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China Private Equity Summit
The 2003 Venture Capital Rules – An Overview
July 11, 2003
Alan Seem, Shearman & Sterling LLP, Hong Kong Office
Introduction
Administration of Foreign-Invested Venture Capital Investment
Enterprises Provisions (the “New VC Rules”):
were jointly issued on January 30, 2003 by:
• the Ministry of Foreign Trade and Economic Cooperation
(“MOFTEC”);
• the Ministry of Science and Technology (the “MST”);
• the State Administration for Industry and Commerce (the “SAIC”);
• the State Administration of Taxation (the “SAT”); and
• the State Administration of Foreign Exchange (“SAFE”).
became effective on March 1, 2003
supersede the Establishment of Foreign-Invested Venture Capital
Investment Enterprises Tentative Provisions that were jointly issued by
MOFTEC, the MST and the SAIC on August 28, 2001 (the “Old VC
Rules”).
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Introduction
The New VC Rules:
institute a modified framework for the establishment and
administration of foreign-invested venture capital investment
enterprises (“FIVCIEs”) in the PRC;
reflect the efforts of the PRC government to develop new legal
vehicles for foreign investment based on the PRC’s existing
foreign investment regime;
were formulated by the PRC government after taking into
account input from various sources, including foreign fund
managers and advisors; and
represent a substantial improvement over the Old VC Rules from
the standpoint of investors and venture capital fund managers,
but significant issues still remain.
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Introduction
FIVCIEs:
were created under the Old VC Rules to facilitate
foreign investment principally in unlisted high and
new technology enterprises in the PRC; and
provide an easier way for foreign fund managers to
access capital for investment from PRC sources.
However, due to uncertainties and certain burdensome
restrictions contained in the Old VC Rules, no foreign
investors took advantage of the Old VC Rules to
establish a FIVCIE.
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Legal Form of a FIVCIE
There are two options when establishing a FIVCIE:
a non-legal person entity – a partnership-type
enterprise such as a non-legal person cooperative
joint venture (a “Non-Legal Person FIVCIE”); or
a limited liability company, such as an equity joint
venture, legal person cooperative joint venture or
wholly foreign-owned enterprise (a “Corporate
FIVCIE”).
The term of the FIVCIE generally should not exceed 12
years, and may be extended with governmental approval.
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Requirements for Establishing a FIVCIE
Between 2 and 50 investors (inclusive), including at least one
“mandatory” or “requisite” investor;
Investors in the FIVCIE can be both PRC and foreign entities or
foreign individuals (not PRC individuals);
For Non-Legal Person FIVCIEs, the potential liability of all the
investors will be joint and several, except if agreed in the contract of
formation of the FIVCIE that the liability of non-requisite investors
is to be limited to the amount of their respective capital
commitments;
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Requirements for Establishing a FIVCIE
Each FIVCIE must have at least three professional personnel who
possess venture capital investment experience (unless its activities
will be contracted to a venture capital investment management
company);
Minimum aggregate investment of US$10 million for Non-Legal
Person FIVCIEs or US$5 million for Corporate FIVCIEs; and
Minimum capital contribution requirement for each investor is US$1
million, except requisite investors, which must contribute in the
aggregate:
for Non-Legal Person FIVCIEs, at least 1% of the total committed
and contributed capital; or
for Corporate FIVCIEs, at least 30% of the total committed and
contributed capital.
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Qualifications of a Requisite Investor
Venture capital investment must be such investor’s main business;
During the three years preceding the application to establish the
FIVCIE, such investor must have had cumulative capital under
management of at least:
for foreign investors, US$100 million, at least US$50 million of
which was used to make venture capital investments; or
for PRC investors, RMB100 million, at least RMB50 million of
which was used to make venture capital investments;
For Non-Legal Person FIVCIEs, the requisite investors will be
jointly and severally liable for the obligations of the FIVCIE (similar
to a general partner of a limited liability partnership);
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Qualifications of a Requisite Investor
Must have at least three professional management
personnel who possess at least three years of
experience in venture capital investing; and
Must not have been prohibited from engaging in
venture capital or investment consultancy business or
penalized for commitment of fraud in its home
country.
These requisite investor requirements may also be
satisfied through the qualifications of an affiliate of
such investor.
