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China Private Equity SummitThe 2003 Venture Capital Rules – An Overview
July 11, 2003
Alan Seem, Shearman & Sterling LLP, Hong Kong Office
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Administration of Foreign-Invested Venture Capital Investment
Enterprises Provisions (the “New VC Rules”):
were jointly issued on January 30, 2003 by:
• the Ministry of Foreign Trade and Economic Cooperation (“MOFTEC”);
• the Ministry of Science and Technology (the “MST”);
• the State Administration for Industry and Commerce (the “SAIC”);
• the State Administration of Taxation (the “SAT”); and
• the State Administration of Foreign Exchange (“SAFE”).
became effective on March 1, 2003
supersede the Establishment of Foreign-Invested Venture Capital Investment Enterprises Tentative Provisions that were jointly issued by MOFTEC, the MST and the SAIC on August 28, 2001 (the “Old VC Rules”).
Introduction
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The New VC Rules:
institute a modified framework for the establishment and administration of foreign-invested venture capital investment enterprises (“FIVCIEs”) in the PRC;
reflect the efforts of the PRC government to develop new legal vehicles for foreign investment based on the PRC’s existing foreign investment regime;
were formulated by the PRC government after taking into account input from various sources, including foreign fund managers and advisors; and
represent a substantial improvement over the Old VC Rules from the standpoint of investors and venture capital fund managers, but significant issues still remain.
Introduction
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FIVCIEs:
were created under the Old VC Rules to facilitate foreign investment principally in unlisted high and new technology enterprises in the PRC; and
provide an easier way for foreign fund managers to access capital for investment from PRC sources.
However, due to uncertainties and certain burdensome restrictions contained in the Old VC Rules, no foreign investors took advantage of the Old VC Rules to establish a FIVCIE.
Introduction
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There are two options when establishing a FIVCIE:
a non-legal person entity – a partnership-type enterprise such as a non-legal person cooperative joint venture (a “Non-Legal Person FIVCIE”); or
a limited liability company, such as an equity joint venture, legal person cooperative joint venture or wholly foreign-owned enterprise (a “Corporate FIVCIE”).
The term of the FIVCIE generally should not exceed 12 years, and may be extended with governmental approval.
Legal Form of a FIVCIE
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Between 2 and 50 investors (inclusive), including at least one “mandatory” or “requisite” investor;
Investors in the FIVCIE can be both PRC and foreign entities or foreign individuals (not PRC individuals);
For Non-Legal Person FIVCIEs, the potential liability of all the investors will be joint and several, except if agreed in the contract of formation of the FIVCIE that the liability of non-requisite investors is to be limited to the amount of their respective capital commitments;
Requirements for Establishing a FIVCIE
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Each FIVCIE must have at least three professional personnel who possess venture capital investment experience (unless its activities will be contracted to a venture capital investment management company);
Minimum aggregate investment of US$10 million for Non-Legal Person FIVCIEs or US$5 million for Corporate FIVCIEs; and
Minimum capital contribution requirement for each investor is US$1 million, except requisite investors, which must contribute in the aggregate:
for Non-Legal Person FIVCIEs, at least 1% of the total committed and contributed capital; or
for Corporate FIVCIEs, at least 30% of the total committed and contributed capital.
Requirements for Establishing a FIVCIE
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Venture capital investment must be such investor’s main business;
During the three years preceding the application to establish the FIVCIE, such investor must have had cumulative capital under management of at least:
for foreign investors, US$100 million, at least US$50 million of which was used to make venture capital investments; or
for PRC investors, RMB100 million, at least RMB50 million of which was used to make venture capital investments;
For Non-Legal Person FIVCIEs, the requisite investors will be jointly and severally liable for the obligations of the FIVCIE (similar to a general partner of a limited liability partnership);
Qualifications of a Requisite Investor
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Must have at least three professional management personnel who possess at least three years of experience in venture capital investing; and
Must not have been prohibited from engaging in venture capital or investment consultancy business or penalized for commitment of fraud in its home country.
