Opportunities Expand for Foreign Investment in High Technology Businesses in China

By R. Z. Margaret Lu, Claude P. Goetz, Vincent Wang
[January 2004]

In the spring of 2003, China's Regulation on Administration of Foreign Invested Venture Capital Investment Companies (the "Regulation") replaced the provisionary regulation jointly published by several Chinese government authorities in 2001. The Regulation allows foreign investors to establish wholly owned subsidiaries or Sino-foreign joint venture companies in China ("VCIC") for the purposes of investing in unlisted high technology businesses ("Invested Company"), providing venture investment consultation services, and providing management services to Invested Companies. Until then, a holding company was the only permitted form of foreign invested investment company in China.

The Regulation reflects the Chinese government's efforts to fill a void in an area of law new to China, but clearly needed in order to attract foreign investments and make China an equal player in the international business arena. The efforts reflect some open-mindedness on the part of the drafters, considering that the Regulation explicitly allows investors to a VCIC to formulate an internal income distribution system based upon international customary practices. The effort also needs to be perfected, with relevant parts of the Regulation providing for detailed rules governing buy-back of equity shares from a VCIC by an Invested Company after it becomes listed to be separately formulated by responsible government authorities. Such rules are not yet in place.

This article provides a highlight of the Regulation for the purpose of exemplifying the way venture capital investment in China works:

Investors and Indispensable Investor

A VCIC is required to have at least one investor that meets the qualifications stipulated under Article 7 of the Regulation (an "Indispensable Investor"), holding a certain percentage of the equity interests of the company. One of the qualifications under Article 7 is that an Indispensable Investor, if a foreign investor, must have managed investment funds in an aggregated amount of no less than $100 million during the last three years, among which, at least $50 million is already used as venture capital investment. For an Indispensable Investor that is a Chinese investor, the same numbers apply, but the denomination will be in Renminbi, the Chinese currency.

Article 7(4) allows an investor to qualify as an Indispensable Investor if the investor controls, or is controlled by, or is under control of a company which also controls, an affiliate that satisfies the Article 7 qualifications ("Qualified Affiliate"). For the purpose of the Regulation, "control" means that the controlling entity owns more than 50 percent of the voting power of the entity under its control.

In support of an application to establish a VCIC, an Indispensable Investor is required to submit a written statement, representing and warranting the truthfulness and correctness of information provided and its agreement to strictly comply with all applicable laws and regulations. A formal legal opinion issued by a law firm regarding the lawful existence of the Indispensable Investor and the necessary authorization for the execution of the written statement is also required for submission in support of the application.

During the term of a VCIC (usually no more than 12 years), its Indispensable Investor(s) are not allowed to withdraw from equity ownership. Upon consent of the majority of other investors, an Indispensable Investor may transfer its equity ownership in a VCIC to another Indispensable Investor.

Legal Person Status Versus Corporate

A VCIC may take the form of an entity without legal person status or the form of a corporation. Each and every investor to a VCIC organized in the form of an entity without legal person status will be jointly and severally liable for all the debts of the VCIC, unless the investors' agreement in writing explicitly stipulates that only the Indispensable Investor shall be held jointly and severally liable. If so, then the other investors shall be liable for the company debts up to the limits of their respective amount of subscribed capital, an arrangement similar to that between a general partner and limited partners to a limited partnership in the United States.

The Indispensable Investor's joint and several liabilities shall survive the cancellation of the registration of a VCIC organized in the form of an entity without legal person status. If an Indispensable Investor to a VCIC organized in the form of an entity without legal person status is qualified pursuant to Article 7(4), a written guarantee issued by the Qualified Affiliate agreeing to assume joint and several liability is required to be submitted in support of an application for establishment.

Each investor to a VCIC, except the Indispensable Investor, is required to subscribe to no less than $1 million capital contribution to be paid in over a period up to five years.

The minimum capital requirement for a VCIC organized in the form of an entity without legal person status is $10 million, which doubles the $5 million minimum capital requirement applicable to a VCIC organized in corporate form. However, when a VCIC taking the form of an entity without legal person status sells, or otherwise disposes of, its equity interests in an Invested Company, the proceeds from the disposition are allowed to be distributed to its investors directly, and the distributed amount constitutes a reduction of capital contribution already made by the investor receiving distribution even if the investor has not made full payment of its subscribed capital contribution. After the distribution, that VCIC will no longer be obligated to comply with the minimum capital requirement, provided that it is verified that the amount of subscribed capital contribution yet to be paid in by its investors and other funds it owns are sufficient to satisfy its existing investment obligation owed to its Invested Companies. Furthermore, the distribution cannot be used as a defense to any legal claims against that VCIC for breach of its investment obligations owed to its Invested Companies.

By comparison, the liability of the investors, including the Indispensable Investor(s), to a VCIC organized in the form of a corporation is limited to their respective amount of the subscribed capital contribution. But, an Indispensable Investor to a VCIC taking the form of an entity without legal person status is only required to subscribe to, and actually make, a capital contribution in an amount equivalent to no less than 1 percent of the total amount of the capital of the company, whereas an Indispensable Investor to a VCIC organized in the form of a corporation is required to subscribe to, and actually make, a capital contribution in an amount equivalent to no less than 30 percent of the total amount of capital.

