Utilizing the CLS for Group Restructuring

The CLS can be established either by converting an existing FIE (the Transition Model) or by setting up a brand new CLS company (the New Co. Model). Both models require the following: (1) there should be at least five promoters (shareholders) to establish the CLS; (2) among all the promoters, there should be at least one offshore (foreign) promoter, and more than half of the promoters should be Chinese companies; (3) the foreign shareholders should hold at least a 25% share in the CLS; (4) the minimum registered capital (or the minimum share value at the inception of the CLS) should be Rmb30 million; and (5) if the Transition Model is to be utilized, the existing FIE to be converted to a CLS should have been profitable for the previous three years consecutively.

It should be noted that both of these models refer to the so-called “promotional method”, which differs from the “share float method”. If the share float method is to be utilized, then in addition to the above requirements, at least one promoter should have been profitable for three consecutive years prior to the share float. Since the share float method has not been tested by multinationals in practice, we will focus on the promotional method and the two models associated with it.

According to the first requirement above, only corporate entities (not individual natural persons) are allowed to become local promoters of the foreign-invested CLS, while a 100% local CLS does not face such a restriction. This is in line with the long-standing policy that only domestic corporate entities are allowed to establish FIEs with foreign investors (who can be natural persons) in China.

There has been confusion in the past over whether the local holding company of a multinational group should be treated as a foreign company or a Chinese company, which brings us to the second requirement above. According to MOFTEC holding company regulations from 2001, a Chinese holding company should be treated as a foreign company. Now such a provision has been abolished and the Chinese holding company for the purpose of the second requirement above should be treated as a local Chinese company. But for the purpose of the third requirement above, such a local holding company is treated as a foreign shareholder in a CLS. In other words, the benefits of utilizing the Chinese holding company are double: on one hand it reduces the number of required local Chinese promoters, often a concern for multinationals in CLS restructurings, and on the other hand the shares held by the Chinese holding company can count against the minimum 25% “foreign” equity.

The fourth and fifth requirements are relatively easy to satisfy. The CLS share value is defined according to the net asset value of the CLS. (For example, an EJV with Rmb100 million in net assets can be converted to CLS with 100 million shares at a par value of Rmb1 per share.) The outdated total investment amount concept does not apply to the CLS.

Structural Planning

At first glance, multinationals are mainly concerned with the number of promoters (shareholders) required and even more concerned with the majority number of the local Chinese promoters (shareholders) required. Whether it is possible to structure the CLS as a wholly foreign-owned enterprise is a frequent question, as is whether in the future the number of CLS shareholders can be reduced by buying out the Chinese shareholders.

The problem is actually far less severe than it appears. First, if the group restructuring involves joint ventures whose local partners will continue their participation, the local partners can become the Chinese promoters of the CLS. Among the minimum five promoters, there should be at least three Chinese companies. If the local holding company becomes one local promoter, only two other local Chinese promoters will be needed to satisfy the regulatory requirements. Since a two-thirds shareholding can give the multinational company the desired control, admitting the local Chinese partners into the CLS, if needed, but with less than one-third shareholding, is advisable from both legal and business perspectives for the multinational's group restructuring.

Secondly, the multinational company can appoint local Chinese trust companies to satisfy the local promoter requirement. In theory it is possible to establish the CLS as 100% controlled by the multinational company by using trust companies, but in practice no such cases have been published. However, once the CLS has been in existence for more than three years, the law allows the Chinese shareholders to transfer the shares to foreign shareholders, which means the multinational company can own and operate the CLS as a wholly foreign-owned enterprise.

Some other issues remain unsettled, such as the possibility to reduce the number of the shareholders below five through buying out the Chinese promoters. Due to a lack of clear regulatory guidelines on this and other issues, they will have to be tested with the approval authorities on a case-by-case basis.