Finance Leasing with Chinese Characteristics

In April 2006, the NPC issued a second version of the Draft PRC Finance Leasing Law [the Draft Law] for comments. The Draft Law, which is expected to be promulgated by the end of 2007, contains rules on the establishment of FLCs and finance leasing contracts, which are largely borrowed from Article 2A of the Uniform Commercial Code. The Draft Law would vest in the CBRC the power to approve FLCs. Shorlty after the Draft Law, MOFCOM expanded the ability of foreign investors to conduct finance leasing activities by issuing the Supplementary Regulation for Administration of Foreign Invested China Holding Companies [effective since July 1 2006], according to which foreign-invested holding companies with "regional headquarters" status are no longer required to set up a finance leasing company to conduct finance leasing business, and are allowed to provide operating lease or finance lease products on their own account. Finally, the issuance of the CBRC Measures in January 2007 casts serious doubts that the Draft Law would eventually unify the two parallel regimes.

REQUIREMENTS FOR ESTABLISHMENT

A key difference between the CBRC and MOFCOM regimes is that the CBRC Measures mostly target large financial institutions instead of equipment manufacturers. Under the CBRC Measures, the main requirements are imposed on the company's investors, which are either "Principal Investors" or "General Investors", the former being subject to more stringent qualification requirements. Under the CBRC Measures, the Principal Investor must hold at least 50% of the company's registered capital. Only qualified domestic and foreign commercial banks, domestic and foreign leasing companies and "large enterprises registered in China and manufacturing goods suitable for financial leasing" can act as Principal Investors.

The reference to enterprises "registered in China" confirms that large manufacturing foreign-invested enterprises [FIEs] can act as Principal Investors under the CBRC regime. Also, the removal of restrictions on inter-company investments by FIEs should allow large manufacturing FIEs to set up MOFCOM FLCs or to act as Principal Investors of Financial Institution FLCs¹.

The CBRC Measures subject domestic and foreign commercial banks, leasing companies and large manufacturing enterprises seeking to act as the Principal Investor of a CBRC FLC to different qualification requirements. To act as the Principal Investor of a CBRC FLC, a large manufacturer must comply with a number of conditions, including:

• having a business income of at least Rmb5 billion in the previous year;
• having been profitable for the last two years preceding the application; and
• having at least 80% of its total business income deriving from sales activities.

It may take a few years before any of the foreign-invested banks approved (or to be approved) under the Foreign Invested Banks Regulations [issued by the State Council on November 11 2006] can act as Principal Investor in a Financial Institution FLC. Under the CBRC Measures, banks seeking to act as Principal Investor must have been profitable in the last two consecutive years and must have assets of at least Rmb80 billion.

In comparison, the requirements for establishing a MOFCOM FLC are more investor friendly. These conditions include having total assets of at least US$5 million [nearly Rmb38 million] and a minimum of three years experience in finance leasing. The amount of registered capital to be contributed for establishing any of these two vehicles will carry little weight in the balance of MOFCOM FLCs [about Rmb76 million] and Financial Institution FLCs [Rmb100 million].

FOREIGN SHAREHOLDING RESTRICTIONS

The CBRC Measures and the MOFCOM Measures do not subject a foreign investor's shareholding in an FLC to any cap. However, other provisions of PRC law will produce a similar effect. Take for instance the Civil Aircrafts Nationality Registration Provisions [issued on October 21 1997], according to which an entity with a foreign equity interest exceeding 35% cannot register aircrafts [and corresponding mortgages] on the PRC register. Likewise, a Chinese entity with a foreign equity interest exceeding 50% cannot register vessels on the PRC register under the Vessels Registration Provisions [issued on June 2 1994]. A possible way to circumvent this restriction would involve the foreign investor "splitting" its investment with one of its PRC subsidiaries.

PERMITTED BUSINESS ACTIVITIES

The authorised business scope of each FLC vehicle is another key difference between the CBRC Measures and the MOFCOM Measures. Financial Institution FLCs have a much wider business scope than MOFCOM FLCs. The table below provides a comparative overview of the business scope of these two vehicles.

