Foreign Investment in NPL Assets: Is China's Legal Environment Up to the Task?

Reportedly, the CJV AMCs' scope of business as listed in their respective articles of association is as follows: management, swap, transfer and sale of assets in the form of creditors' rights; and recovery of creditors' claims, as well as debt restructuring. The CJV AMCs' scope of business does not include engaging in such banking businesses as taking deposits, extending loans and settling payments.

Also according to media reports, CJV AMCs will be established in the Beijing Economic and Technological Development Zone, with a term of seven years only. Moreover, CJV AMCs will not be allowed to incur any debts vis-à-vis third parties,³ nor will they be allowed to make any investments in other companies or enterprises. And if for some reason, a CJV AMC is unable to dispose all of its NPL assets at the end of its term, the Chinese party may continue to dispose of these assets in the capacity of the creditor.

Legal and Regulatory Barriers to Foreign Investment in NPL Assets

The legal framework for tackling the NPL problem began to take shape in 2001. On October 26 of that year, MOFTEC, the Ministry of Finance (the MOF) and the People's Bank of China (the PBOC) issued the Absorption of Foreign Capital by Financial Asset Management Companies to Participate in Asset Restructuring and Disposal Tentative Provisions (the Tentative Provisions). The Tentative Provisions only offer limited guidance to foreign investment in disposition of NPLs and have not solved all of the legal and regulatory problems associated with this type of foreign investment.

Investing through an Onshore Entity

Where they participate in the disposition of NPL assets through an onshore vehicle, i.e., a foreign-invested enterprise (FIE), foreign investors face a few major legal and regulatory problems. First, it is not at all clear whether under PRC law a foreign investor may contribute its acquired NPL assets in the form of creditor's rights vis-à-vis, or equity interest in, Chinese companies to the registered capital of an FIE established to own (and probably dispose) the NPL assets.⁴ ThePRC Sino-foreign Cooperative Joint Venture Law (中华人民共和国中外合作经营企业法) (Article 8) and its implementing regulations (Article 18) provide that a party to a CJV may make contributions to the registered capital of the CJV with currency, in-kind assets or property rights, such as industrial property rights, proprietary technology and land use rights. However, the implementing regulations do not specifically list investor's creditor's rights vis-à-vis, and equity interest in, another company as a form of permissible investment.⁵

Another issue is that the scope of business of an FIE normally does not include disposition of NPL assets, which is traditionally reserved for Chinese banks and non-bank financial institutions (e.g., China's state-owned AMCs); whether a foreign investor is able to include in the scope of business of its FIE "disposition of NPL assets" was uncertain.

A third issue is that an FIE may invest in other Chinese companies or enterprises, but its total equity investment in other companies generally shall not exceed 50% of its net asset value.⁶ This limits foreign-invested AMCs' ability to purchase NPL assets in the form of equity in other Chinese companies to 50% of the respective net assets of the AMCs.

Finally, under existing PRC corporate law and China's foreign exchange regime, in terms of repatriation of foreign capital an FIE can only remit abroad repayment of the foreign investor's investment as a capital account item payment after the liquidation and termination of the FIE in question. Without special MOC and SAFE approval it would be extremely difficult for a foreign-invested AMC to repatriate its entire proceeds (other than its after-tax profits, repayment of loan principal and payment of interest) from disposition of its NPL assets, short of liquidating and terminating the AMC in question.

Investing from Offshore

There are different problems associated with offshore investments in NPL portfolios. Purchasing NPL assets by foreign firms directly from Chinese state-owned banks or AMCs raises first of all the question of whether foreign investors owning NPL assets involving Chinese enterprises would require them to carry out foreign debt registration. If the transaction is considered as a foreign debt, who carries out the foreign debt registration? There may be numerous debtors involved in a sale of "packaged" NPL assets, and some of them may no longer exist as legal entities.

Second, if part of the acquired NPL assets were in-kind assets, from the regulatory and tax perspective it would be difficult for foreign investors to re-sell these in-kind assets. This is partly due to foreign investors' inability to register under existing PRC law and regulations as a foreign company doing business in China,⁷ and partly due to the fact that foreign investors would not be able to issue VAT invoices for the sale of in-kind assets, because they can not register with the PRC tax authorities as a taxpayer authorized to issue VAT invoices.

