Merger approval has become more complex in China with the enforcement of the Anti-Monopoly Law of the People’s Republic of China 2007 (2007 Anti-monopoly Law) as the State Administration for Market Regulation (SAMR) may still raise questions after a global transaction has obtained clearance from the EU and US authorities. To help understand the procedures involved in China-specific merger and acquisition (M&A) transactions, this note outlines, among other things:

•          Merger notification triggers and thresholds.

•          Penalties that the SAMR may impose for failure to notify.

•          The merger review process.

An illustrative timeline details a China merger review process in a global transaction. In addition, global share and asset acquisitions in direct and indirect acquisitions, spin-off of bad assets, and a more tax efficient structure, are set out in diagrams, which help to understand the various scenarios that can occur. As this note discusses these issues in the context of a global M&A transaction, it assumes that the Chinese target company is a foreign-invested enterprise (FIE).

China market conditions overview

An increasing number of companies of all sizes (including both global Fortune 500 companies and small and medium-sized enterprises (SMEs) have assets, operations or subsidiaries in China. As a result, an increasing number of M&A deals outside of China now have China elements that must be addressed, whether the China business is a key part of the global transaction or a relatively insignificant part of it.

As approval timelines in China often take longer than foreign counsel may anticipate, it is important to assess the China-related procedural elements early in the transaction planning process to ensure that the projected closing dates for the global transaction are not adversely impacted. Some of the China-specific issues that can give rise to potential delays in global M&A deals typically relate to:

•          Merger control filing requirements in China.

•          Restructuring of the China business to address various categories of onshore and offshore regulatory compliance issues.

China implications of various common deal structures

Irrespective of the transaction structure used for the global deal, certain China elements will remain the same, including:

•          Due diligence.

•          Regulatory compliance review.

•          Related China-specific clauses in the acquisition agreements.

In addition, merger control filings are always required where applicable thresholds are exceeded. However, other China elements may change depending on the nature of the transaction structure.

Existing ultimate offshore parent company

For example, in a typical acquisition of shares of the existing ultimate offshore parent company of the China entities (that is, FIEs) involving no merger control filings in China, no share transfer registrations are required at China level. However, if the global transaction is structured as an asset acquisition or hive down, and subsequently, the registered owner of the registered capital of an FIE is changed, then the equity transfer requires a Ministry of Commerce (MOFCOM) approval or record-filing. The change of the registered shareholder of an FIE also requires and update registration with the central or competent local office (local AMR) of the SAMR. (The SAMR is the new market supervision agency which has absorbed the functions of the dismantled State Administration for Industry and Commerce (SAIC) according to a massive government re-organisation reform in 2018.

Spin-offs

The same conceptual framework also applies to spin-offs of the China business on a stand-alone basis. If the target China operations are to be acquired through the sale and purchase of shares in an offshore holding company, then no onshore equity transfer approvals and registrations are required in China as the name of the registered shareholder remains unchanged. However, if the ownership of the registered capital in the FIE is transferred directly, from the original offshore holding company to a new offshore holding company, then a MOFCOM approval or record-filing and an update registration with the local AMR will be required to reflect the change in shareholder.

Similarly, where due diligence discloses problems in the China operations that require certain “bad assets” to be spun off, it is common for the seller to divest its interests in the registered capital of the FIE in question. This also requires a MOFCOM approval or record-filing (where appropriate) and an update registration with the local AMR. If some of the original assets are to be retained by the target, then the seller must set up a new entity to purchase these “good assets” from the entity being spun off. (Apart from these spin-offs of bad assets, inbound cross-border asset acquisitions are not common in China, but if undertaken typically would adopt a similar structure, namely the establishment of a new entity in China as the China asset acquisition vehicle.)

Timelines and other formalities

While the documentation and approval or record-filing and registration process for transfers of equity in FIEs is well established, related timelines must be taken into account regarding the management of the overall global transaction. These include the time requirements for establishment of a new FIE to purchase good assets from the China entity to be spun off.

Even where the share transfers are all to take place at an offshore level and no China approvals, record-filings or registrations are therefore required, certain other formalities may be required in China for:

•          Changes in certain officers and directors (which must be registered with relevant Chinese authorities).

•          Any amendments to be made to the articles of association of the China entities (where those amendments are subject to government approval in China).

Where new inter-company agreements are to be put in place or existing ancillary agreements are to be terminated or revised, government approval is not required in most cases, but this should be confirmed on a case-by-case basis with China-based legal counsel.