These requisite investor requirements may also be satisfied through the qualifications of an affiliate of such investor.
Qualifications of a Requisite Investor
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Application must be made to the relevant provincial level commission of foreign trade and economic cooperation (“COFTEC”), which will review the application materials and forward them to the Ministry of Commerce (the “MOC”) within 15 days.
The MOC (upon consultation with and approval from the MST) is then required to complete its review and decide whether to issue an approval certificate for the FIVCIE within 45 days.
Once the approval certificate is obtained, the FIVCIE must register with the SAIC or the relevant provincial level administration of industry and commerce, as the case may be, within one month to obtain a business license.
Approvals Required for Establishing a FIVCIE
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For Non-Legal Person FIVCIEs:
Investors must contribute capital in installments based upon the progress of the venture capital investments made by the FIVCIE and must complete their capital contributions within a maximum period of five years;
capital may be reduced with the approval of investors representing more than 50% of the total contributed capital (including the requisite investor(s)) and the relevant examination and approval authority and so long as such reduction does not cause the FIVCIE to be in violation of the US$10 million minimum subscribed capital requirement;
additional investors may be admitted upon consent of the requisite investor(s);
Capital Contributions, Reductions and Withdrawals
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For Non-Legal Person FIVCIEs (cont.):
no withdrawal of a requisite investor is permitted without approval of investors representing more than 50% of the total contributed capital and the interest of such withdrawing requisite investor must be transferred to a new requisite investor;
upon a sale or other disposition of an equity investment, distributions up to the FIVCIE’s original amount of capital contribution by the FIVCIE to such entity may be distributed directly to the FIVCIE investors without any requirement for further approval and will be recorded as a reduction in capital; and
the method of distribution of capital is not specified under the New VC Rules and may be agreed by the investors in the FIVCIE’s contract of formation.
Capital Contributions, Reductions and Withdrawals
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For Corporate FIVCIEs, capital contributions continue to be handled in accordance with existing provisions, which are the rules under the relevant joint venture or wholly foreign-owned enterprise laws.
Capital Contributions, Reductions and Withdrawals
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Body responsible for managing the FIVCIE on behalf of the
investors is:
for Non-Legal Person FIVCIEs, the joint management committee; and
for Corporate FIVCIEs, the board of directors.
Management personnel shall also be appointed to:
manage the FIVCIE on a day-to-day basis;
implement investment decisions made by the joint management committee or board of directors; and
report to the joint management committee or board of directors (as applicable) regarding important matters, as specified in the New VC Rules.
Management Structure of FIVCIEs
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Managerial and operational responsibilities may also be contracted out to a venture capital investment management enterprise incorporated within or outside the PRC, subject to the approval of all investors and the relevant examination and approval authority.
The New VC Rules also contain provisions relating to the requirements and procedures for establishing a venture capital investment management enterprise.
Management Structure of FIVCIEs
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The permitted scope of business is as follows:
equity investments using its own capital, including for the establishment of new enterprises, subscribing for equity interests in existing enterprises, acquiring equity interests in existing enterprises, and any other form of investment permitted by applicable laws and regulations;
providing consulting services relating to venture capital investment;
providing management consulting services to investee enterprises; and
conducting other businesses approved by the relevant examination and approval authority.
Permitted Scope of Business of FIVCIEs
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Investments must comply with the Guiding the Direction of Foreign Investment Provisions and the Foreign Investment Industrial Guidance Catalogue.
FIVCIEs may invest in “encouraged” and “permitted” industries without further approval and may invest in “restricted” industries with approval from the provincial COFTEC.
Permitted Scope of Business of FIVCIEs
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The following activities are not permitted:
investing in industries that are not open to foreign investment as determined by the PRC government;
investing, directly or indirectly, in publicly traded stocks and corporate bonds, except for shares that are acquired in an investee enterprise prior to its public listing;
investing, directly or indirectly, in real estate other than for self-use;
borrowing to make investments; using funds of entities or individuals other than its investors to
make investments; extending loans or guarantees, except for corporate bonds with at
least one year's maturity and convertible bonds issued by an investee enterprise of the FIVCIE; and
any other activity prohibited by laws, regulations or contract.
