Emerging Trends 07.27.20
Implementing China’s New Foreign Investment Law, Part One
While China’s Foreign Investment Law has established the most relaxed and friendly legal regime on foreign investment in the country’s history, foreign investors that have established foreign invested enterprises (FIE), including but not limited to wholly foreign owned enterprises (WFOE) and Sino-foreign equity joint ventures (EJV), may have a wide variety of reasons to decide to exit China. The reasons may vary from the trade war between U.S. and China, lack of market demand, problems to adapt to the local market, to increasing costs within China, or one of many other reasons. From a legal perspective, a foreign investor may consider one of the following three options:
I. Transfer of all of the foreign investor’s equity interest in the FIE
II. Sales of all or part of the FIE’s assets followed by voluntary dissolution of the FIE
III. Voluntary dissolution of the FIE
This alert discusses the key regulatory procedures and legal issues foreign investors should be aware of in planning and carrying out its exit strategies.
I. Equity Transfer
A foreign investor may exit from the FIE by transfer all of its equity interest in the FIE (Foreign Transferor). The transferee could be its joint venture partner(s) in the EJV or a third-party transferee that is a PRC incorporated enterprise/individual (Chinese Transferee) or a foreign incorporated enterprise/individual (Foreign Transferee). The regulatory procedures for completing the equity transfer are somewhat different depending on the nature of the transferee. As a general rule, if the business of the FIE in which the Foreign Transferor holds equity interest is not in the Negative List for foreign investment, the equity transfer is not required to obtain any prior approval from the competent commerce department. Under such circumstance, a post-transfer registration with the company registration authority and filing with the commerce department are sufficient.
1. Transfer to a Chinese Transferee
In case the Foreign Transferor that directly owns the equity interest in the FIE transfers all of its equity interest to a Chinese Transferee, the FIE will be converted into a purely domestic company after the equity transfer. The Chinese Transferee should work with any remaining shareholders in the company to complete registration of change of shareholder with the relevant counterpart of the State Administration of Market Regulation (SAMR) and Ministry of Commerce (MOFCOM).
If the transfer price will be paid by the Chinese Transferee from within China to the Foreign Transferor outside China, the Chinese Transferee must register with the relevant counterpart of the State Administration of Foreign Exchange (SAFE) in order for the bank of the Chinese Transferee to process such cross-border payment.
Please note that the Chinese Transferee must also complete tax registration before paying the transfer price and is obligated to withhold and pay income tax on behalf of the Foreign Transferor.
2. Direct Transfer to a Foreign Transferee
In case the Foreign Transferor directly transfer all of its equity interest in the FIE to a Foreign Transferee so that the Foreign Transferee will become a shareholder of the FIE, the Foreign Transferee should work with any remaining shareholders in the company to complete registration with SAMR and MOFCOM as described above.
In this case, since the transfer price will be paid by the Foreign Transferee to the Foreign Transferor, andboth are foreign incorporated entities or individuals, the flow of the funds occurs outside of the PRC, and therefore no SAFE registration is required.
However, the Foreign Transferee is still obligated to withhold and pay income tax on behalf of the Foreign Transferor.
3. Indirect Transfer to a Foreign Transferee
The foreign investor may also indirectly transfer its equity interest in the FIE by transferring all the shares or equity interest it holds in an offshore entity that directly or indirectly owns all the equity interest in the FIE. After this indirect transfer, the director foreign shareholder of the FIE remains unchanged. Therefore, no registration with SAMR is required for the indirect equity transfer. However, since the ultimate de facto controlling person of the FIE has changed as a result of the transaction, the new ultimate de facto controlling person of the FIE must be filed with MOFCOM.
An issue here is that if such an indirect transfer constitutes a transfer of certain taxable assets in the PRC (Chinese Taxable Assets) through an offshore structure or arrangement (Offshore Indirect Transfer) that does not have a reasonable business purpose to avoid liability for PRC taxes, the Offshore Indirect Transfer will be deemed and re-characterized by the PRC tax authority as a direct transfer of Chinese Taxable Assets, and any gain attributable to the Chinese Taxable Assets will be subject to PRC enterprise income tax (EIT). If an Offshore Indirect Transfer structure is deemed by the relevant PRC tax authority to be a transaction structured for unreasonable commercial purposes to avoid PRC taxes, the PRC tax authority will decide that such transaction is a direct transfer of Chinese Taxable Assets and the 10% PRC EIT is applicable. Under this circumstance, the Foreign Transferee is obligated to withhold as a withholding agent of the PRC EIT and pay the PRC EIT to the PRC tax authority on behalf of the Foreign Transferor.