For all of the above items, if the China entity is a wholly foreign-owned enterprise (WFOE), then some or all of these action items can be postponed until after closing if the parties choose. However, if the China entity is a Sino-foreign equity joint venture company (EJV) or Sino-foreign co-operative joint venture company (CJV), then co-ordination with the Chinese partner will be required consistent with the:

•          Provisions of the joint venture contract (JVC)

•          Articles of association.

•          Applicable laws and regulations governing Sino-foreign joint ventures.

Where the China assets and operations are not material to the global deal and are to be spun off, there may be a temptation to task the seller’s (or buyer’s) China counsel to manage this on a post-closing basis. However, once the global transaction is closed, management resources and attention may likely be diverted to more urgent operational matters, leaving this activity under-supported by management. If the China operations to be spun off on a post-closing basis involve Sino-foreign joint ventures, then partner co-operation issues must also be taken into account, which may create further complications and delays.

Process management issues and considerations

Whether or not the lead transaction counsel has China offices, it is increasingly common for lawyers from leading Chinese law firms to play a central role in due diligence, merger control filings, regulatory compliance matters and other related China matters.

Chinese law firms have important advantages in terms of cost structure and close working relationships with the relevant regulatory authorities at central and local levels.

Foreign lawyers in China can engage local Chinese legal counsel solely to submit filings on behalf of the client. However, best practice is to employ experienced Chinese legal counsel with relevant substantive and procedural expertise to provide a more complete spectrum of services in co-operation with the lead transaction counsel. This arrangement permits the local Chinese counsel to provide valuable strategic input about the nature and content of any submissions or enquiries to be made to the relevant authorities, and to be in a position to address queries or comments from these authorities in a pro-active and timely manner.

Timing issues for various China elements of global M&A deals should be dealt with at an early stage in the overall transaction planning process to ensure that completion of the China steps do not unnecessarily delay the overall transaction timetable. At the same time, local China-based legal counsel need to be aware of, and sensitive to, the timeline requirements of the overall transaction and work within those constraints to the extent possible. As with all international transactions, early, regular, clear and comprehensive communication between the lead transaction counsel and the local China-based counsel will be essential.

Buy-side vs sell-side considerations

In negotiated private treaty transactions, buy-side counsel typically take the lead in all aspects of the deal, including the China elements. Therefore, in a standard share acquisition transaction, buyer’s China counsel will provide direct support to the lead transaction counsel regarding:

•          China merger control filings (if required).

•          Due diligence.

•          Regulatory compliance assessment.

•          Related warranties, conditions and covenants in the share purchase agreement (SPA).

However, if problems are found in the target’s China operations that require restructuring as a condition to closing, the seller’s China counsel may in many cases take the lead under the close supervision, and with the co-operation of, the buyer’s China counsel. The buyer’s China counsel may be asked to take a more direct role in cases involving sensitive issues. These include concerns regarding:

•          Non-compliance with the US Foreign Corrupt Practices Act 1977 (FCPA) or the UK Bribery Act 2010 (Bribery Act 2010). For more on the FCPA, the Bribery Act 2010 and China’s anti-bribery and corruption laws and how companies can navigate a safe path between them.

•          Export controls.

•          Other issues of regulatory non-compliance.

Common issues and elements of China aspects of global M&A

Merger control filings

The introduction of the 2007 Anti-monopoly Law heralded a new era for merger control enforcement in China, and since then China’s influence on global mergers and acquisitions has been steadily increasing. Previously, companies could seek approvals in the US and the EU and assume that merger clearance from other jurisdictions would be relatively straightforward. Now, however, a global transaction may obtain clearance from the EU and the US authorities, but the SAMR’s Anti-Monopoly Bureau may still raise questions about the transaction’s competitive effect on the Chinese market.

Triggers and thresholds

An obligation to submit a merger notification is triggered in China where both a change of control occurs and the turnover threshold is met. These are often referred to as the merger notification “twin tests”. A change of control occurs when there is a merger or an undertaking gains control of another undertaking in various ways. When reviewing a transaction, the SAMR will interpret an “undertaking” as being an economic entity and “control” as the ability to exercise economic decision-making power.

The turnover threshold is met when in the last financial year either:

•          The combined worldwide turnover of the undertakings to the concentration exceeded RMB10 billion, and the Chinese turnover of each of at least two of the undertakings exceeded RMB400 million.

•          The combined Chinese turnover of the undertakings to the concentration exceeded RMB2 billion and the Chinese turnover of each of at least two of the undertakings exceeded RMB400 million.

(Article 3, Provisions of the State Council on the Thresholds for Declaring Concentration of Business Operators 2008 and Article 2, Guiding Opinions on the Application for Concentration of Business Operators 2018 (关于经营者集中申报的指导意见)).

