Capital accounts unlocked

On July 15 2014, the State Administration of Foreign Exchange (SAFE) issued the Circular on Issues Relevant to Launching a Pilot Project for Reform of the Administration Method for the Settlement of the Foreign Exchange Registered Capital of Foreign-invested Enterprises in Certain Regions (国家外汇管理局关于在部分地区开展外商投资企业外汇资本金结汇管理方式改革试点有关问题的通知) (Circular 36), which came into effect on August 4 2014. Circular 36 provides greater flexibility to foreign-invested enterprises (FIEs) in certain areas in China for converting foreign exchange in their capital accounts into renminbi, and particularly lifts the restriction on the use of funds from their capital accounts for onshore equity investments.

Strict rules for FIEs

As renminbi is not a fully convertible currency, FIEs are subject to foreign exchange control when conducting transactions with either their current or capital accounts. While conversion for current account items (such as payments for imported goods and services, loan interest payments and profit distributions) is relatively straightforward, capital account transactions (such as payment of registered capital, cross-border fund borrowings and debt repayments) are subject to more restrictions.

As a general rule, FIEs can only convert the foreign exchange in their capital accounts into renminbi and withdraw the converted funds on an as-needed basis. For each conversion and withdrawal, an FIE is required to provide various supporting documents showing the authenticity of the transaction to the bank for review and verification.

Furthermore, there are stringent rules on the purpose for which the converted renminbi may be used. The converted renminbi should only be used by FIEs in line with their approved business scope, for instance, for acquiring equipment and real property for self-use. Notably, FIEs are generally prohibited from using the renminbi converted from their capital account balance to make equity investments in other companies in China due to restrictions set out in the Circular on Operational Issues Relevant to Improving the Control of the Payment and Conversion of Foreign Exchange in Connection with the Foreign Exchange Capital of Foreign-invested Enterprises (关于完善外商投资企业外汇资本金支付结汇管理有关业务操作问题的通知) (Circular 142) issued by SAFE in 2008.

Through a notice issued in February 2014, SAFE introduced certain liberalisation measures to lift these restrictions on companies incorporated in the China (Shanghai) Pilot Free Trade Zone (Shanghai FTZ). The issuance of Circular 36, which mirrors the measures implemented in the Shanghai FTZ, is seen as a step to further relax capital account settlement in more locations across the country. Circular 36 applies to 16 designated pilot areas (see box).

Restrictions relaxed

Conversion-at-will

Under Circular 36, FIEs in the pilot areas may choose to convert any amount of foreign exchange in their capital accounts into renminbi at any time.

Once the foreign exchange is successfully converted, the currency will be kept in a designated renminbi account. Circular 36 does not require any supporting documents from FIEs for the conversion; however if an FIE needs to make further payment of the converted renminbi from the designated account, it still needs to provide supporting documents and go through the review process with the banks.

If under special circumstances an FIE cannot provide supporting documents in time, Circular 36 grants the bank the power to provide a grace period to the FIE and make the payment before receiving the supporting documents. The FIE will then need to submit the documents within 20 working days of payment.

It should, however, be noted that unless otherwise approved by SAFE, the converted renminbi cannot be converted back to foreign exchange and returned to the capital account.

Also, Circular 36 does not apply to foreign exchange loans borrowed by the FIEs. In this connection, if an FIE wants to convert any foreign exchange loans into renminbi, it still needs to provide supporting documents and go through the bank review process for each conversion and withdrawal.

While the above reform allows an FIE to convert the foreign exchange in its capital account at any time, the converted renminbi must remain in a designated account. The release of the funds from the designated account still requires the submission of supporting documents to show the purpose of use. The only benefit of this change is that an FIE may hedge its exchange risks since it may convert its foreign exchange into renminbi at any time when the exchange rate is favourable, without waiting until there is an actual use of the funds.

Use of the converted renminbi

Pursuant to Circular 36, FIEs are still required to use the converted renminbi within their approved business scope and may not use the renminbi to invest in securities; extend renminbi-entrusted loans or repay loans; and purchase real estate for non-self use (except for real estate FIEs).

As a key highlight of Circular 36, FIEs in pilot areas are allowed to use their converted renminbi to make equity investments in China (whether within or outside the pilot areas). Previously, due to the provisions of Circular 142, only FIEs with a primary business purpose of equity investments, such as holding companies, venture capital and private equity firms (Investment FIEs) were permitted to convert funds in their capital accounts for use in equity investments, while other FIEs (Non-investment FIEs), such as manufacturing companies were practically restricted from making equity investments unless they have sufficient renminbi income through their operations without the need to convert foreign exchange in their capital accounts into renminbi. The change brought about by Circular 36 potentially opens the door for foreign investors to set up investment platforms in the pilot areas to invest and hold equity interest in other companies in China.

Non-investment FIEs

However, given that FIEs are still required to use the converted renminbi within their approved business scope under Circular 36, two practical issues naturally remain for Non-investment FIEs:

First, whether the target companies should be restricted to those that have the same business scope as those of the Non-investment FIEs making the investment.

Circular 36 is silent on this point. However, currently a Non-investment FIE may, in practice, invest in companies which have a different business scope from its own, by using its operational income received in renminbi or converted into renminbi from foreign exchange in its current account. Therefore, by the same token, a Non-investment FIE should be able to invest in companies with any business scope under the Circular 36 regime.

Secondly, whether Non-investment FIEs need to expand their business scope to include “investment” before making equity investments.

It is possible that banks that process renminbi conversion will check whether "investment" is contained in the business scope of the Non-investment FIEs if these FIEs intend to use the converted renminbi to conduct investment activities. If so, the question is whether the approval authorities and the Administration for Industry and Commerce in the pilot areas will allow any company to include investment in its business scope. The answer to this is so far unclear. Unless the various government authorities can clarify their position on this question and remove the potential hurdles resulting from the lack of an investment business scope, the practical value of Circular 36 may be limited.

Investment FIEs

In addition, Circular 36 allows Investment FIEs to remit the converted renminbi from their capital accounts to invest in their portfolio companies.

Under the previous regime, Investment FIEs may only use foreign exchange in the capital account or renminbi profit and income obtained through business operation to invest in their portfolio companies, and if the Investment FIEs choose to invest with foreign exchange, the portfolio companies must register with the local SAFE and open a domestic reinvestment account with the bank to receive the investment. When the portfolio companies need to convert the foreign exchange in the reinvestment account into renminbi and withdraw the converted funds, they must provide supporting documents showing the authenticity of the transaction to the bank for each conversion and withdrawal.

The new regime under Circular 36 makes this process much easier, i.e. the Investment FIE may convert the foreign exchange in its capital account into renminbi and remit this currency to the portfolio companies' basic renminbi accounts for further use.

Burdens remain

Under the prevailing regime across the country, stringent control is still imposed on foreign exchange conversion by FIEs. However, recent legislative reforms have witnessed a gradual liberalisation process being rolled out by the Chinese government. Starting with the Shanghai FTZ, SAFE has provided foreign investors with more options and flexibility in the conversion and use of foreign exchange. Both the reforms implemented in the Shanghai FTZ and the newly introduced Circular 36 are positive signs which reflect the government's determination to reduce any unnecessary burden on FIEs, liberalising the conversion of foreign exchange funds and further pushing for the internationalisation of the renminbi.

On the other hand, uncertainties may still exist in practice which hinder FIEs, especially Non-investment FIEs, from benefiting from Circular 36. Operational guidelines or an official explanation on Circular 36 are therefore expected to soon be released to clarify uncertainties and resolve these practical issues.


Betty Tam and Lucy Yao, Mayer Brown JSM, Shanghai


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