Changing equity stakes in foreign investment enterprises

By Vera Wei, Martin Hu & Partners
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With increasingly equal treatment of domestic companies and foreign investment enterprises (FIEs) in the PRC, the gap between the two has narrowed.

Accordingly, foreign shareholders in FIEs are adjusting the structures of their enterprises through equity transfers and other means. Transfers of equity interests in FIEs involve such issues as the execution of equity transfer contracts, board resolutions, shareholders’ pre-emption rights, foreign investment approval procedures, re-registration and income tax registration.

Types of equity transfer

Vera Wei 韦炜, Japan practice Martin Hu & Partners 胡光律师事务所日本业务部, Senior Associate 资深律师
Vera Wei
Senior Associate
Japan practice
Martin Hu & Partners

In a foreign-to-Chinese transfer, a foreign company transfers all or part of its equity interest in an FIE to a Chinese company (the original Chinese investor or another Chinese enterprise), reducing the foreign company’s equity holding in the FIE (partial transfer) or resulting in the conversion of the FIE into a wholly Chinese-owned enterprise (complete transfer).

In a foreign-to-foreign transfer, a foreign company transfers all or part of its equity interest in an FIE to another foreign company, reducing its equity holding in the FIE (partial transfer) or resulting in a change in the foreign investor in the FIE (complete transfer).

The foreign investor in a Sino-foreign equity joint venture (JV) may carry out its equity transfer onshore or offshore.

Restrictive provisions

In a foreign-to-Chinese transfer, unless the foreign investor transfers all of its equity interest to the Chinese investor, the stake held by the foreign investor must not fall below 25% of the registered capital of the enterprise.

In a foreign-to-foreign transfer, pursuant to the Foreign Investment Industrial Guidance Catalogue, a change in equity interests must not result in all of the equity in an enterprise being held by foreign investors if the enterprise operates in an industry in which wholly foreign-owned enterprises (WFOEs) are not permitted. If a change results in the enterprise becoming a WFOE, the conditions for the establishment of a WFOE specified in the Wholly Foreign-owned Enterprises Law Implementing Rules must also be satisfied.

In industries where state-owned assets are required to occupy a controlling or guiding position, a change in equity interests may not result in any enterprise that is not a PRC state-owned enterprise occupying such a position.

Effectiveness of a contract

Under foreign investment rules, a transfer of an equity interest in an FIE requires the approval of the original approval authority and the amendment of registration. According to the Supreme People’s Court Several Issues Concerning the Trial of Disputes Involving Foreign Investment Enterprises Provisions (1), the party that was obliged to carry out the original approval procedures must obtain approval of the transfer. If it fails to do so, the other party may take legal action in court, requesting that the contract be terminated with compensation; or it can request the court to order the other party to carry out the approval procedures. Alternatively, it can request the court to permit it to carry out the approval procedures itself.

Foreign investment rules provide that “transfer by one JV party to a third party of all or part of its equity interest shall require the consent of the other JV party … When one JV party is to transfer all or part of its equity interest, the other JV party has a pre-emptive right of purchase”. The PRC Company Law contains similar provisions. Although current laws do not address pre-emption rights in detail, the Supreme People’s Court provisions state that “any other shareholder may petition to have the equity transfer contract rescinded on the grounds that its consent was not obtained, unless the transferor can prove any of the following: (1) the other shareholders gave their consent; (2) the transferor gave written notice of the equity transfer, but none of the other shareholders responded within 30 days of receipt of the written notice; or (3) although other shareholders did not consent to the transfer, they did not offer to purchase the equity that was being transferred.”

It should be noted that a shareholder that objects to an equity transfer must institute any legal action within a year of the date on which it learned or ought to have learned of the execution of the equity transfer contract. Otherwise, the shareholders action will be time-barred.

Income tax

The new PRC Enterprise Income Tax Law and the Ministry of Finance and State Administration of Taxation Several Issues Concerning the Enterprise Income Tax Treatment of Enterprise Restructurings Notice (Cai Shui [2009] No. 59) contain clear provisions on the levy of (and exemption from) income tax on proceeds derived by a foreign company from a foreign-to-Chinese equity transfer. However, tax laws are silent on the method of filing and paying income tax in respect of the transfer by a foreign company of equity in an FIE to another foreign company offshore. Some foreign companies have exploited this loophole to evade PRC tax.

Accordingly, in 2009, the State Administration of Taxation issued the Strengthening the Administration of Enterprise Income Tax on Income Derived From Equity Transfers by Foreign Companies Notice, stipulating who may act as withholding agents for enterprise income tax on equity transfers by foreign companies. This notice also sets out the filing and payment obligations of foreign companies, and provides that if a foreign investor (that is an actual controller) indirectly transfers its equity in a PRC enterprise by means of a specially designed organizational structure, but does not have a legitimate commercial objective in doing so and therefore evades enterprise income tax, the competent tax authority may, after reporting this situation to the State Administration of Taxation, reclassify the nature of the equity transfer transaction, ignoring the existence of any offshore holding company that is established for tax purposes.

Vera Wei is a senior associate in the Japan practice of Martin Hu & Partners

Martin Hu & Partners (MHP Law Firm)19/F Yongda International Tower

2277 Longyang Road

Shanghai, China, 201204

Fax: +86 21 5010 1222

www.mhplawyer.com

Vera Wei

Tel: +86 21 5010 1666

E-mail: vera.wei@mhplawyer.com

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