Foreign investors should be aware of the strict controls imposed by the Chinese government on the usage of registered capital of foreign-invested enterprises (FIEs) that have been established in China. Any flexible arrangements for using such registered capital beyond the approved business scope of the FIEs may be caught by Section 44 of the PRC SAFE Rules and be subject to severe administrative penalties plus, in the worst-case scenario, relevant criminal liabilities.
According to a recent news release issued by the State Administration of Foreign Exchange of China (SAFE) on 25 May 2010, during a nationwide investigation into cross-border money flows that was launched in February 2010, the regulator found 190 suspected irregularities valued at $7.35 billion. These irregularities will be subject to an administrative penalty of up to the full transaction value as well as relevant criminal liabilities if such irregularities constitute crimes.
It may be fair for the regulator to impose various sanctions on funds that flowed into China illegally for the purpose of speculating on the appreciation of the Chinese currency (renminbi, or RMB) by making quick profits from the Chinese realty and stock markets. However, foreign investors who have legitimate business purposes for their Chinese investments may be also greatly dismayed by the fact that the deal structure for a lawful acquisition of equity interest or realty property by FIEs in China may also lead to technical violation of Section 44 of the SAFE rules and, thus, be subject to severe administrative penalties.
Control on the Usage of Registered Capital of FIEs Under the SAFE Rules
The Regulation of the People’s Republic of China on the Administration of Foreign Exchanges was first issued by the Chinese State Council in January 1996, subsequently amended in January 1997 and recently amended in August 2008 (the SAFE Rules).
The SAFE Rules laid down the fundamental foreign exchange policy and legal framework in China, which, among other things, maintains strict control on the usage of the foreign exchange revenues of the capital account (including the converted RMB funds thereof) of the foreign-invested enterprises. As a general principle, the foreign exchange registered capital of an FIE may only be used to finance its business and operational activities, and any usage outside the above permitted scope may be subject to severe administrative sanctions, as well as criminal liabilities in the worst-case scenario.
To implement the above control on the usage of the foreign exchange registered capital of foreign-invested enterprises, the SAFE published various detailed implementation rules to govern the conversion of the registered capital of foreign-invested enterprises. Essentially, to convert the registered capital into RMB funds, a foreign-invested enterprise must apply to the bank with a specific declaration of the usage of the converted RMB funds, along with supporting documents such as purchase contracts or invoices.
Any deviation from the usage declared to the bank in a conversion application will be deemed an illegal usage of the foreign exchange and thus subject to severe administration sanctions under Section 44 of the SAFE Rules, including correction, confiscation of the illegal proceeds and imposition of a fine up to the amount of the violation. In the worst-case scenario, where the converted RMB funds described above are used for unlawful purposes or involve money laundry, the FIEs (including their responsible employees) may be subject to criminal liabilities under the PRC criminal laws.
Pitfalls in Deal Structuring for Acquiring PRC Equity and Realty Assets by FIEs
Under the regulatory framework for foreign investment in China, foreign invested enterprises may be generally classified into three types: manufacturing enterprises, commercial enterprises (including wholesale and retail businesses) and investment enterprises. Each type of enterprise has a different business scope as approved by the competent government agencies in charge of foreign investments in China.
As a result, only investment enterprises have the right to use their foreign registered capital to make equity investments in domestic companies in China, even though, after meeting certain statutory conditions such as the commencement of the operation and earning of profits, the non-investment FIEs may also acquire the equity interests of a domestic company or set up wholly owned subsidiaries in China.
However, prior to the issuance of a SAFE circular on 29 August 2008, which expressly prohibits the FIEs from using the RMB funds converted from their registered capital to make domestic equity investments, the PRC laws were not very clear as to whether or not the non-investment FIEs may use their foreign exchange registered capital to acquire the equity interest of domestic companies or to set up a wholly owned subsidiary in China.
Hence, following a regulation jointly promulgated by the SAFE and other ministerial authorities in 2006, which allows non-investment FIEs to make domestic equity investments by deleting the previous statutory conditional restrictions, many law firms (including reputable international law firms) designed various deal structures whereby foreign investors may use their non-investment FIEs to acquire the equity interest of domestic companies. In many cases, these equity acquisitions served as a means to ultimately control the target business or properties owned by such domestic companies, for a variety of reasons (including exemption from government approvals and the considerable tax and cost savings).
The above deal structure may look very attractive from all legal aspects; however, banks will generally refuse to approve the capital conversion for the usage of acquiring the equity interests of Chinese domestic companies or for setting up a wholly owned subsidiary in China, as the SAFE tends to view such domestic equity investment as something beyond the normal operational activities of the non-investment FIEs (i.e., the specific manufacturing or operational activities as stated in the business scope of such non-investment FIEs).
By cooperating with their banks, non-investment FIEs are often able to convert their registered capital through the banks in the name of acquiring the target business or properties, while actually paying such converted RMB funds to acquire the equity interest of the domestic companies that own the target business or property as contemplated by the above deal structures for various commercial considerations.
The banks are normally well aware of the difference between the declared and the actual usage by their customers, but for various reasons, the banks generally accept such deviation without any protest or concerns. As such, the risks of violating the SAFE control on the usage of the converted RMB funds as discussed above are often underestimated by FIEs and their outside counsel. Should things go wrong—for example, in the event the angry Chinese partners or competitors blow the whistle to the Chinese government about the above-described secret change to the usage for the converted RMB funds, or if the SAFE launches annual inspections on the FIEs’ usage of their registered capital—it would be too late for an FIE to realize that such a technical change to the above-declared usage is a very devastating time-bomb. In this situation, an FIE may also be subject to the various administrative sanctions under Section 44, no matter how legitimate the actual and final usage.
General Tips to Mitigate Risks Under Section 44 of the SAFE Rules
Based on our extensive experience in handling various SAFE investigation matters, we offer the following tips to mitigate potential risks under Section 44 of the SAFE Rules:
- Prior, detailed consultations with the SAFE and other related PRC government authorities should be conducted before finalizing any deal structures where foreign exchange will be used. Detailed meeting minutes shall be prepared for such consultations with the SAFE and other related government authorities for the purpose of record and clarification.
- A good record of evidence should be kept, to demonstrate that the relevant banks have full knowledge of your business plan and have duly endorsed the conversion and usage of the disputed registered capital.
- In the event the violation has already occurred, take immediate action to correct such violations by working closely with the banks.
- If the violation has been caught by the SAFE, focus on the collection of evidence that demonstrated that you have statutory elements which may justify your request for exempted or reduced sanctions. Such demonstrations may include the prompt correction of the violation, poor guidance by the local government or banks, the legitimate business purpose, etc.
Conclusion
Contrary to what its name may suggest, the SAFE imposes rather rigid and dangerous provisions that may surprise unwary foreign investors despite their legitimate business purposes in China. To mitigate the risks under Section 44 of the SAFE Rules, foreign investors should consult with experienced counsel to design the deal structure, supervise the implementation of the transactions to ensure full compliance with the SAFE Rules, and formulate an effective defense strategy based on the specific factual circumstances should there arise a violation of such rules.
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