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    Taking a hard line

2005-05-09 10:51

Residents of the Chinese mainland, along with certain foreigners and residents of Hong Kong, Macao and Taiwan, face more scrutiny, procedures and restrictions on various cross-border investments and related transactions under a recent crackdown by the State Administration of Foreign Exchange (SAFE).

The targets of the crackdown are investments abroad by domestic residents, round-trip investments back into China by foreign companies controlled by domestic residents, and all cross-border swaps of company shares or other assets.

The indirect effects of the crackdown are being felt by foreigners who co-invest with domestic residents.

In a related move, tighter supervision of management buyouts (MBOs) of State-owned enterprises has been discussed by the State Assets Supervision and Administration Commission (SASAC).

Foreigners and residents of Hong Kong, Macao or Taiwan, who have settled in the Chinese mainland, or even those who have been physically present in the mainland, continuously, for more than one year, appear to fall within the definition of "domestic residents" whose investments are covered by the new requirements.

It is widely hoped SAFE will move quickly to clarify that these persons' transactions are not covered by the new requirements.

The key public document underlying the crackdown is SAFE' s "Notice on Questions Concerning Perfecting Foreign Exchange Management over Foreign Investment M&A",which took effect last January 24.

SAFE's notice also requires increased scrutiny of foreign investment enterprises (FIEs) established in the past through mergers or acquisitions by foreign companies owned by domestic residents, during and after their handling of foreign exchange registration procedures.

Each local SAFE office must prepare detailed name lists of these FIEs, to ensure continued scrutiny.

This indicates, in contrast to the usual "grandfathering" approach to changing laws in China, the change is also directed at transactions completed before the new requirements were announced.

Going beyond the text of the notice, SAFE personnel have made informal verbal comments that the new approval requirements will apply to investments abroad using funds already held outside the People's Republic of China (PRC).

It remains unclear whether it is legal for domestic residents to receive foreign currency loans, in accounts outside the PRC, from foreign lenders, or whether SAFE approval is also required for this.

Implementation of rules may eventually clarify these points. Such rules are expected to be implemented after consultations involving SAFE and the Ministry of Commerce.

While the notice tightens control over Chinese individuals' transactions, which previously were not clearly regulated, the trend is different for Chinese companies.

Investments and acquisitions abroad by Chinese companies have long been subject to SAFE regulations, but the related rules have been streamlined in recent years, and many provincial-level SAFE offices have been delegated authority to approve transactions worth up to US$ 3 million.

Informal estimates indicate round-trip investments account for 20 per cent to 30 per cent of total foreign direct investment to China.

The nation's long-planned tax reform will reduce one of the attractions of round-trip investment if it eliminates or reduces the difference in income tax rates between foreign investment enterprises and domestically owned enterprises.

But there are other attractions of offshore joint ventures between domestic residents and foreign investors. Foreign investors often prefer buyout rights and other relations among shareholders to be governed by a foreign legal system.

Many offshore jurisdictions do not tax the gain from a sale of company shares. Managers' incentives can be strengthened through shares or share options in offshore jurisdictions.

Offshore jurisdictions also permit a high level of flexibility on public offerings of shares and other securities, including on timing, profitability requirements, percentage of public float, cash-out opportunities and creation of different classes of shares and/or other securities.

All of this continues to be difficult, or impossible, in China due to less-flexible regulations.

The Chinese Government is aware deregulation would attract more of this activity to China's market, but progress is being slowed by the need to balance many conflicting issues.

Local SAFE offices have stopped processing M&A applications received from foreign companies owned by Chinese mainland residents until they receive more guidance on how to implement SAFE's notice.

One result of this has been the delay of numerous planned offerings of "red-chip" securities, by Chinese-controlled foreign companies, on stock exchanges in Hong Kong or abroad.

Such offerings have become increasingly popular as a way to enjoy offshore benefits and to complete a public offering without going through the difficult approval and other procedures that apply to Chinese companies.

The current crackdown is the latest in a long history of policy adjustments. After a period of tightening, we may again see selective loosening.

In the meantime, Chinese residents, foreign investors and other players in cross-border transactions will need to pay close attention to the new requirements.

(China Daily 05/09/2005 page7)

 
                 

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