Round-trip investments key to reversing FDI decline

Circulars 50 and 51 were issued on August 11 2008, with investors in private equity and retail among the biggest benefactors. Then on March 5 and 6 this year, Mofcom issued two new sets of guidelines further streamlining the process for approval of foreign investments.

One of the key developments came from Circular 8, which expanded the previously set project caps to include holding companies. Now, unless investments in holding companies exceed US$100 million for encouraged projects, or US$50 million for restricted projects, foreign investors need not apply to Mofcom for approval but can go directly to local authorities.

“In practice US$100 million is not a lot of money,” said Paul Weiss partner Jeanette Chan. “But they've decided it's the right cut-off, whether you're a trading company or a holding company.”

The move to hand down power is part of a bigger strategy driven by a State Council Notice issued in 2007 (Decision on Abolishing or Adjusting a Fourth Batch of Items Subject to Administrative Examination and Approval) that has generally been welcomed by practitioners.

Beijing-based AT&T chief counsel Andrew Starger said: “Normally you do everything you can to avoid the Beijing approval process so I think [the circulars] will be welcomed.”

B&Q China general counsel Thomas Hsu added: “It would have to speed up the approval process so the circulars will certainly benefit a lot of manufacturing businesses.”

Pointing to the length of time it often takes to secure approval from Mofcom, Freshfields Bruckhaus Deringer partner Carl Cheng agreed, adding: “In contrast, the local guys are doing somersaults to get your deals approved.”

Measures employed by provincial authorities to attract foreign investors include simplifying the procedure for approval on foreign-funded projects and supporting trade tours to seal foreign-funded deals.

Welcoming the move to streamline the approval process, Qiang Li, a partner of O'Melveny & Myers in Shanghai, said that it demonstrated a certain level of confidence on the part of Mofcom that local agendas no longer conflicted with central policy.

“Mofcom is pretty confident with its own system and this trend shows that the recentralising efforts of the last few years … were largely successful,” he said. “Mofcom now has the confidence that the system needs to be re-decentralised.”

But there are other, more convenient, reasons for delegating powers to lower-level authorities, such as the fact that Mofcom does not have the manpower to cover everything it is mandated to cover. One explanation for this has been the recent government investigation into high-level corruption, which has led to half a dozen officials being forced to step down and detained on bribery charges.

“China is trying to shrink the size of central government,” said Chan, “and it doesn't want Mofcom to have too much authority so it is trying to reduce its budget.”

She added: “No government official in my view likes to give up power, or is that convinced that someone else can do the job better. So I'm not sure that delegating powers to lower level authorities is done out of any sense of confidence. It has more to do with pressure from the State Council over streamlining investment, as well as simply being over-worked.”

While the Mofcom circulars are a step in the right direction, Chan argues that further changes are needed to the Foreign Investment Industrial Catalogue – so that those industries that are prohibited become restricted, and those restricted become encouraged.

But Li said that tweaking the regulatory process will not in itself drive deal flow. “There has been a deleveraging process going on whereby many Chinese arms of multinationals have had to take cash back to their home countries in order to save the mother-ship.”

He added: “The one big question mark is over round-trip investments and whether Mofcom will now approve them.”

Chinese entrepreneurs previously favoured round-trip investments (see box: Merits of round-trip investments) because provincial governments were happy to approve them. Many red-chip IPOs were completed this way, but these were not taxable under PRC law and the Chinese government became increasingly uncomfortable with them, preferring that the parent companies of domestic companies were Chinese so that it could monitor their shareholdings, control foreign currency flows and secure tax revenues.

In September 2006, the central government implemented amended regulations on M&A by foreign investors. Under the regulations, central government approvals were for the first time required for all such deals. None have been forthcoming.

“But my guess is that Mofcom is now considering this,” said Li. “Once they feel comfortable that they have plugged this tax gap, they will start approving these deals.”

Mofcom's new outbound rules, which took effect on May 1, suggest that this view may be slightly optimistic – with the issue of round-trip investments and the use of special purpose vehicles clearly addressed in Article 6.

“It states that if you invest in a special-purpose vehicle overseas then, regardless of the amount, it needs Mofcom approval,” said Chan. “They think that round-trip investments are to do with money-laundering, so unfortunately I don't think that approval for these deals is going to happen soon.”

Merits of round-trip investments

Over the past couple of years, China has tightened its regulation of so-called round-trip investments. In a typical round-trip investment, a Chinese resident will establish or control an offshore holding company, and use this offshore company to control a Chinese company by either direct acquisition or captive contractual arrangement.

This type of restructuring has been used to facilitate private equity investments in Chinese companies and to prepare companies for offshore listings in Hong Kong, the US or elsewhere. They were called round-trip investments because the Chinese shareholder ended up receiving shares in the offshore holding company in order to indirectly own shares in his original domestic target company, which became a subsidiary (see Figure 1).

Traditionally it has been important for a Chinese company seeking international financing, to be structured as an offshore holding company in a common law jurisdiction (such as the Cayman Islands or Hong Kong) where the documentation and legal regime, including preferred share provisions, shareholder agreements and corporate governance, are more familiar to international investors. Doing this at the domestic Chinese company level was less attractive because of the less-developed state of Chinese law.