SAFE Tightens Control over Offshore Transactions

By Alex Zhang and Gilbert Zeng

Website: www.jonesday.com

Nearly three months following the promulgation of the Issues Relevant to Improving the Foreign Exchange Administration Regarding Mergers and Acquisitions by Foreign Investors Circular on January 24 2005 (January Circular), the PRC State Administration for Foreign Exchange (SAFE) issued the Issues Relevant to Registration Regarding Offshore Investments of Individual Domestic Residents and Foreign Exchange Regarding Mergers and Acquisitions by Foreign Investors Circular on April 21 2005 (April Circular). With the intention to "maintain the balance of international payments and ensure the lawful and orderly flow of cross-border capital" the April Circular mirrors the January Circular and is regarded as its implementation rules.

Outbound Investments by PRC Domestic Residents

The January Circular requires a PRC domestic resident intending to directly or indirectly invest in or control an offshore enterprise to file a registration with SAFE. The April Circular further provides that without this, a PRC domestic resident is prohibited from foreign exchange operations related to outbound investments or other activities using a capital account. However, SAFE has neither elaborated on the definition of a 'domestic resident' in these two Circulars, nor detailed their scope.

In conjunction with the Acquisition of Domestic Enterprises by Foreign Investors Tentative Provisions jointly promulgated on March 7 2003, the January Circular requires any sale or exchange of onshore assets or equity interests for equity interests or other property rights of an offshore company by a PRC domestic resident be subject to SAFE's examination and approval. Moreover, under the April Circular, where a PRC company is acquired (or the PRC company is established for purpose of acquisition) by an offshore company in which a PRC domestic resident directly or indirectly holds equity interests, the registration with the local SAFE of such an outbound investment is retroactively required of the PRC domestic resident. This applies even if the Foreign Invested Enterprise Approval Certificate, with regard to the acquisition transaction, was obtained prior to January 24 2005.

Once the SAFE registration is completed, the PRC domestic resident who directly or indirectly controls the offshore company is required to file any amendments, concerning any material events affecting the offshore company to SAFE's registration within 30 days of occurrence.

FIEs Established through M&As

When a foreign invested enterprise (FIE) established through an M&A transaction files a foreign exchange registration, the local SAFE is required under the January Circular to closely examine whether the foreign shareholder of such an FIE is (i) established or controlled by any PRC domestic resident; or (ii) has the same management team as the PRC company acquired by such a foreign shareholder. Accordingly, a registering FIE is required to either make a statement in the written application that its foreign shareholder has no direct or indirect equity or asset-based relationship to the PRC company which is selling the equity interests or assets, or to reveal accurately the equity or asset-based relationship between the foreign shareholder of such an FIE and the PRC company.

In the event that the applying FIE is found to have been established for the purpose or as a result of an M&A by a PRC domestic resident through an offshore company, the local SAFE will forward the foreign exchange registration application to the central SAFE for approval. The April Circular reiterates that when registering with the local SAFE, the newly-established FIE shall clarify its ultimate control person, or clearly state in writing that it is not directly or indirectly owned by any PRC domestic entity. The FIE and its legal representative will be held liable for any false or misleading representation.

Consequences for Non-compliance

The April Circular imposes specific legal consequences on the PRC domestic resident or corporate entity with a direct or indirect stake in an offshore company that fails to register with SAFE. These include: (i) the PRC subsidiaries of an offending offshore company will not be allowed to go through the foreign exchange registrations; and (ii) the PRC subsidiaries of an offending company may be prohibited from distributing profits to the offshore companies and from paying the offshore companies proceeds from any capital reduction, share transfer, or liquidation with regard to their PRC subsidiaries.

Additionally, the April Circular requires a PRC domestic resident to remit for foreign exchange settlement within China his or her offshore revenues obtained directly or via an offshore special purpose vehicle within 30 days of the receipt of such revenues.

Failure to comply with the SAFE registration requirements described above could result in liability for foreign exchange evasion under pertinent PRC laws and regulations.

Conclusion

It remains to be seen how the January and April Circulars will impact China's cross-border investments, whether they be private equity, venture capital, strategic M&A, or in IPOs outside the country. Given the perceived widespread impact of the January and April Circulars and the uncertainty concerning the reconciliation of the two Circulars with other approval requirements, many questions will certainly arise in practice and require further and considerable clarification in their respective implementation.