to receive the investment fund paid by the foreign investor.
• If the investment mode is an equity or share transfer, then the transferor must open an Asset Realization Account in the bank (not applicable when the transferor is an overseas entity) to receive the equity transfer paid by the foreign investor.

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In the case of an equity transfer, based on our previous experience, some banks will require the equity shares to be fully paid by the original shareholder (that is, the capital contribution amount subscribed by the shareholder should be fully paid) before the bank can open the Asset Realization Account.

If the equity shares that are to be transferred are not fully paid by the original shareholder, and the original shareholder has not notified the bank of this situation, then it’s possible that the foreign investor cannot fulfill their equity share contribution obligations after receiving the equity share.

Given this, we suggest that the transferor fulfills their capital contribution obligations before they transfer the equity shares to the foreign investor. Otherwise, the transferor should notify the bank that the equity share has not been fully paid/transferred, so as to allow the foreign investor to contribute the capital later.

Tax requirements for individual transferors

If the transferor of equity shares in a foreign-invested M&A project is an individual, then they must declare and pay taxes in the jurisdiction where the Target Company is located within the first 15 days of the month following the equity transfer.

Local tax bureaus will also require stamp duty to be paid before the individual makes their individual income tax (IIT) declaration. All local SAMRs require for the IIT payment certificate to be submitted when conducting shareholder amendment formalities with the SAMR.

For more information regarding tax liabilities in equity transfer, please read our China Briefing article: Tax Liabilities for Equity Transfer in China: An Introduction

Assessment procedures

Equity value assessment in equity investment is made according to the Provisions on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (the “Provisions”).

According to the Provisions, the value of the equity that will be transferred must be determined by an asset evaluation institution. The parties to the M&A must use their appraisal of the equity value as the basis for determining the transaction price. It is prohibited to transfer equity at a price significantly lower than the appraisal result or disguise the transfer of capital abroad.

Since the implementation of the Foreign Investment Law, the supervision system for foreign investment has been changed to an information reporting system. You can read more about the information reporting system for foreign investment here.

When a domestic company initially changes into a foreign-invested enterprise (FIE), it will have to submit an initial information reporting form (detailing basic information on the transaction and the establishment of an FIE). This form asks for the equity evaluation value, and a declaration is required if the payment consideration is lower than 90 percent of the evaluation value.

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At present, the commercial authorities do not strictly supervise whether the transaction is evaluated and priced. Therefore, in practice, failure to evaluate and price according to the Provisions will not affect the SAMR amendment procedures in most cases.

However, if the Target Company plans to go public in the future, it is highly advised to comply with the evaluation and pricing procedures required by the Provisions to ensure that the transaction is completely above board, as issues of investment regulation compliance may become a focal point during the requisite audits and other supervisory activities before the listing.

Bank requirements

According to banks’ audit requirements, foreign investors who directly or indirectly acquire the equity of an enterprise must follow the commercial principles and conduct the equity transaction at a fair price. The banks will therefore examine the fairness of the transaction price, and usually will require the Target Company to provide financial statements, audit reports, and a written explanation of the basis of the transaction price. For transactions based on the net asset value of the Target Company or other transactions price considered to be low by the bank, the bank is likely to require an evaluation report to verify the fairness of the transaction price.

Therefore, in practice, it is necessary to communicate with banks in advance to confirm whether an evaluation report is required.

Tax bureau requirements

According to the Law of the People’s Republic of China on the Administration of Tax Collection, the competent tax bureau may determine the tax payment if the tax basis declared by a taxpayer is obviously low without a valid reason.

In cases where the assets of the Target Company, such as land, real estate, intellectual property, and equity, account for more than 20 percent of the total assets of the enterprise,  the competent tax authorities may verify the income from the equity transfer by referring to the asset evaluation report issued by a qualified asset evaluation institution provided by the taxpayer. This is stipulated in the Measures for the Administration of Individual Income Tax on Equity Transfer Income (Trial).

If the equity transfer price is considered a low-price transaction, then the tax bureau may require the evaluation report and other materials to prove the fairness of the equity transfer price during the examination and verification.

In our experience, a transaction could be considered low-price if its transfer price is lower than the corresponding net assets of the Target Company or the investment cost, or if the equity transfer price is different from other transactions of the same batch. For example, where a shareholder transfers all his equity in a company to three buyers at the same time, the tax bureau will pay extra attention to the transaction if the equity transfer prices to these three buyers are significantly different from each other.

In these cases, the competent tax bureau may make a special tax adjustment if the tax basis is obviously low without a valid reason.

In practice, it is necessary to communicate with the tax bureau in advance to confirm whether a price evaluation report is required.

Qualification certificate of the foreign investor

The Qualification Certificate of the Foreign Investor (外国投资者主体资格证明) is one of the statutory documentation for the amendment registration with the SAMR.

This document must be notarized by a local Notary Public and then legalized by a Chinese embassy or consulate) in the investor’s home country. As the notarization and legalization procedures can be quite complicated and time-consuming, foreign investors are advised to begin these procedures with ample time and ask a Chinese lawyer or agent to review the draft document before the final documents are issued. In addition, if the Qualification Certificate and the notary paper are issued in a foreign language, a Chinese translation by a certified translator or translation agency is required.

Since the Foreign Investment Law came into effect on January 1, 2020, DSA has assisted a large number of foreign enterprises to complete foreign equity investment and M&A projects in Shenzhen, Shanghai, Beijing, Hangzhou, and other cities. In this process, we have also established good cooperative relations with a number of local banks, industrial and commercial agents, and other intermediaries. For professional assistance with equity transfer in China, please contact China@dezshira.com.

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