The first year of China’s entry into the World Trade Organisation witnessed an increasing level of investment and the use of innovative investment tools, which have raised many questions as to China’s legal framework in relation to foreign investment. On December 30, 2002, China enacted ‘New Regulations Circular on Certain Issues regarding the Strengthening of the Administration of Examination, Approval, Registration, Foreign Exchange and Taxation of Foreign Invested Enterprises’ (‘New Regulations’), representing China’s efforts to fill a legal vacuum and address issues unanswered by the existing foreign investment law.

What are the areas of investment that the New Regulations clarify?

The New Regulations mainly clarify two different fields: first of all they expressly permit, for the first time, foreign investors to acquire equity in Chinese local companies; secondly they clarify and explicitly permit the existence of companies with foreign investment of less than 25% of the registered capital. The New Regulations also provide reasonable details as to how these newly permitted investment forms shall be implemented.

How do the New Regulations clarify the legal situation in the field of merger and acquisition?

In the past, merger and acquisition activities have suffered due to the lack of specific legislation in China. The New Regulations permit for the first time foreign investors to acquire equity in Chinese local companies. It is true that many such transactions had occurred in the past, but often as a result of negotiations with local authorities. The New Regulations provide some clarifications in respect of the approval procedures and the required time for payment of the purchase price.

Notably the New Regulations remove a serious legal obstacle often met by foreign investors when acquiring private business – the restriction on Chinese individuals to act as shareholders to a foreign investment enterprise [FIE]. In accordance with to the New Regulations, in the case of a share acquisition of a local Chinese company by a foreign investor, a Chinese shareholder who has been a shareholder in a local Chinese company for more than one year may continue to be the shareholder of the FIE after the acquisition.

However, the New Regulations do not comment on the acquisition of assets by foreign investors.

What status and conditions will be applied to those Chinese local companies with foreign acquired equity shares?

The New Regulations confirm what was already a common practice – that if the foreign investor acquires more than 25% of the domestic target company, then it would be converted into a FIE and accordingly enjoy the benefits and tax incentives of an FIE. In keeping with other Chinese legislation, the New Regulations set out strict time requirements for the payment of the purchase price by foreign investors. The basic rule is that the payment must be concluded within three months after issuance of the new business license of the target company as a FIE. Under special circumstances this period may be prolonged up to one year.

What are the changes in status and procedures for companies with foreign investment of less than 25% of the registered capital?

The New Regulations clarify that an enterprise with foreign investment which is less than 25% (“Below 25% FIE”), shall follow the examination and approval procedures for normal FIEs set out by the prevailing laws and regulations. The registered capital of a Below 25% FIE must be paid-up within three months upon the issuance of its business license in case of cash contribution, or within six months in the case of in-kind capital contribution. Below 25% FIEs enjoy the same treatment as normal FIEs – that is, they may open foreign exchange bank accounts, receive foreign exchange income and remit foreign exchange expenditure. However, a Below 25% FIE is not entitled to any preferential tax treatment normally applicable to FIEs, such as exemption and reduction of corporate income tax, exemption of import duty and VAT for imported equipment and machinery.

Xu Ping is a corporate partner at Chinese law firm King & Wood