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Approvals Required for Establishing a FIVCIE
Application must be made to the relevant provincial level
commission of foreign trade and economic cooperation
(“COFTEC”), which will review the application materials and
forward them to the Ministry of Commerce (the “MOC”) within
15 days.
The MOC (upon consultation with and approval from the MST)
is then required to complete its review and decide whether to
issue an approval certificate for the FIVCIE within 45 days.
Once the approval certificate is obtained, the FIVCIE must
register with the SAIC or the relevant provincial level
administration of industry and commerce, as the case may be,
within one month to obtain a business license.
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Capital Contributions, Reductions and Withdrawals
For Non-Legal Person FIVCIEs:
Investors must contribute capital in installments based upon
the progress of the venture capital investments made by the
FIVCIE and must complete their capital contributions
within a maximum period of five years;
capital may be reduced with the approval of investors
representing more than 50% of the total contributed capital
(including the requisite investor(s)) and the relevant
examination and approval authority and so long as such
reduction does not cause the FIVCIE to be in violation of
the US$10 million minimum subscribed capital
requirement;
additional investors may be admitted upon consent of the
requisite investor(s);
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Capital Contributions, Reductions and Withdrawals
For Non-Legal Person FIVCIEs (cont.):
no withdrawal of a requisite investor is permitted without
approval of investors representing more than 50% of the total
contributed capital and the interest of such withdrawing requisite
investor must be transferred to a new requisite investor;
upon a sale or other disposition of an equity investment,
distributions up to the FIVCIE’s original amount of capital
contribution by the FIVCIE to such entity may be distributed
directly to the FIVCIE investors without any requirement for
further approval and will be recorded as a reduction in capital;
and
the method of distribution of capital is not specified under the
New VC Rules and may be agreed by the investors in the
FIVCIE’s contract of formation.
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Capital Contributions, Reductions and Withdrawals
For Corporate FIVCIEs, capital contributions continue to be
handled in accordance with existing provisions, which are
the rules under the relevant joint venture or wholly foreign-
owned enterprise laws.
13
Management Structure of FIVCIEs
Body responsible for managing the FIVCIE on behalf of the
investors is:
for Non-Legal Person FIVCIEs, the joint management
committee; and
for Corporate FIVCIEs, the board of directors.
Management personnel shall also be appointed to:
manage the FIVCIE on a day-to-day basis;
implement investment decisions made by the joint
management committee or board of directors; and
report to the joint management committee or board of
directors (as applicable) regarding important matters, as
specified in the New VC Rules.
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Management Structure of FIVCIEs
Managerial and operational responsibilities may also be
contracted out to a venture capital investment management
enterprise incorporated within or outside the PRC, subject to the
approval of all investors and the relevant examination and
approval authority.
The New VC Rules also contain provisions relating to the
requirements and procedures for establishing a venture capital
investment management enterprise.
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Permitted Scope of Business of FIVCIEs
The permitted scope of business is as follows:
equity investments using its own capital, including for the
establishment of new enterprises, subscribing for equity interests
in existing enterprises, acquiring equity interests in existing
enterprises, and any other form of investment permitted by
applicable laws and regulations;
providing consulting services relating to venture capital
investment;
providing management consulting services to investee
enterprises; and
conducting other businesses approved by the relevant
examination and approval authority.
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Permitted Scope of Business of FIVCIEs
Investments must comply with the Guiding the Direction of
Foreign Investment Provisions and the Foreign Investment
Industrial Guidance Catalogue.
FIVCIEs may invest in “encouraged” and “permitted” industries
without further approval and may invest in “restricted”
industries with approval from the provincial COFTEC.
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Prohibited Activities
The following activities are not permitted:
investing in industries that are not open to foreign investment as
determined by the PRC government;
investing, directly or indirectly, in publicly traded stocks and
corporate bonds, except for shares that are acquired in an investee
enterprise prior to its public listing;
investing, directly or indirectly, in real estate other than for self-
use;
borrowing to make investments;
using funds of entities or individuals other than its investors to
make investments;
extending loans or guarantees, except for corporate bonds with at
least one year's maturity and convertible bonds issued by an
investee enterprise of the FIVCIE; and
any other activity prohibited by laws, regulations or contract.