Further, the existing foreign exchange regime does not provide a basis for foreign investors to convert renminbi revenue from disposition of NPL assets into hard currency, and then remit the same out of China.

When holding an equity interest in debtor enterprises via a debt equity swap or otherwise, a foreign investor or foreign-invested AMC would be subject to the restrictions imposed by the Foreign Investment Industrial Guidance Catalogue(外商投资产业指导目录). If the debtor enterprise engages in an industry sector in which foreign investment is prohibited, the foreign company or its foreign-invested AMC would not be allowed to hold any equity in a PRC enterprise as a result of debt restructuring (including debt equity swap) of the enterprise. And if the Chinese party must hold a majority equity in FIEs engaged in the same business as that of the debtor enterprise, then the foreign investor (together with other foreign investors) can not directly or through its foreign-invested AMC hold majority equity interest in the debtor enterprise as a result of the debt restructuring of the debtor enterprise. This would prevent foreign investors from converting all or a major portion of the acquired NPL assets into equity of debtors in all industry sectors and at the same time. Thus, the options available to foreign investors for disposing of NPL assets they own directly or through their foreign-invested AMCs are quite severely limited.

A Practical, not Long-term Solution

The administrative approval for the Morgan Stanley/Goldman Sachs_led consortia to contribute or transfer their acquired NPL assets to the registered capital of the respective CJV AMCs practically solved the problem of foreign debt registration for these particular investment projects in two ways. The creditors in respect of the acquired NPL assets will be CJV AMCs once such contribution or transfer is completed, and the approval also legitimized Morgan Stanley and Goldman Sachs_led consortia's contribution/transfer of their acquired creditors' rights (to the NPL assets) to their respective CJV AMCs.

Furthermore, the reported SAFE approval that a portion of the NPL assets transferred by the Morgan Stanley/Goldman Sachs_led consortia to the relevant CJV AMC would be treated as a shareholders loan allows CJV AMCS to repatriate a big portion of the proceeds from disposition of NPL assets in the form of loan repayments and interest payments.

Notwithstanding the practicality of the approach taken by the PRC government authorities in approving the establishment of CJV AMCs, the approach is not a panacea to all legal and regulatory problems for foreign investment in NPLs. For example, how would a foreign company take title to in-kind property such as production equipment that forms part of the acquired NPL assets, and then sell such in-kind property to a domestic or foreign company? It remains to be seen how the PRC government will deal with issues such as this when more foreign companies actually participate in the disposition of NPLs.

Tax Issues Relating to the Disposition of NPL Assets

In China, Chinese companies (including FIEs such as CJV AMCs) and foreign companies are subject to PRC enterprise income tax on their income from PRC operations and capital gains from sale of property and real estate situated in China, equity interest in FIEs, and other sources. Moreover, as a general rule, all taxpayers are required to pay a 5% business tax on their gross receipt from disposition of their real estate and certain intangible property (excluding equity interest in another company), and a 2% (as opposed to the regular 17%) value-added tax (VAT) on their sale of used goods without allowing offset of their input VAT against their output VAT in respect of used goods (where the used goods sold are motor vehicles, motorcycles or yachts, VAT will be payable only if sales proceeds exceed the historical cost of such goods).⁸ However, how exactly AMCs with foreign investment and foreign companies engaged in buying and disposing NPL assets would be treated for tax purposes was not clear before the issuance of a tax circular by the PRC State Administration of Taxation (the SAT) on disposition of NPL assets earlier this year.

On January 7 2003, the SAT issued its Tax Issues Relevant to the Engagement in the Business of Financial Asset Disposal by Foreign-invested Enterprises and Foreign Enterprises Circular (Guo Shui Fa [2003] No. 3, the Tax Circular on Disposition of NPL Assets).⁹ This circular has clarified a number of tax issues relating to the disposition of NPL assets by foreign-invested AMCs like CJV AMCs, and foreign firms such as Morgan Stanley and Goldman Sachs.