Failure to notify

If the parties fail to notify a transaction, or parties close a transaction before the SMAR approves it, the SAMR can:

•          Order the parties to unwind the transaction.

•          Impose a fine of up to RMB500,000.

•          Impose any measures it deems appropriate to restore the pre-transaction market conditions (for example, dispose of the shares or assets in question, or transfer the concerned business within a specified time limit).

(Article 48, 2007 Anti-monopoly Law).

Timing of regulator’s review

Before the parties can implement the transaction, they must obtain clearance from the SAMR or the review period must expire without objection or request for further information (Article 25, 2007 Anti-monopoly Law).

The clearance process consists of two stages, the pre-consultation phase and the review phase. There is no statutory deadline for the pre-consultation phase. However, under statute, the regulator has a total of 180 calendar days for its review phase (Articles 25-26, 2007 Anti-monopoly Law). In practice, the timing of the actual start of the formal review by the regulator can take several weeks or span several months depending on:

•          The complexity of the transaction.

•          The parties’ responsiveness to the regulator’s information requests.

•          The regulator’s internal priorities.

New FIE record-filing regime

On 8 October 2016, MOFCOM released the Interim Measures for Record-filing Administration of the Establishment and Change of Foreign-invested Enterprises 2016, with immediate effect.

The measures, together with the Decision of the Standing Committee of the National People’s Congress on Revising the Law of the People’s Republic of China on Foreign-invested Enterprises and Other Three Laws 2016, which took effect 1 October 2016, usher in a new system for regulating the establishment (and subsequent amendment) of FIEs in China.

Under the new system, foreign investors may establish and amend an FIE by carrying out a record-filing procedure (备案) with MOFCOM, except where the FIE operates (or will operate) in an industry sector requiring special administrative measures. Where the foreign investment project is subject to special administrative measures, the FIE is still subject to MOFCOM’s traditional examination and approval procedure (审批) for foreign investment. The list of industry sectors requiring special administrative measures is commonly referred to as the negative list.

Foreign investment restrictions

Foreign investment in China is subject to certain restrictions on the nature and category of the industry sector and business operations. Foreign investment in certain sensitive areas may also trigger national security review (NSR), which in turn may result in rejection of the foreign investment project or the imposition of other restrictions.

These rules may apply if the China operations are to be restructured as part of a global M&A transaction, in particular if the percentage of foreign-owned shareholdings in a Sino-foreign joint venture increases as a result of the restructuring.

If as part of any China restructuring a new FIE is to be set up or the capitalisation or business scope of the existing FIE is to be revised, the then effective foreign investment catalogue will need to be consulted. For more information on foreign investment restrictions.

National security review (NSR)

The 2007 Anti-monopoly Law requires the parties to a merger to undergo a separate national security review (NSR) process where a foreign investor participates in the concentration of undertakings by acquiring a domestic Chinese company (or through other means) and the transaction has a national security concern (Article 31). However, the 2007 Anti-monopoly Law does not provide any operative mechanism on how to conduct an NSR process.

Since 2011, China has established and progressively increased the severity of an NSR process for foreign investments. Under the NSR regime, a joint-ministerial committee chaired by MOFCOM and the National Development and Reform Commission (NDRC) under the leadership of the State Council will review a foreign acquisition in the context of its impact on areas such as:

•          National defence.

•          Steady running of the national economy and general order of society.

•          Research and development capacity for key technologies related to the national security.

The joint committee may have wide discretion to scrutinise and restrict the transaction in China.

For more information on the NSR regime.

Due diligence

Buyers of offshore targets with China subsidiaries and business activities will need to conduct related due diligence on the China assets and operations. The lead transaction counsel on the global transaction may instruct a local Chinese law firm to conduct the due diligence process.

Due diligence exercises concerning Chinese subsidiaries of offshore target companies will sometimes disclose certain problems involving fragmentary documentation of transactions or technical non-compliance with applicable legal requirements, particularly in cases where the:

•          Target company is a start-up enterprise or SME with limited resources and experience in China.

•          China entity is a minority foreign-owned joint venture controlled by a less sophisticated Chinese partner that conducts business in a less rigorous manner.

The corporate records of China subsidiaries of major foreign MNC target companies tend to be more complete with fewer compliance gaps. However, even some China subsidiaries of major MNC target companies operating in industry sectors that are subject to restrictions on foreign investment may use nominee shareholder and other similar arrangements to try and circumvent these restrictions. These arrangements entail additional regulatory and practical risks that require careful analysis and assessment.