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Tax Treatment of Investee Enterprise
An investee enterprise will be entitled to preferential tax
treatment as a foreign-invested enterprise if the actual capital
contribution held by foreign investors of the investing
FIVCIE or the combined equity percentage of foreign
investors of such FIVCIE and all other foreign investors in
such investee enterprise is at least 25% of the investee
enterprise's registered capital.
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Exit Mechanisms
Exit mechanisms specified in the New VC Rules include the
following:
entering into a repurchase agreement pursuant to which the
investee enterprise will repurchase the equity interest held by the
FIVCIE;
listing of the investee enterprise on a domestic or foreign stock
exchange and selling the shares in such investee enterprise
through such stock exchange;
transferring to other investors all or any part of the FIVCIE’s
equity interest in an investee enterprise; and
other mechanisms permitted by PRC laws and regulations.
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Exit Mechanisms
Return of the original capital contributions received by foreign
investors from a FIVCIE may be remitted out of the PRC by
purchase of foreign exchange in accordance with the law.
The opening and use of foreign exchange accounts, capital
adjustments and other foreign exchange receipts and payments
of a Corporate FIVCIE are to be handled in accordance with
existing foreign exchange administration regulations.
Foreign exchange regulations relating to Non-Legal Person
FIVCIEs will be subsequently promulgated by SAFE.
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Significant Changes Vs. Old VC Rules
The New VC Rules:
provide for a longer maximum investment period (five years) for
Non-Legal Person FIVCIEs, compared to three years under the
Old VC Rules;
significantly lower and simplify the minimum investment
requirements (both aggregate and for each investor) for FIVCIEs;
allow for investment into investee enterprises in “encouraged”
and “permitted” industries without additional approvals;
specifically allow for subcontracting to venture capital
investment management companies, and provide guidelines for
their establishment.
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Significant Changes Vs. Old VC Rules
The New VC Rules (cont.):
no longer require that 25% of the capital contributions be made
by foreign investors;
include the new concept of a “requisite investor”, and allow the
requisite investor qualifications to be met by an investor’s
affiliate. This allows foreign investors to establish a special
purpose subsidiary to serve as the requisite investor, which can
help shield the parent company from liability; and
provide that FIVCIEs only are required to report to the relevant
examination and approval authority on an annual basis, instead of
semi-annually as under the Old VC Rules, and reduce the scope
of required reporting.
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New Tax Circular
On June 4, 2003, the SAT issued a notice regarding taxation of
FIVCIEs, which notice:
is effective as of March 1, 2003;
confirms the provisions in the New VC Rules that state:
Corporate FIVCIEs will be subject to PRC enterprise income
tax; and
investors in Non-Legal Person FIVCIEs may choose to declare
their income and pay enterprise income tax either separately or
jointly.
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New Tax Circular
The new tax circular further provides that:
if Non-Legal Person FIVCIE investors elect to declare and pay
taxes individually, the foreign investors among them will be
subject to enterprise income tax as if they had a permanent
establishment in the PRC (subjecting them to a rate of 33%); and
foreign investors in Non-Legal Person FIVCIEs that subcontract
their investment management activities to third parties will be
taxed as if they do not have a permanent establishment in the
PRC, which would usually amount to a 10% withholding tax.
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Remaining Issues
The New VC Rules:
are a significant improvement over the Old VC Rules;
help to facilitate access to capital for investment from PRC
entities; and
streamline the approval process for investments and
divestments by FIVCIEs in PRC investee enterprises.
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Remaining Issues
However, remaining issues include the following:
the tax issues highlighted above;
the comparatively high level of review and approval by the PRC
government with respect to most aspects of establishing or amending
the structure and composition of a FIVCIE;
the continued prohibition on funding investments through borrowing;
the five-year investment period may still be too short for sourcing
and evaluating enough investments to utilize all committed capital;
the lack of legal certainty regarding limited liability protection when
investing in a Non-Legal Person FIVCIE; and
investors in Corporate FIVCIEs will still be subject to the relatively
inflexible foreign-invested enterprise laws. 93046.1
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THANK YOU!
Alan Seem
alan.seem@shearman.com
Tel: (852) 2978-8082
Fax: (852) 2978-8099
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