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New Law on Foreign Invested Venture Capital Investment
Companies
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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