Downstream equity investments by FIEs under the FIL regime

This article is the second in our series of articles on the impact of the new Foreign Investment Law (FIL) aimed at assisting companies to navigate the new regime. One of the most eye-catching developments has been the liberalisation of foreign exchange control. Non-investment foreign invested entities (FIEs) are now permitted to use their capital for downstream equity investments in China. In this article, we provide some insights on this liberalisation and its impact.

Background

Under the old regime, non-investment FIEs were not all allowed to use capital injected by foreign investors for making downstream equity investments in China unless specifically approved by the State Administration of Foreign Exchange (SAFE), but they can use their retained earnings to do so. In contrast, “investment” FIEs can use capital, either in foreign currency or by converting it into RMB, to make such investments. However, as discussed further below, it is not easy to establish an “investment” FIE in China. As a result, for a long time it has been quite difficult for FIEs to make downstream equity investments in China until they have generated profits.

“Investment” FIEs are FIEs whose registered business scope includes investment. They mainly include foreign-invested investment companies (known as China Holding Companies (CHC)), foreign invested venture capital enterprises and foreign invested equity investment enterprises (for example Qualified Foreign Limited Partnerships (QFLP)). To establish an “investment” FIE, approvals from the local counterpart of the PRC Ministry of Commerce (MOFCOM), the State Administration for Market Regulation (SAMR) and other authorities (e.g. a joint conference consisting of various governmental authorities for QFLP) are required. In addition, there are usually substantial qualifications and requirements as to the scale of the assets, investment experience and existing investments in China of the foreign investor, as well as other requirements in relation to the proposed FIE such as the amount of its registered capital. In October 2019, SAFE indicated that there were only around 3,000 “investment” FIEs in China at that time, accounting for less than 5% of all the FIEs in China.

SAFE liberalisation

With an aim to attracting and fully utilising more foreign investment, in October 2019 SAFE issued new rules which came into effect on 1 January 2020. These rules liberalised certain foreign exchange control restrictions and now allow non-investment FIEs to use their capital to make downstream equity investments in China, subject to certain conditions being met. Investee companies can also make subsequent downstream equity investment in China following the same rules. These conditions include that the equity investment project is genuine, compliant and is not restricted under the Negative List for foreign investment. Banks acting on behalf of SAFE play an important role in verifying the project meets these conditions. The banks will need to see supporting documents before they will facilitate the remittance of funds.

Regulation on downstream equity investment by FIEs

The FIL and its implementation rules

Article 47 of the FIL's implementation rules makes it clear that the FIL and the implementation rules apply to downstream investment in China by FIEs. Therefore, regimes such as national treatment, intellectual property protection, compliance with the Negative List for foreign investment, corporate governance structures and reporting and registration requirements in the FIL will also apply to investee companies of FIEs.

Negative list

In addition to the FIL and its implementation rules, the SAFE rules also provide that downstream investments by FIEs must still comply with the Negative List for foreign investment.

Fund flow supervision

The requirements and controls on fund flows set out in the relevant rules of SAFE differ depending on the type of FIE.

Investment FIE

Where an investment is made by an “investment” FIE, the investee company will need to make a re-investment registration with SAFE (or an authorised bank) and open a foreign exchange capital account to receive the foreign exchange capital. When the investee company converts the foreign exchange capital into RMB, the money needs to be paid into a special RMB account.

Where the investment is made by the “investment” FIE in converted capital (i.e. RMB capital), the funds can be paid directly into the common RMB account of the investee company. In these circumstances, no re-investment registration with SAFE (or an authorised bank) is required.

Non-investment FIE

Similarly, where an investment is made by a non-investment FIE, the investee company will need to make the re-investment registration with SAFE (or an authorised bank) and open a foreign exchange capital account to receive the foreign exchange capital. However, unlike investment FIEs, converted capital from a non-investment FIE needs to be paid into a special RMB account of the investee company. In addition, the investee company will still need to handle the re-investment registration with SAFE (or an authorised bank) to open the special RMB account.

Usage restrictions

There are restrictions on the use of capital received by investee companies from FIEs. Such capital cannot be used for any businesses outside of the registered business scope. In addition, the capital cannot be used for investing in securities, purchasing non-guaranteed asset management products, making entrustment loans to non-affiliated entities or purchasing real estate other than for self-use. The relevant banks where the accounts are held are required to verify that the investee company only uses the capital for legitimate purposes. The special RMB account is also subject to more stringent supervision requirements than those applied to common RMB accounts.

MOFCOM reporting and SAMR registration

The rules of MOFCOM and SAMR require that “investment” FIEs are treated as foreign investors and their investee companies are treated as FIEs directly invested by foreign investors. Therefore, in the same way as for other FIEs, investee companies of “investment” FIEs are required to report and register any changes to their registered/filed information and file annual reports with local MOFCOM and SAMR in accordance with the FIL and the rules of MOFCOM and SAMR.

Non-investment FIEs are not treated as foreign investors, but investee companies of non-investment FIEs are subject to reporting and registration with local MOFCOM and SAMR. The formalities are, however, slightly different from those that apply to other FIEs. For example, the investee companies do not need to make reports to MOFCOM directly as the local SAMR will share relevant registration information with MOFCOM.

Impact on future investment strategies and structures

The liberalisation of the restrictions on downstream equity investment by non-investment FIEs gives foreign investors another choice of investment platform in China which can avoid the more stringent set up requirements for an “investment” FIE. However, “investment” FIEs may still be a preferred structuring option in certain circumstances as they continue to enjoy certain advantages (particularly in the case of CHCs) under the existing rules, some of which are set out below:

• CHCs enjoy a higher quota for borrowing foreign debt. Under the current SAFE rules on foreign debt, a CHC can borrow up to four times its registered capital in foreign debt (where its registered capital is not less than USD 30 million) or six times its registered capital in foreign debt (where its registered capital is not less than USD 100 million). By comparison, a regular FIE can only borrow foreign debt up to the difference between its total investment and its registered capital or 2.5 times its net assets. Further, non-investment FIEs are still restricted from using foreign debt funding to make equity investments, whereas CHCs are permitted to do so.

• Converted capital from a CHC will sit in the common RMB capital account of the investee company, which is not subject to further supervision. However converted capital from a non-investment FIE is required to sit in a special account subject to special supervision.

• CHCs can be recognised as a regional headquarters under local rules, entitling them to certain favourable governmental subsidies, tax treatment and other policies.

Note though that these advantages should be kept under review, particularly if the rules governing CHC are changed in light of the FIL's implementation.

From a practical perspective, although banks in China have started to handle capital conversions for downstream investments by FIEs under the new regime from the beginning of the year, many market players are still holding a wait-and-see attitude. This is partly because many local banks are not familiar with the procedures and requirements for this new service and thus taking a conscious approach – for example the KYC process can take longer than that for other bank transactions. Therefore, consultation with your local banks is essential when planning any new investment structure.

KEY CONTACTS

Nanda Lau 刘依兰

Head of Shanghai Office

Nanda.Lau@hsf.com

Gavin Guo 郭武汉

International Partner

Kewei (Shanghai)

Gavin.Guo@hsfkewei.com

Angela Zhao 赵秋丹

Senior Associate, Shanghai

Angela.Zhao@hsf.com

Tianchan Li 李天婵

Associate, Shanghai

Tianchan.Li@hsf.com

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