The CBRC Measures no longer allow Financial Institution FLCs to extend working capital loans to lessees or to provide guarantees. In the past, a number of Financial Institution FLCs established under the PBOC Regulations had their main business activities consisting of the extension of loans and the provision of guarantees, with limited financial leasing operations.

Another notable difference between the CBRC Measures and the PBOC Regulations is that the CBRC Measures no longer allow Financial Institution FLCs to pursue operating lease business activities. To some extent, this will not prevent FLCs to provide products similar to operating leases. A carefully drafted hybrid lease presenting characteristics of both finance and operating leases could still fall under the ambit of finance lease in PRC law [see below]. MOFCOM FLCs can offer both operative and finance leases.

DEFINING PRC FINANCE LEASES

PRC law applies different standards for defining finance leases. For accounting purposes, the benchmark to be used for assessing whether a lease is a finance lease or an operating lease will be the definition of finance lease in the "Enterprise Accounting Standard No.21 - Lease" [issued by the Ministry of Finance on February 15 2006]. Standard No.21 defines a finance lease as a lease under which all risks and rewards related to the ownership of the leased asset are transferred from the lessor to the lessee. Standard No.21 also provides that a lease will be qualified as a finance lease in certain circumstances, such as:

• the ownership of the asset is transferred at the expiry of the lease;
• the finance lessee has the option to purchase the asset at the expiry of the lease;
• the lease term covers most of the useful life of the asset; or
• if the total rents approximately amount to the value of the leased asset.

Under Standard No.21, if the lease is qualified as a finance lease, the finance lessee will be allowed to enter the leased asset in its balance sheet and depreciate the leased asset as if it was the owner of such asset.

In addition, "finance lease" is also defined in the CBRC Measures, the MOFCOM Measures, the PRC Contract Law [effective since October 1 1999] and the Draft Law. Under the Draft Law, finance leasing is defined as a "business whereby a Lessor purchases property from a Supplier based on the Lessee's selection [or approval] of Supplier and property, and, whereby the Lessor leases to the Lessee, pursuant to a finance lease, the right to possess and use the property in consideration of a lease payment for a minimum term of one year". Generally, these definitions are less conclusive and clear than those of Article 2A of the Uniform Commercial Code.

TRANSACTIONS BETWEEN RELATED PARTIES

The CBRC Measures introduce strict rules on connected transactions, whereby any such transaction must be in accordance with commercial principles at terms no more favourable than those given to non-connected parties for similar transactions. As a general principle, the FLC must establish a "sound connected transactions management system", which must include such features as a reporting mechanism, pricing policies, and connected transactions approval procedures.

Under the CBRC Measures, material connected transactions require the approval of non-interested directors at a meeting of the Board of Directors. A "material connected transaction" is defined as any single transaction between the FLC and a Connected Party [including a shareholder] involving an amount in excess of 5% of the net capital of the finance leasing company or any transaction in which, following the transaction between the FLC and the connected party, the transaction balance between them will account for more than 10% of the net capital of the company. Net capital refers to the company's worth minus deductions taken for non-convertible assets.

These rules on connected transaction will have practical impacts on foreign-invested FLCs established by manufacturing companies for the purpose of providing consumers with more financing flexibility. Under such a scenario, the FLC would purchase the products from its Principal Investor. This rule on connected transaction could act as a deterrent for large manufacturers considering establishing a CBRC FLC. Other provisions of the CBRC Measures which could act as a disincentive are rules preventing a CBRC FLC to have overly concentrated transactions with a single client or connected party.

NO ACCELERATED DEPRECIATION

Accelerated depreciation may allow more flexibility in matching repayments with the useful life of the asset. In many cases a new asset may not produce cash flow immediately or regularly. Knowing how and when the asset will generate income will help the lessee determine the best way of paying for it. The lessee doesn't want to continue paying for an asset long after its useful days are over. Alternatively, the lessee doesn't want to be paying off an asset too quickly and putting unnecessary strain on its cash flow.

