Practical implications of China's 25% or less rule

China''s Ministry of Foreign Trade and Economic Cooperation (Moftec) may have opened the gates for foreign investment in Mainland companies of 25% or less, but questions still remain on the practical implications of the rule change say Linklaters partners

On January 1 this year Moftec, in conjunction with other relevant Government departments, released Circular on Relevant Issues Concerning Strengthening the Administration of Examination and Approval, Registration, Foreign Exchange and Taxation Matters of Foreign Invested Enterprises..

In essence, the Circular implicitly provides that foreign participation in the registered capital of Sino-foreign equity joint ventures or cooperative joint ventures may be less than 25%. This is the first time that a Moftec rule has recognised the possibility of foreign entities holding less than 25% in such joint ventures. Interestingly, the Circular states that the examination, registration and approval procedures required for such an investment shall be identical to those where foreign participation is 25% or above.

Previously, applications for the formation of a less than 25% foreign-invested enterprise (FIE) were dealt with on an ad hoc basis by the administrative authorities, and such investments were rarely approved or registered, except in special industry areas.

A welcome result of the new rule change is that FIEs will be accorded some benefits previously only enjoyed by investors in a 25% stake or more. As the State Administration of Foreign Exchange (SAFE) jointly issued the Circular, distribution of dividends to foreign parties should become possible through foreign exchange banks without being subject to SAFE approval. FIEs should also now be able to open their own foreign exchange settlement bank accounts to hold current account foreign exchange income - only possible in limited specified circumstances for enterprises with no foreign investment.

While the Circular provides welcome clarification of the 25% investment rule, some of the implications of the new regulation may not be so welcome for foreign investors. For example, where a foreign entity is granted approval to invest in less than 25% of the registered capital of a joint venture, the FIE approval certificate and business license of the joint venture will both be affixed with the wording "foreign participation of less than 25%."

The practical implication of such wording is that FIEs will not be entitled to the tax exemptions or reductions normally enjoyed by enterprises with foreign investment of over 25%. Therefore, an FIE will not be entitled to the five-year corporate income tax exemption and reduction period, or possible exemption from duty and VAT on imported equipment for encouraged industry category investors, unless such treatment is granted under separate laws.

A further apparent disincentive to foreign entities investing less than 25% is that the time limits for payment of registered capital are significantly more restrictive than for larger investments. For example, where investors make their contributions in cash, such contributions must be made within three months of the business license being issued. These considerations will need to be seriously considered by foreign investors in weighing up the advantages and disadvantages of any mainland investment strategy.

The restrictions that currently exist with investments over 25% - such as their inability (with limited exceptions) to obtain full rights to import and distribute finished products, or to engage in the trading of finished products acquired domestically - will, in the absence of any liberalisation in this regard, also apply to the FIEs with less than 25% foreign investment.

Finally, those enterprises with foreign participation of less than 25% that existed prior to the implementation of the new rules should also be aware of their precarious situation. Such "retrospective" FIEs are required to undergo re-examination and approval within 6 months of the implementation of the Circular (i.e. before 1 July 2003). This seems to be a very onerous result for those investors who had previously managed to obtain extraordinary approval for such investments.

The new rules go a long way in helping to establish a more transparent and understandable FIE arena, by making it clear that foreign investors may choose to invest in less than the traditional 25% de minimis amount of the registered capital of a joint venture. While the consequences of making such a decision may be less than favourable for investors, the certainty which the Circular provides will allow for more informed and reliable decision-making as to appropriate foreign investment vehicles in China.

Peter Corne

Yuen Cheng

Leigh Schulz

Share our publication on social media
Share our publication on social media