Authorized Scope of Business

A VCIC is authorized to engage in investment businesses and other businesses pre-approved by the responsible government authorities, and to provide consultation regarding venture capital investment and management consultation to Invested Companies in which it has invested. A VCIC is prohibited from investing in industry sectors in which foreign investment is prohibited by law; directly or indirectly investing in publicly traded stocks or company bonds (with the exception of shares held by Invested Companies); directly or indirectly investing in fixed assets not for its own use; borrowing money or using fund of others for investment; or providing third parties with loans or guarantee (with the exception of certain types of bond).

Investment Target in China

Under the Regulation, an Invested Company must be an "unlisted company engaging in new and high technology businesses in China". It can be a wholly Chinese owned company or a foreign invested company. A VCIC's investment in an Invested Company must follow the guidelines provided under the Industry Guide for Foreign Investment and other pertinent requirements of responsible government authorities.

An Invested Company qualifies for the status of a foreign invested enterprise and is entitled to beneficial treatments available to a foreign invested enterprise in China if the amount contributed by one or more foreign investors to the registered capital of the Invested Company is equivalent to 25 percent or more of the total amount of registered capital. Thus, if a VCIC is a 100 percent foreign owned subsidiary, and it invests in an Invested Company an amount equivalent to 25 percent or more of the registered capital of the Invested Company, then the Invested Company qualifies for the status of a foreign invested enterprise. But, if it invests less than 25 percent to the registered capital of the Invested Company or if the VCIC is a Sino-foreign joint venture, then the calculation must be based upon the amount of foreign investment in the registered capital of the VCIC, the amount of registered capital of the Invested Company and the percentage of registered capital of the Invested Company contributed by the VCIC for determining whether the Invested Company qualifies for the status of a foreign invested enterprise in China.

Even though existing Chinese laws and regulations still prohibit an individual Chinese national from jointly establishing a company in China with a foreign investor, an individual Chinese national who is an existing investor to an Invested Company is allowed to retain its ownership in the Invested Company after the Invested Company becomes a foreign invested company as a result of receiving investment from a VCIC.

Upon satisfying all stipulated requirements, an Invested Company may apply to be listed on stock markets within and outside of China. The holdings of VCIC in a listed company must comply with applicable Chinese laws and regulations. As a side note, current laws and regulations allow a foreign investor to hold shares issued by a company listed on the Chinese stock market (called "A Shares") that are not publicly traded. Foreign ownership to publicly traded A Shares of a listed company in China is only available to qualified foreign institutional investors under a specific law, and such holdings are limited to roughly no more than 10 percent for each foreign investor and no more than 20 percent in the aggregate.

Governance and Management

The highest management authority of a VCIC organized in the form of a corporation is its board of directors (BOD). The highest management authority of a VCIC organized in the form of an entity without legal person status, however, is its joint management committee (JMC). A BOD/JMC may delegate its day-to-day operation and management authority to an internal management team consisting of three or more qualified professionals. Or, it may contract with an outside qualified venture capital investment management entity or another VCIC to manage its operation. A qualified venture capital investment management entity may be a wholly Chinese owned company, a foreign invested company registered in China to do business, or a foreign company located outside of China. Pertinent provisions of the Regulation provide for the qualification, and the documentation and examination/approval process for the establishment, of a foreign invested venture capital investment management company in China, which may also take the form of an entity without legal person status or a corporation.

The contract for the management of a VCIC is subject to approval by responsible government authorities.

Taxation

According to relevant provisions of the Regulation and the Notice of the State Tax Administration on Taxation of Enterprise Income Taxes to be Paid by Foreign Invested Venture Capital Investment Companies published in June of 2003, a VCIC organized in the form of a corporation shall be taxed as an enterprise tax-payer. A VCIC organized in the form of an entity without legal person status, however, may choose to file tax returns by each individual investor or to request for an approval by the local tax authority to pay taxes as an enterprise tax-payer. If it chooses to have its enterprise taxes "pass through", then its individual investors shall be taxed on the same basis as foreign companies that have established formal presence in China. Nevertheless, if that VCIC does not have its own management team or does not directly engage in venture capital investment management or consultation businesses, but contracts its day-to-day operation and management to a qualified venture capital investment management company or another VCIC, then its foreign investors shall be taxed on the same basis as foreign companies that have not established formal presence in China.

Published by DWT's China Practice Group

This China Practice Article is a publication of the China Practice/Shanghai Office of Davis Wright Tremaine LLP. Our purpose in publishing this Article is to inform our clients and friends of recent legal developments in China. It is not intended, nor should it be used, as a substitute for specific legal advice as legal counsel may only be given in response to inquiries regarding particular situations.

Copyright © 2004, Davis Wright Tremaine LLP.

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