Administrative Measures on Capital Contributions with Equity Interests Involving Foreign-Invested Enterprises (Draft for Comment)

Issuing Body: Ministry of Commerce
Issuing Date: May 4, 2011

China's Ministry of Commerce (MOFCOM) has taken a key step toward expanding the type of non-monetary capital contribution that investors may make to a foreign-invested enterprise. MOFCOM released for comment a draft version of rules that would permit investors to contribute equity in a separate company, in addition to or instead of cash or non-monetary assets such as equipment or intellectual property. MOFCOM issued the Draft Administrative Measures on Capital Contributions with Equity Interests Involving Foreign-Invested Enterprises (Draft Equity Contribution Measures) on May 4, 2011. The period for public comment ended May 20.

Pursuant to the PRC Company Law, investors are already permitted to make non-monetary capital contributions to foreign-invested enterprises in the form of equipment, intellectual property, and land-use rights, with such contributions being capped at 70 percent of the company's total capital. As currently written, the Draft Equity Contribution Measures allow for capital contributions of equity interests in an existing PRC company to be contributed in order to establish a new foreign-invested enterprise, or to merge or acquire an existing PRC enterprise.

This type of investment has been available to domestic companies since 2009, when the State Administration of Industry and Commerce (SAIC) issued the Administrative Measures on the Registration of Capital Contributions with Equity Interests. Those SAIC rules allow investors to use equity interests in an existing PRC company as consideration for their investment in another PRC company. Due to the absence of detailed rules and guidelines, however, such capital contributions of equity interests in a PRC company to a foreign-invested enterprise have not been readily available.

General Definitions and Purposes

Under the Draft Equity Contribution Measures, a domestic or foreign investor (Capital Contributor) will be allowed to contribute equity interest in a domestic limited liability or joint stock company (Equity Enterprise) to an existing or a newly established foreign-invested enterprise (Invested Enterprise).

If enacted in their current form, the Draft Equity Contribution Measures will allow contributions with equity interests for the following types of investment:

• To establish a new foreign-invested enterprise;
• To increase the registered capital of an existing domestic-funded enterprise so the domestic-funded enterprise shifts to become a foreign-invested enterprise after the capital increase;
• To increase the registered capital of an existing foreign-invested enterprise, leading to a change in the equity interest.

In all cases, the sum of the value of the contributed equity interests and other non-monetary assets may not exceed 70 percent of the Invested Enterprise's registered capital.

Requirements for Contributed Equity Interests

The equity interest used for a capital contribution must have clear and complete title, and must be legally transferrable.

An equity interest may not be used for a capital contribution if:

• The registered capital of the Equity Enterprise has not been fully paid up;
• The equity interest is subject to a pledge;
• The equity interest has been legally frozen;
• The articles of association of the Equity Enterprise prohibit transfer of the equity interest;
• The Equity Enterprise does not participate in or fails to pass the annual inspection of a foreign-invested enterprise;
• The Equity Enterprise is a foreign-invested holding company or a foreign-invested venture capital investment (equity investment) enterprise;
• Prior approval has not been granted;
• Other scenarios proscribed in laws or regulations apply.

Evaluation of Contributed Equity Interests

Prior to use as a capital contribution, the equity interest must be evaluated by an appraisal firm that is duly established in China. Based on that firm's appraisal, the Capital Contributor and shareholder(s) of the Invested Enterprise or other investors may determine through consultation the value of the equity interest that is to be contributed.

As previously mentioned, the sum of the value of all contributed equity interests and the value of non-monetary assets contributed as capital may not exceed 70 percent of the Invested Enterprise's registered capital.

The equity interest contribution must be verified by a duly established accounting firm, and a capital verification report is required.

Approval for Contribution with Equity Interests and Registration Requirements

MOFCOM and its provincial offices are the approval authorities for capital contributions with equity interests. Application documents required for approval include an application letter, agreement to the contribution with equity interests, certificate of the Capital Contributor's legal possession of the equity interests, an equity interest appraisal report, a legal opinion on qualification of the equity interest to be contributed, and the compliance status with relevant foreign investment laws and regulations for the Equity Enterprise, the Invested Enterprise, and their affiliated enterprises with direct or indirect shareholding links.

The Draft Equity Contribution Measures also mandate that all registration procedures, including tax, customs, and foreign exchange requirements, must be completed after the equity contribution.

Other Key Provisions

After the contribution of equity interest, the business scope of the Equity Enterprise, the Invested Enterprise, and their affiliates having direct or indirect shareholding links must be compliant with the Provisions on Guiding Foreign Investment Direction enacted by the State Council in 2002, the Foreign Investment Industrial Guidance Catalogue, and other relevant provisions regarding foreign investment. If non-compliance occurs, relevant assets or equity interests must be divested before the equity interest contribution is made.

If the capital contribution of equity interest involves national security issues, the Notice of the State Council on the Establishment of a Security Review System for Foreign Mergers and Acquisitions of Domestic Enterprises will apply to such contribution, and foreign investors should file a security review application. China Law Update summarized that notice in our March 2011 issue. We summarized the most recent draft of the Foreign Investment Industrial Guidance Catalogue in our May 2011 issue.

Relevant rules on the administration of state-owned assets apply if the equity contribution involves state-owned equity interests or properties.

Conclusion

If enacted in their current form, once the Draft Equity Contribution Measures take effect, equity interests in PRC companies may be used as a form of capital contribution for investment in a foreign-invested enterprise. As a result, foreign investors may enjoy more flexibility in structuring their businesses and investments in China, because they will be allowed to make additional investments in China by contributing equity interests instead of cash; stock-for-stock takeovers, for example, may be feasible.