Legislation attempts on foreign VC firms in China
(chinadaily.com.cn)
Updated: 2004-04-08 16:20

Below is the summary of a speech byXiaohu Ma, partner of Morrison & Foerster LLP, at the forum.

I. Origins of PRC venture capital model

1985“Venture Capital” first mentioned in the Decision of Revolution on Scientific Technology by the central government in 1985. Investment activities by private and foreign investors accelerated the development of the model.

1999-2001A surging technology sector caused private and foreign investors to significantly increase their VC investment activity in the PRC.

Three types of VC investment activity in PRC：

━Investments by Offshore funds under the overseas operational structure

━Investments made by holding companies established by foreign investors

━Investments by domestic venture capital funds (quite rare in practice)

II. Domestic regulation first appears at local level

Promotional effects of local venture capital legislation

Shenzhen- “Tentative Regulations on Investment of High and New Technology Industry by Venture Capital” (October 2000)

━Concept of “Venture Capital” defined: investment in equity interests of technological and fast-growing venture capital enterprises through assets transfer so as to obtain profits

━Corporate Form: Limited Liability Company & Stock Limited Company

━Conditions for Establishment, Business Scope and Capital Repatriation Mechanisms of Venture Capital Enterprise         

Beijing- Administration Regulation on Limited Partnership (February 2001)

━Introduced the limited partnership form and clarified the establishment requirements for the first time

━Permitted the establishment of  venture capital “institutes” in the form of limited partnership

━Limitations of local venture capital legislation

Restricted by the existing PRC legal framework

Without the support of uniform state laws on limited partnerships and investment companies, it is difficult for local legislation to operate in practice

III.  National Legislation on Foreign-Invested Venture Capital Investment

Legislation Governing Investment: Based on existing laws regulating PRC foreign investment

The Law of Chinese Foreign Equity Joint Ventures of PRC and its implementing regulations ?The Law of Chinese Foreign Cooperative Joint Ventures of PRC and its implementing regulations

The Law of Wholly Foreign-Owned Enterprises of PRC and its implementing regulations

Other regulations in relation to foreign investment

Legislation Governing Formation of Venture Capital Enterprise

2001 Tentative Rules on Forming Foreign-Invested Venture Capital Investment Enterprises (the “2001 Tentative Rules”)

━Innovation: Enables Chinese and foreign investors to co-invest in a Venture Capital Enterprise to be managed by foreign fund management experts

━Drawbacks: High threshold on investment, stringent investor qualified requirements, restrictive capital repatriation rules, difficult reinvestment mechanics, unresolved tax issues

2003 Regulation on the Administration of Foreign-Invested Venture Capital Enterprises (the “2003 VC Regulation”)

IV. Current PRC legal framework restricts the development of Venture Capital

1. Limited Partnership

Existing legal status of limited partnership unclear

2.Restriction on investment made by a company

Without government approval, the investment cannot exceed 50% of a company’s net assets

3.Foreign Invested Holding Company may not operate as VC fund

Foreign Invested Holding Company can only be used by long-term strategic investors

4.Taxation system and other preferences not favorable compared with international venture capital regimes

5.Restriction on payment of registered capital

The law requires one-off contribution or by installment within 5 years and there is no provision for capital calls on an as-needed basis

6.Restriction on Capital Repatriation Mechanisms

No capital repatriation mechanisms provided by existing laws and regulations

V. Analysis and suggestion of existing PRC foreign-invested venture capital laws

1. Based on existing legal framework

2. Innovation and legislative breakthroughs

3. Challenges and opportunities for improvement

V.1 Based on Existing Legal Framework

PRC foreign investment laws:

The Law of Chinese Foreign Equity Joint Ventures of PRC

The Law of Chinese Foreign Cooperative Joint Ventures of PRC

The Law of Wholly Foreign-Owned Enterprises of PRC     

Designed for the purpose of facilitating long-term strategic investment commitments — not short-term, venture capital investments

Other relevant foreign investment regulations

V.2 Innovative Provisions and Legislative Breakthroughs: “2003 VC Regulation”

1) Non-legal Person Venture Capital Enterprise

2)Three Capital Repatriation Methods

3) Elimination of Restriction on Investment of more than 50% of Net Assets

4) Reduction of Investment Threshold

5)Contribution, Capital Reduction, Contribution Transfer, and Investment Repatriation 6)Venture Capital Management Enterprise

7)Taxation

V.2 Innovative Provisions and Legislative Breakthroughs: “2003 VC Regulation”

1) Non-legal Person Venture Capital Enterprise

Form:

a. Investors jointly and severally liable

b. Only principal investors bear unlimited liability. 

