Powering up China's power industry

PricewaterhouseCoopers examines structural reform in China''s power industry and the implications for foreign investors.

Despite the global economic downturn, China's economic growth has maintained a strong momentum, benefiting from the government's policies for spurring domestic demand. As an indispensable fuel for economic development, power demand has also been growing rapidly.

Aiming to power up the once highly regulated and monopolistic power industry and support future economic development, the State Council recently approved a long-awaited structural reform plan for the industry. To ensure successful investments in the PRC power industry, it is imperative for foreign investors to obtain a thorough understanding of the relevant PRC governing regulations as well as the trend for the China power industry going forward.

A shut door to state-owned power assets

The China power industry has long remained as an industry monopolized by state-owned enterprises. To break up the monopoly and encourage competition, the State Council launched preliminary reform of the industry in 1998. However, in order to ward off bargain sales of state assets in the local level, new regulation was released two years later banning all forms of restructuring and sale of state-owned power assets unless otherwise approved by the State. As a result, foreign investors are prohibited from further acquisitions of state-owned power assets.

May reform reopen the door?

After a four-year pilot reform programme, the State Council approved a long-awaited power industry structural reform plan in April, which kicks off a new round of interest redistribution in the industry.

The reform encompasses four key measures: segregate power generation and transmission operators, implement price competition for power operations, break up monopoly and encourage competition. As a key step, the reform calls for power generation and transmission assets previously held under the State Power Corporation to be restructured and redistributed among several large-scale power generation and transmission group companies nationwide. These group companies will either take the form of limited liability companies or joint stock limited liability companies.

By segregating the power generation and transmission operators, power generators will have to compete in prices at which power is sold to transmission operators. Nonetheless, the reform has not touched the pricing mechanism for power transmission and end sales - an arena still monopolized by power transmission operators.

The new reform will inevitably entail significant restructuring within the industry. Hence, it is anticipated that foreign investors may not be allowed to resume their acquisition of China power assets until the segregation of generation and transmission operators is duly implemented. Upon the completion of the reform, it is anticipated that more modes of entry may become available to foreign investors.

Modes of entry for foreign investors

Under the new "Foreign Investment Industry Directive Catalogue" ("the New Catalogue"), power transmission is still a prohibited area for foreign investment. Out of the seven types of power projects classified under the "Encouraged" category pursuant to the New Catalogue, only nuclear project requires majority stakeholdings by the Chinese party, no restrictions as to the extent of foreign ownership are stated for the other types.

As for the thermal power project, since China has perceived itself entering into a new phase of large-scale power generation and transmission as well as automation, only thermal power projects with single-generator capacity of at least 300,000 kw/h are classified under the "Encouraged" category.

Investment vehicle

Currently, foreign investors commonly use two forms of legal entities as the vehicle for investing in the China power industry, namely foreign invested limited liability company or foreign invested joint stock limited liability company:

1. For investing in new power projects, foreign investors may consider setting up a wholly foreign owned limited liability company or a Sino-foreign joint venture limited liability company. For acquisition of existing power assets, the legal status of the target company after acquisition is subject to the percentage of interests acquired.

2. With respect to foreign invested joint stock limited liability company, foreign investors may (1) set up a fresh new joint stock limited liability company with a Chinese partner or (2) acquire the non-publicly traded shares of an existing joint stock limited liability company or invest in the non-public traded shares of an existing joint stock limited liability company by way of additional share offerings. Regardless of the types of investment vehicles used, the foreign ownership should represent over 25% of the total registered capital in order for the company to be eligible for the treatments available to a foreign investment enterprises.

As a result of the structural reform and practical restrictions, foreign investment has mainly taken the form of new construction of plants under the set up a new Sino-foreign equity joint venture limited liability company (though recently, several projects took the form of joint stock limited liability company). Upon completion of the segregation of power generation and transmission operators, it is expected that there will be more business opportunities for foreign investors.

Merger and acquisition

Foreign investment in the Chinese power industry may take two ways: investment in new power projects and investment by merger and acquisition of existing projects. For both types of investment, approvals must be sought from the relevant authorities. For the second type, the following tax and business factors should be taken into account:

Merger and acquisition typically involves asset or share deal. Under a typical share deal model, the foreign investor acquires the equity interest of the Chinese target company from the seller. The target company will remain as a going concern and thus the foreign investor will inherit all tax and business risks associated with the target company. A financial and tax due diligence review is recommended before the signing of the Sales & Purchases Agreement.

A typical asset deal model involves the formation of a new company or use of an existing company to acquire the selected assets, liabilities and commercial operations of the target business. Under an asset deal, the translation costs may be high where there is land.

However, foreign investors may still prefer to form new company to take over the business operations to minimize their exposures to any inherent tax and business risks, hidden or contingent, that may be associated with the target company. Moreover, if customs duty is delinquent on the original importation or upon transfer of assets by the seller, the buyer could still inherit the tax risk associated with the assets transferred.

The adoption of an asset deal or a share deal for an acquisition in China largely depends on the regulatory situations, as well as the commercial and tax objectives of the investors. In both cases, the tax implications in the deal should be carefully evaluated and tax planning is essential in maximizing the tax opportunities which may arise from such an acquisition as well as to manage the tax exposures associated with the merger and acquisition transactions.

Tax and regional incentives for power investments

National Tax Incentives

The New Catalogue basically categorizes power projects under the "Encouraged" category. From a macro perspective, foreign investors can, based on the New Catalogue, pursue investment opportunities nationwide. With respect to tax incentives, apart from the typical tax incentives applicable to foreign investment productive enterprises, foreign investors engaging in power projects are also eligible for a reduced 15% income tax rate nationwide starting from year 1999 upon obtaining approval from the State Administration for Taxation.

West-East Power Project

If investors are interested in exploring the central and western region of China, they should identify specific areas the local government which promote and encourage the development of power industry. In order to promote the economic development in the region, the central government has implemented a so-called "West-East Power Project", which aims at transmitting electricity from the energy-abundant Central and Western region to the energy-hungry Eastern region.

Depending on local environments, some areas in the central and western region did not include all or part of the power projects into the Favourable Industries Catalogue. This may increase the foreign investors' difficulty in obtaining relevant approval in these areas.

For instance, only three areas, namely Shanxi province, the Inner Mongolia autonomous region and Henan province, included thermal power project into their Favorable Industries Catalogue. Further, twelve out of the twenty provinces / autonomous regions / municipalities in the central and western region had not included any kind of power projects in the Favourable Industries Catalogue.

Other considerations

Some of the above incentives have been traditionally only available to foreign investment enterprises (FIEs). With the emergence of foreign invested joint stock limited liability companys, there are concerns whether such companies are entitled to the same tax incentives as those applicable to FIEs. Based on the principles set out in Circular Guoshuifa [1993] No. 87, the State Administration for Taxation basically holds the opinion that: -

1. For enterprises that are approved to be transformed to foreign invested joint stock limited liability company for the purpose of B share or overseas listing, the company would not be eligible for tax incentives applicable to FIEs

2. For an FIE transformed into a joint stock company (including listing), regardless of whether it is transformed into a foreign invested joint stock limited liability company or not, it will continue to be eligible for the unexpired tax incentives; and

3. For joint stock limited liability company newly established by foreign investors or that acquired by foreign investors through purchase of non-publicly traded shares or by additional share offering, the company will be eligible for tax incentives applicable to foreign investment enterprise so long as the foreign ownership represents over 25% of the total registered capital of the company.

Kai Jiang, Manager, China Tax Division, PricewaterhouseCoopers

Email: [email protected]

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