II. Asset Sale followed by Voluntary Dissolution
In some cases, the buyer may not want to acquire the equity interest held by the foreign investor in the FIE and, instead, is interested in purchasing certain assets of the FIE. Under this option, the FIE will sell certain assets to the buyer and be dissolved after such asset sale.
As typical in an asset deal, the buyer will acquire certain assets and on-going business of the FIE and will not assume any claims, debts and employment relationships of the FIE, except to the extent agreed between the parties.
After the asset sale, the FIE will go through the dissolution and liquidation procedures as described in more detail under Section III below.
Since the FIE is to be dissolved, it is likely that the buyer would require the foreign investor to make representations and warranties with respect to the assigned assets and to indemnify the buyer for any breach. The foreign investor should seek to limit the scope of its representation and warranties.
III. Voluntary Dissolution
A foreign investor may want to dissolve its WFOE directly without any equity or asset sale or to agree with its Chinese partner(s) to dissolve their EJV directly. In practice, an FIE can voluntarily liquidate and dissolve its business under any of the following circumstance:
(a) expiration of the term of the FIE;
(b) consent of investors to dissolve the enterprise due to poor operation and serious losses;
(c) failure of any party of an EJV to fulfill its obligations defined by the contract;
(d) inability of enterprise to continue operations because of serious losses due to force majeure or government intervention;
(e) other reasons as defined by the contract and articles of association.
Under current PRC law and practice, an FIE must go through the following procedures to complete a voluntary dissolution:
(a) Shareholders’ meeting or board of directors of the FIE resolve to dissolve the FIE and establish the liquidation group;
(b) Filing the liquidation group with the company registration authority of the FIE;
(c) The liquidation group must notify the known creditors in writing, within ten days after its formation, and make public announcement in national or provincial newspapers within 60 days of its establishment. Such public announcements should include information such as the FIE’s name and address, reasons for the liquidation, liquidation commencement date, contact details of the liquidation committee, its members, and names of contact persons;
(d) The liquidation group must compile balance sheets and property inventories, propose the basis for asset valuation and assessment, and formulate liquidation plans for approval by the shareholders’ meeting;
(e) Payment of debts, employee compensation, etc.
(f) The liquidation group is to prepare a liquidation report for approval by the shareholders’ meeting and distribute any remaining assets;
(g) Deregistration with the tax authority;
(h) Deregistration with the customs;
(i) Deregistration with the company registration authority and commerce department
(j) Closing bank account;
(k) Deregistration of company chops.
Dissolution is a lengthy process that can take several months or even more than a year to complete. Foreign investors need to plan ahead to mitigate possible legal risks and delay. Below are certain key points in relation to the voluntary liquidation of an FIE.
1. Decision-Making on Liquidation
Under the PRC Company Law, the decision to liquidate a company shall be approved by shareholders representing at least two-thirds of the voting rights. In practice, many FIEs set forth in the articles of association that liquidation of the company must be unanimously approved by either the shareholders or the board of directors, or by both a shareholder meeting and the board of directors. Also, in practice, many local authorities (such as the company registration authority) may insist on an unanimous resolution adopted by the shareholders meeting to minimize the risk of a dispute among shareholders.
2. Liquidation Group/Committee
After having obtained internal approval, the FIE must form a liquidation group (also referred to as liquidation committee) within 15 days that includes all the shareholders. In practice, each shareholder should appoint an individual representative to be a member of the liquidation group and deal with the liquidation procedures. The liquidation group ultimately reports back to the shareholders. If the liquidation group involves multiple members representing different shareholders, it may be necessary to establish rules of procedures of the liquidation group to facilitate the decision-making process and resolution of any deadlocks.