Remaining investors liable is limited to the extent of their invested capital The non-legal person enterprise may be established under the Law of Chinese- foreign Cooperative Enterprise of PRC, however, there is little practical experience

3) Three capital repatriation methods 

Exit from overseas capital market

Share transfer to a third party in PRC

Share redemption by the invested enterprise

V.2 Innovative Provisions and Legislative Breakthroughs: “2003 VC Regulation”

3)Elimination of Restriction on Investment of no more than 50% of Net Assets

 “2003 VC Regulation” permits VC enterprise to invest all of its capital

5) Reduction of investment threshold

Amount of registered capital:

━“2001 Tentative Rules”: US$25,000,000 (minimum capital commitment of each of foreign investor is US$1,000,000)

━“2003 VC Regulation”:   Non-legal Person VC Enterprise: US$1,000,000 

Company VC Enterprise: US$500,000

Capital contributed by Foreign Investors may be less than 25% of total committed capital

V.2 Innovative Provisions and Legislative Breakthroughs: “2003 VC Regulation”

Principal Investor Qualifications Reduced: qualitative requirements of Investor may be met by such investor’s affiliates

Investment Ratio of Principal Investor:

━Non-legal Person VC Enterprise: not less than 1% of the VC Enterprise’s total committed capital and paid-in capital (decreased from 3% under “2001 Tentative Rules”)

━Company VC Enterprise: not less than 30% of the VC Enterprise’s total committed capital and paid-in capital

V.2 Innovative Provisions and Legislative Breakthroughs: “2003 VC Regulation”

5)Capital Contribution Reduction, Transfer of Registered Capital, and Repatriation of Capital

Capital Contribution: Distinction between paid-in capital and committed capital

━Non-legal Person VC Enterprise: Elimination of requirement for the first installment of not less than 15% of the registered capital to be paid within 3 months after issuance of business license

━Injection by installments permitted: 3 years—5 years?Capital Reduction:

━Non-legal Person VC Enterprise: consent of majority of investors, Principal Investor and MOFCOM required?Transfer of Registered Capital:

━Transfer by Principal Investor: consent by more than 50% of investors, revised contract and articles to be submitted to approval authority for approval

━Transfer by other Investors: in accordance with contract revised contract and articles to be submitted to approval authority for filing

Repatriation of Capital: no prior approval necessary, only filing required

V.2 Innovative Provisions and Legislative Breakthroughs: “2003 VC Regulation”

Venture capital management enterprise

Internal management

Non-legal Person VC Enterprise: Joint management committee

Company VC Enterprise: Board of Directors

Exterior management

the overseas company permitted to manage the Chinese VC enterprise as management enterprise

Taxation

V.3 Challenges and Opportunities for Improvement

1) Restrictions on Company VC Enterprise

Company VC Enterprises are limited by the existing company system and provisions of company laws of PRC, and unable to adopt innovative provisions regarding taxation and capital repatriation of limited partnership VC enterprises

3) Resolution of VC enterprise taxation issues within the existing tax legislation framework

Avoidance of Double Taxation: as a limited liability partnership no tax to be paid on realization of investment, tax is to be paid on distributed profit and return on investment

Taxes on Capital Increase: issues concerning taxation on profits made from investor disposal of equities

3) Redemption of equity interest in VC enterprise

Requirements and Procedures to be clarified

4 Procedural differences between filing, examination and approval

Standards for filing, examination and approval procedures remain unclear

5) Coordination and supervision over the enforcement of law by different governmental departments

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