Tax Definitions in Respect of Disposition of NPLs

The Tax Notice on Disposition of NPL Assets refers to the "business of disposing financial assets", and defines it to mean the acquisition of equity in, creditors' claim against, and in-kind assets of, enterprises in China or a combination of all these assets (hereinafter, Acquired Assets) from PRC state-owned financial asset management companies, by way of purchase or debt equity swap; and subsequent disposal of such assets via transfer, repossession, exchange or sale, thereby realizing investment returns accordingly.

The Tax Notice on Disposition of NPL Assets further elaborates that an enterprise may dispose financial assets in one of the following ways: (i) recovering or transferring creditors' claims; (ii) debt equity swap; (iii) disposing in-kind assets that the enterprise has the right to dispose; (iv) sale or transfer of equity interest in other companies that the enterprise holds; (v) sale-back of the Acquired Assets; and (vi) means other than those listed in items (i) through (v) in this paragraph.

Tax Treatment of Disposition of NPLs

The Tax Notice on Disposition of NPL Assets spells out the following tax treatment of disposition of such assets:

(i) no business tax will be imposed on an FIE or foreign company when it disposes its Acquired Assets in the form of debt claims against or equity in other PRC enterprises, including debt equity swaps;

(ii) where an FIE or foreign company disposes its in-kind assets, business tax (5%) will be imposed on its revenue from disposition of immovable property, while VAT will be imposed with respect to the disposition of Acquired Assets that are in the form of goods in accordance with the Value-added Tax Tentative Regulations and relevant provisions;¹⁰ where business tax or VAT is payable with respect to revenue from disposition of Acquired Assets, the FIE or foreign company in question is required to follow the relevant tax collection administrative law and regulations to determine where it should report and pay these taxes;¹¹

(iii) the historical cost of an Acquired Asset shall be the actual price paid to acquire the asset or the price at which a debt was converted into equity. Where an enterprise "repackages" part or all of its Acquired Assets, the enterprise may re-determine the historical cost of each item of Acquired Assets or a pool of Acquired Assets, but the overall value of these "repackaged" Acquired Assets shall not exceed the total historical cost of these assets at which the enterprise acquired them;

(iv) the FIE or foreign company disposing NPL assets shall pay income tax on its gains from disposition of the Acquired Assets after deducting from such gains the historical cost of, and expenses and losses relating to, the disposed Acquired Assets. Where the FIE or foreign company disposes the Acquired Assets in instalments or different batches, if the aggregated revenue from disposition of the Acquired Assets (one single item or packaged Acquired Assets) exceeds the historical cost of the Acquired Assets, the FIE or foreign company is required to include the excess amount in its taxable income for the relevant tax period and then calculate the amount of enterprise income tax payable. Likewise, as a general rule, if an FIE or foreign company suffered losses in disposing of its Acquired Assets, it will be allowed to offset such losses against income for the tax period during which such losses incurred. However, if the FIE or foreign company disposes "packaged" Acquired Assets, it will not be allowed to write off such losses until the entire "packaged" Acquired Assets have been disposed¹² and lastly;

(v) foreign companies without a business establishment in China but engaged in disposition of NPL assets shall file an enterprise income tax return on their own or through an authorized agent located in China, and pay income tax to the tax authorities having jurisdiction over the PRC enterprise to which one of the Acquired Assets is related.¹³

Conclusion

The PRC has so far not attempted to once and for all do away with the legal and regulatory barriers for foreign investment in NPLs held by Chinese state-owned AMCs and banks. Instead, it has taken a practical and case-by-case approach. Moreover, it still maintains the restrictions on foreign investment under the Foreign Investment Industrial Guidance Catalogue (外商投资产业指导目录).

Instead of making an extensive and coordinated effort to amend various laws and regulations affecting foreign investment in NPLs to facilitate foreign investment in this sector, the PRC government has given, and will probably continue to grant, special approvals to foreign investors, so that they can purchase and dispose NPL assets, and then repatriate revenue from such disposition without regulatory hiccups.