3. Winding Down Business and Liquidation Proceeds
The FIE should run an inventory of existing business contracts and establish a plan to wind down the business. Before formally resolving to dissolve the FIE, the FIE should attempt to terminate existing business contracts early to the extent possible so that it will only need to deal with a limited number of creditors during the liquidation procedures.
Before the commencement of step (g) (i.e. tax deregistration), the FIE should settle all accounts payables and receivables. After the commencement of step (g), the FIE can still pay necessary expenses (such as office rental, salaries, fees to law firms, accounting firms and agents which worked on the deregistration, etc.); however, the FIE should not conduct any new business and generate additional revenues.
Once the liquidation group has been formed, it can start liquidating the company’s assets.
The assets of the company and any receipts of the sales must be used to settle outstanding costs and debts in the following order:
1) Liquidation expenses.
2) Outstanding employee salaries, social insurance fees and severance fees.
3) Outstanding tax liabilities.
4) Other outstanding debts.
Any funds that are left after all outstanding debts and costs are settled can be distributed among the shareholders according to their respective shareholding percentage. If the receipts of the sales of the assets are not sufficient to pay off the outstanding debts, the liquidation group will have to file a bankruptcy declaration with the people’s court. The main difference between a liquidation procedure and a bankruptcy procedure is a loss of control over the entity. In practice, the shareholders may decide to provide funds to the FIE to settle the debts owed by the FIE to its creditor.
4. Terminating Employees
Article 44(5) of the PRC Employment Contract Law provides that the employment contract terminates if the employer decides to dissolve the company early. While early dissolution presents a lawful ground for terminating employment contracts, this does not imply that all costs pertaining to employees will thereby be discharged. Severance pay, calculated with reference to the salary and other work-related incomes and the number of years that the employee has worked, is due and is generally paid immediately upon termination of the employment contracts.
It is suggested that the FIE prepare a detailed matrix containing information necessary for evaluating termination strategies, including starting date and expiry date of current employment contract, number of renewals, total annual salary (including basic salary, bonus and any allowance).
The amount of statutory severance pay (Statutory Severance Pay) is calculated based on (a) the number of years an employee has worked with the employer and (b) the average monthly income (AMI) for the twelve months immediately preceding the termination, which, from January 1, 2008, is capped at three times the average monthly salary in the employer’s location.
When calculating the AMI, an employer must include all cash income, including salaries, allowances, commissions and bonuses paid to the employee during the twelve months immediately preceding the termination date. The severance pay to an employee for each one year period of employment should be one-month income (a period from six months to less than one year is considered as one year) and for any period of less than six months should be one-half of his/her monthly income.
In practice, the termination date of the employment contract is the date of the resolution of the shareholders’ meeting to dissolve the company, and this date should be used to calculate the period of employment of the employees.
PRC Employment Law does not provide for any mandatory procedures that the company must follow in terminating employees in case of voluntary dissolution. In practice, companies are advised to inform employees on a timely and transparent basis of their plans for dissolution and termination of employment contracts. Where the number of employees to be terminated is significant, the company may consider informing the local employment authority of its termination plan in advance so the government can anticipate any potential protest by the employees and provide guidance to the company in terminating the employees.
There are circumstances where it may take a few months for the shareholders to prepare for and make a formal resolution to dissolve the company during which period certain employees are not actually needed by the company. In this case, the company may consider reaching mutual termination agreement with such employees so that it does not need to pay salaries of such employees for the following months. Please note that in case a mutual termination where the employee is not obligated to agree to be terminated, it is typical for the employee to require more than the minimum Statutory Severance Pay, such as 2-4 months of salary in addition to the Statutory Severance Pay. As such, the company needs to evaluate whether to reach mutual termination or pay Statutory Severance Pay a few months later when the company formally dissolves.
Given the complexity and lengthy procedures of dissolution, the ideal way for a foreign investor to exit from its exiting FIE is to transfer all of its equity interest in such FIE to a third party. However, many foreign investors want to exit due to the poor performance and unpromising prospects of their FIEs, which are not attractive targets to potential buyers. These foreign investors will inevitably need to go through the dissolution and liquidation procedures. Among other steps, the FIE should attempt to terminate existing business contracts early to the extent possible, so that it can limit the number of creditors it will need to deal with during the liquidation procedures. The FIE should also prepare a matrix to include information necessary for evaluating termination strategies.