Investments by offshore funds in China’s mining sector

In recent years, private equity funds have been increasingly keen to invest in mineral resources companies. Their interest has been further heightened by the rising prices of mineral products. This article will briefly examine some of the legal issues relating to offshore funds investing in China’s mining companies and seeking to exit once the company has been listed on the A-share market.

Industry access

An offshore fund registered in China as a foreign entity should refer to relevant legislation and policy (such as the Foreign Investment Industrial Guidance Catalogue) to ascertain whether foreign investment is allowed in a domestic Chinese company. For example, foreign investment is restricted in the exploration and mining of special and scarce coals and barites; and foreign investment is banned in the exploration and mining of tungsten, molybdenum, tin, antimony, fluorite and rare earths.

Due diligence

The most important assets of a mining company are its prospecting and mining rights, as well as land use rights and other intangible assets. An offshore fund should conduct detailed legal due diligence of these intangible assets to determine whether the company has lawful and effective control over the mineral resources and can carry out exploration and mining activities accordingly.

Tax planning

Offshore funds should design an optimal investment portfolio by referring to the relevant Chinese tax laws and tax agreements or arrangements. For example, an offshore fund should consider where (such as Hong Kong or the BVI) it should set up its company for special investment purposes, and whether its investment will give rise to any need for a Chinese domestic company and/or its related entities to pay resources, land capital gains and income taxes.

Approval and registration

Any investment made by offshore funds in domestic Chinese companies must be approved and registered pursuant to the Merger and Acquisition of Domestic Enterprises by Foreign Investors Provisions (M&A Provisions) and other laws and regulations. Offshore funds should be familiar with the requirements of relevant laws and regulations (for example, the valuation of domestic companies, timeframe for capital contributions and proportion of capital contribution) in designing an investment portfolio, negotiating investment terms, drafting investment documents and arranging investment.

Becoming a joint-stock company

A domestic Chinese company which has been invested in by an offshore fund will become a Sino-foreign equity joint venture, a Sino foreign cooperative joint venture or a foreign-invested joint-stock limited company. If a Chinese domestic company has transformed into a Sino foreign equity joint venture or a Sino-foreign cooperative joint venture, it will need to become a joint-stock company after its listing objectives and plans are finalized, subject to approval by the competent authorities. It should be noted that according to the requirements of the PRC Company Law, shares held by the sponsor shareholders of a joint-stock company must not be transferred within one year of the establishment of the company.

Foreign investment and exchange controls

Offshore funds should primarily focus on equity investment in domestic companies. They may also think of investing in debt. However, the sum of a fund’s debt investments and other foreign debts of domestic companies it has invested in must not exceed the total investment minus its registered capital. In addition, according to foreign exchange control regulations, RMB funds settled by the capital acquired from offshore funds by a Chinese domestic company must not generally be used for domestic equity investments.

Natural person shareholders

According to the M&A Provisions and written explanations from the Ministry of Commerce, if a natural person from a Chinese party has formerly been a shareholder in a domestic Chinese company, and becomes an investor in the Chinese party to a Sino-foreign equity joint venture as a result of the acquisition of that company by a foreign investor, the Chinese party may remain a shareholder.

For an offshore fund to float a domestic company it has invested in on the A-share market, the company must first become a joint-stock company. The offshore fund must therefore assess whether the natural person shareholders of the domestic company can continue to hold shares after the change has taken place.

If existing natural person shareholders of a domestic company need to continue to hold shares in the company for tax purposes, they should appear as a shareholder when the offshore fund makes the investment. However, the offshore fund and the domestic company should examine this issue in the light of the special corporate governance requirements for foreign-invested enterprises (e.g. the requirement for unanimity among shareholders and directors on certain major matters), especially if a domestic company has many shareholders.

Preference shares and protective provisions

Offshore funds often invest via the issue of preference shares (or convertible bonds) in a red-chip structure, supplemented by protective provisions (such as a veto) to protect their investment interests. Although the PRC Company Law does not expressly allow companies to issue preference shares, it allows companies to emulate some characteristics of preference shares in their articles of association with respect to the specific rights of shareholders, such as voting rights and rights to profit distribution. When making such arrangements, it must be noted that foreign investment laws and regulations contain requirements which differ in some respects from the PRC Company Law. For instance, the profit of a Sino-foreign equity joint venture must be distributed in accordance with the proportion of capital contributions, and the highest authority is the board, rather than a shareholders’ meeting as stipulated under the PRC Company Law. Therefore, offshore funds should conduct a comprehensive review of the relevant Chinese laws and regulations, and make necessary amendments to the terms for the issue of preference shares (or convertible bonds) under the red-chip regime to protect their investment interests according to Chinese law.

Wang Jihong is the managing partner of V&T Law Firm. She practises in the field of infrastructure development. William Qiu is a partner at V&T Law Firm