Buyback clauses, as one of the exit mechanisms for investment institutions, have always been a major concern in PE/VC projects. But in recent years, with the primary market under pressure from various fronts and failing to perform as well as expected, buybacks are being triggered time and again.
Yet obstacles persist for foreign-invested enterprises in reducing capital of their foreign shareholders (foreign investors) at a premium, as the authors of this article have encountered when designing investor buyback and exit plans, providing specific solutions for different client situations.
Here they review and analyse the obstacles, possible solutions and considerations faced by foreign investors when reducing capital through buybacks from Chinese target companies.
Obstacles in capital reduction
If the agreed exit method for an investor’s exit involves the target company buying back their shares, this is typically more procedurally complicated and uncertain than a share transfer.
When the intending exit is a foreign investor, an additional obstacle arises: through the regular reduction plan, the maximum amount of capital reduction they directly obtain cannot exceed their paid-in registered capital. This means they can only carry out a parity reduction, and not an amount exceeding their paid-in registered capital.
The Company Law and relevant judicial interpretations do not explicitly restrict the amount of capital reduction to be paid to shareholders under China’s foreign exchange regulatory system.
However, before disbursing the reduction amount to foreign investors, the target company must not only comply with procedures stipulated in the Company Law, but also undergo a basic information registration change for foreign-invested enterprises at the bank.
According to the review principles in article 6.2, point 5, part 3 of the Guidelines for the Foreign Exchange Business under the Capital Account (2020 Version), when the target company reduces its capital and registers the change, the gained amount from the reduction (which can be remitted abroad or reinvested in China) is, in principle, limited to the reduced paid-in registered capital of foreign investors – excluding other owners’ equity such as capital surplus, reserve surplus and undistributed profits.
From experience in various projects such obstacles do exist in practice, implying that once the reduction amount is higher than the paid-in registered capital, due to the foreign exchange restrictions the commercial demand of foreign investors to retrieve the agreed reduction amount is often prevented.
In addition, note the same provisions are in article 7.2, point 7, part 2 of the Guidelines for the Foreign Exchange Business under the Capital Account (2023 Edition) (Draft for Comment), issued by the State Administration of Foreign Exchange on 16 November 2023.
Therefore, if the draft guidelines come into effect with the existing provisions, foreign investors will still be subject to the above-mentioned restrictions on capital reduction.
If the agreed buyback price exceeds the paid-in registered capital of a foreign investor, two relatively feasible options are suggested to assist in successfully retrieving the entire buyback price from the target company:
Plan A. Targeted conversion of capital surplus to registered capital followed by reduction. First, the target company carries out a directed capital increase, and the foreign investor subscribes to the additional registered capital with capital surplus (share premium), making its registered capital equal to the agreed buyback price.
The target company will then make a parity reduction to the foreign investor and pay the buyback price.
Plan B. Share transfers followed by reduction. This plan needs to be completed with the co-operation of suitable domestic shareholders of the target company.
First, the foreign investor transfers its share at a price equal to the agreed buyback price to a domestic shareholder, with the transfer payment suspended.
Then the domestic shareholder reduces its capital in the target company and obtains the reduction payment – which includes its own reduction payment and an amount equal to the buyback price proposed by the foreign investor – after which it pays the transfer price to the foreign investor.
From a comprehensive view, plan A is more common in the open market, mainly relying on the target company to take the lead.
Although the conversion of capital surplus to registered capital requires the co-operation of other shareholders, this adjustment is more straightforward, making it relatively convenient to co-ordinate with other shareholders.
Plan B requires the co-operation of a domestic shareholder to transfer shares, which is usually less acceptable to market-based institutional shareholders and will incur certain communication costs. The target company and the foreign investor may consider the assistance of founding shareholders as appropriate.
To select the better option, the two above-mentioned plans require further consideration of tax liabilities related to the targeted conversion and capital increase, capital reduction and transfer process.
For example, the first step of plan A, a targeted conversion of capital surplus, usually incurs no income tax for institutional shareholders. But it may result in tax liabilities for individual ones.
To formulate a suitable plan addressing practical obstacles to the target company’s capital reduction at a premium by foreign investors, it is essential to comprehensively assess – in various steps – the nature of the foreign investor intended to exit by capital reduction, intended amount of capital reduction, composition of the target company and its shareholders, and potential tax liabilities.
Joyce Zhang is a partner at Llinks Law Offices. She can be contacted by +86 21 3135 8685 or by e-mail at email@example.com
Aurora Zhang is a partner at Llinks Law Offices.
She can be contacted by +86 21 6043 3797 or by e-mail at firstname.lastname@example.org