Under the Enterprise Income Tax Law [effective as of January 1 2008], a lessee will be allowed to deduct from its taxable income depreciation expenses incurred on assets rented under a finance lease. The rental payments may, in certain circumstances, be tax deductible if the leased assets are treated as an operating expense [if the asset is used to generate income]. However, the EIT Law does not allow accelerated depreciation. If accelerated depreciation is not allowed, the FLC will not be able to request a "balloon payment" [a higher rent early in the lease] mitigating its risk in the residual value of the leased asset.

It should be noted that accelerated depreciation is allowed under Article 48 of the Draft Law. It will also be interesting to see how the EIT Law restriction will dovetail with local rules. For instance, enterprises located in Tianjin are free to select the accelerated depreciation rate [up to 40% the useful life of fixed assets except real estate property] and register their choice with the taxation authority.

UNPREDICTABLE REGULATORY ENVIRONMENT

In addition to the CBRC Measures and the MOFCOM Measures, the FLC's financial leasing operations will principally be governed by Chapter 14 of the PRC Contract Law(中华人民共和国合同法), which governs the rights and obligations of lessors and lessees parties to financial leasing contracts. The Contract Law [and, when and if promulgated, the Draft Law] will apply to finance leasing operations conducted within China, with the exception of finance leasing of property to individuals or family units. Under PRC law, parties to a finance lease agreement involving a "foreign element" [for instance, a contract to which a foreign entity is a party] may choose the law applicable to the settlement of their contractual disputes. Parties to finance leases not governed by PRC law will have to consider PRC registration requirements if the leased property is located in or transits through China.

The Draft Law is expected to be promulgated before the end of 2007, although it is unclear whether it will take the form of a new law or an amendment to the PRC Contract Law. The Draft Law introduces new rules that will need to be considered in conjunction with the PRC Contract Law. In case of discrepancies between the Draft Law and the PRC Contract Law, it is unclear which one will prevail, since both will have been promulgated by the NPC.

Another example of regulatory uncertainty is the contradiction between the PRC Contract Law and the Draft Law on defaults under the finance lease. Under the Draft Law, if the Lessee fails to pay rent in accordance with the conditions of the finance lease agreement, the Lessee's default must amount to 20 per cent of the total lease price for the Lessor to have the right to ask for the balance of lease rentals, or alternatively, terminate the finance lease agreement, repossess the leased property and ask the Lessee to compensate for losses suffered as a result of the late payment. This provision of the Draft Law conflicts with the PRC Contract Law, which does not impose conditions on the Lessor's right to ask for the entire lease payment. This provision also contradicts or cuts across standard "hell and high water clauses" whereby the Lessee must continue to pay the finance lessor whatever happens.

CONCLUSION

The CBRC and MOFCOM regimes serve different purposes, and there is room for them to coexist, at least for the time being. On one hand, foreign investors simply looking to complement their manufacturing capacity with leasing services will keep opting for the "road-tested" MOFCOM FLC vehicle. On the other hand, the CBRC regime has already gathered a lot of attention from large financial institutions looking to develop finance leasing in China. However, it may take time before the regime fully opens up to foreign investors. Despite the pressure exerted by the CBRC on China's banks to establish Financial Institution FLCs, the CBRC referred to applications by these Chinese banks as pilot projects, and indicated that it would only consider new applications after these experiments are under way.

The entry of more FLCs on the Chinese market will have positive impacts on business. Clients of FLCs will be able to better manage cash flow, conserve capital expenditure and improve asset management. SMEs will have more finance options to upgrade assets, keep up with new technologies, and maintain the upper hand against competitors. For large manufacturers relying on sales of equipment and advanced technologies, the FLC can act as a facilitator and a new revenue stream.

Endnote

1. Under Articles 5 and 6 of the Investments in China by Foreign-invested Enterprises Interim Provisions [jointly issued by MOFTEC and the SAIC and effective since September 1 2000], an FIE's aggregate amount of inter-company investments was not allowed to exceed 50% of the FIE's net assets. The SAIC clarified in April 2006 [in a Circular jointly issued with MOFCOM] that it would no longer implement this restriction.