Prohibited Activities
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An investee enterprise will be entitled to preferential tax treatment as a foreign-invested enterprise if the actual capital contribution held by foreign investors of the investing FIVCIE or the combined equity percentage of foreign investors of such FIVCIE and all other foreign investors in such investee enterprise is at least 25% of the investee enterprise's registered capital.
Tax Treatment of Investee Enterprise
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Exit mechanisms specified in the New VC Rules include the following:
entering into a repurchase agreement pursuant to which the investee enterprise will repurchase the equity interest held by the FIVCIE;
listing of the investee enterprise on a domestic or foreign stock exchange and selling the shares in such investee enterprise through such stock exchange;
transferring to other investors all or any part of the FIVCIE’s equity interest in an investee enterprise; and
other mechanisms permitted by PRC laws and regulations.
Exit Mechanisms
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Return of the original capital contributions received by foreign investors from a FIVCIE may be remitted out of the PRC by
purchase of foreign exchange in accordance with the law.
The opening and use of foreign exchange accounts, capital adjustments and other foreign exchange receipts and payments of a Corporate FIVCIE are to be handled in accordance with existing foreign exchange administration regulations.
Foreign exchange regulations relating to Non-Legal Person FIVCIEs will be subsequently promulgated by SAFE.
Exit Mechanisms
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The New VC Rules:
provide for a longer maximum investment period (five years) for Non-Legal Person FIVCIEs, compared to three years under the Old VC Rules;
significantly lower and simplify the minimum investment requirements (both aggregate and for each investor) for FIVCIEs;
allow for investment into investee enterprises in “encouraged” and “permitted” industries without additional approvals;
specifically allow for subcontracting to venture capital investment management companies, and provide guidelines for their establishment.
Significant Changes Vs. Old VC Rules
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The New VC Rules (cont.):
no longer require that 25% of the capital contributions be made by foreign investors;
include the new concept of a “requisite investor”, and allow the requisite investor qualifications to be met by an investor’s affiliate. This allows foreign investors to establish a special purpose subsidiary to serve as the requisite investor, which can help shield the parent company from liability; and
provide that FIVCIEs only are required to report to the relevant examination and approval authority on an annual basis, instead of semi-annually as under the Old VC Rules, and reduce the scope of required reporting.
Significant Changes Vs. Old VC Rules
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On June 4, 2003, the SAT issued a notice regarding taxation of
FIVCIEs, which notice:
is effective as of March 1, 2003;
confirms the provisions in the New VC Rules that state:
Corporate FIVCIEs will be subject to PRC enterprise income tax; and
investors in Non-Legal Person FIVCIEs may choose to declare their income and pay enterprise income tax either separately or jointly.
New Tax Circular
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New Tax Circular
The new tax circular further provides that:
if Non-Legal Person FIVCIE investors elect to declare and pay taxes individually, the foreign investors among them will be subject to enterprise income tax as if they had a permanent establishment in the PRC (subjecting them to a rate of 33%); and
foreign investors in Non-Legal Person FIVCIEs that subcontract their investment management activities to third parties will be taxed as if they do not have a permanent establishment in the PRC, which would usually amount to a 10% withholding tax.
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The New VC Rules:
are a significant improvement over the Old VC Rules;
help to facilitate access to capital for investment from PRC entities; and
streamline the approval process for investments and divestments by FIVCIEs in PRC investee enterprises.
Remaining Issues
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However, remaining issues include the following:
the tax issues highlighted above;
the comparatively high level of review and approval by the PRC government with respect to most aspects of establishing or amending the structure and composition of a FIVCIE;
the continued prohibition on funding investments through borrowing;
the five-year investment period may still be too short for sourcing and evaluating enough investments to utilize all committed capital;
the lack of legal certainty regarding limited liability protection when investing in a Non-Legal Person FIVCIE; and
investors in Corporate FIVCIEs will still be subject to the relatively inflexible foreign-invested enterprise laws.
Remaining Issues
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