Given the state of PRC laws and regulations and a rigid foreign exchange control system, this practical and case-by-case approach appears to be the most expedient and viable option for China to deal with the legal and regulatory hurdles lying in the way of foreign investment in China's NPLs.

Endnotes

1 Huarong was formed to absorb the bad debt of the Industrial and Commercial Bank of China, one of China's four state-owned commercial banks. Huarong, and the other three AMCs formed to handle the debts of the China's state-owned commercial banks, are wholly state-owned non-bank financial institutions directly funded by the Ministry of Finance.

2 According to an unconfirmed source, part of the NPL assets transferred by Morgan Stanley/Goldman Sachs to the relevant CJV AMC were treated as a shareholders loan that will be registered with SAFE upon establishment of the CJV AMC. If this is true, CVJ AMCs may repay Morgan Stanley/Goldman Sachs (in part) in the form of loan repayment.

3 As indicated in footnote 2, a portion of the NPL assets to be transferred by respective consortia would be treated as a shareholders loan to the CJV AMC in question. This is presumably the only exception to the no third-party debt prohibition.

4 Article 3.3 of the Using Foreign Investment to Reorganize State-owned Enterprises Tentative Provisions issued on November 8 2002 seems to provide a regulatory basis for foreign investors to make capital contribution to a PRC enterprise under a debt equity swap arrangement.

Separately, under the Acquisition of Domestic Enterprises by Foreign Investors Tentative Provisions, which were issued by MOFTEC (now the MOC), the SAT, SAIC, and SAFE and which took effect on April 12 2003, foreign investors are now able to acquire assets directly from domestic enterprises (i.e., enterprises with 100% Chinese investment), and then contribute such acquired assets to a newly established FIE as (part of) its capital contribution to the FIE.

5 As in endnote 4.

6 FIE investment holding companies are not subject to the 50% net asset value restriction when they invest in underlying FIEs.

7 Although the PRC Company Law (中华人民共和国公司法) allows foreign companies to establish a branch in China, so far in practice only foreign companies from very few industry sectors, such as banking and insurance, have been allowed to operate in the form of a branch in China.

8 Readers should refer to the MOF and SAT Value-added Tax Policy Affecting Used Goods and Used Motor Vehicles Circular, (Cai Shui Zi [2002] No. 29), issued on March 13 2002.

9 See China Law & Practice, April 2003, 17(3), pp. 50-52.

10 Under relevant PRC regulations on VAT, if the disposed Acquired Assets are in the form of goods, and these goods are brand new, a 17% VAT would be imposed on the sales price; if such goods are used goods, an effective 2% VAT will be imposed on the sales price (without allowing a credit for input VAT on the goods); however, if the used motor vehicles, motorcycles or yachts are sold at a price lower than the historical cost of such goods, the 2% effective VAT will be waived.

11 Generally, a taxpayer engaged in transactions that trigger business tax liability is required to pay business tax to the tax authorities having jurisdiction over the locality (i) where the taxpayer provided services if revenue was generated from provision of services, (ii) where the land is situated if revenue was derived from transfer of land use rights, or (iii) where the taxpayer is registered if revenue was realized from transfer of intangible property. A VAT taxpayer, however, is required to pay VAT to the tax authorities where the taxpayer is registered as a VAT taxpayer, irrespective of where the goods are sold.

12 The purpose of this restriction is presumably to delay the taxpayers' realization of losses, if any, until the entire "packaged" Acquired Assets have been disposed of, thereby preventing the taxpayers from offsetting the "unrealized" losses against their taxable income (and hence reducing income tax payable) for the current tax period.

13 This tax treatment under Chinese domestic tax law is subject to the provisions of the relevant bilateral tax treaty. For example, if under the US/China Tax Treaty an enterprise from the United States is not deemed to have a permanent establishment (PE) in China, then the Chinese government shall not impose enterprise income tax on such US enterprise. However, since the US/China Tax Treaty does not cover turnover taxes, the Chinese government may impose business tax or VAT on a US enterprise on its revenue from provision of services or sales of goods, real estate and specified intangible property in China, irrespective of whether the US enterprise is deemed to have a PE in China under the US/China Tax Treaty.