Warranties

In cases in which the China assets and operations of the target are relatively insignificant, the standard warranties in the global SPA are typically drafted in sufficiently broad terms that cover all of the relevant China elements.

However, in cases where the China assets and operations of the target are more critical to the overall transaction or the China issues raised are particularly sensitive, it may be important to include more China-specific warranties, including in relation to:

•          Ownership of unencumbered interests in the registered capital of the China entities.

•          Governmental approvals, record-filings and registrations for the China entities, if required

•          Operating licences for the main categories of China operations.

•          China labour law compliance

•          For more information on various aspects of China labour law

•          Ownership and possession of requisite land use rights, construction permits and building ownership permits and compliance with related Chinese regulatory requirements

It may also be appropriate to include specific warranties or indemnities regarding problems disclosed in the China due diligence if those issues are not resolved as a condition precedent to closing.

Closing conditions and timing considerations

The standard closing conditions in the global SPA are typically drafted in sufficiently broad terms to cover the relevant China elements adequately, including, for example:

•          The warranties are true and accurate at closing (particularly in respect of regulatory compliance).

•          All government approvals for the transaction and third-party consents have been obtained.

•          A legal opinion from the seller’s China counsel has been issued in the approved form (if required).

It will be necessary, however, to include related China action items in the closing checklist to ensure that these conditions are met in a timely manner.

In addition, if bad assets are to be spun off in China to avoid sensitive compliance issues, or if there will be other changes to the China business model before closing, then counsel should include specific closing conditions relating to completion of that restructuring. Similarly, certain issues of regulatory non-compliance in China may also merit specific closing conditions to require confirmation that the related rectification steps have been taken before closing.

Given the nature and timing of government approvals required in China regarding not only merger control filings but also corporate restructurings and rectification of regulatory non-compliance, it is essential to plan ahead to co-ordinate the completion of the China closing conditions with the closing of the global transaction.

While response times by government departments in China are set by statute, they typically start running only once the related application documents are formally accepted. If the relevant government authority considers that the submission is incomplete in any respect or requests clarifications or supplemental documentation, this may cause unforeseen delays. Response times vary depending on the circumstances and the level and locality of the particular government authorities. Therefore, counsel should allow sufficient additional time to complete the China-related government approvals that form part of the closing conditions.

Tax considerations

Tax structuring options and reporting obligations for China-related M&A deals vary according to the nature of the deal (onshore or offshore) and whether acting for the buyer or the seller.

For example, if selling an onshore FIE, the seller is subject to a 10% capital gains tax (CGT) (Articles 3 and 27, Law of the People’s Republic of China on Enterprise Income Tax 2007 and Article 91, Regulations on the Implementation of Enterprise Income Tax Law of the People’s Republic of China 2007).

Tax treaties may provide a tax exemption in certain cases. If the buyer is a China entity, it will withhold the applicable CGT. If the buyer is not a China entity, then the CGT is payable on a self-assessment basis by the seller.

Buying an onshore FIE

If buying an onshore FIE, the requirements vary:

•          Where the buyer is an onshore China entity, the buyer must:

•          report the transaction to the tax authorities within 30 days after the share transfer agreement is signed; and

•          withhold the applicable CGT.

•          Where the buyer is a foreign entity, they do not need to withhold the tax. However, the onshore FIE they are purchasing must report the share transfer to the tax authorities and assist in collecting the tax.

Selling an offshore entity

If selling an offshore entity (such as an offshore holding company), the following requirements apply:

•         Where the sale of a non-resident enterprise (NRE) results in a transfer of China taxable assets and was carried out with the aim of avoiding paying enterprise income tax (EIT) (that is also known as CGT in this scenario) on the transfer of those assets, the transaction will be subject to EIT as if the assets had been transferred to the buyer of the NRE directly. The test for determining avoidance is whether the transaction had a “reasonable commercial purpose”.

•         When China taxable assets are transferred indirectly, whoever is directly obliged to pay the seller must also act as the withholding agent for any EIT payable on the transfer. The obligation arises on completion of the offshore transfer of shares.

•         If the withholding agent fails to withhold the tax, the seller must declare and pay the unpaid tax to the competent tax authority.

•         The offshore seller, buyer or the FIE target whose ultimate equity ownership will change due to the transaction may now voluntarily report the transaction to the competent tax authority.

(Announcement of the State Administration of Taxation on Several Issues Concerning the Enterprise Income Tax on Indirect Property Transfer by Non-Resident Enterprises 2015 (Tax Bulletin 7/2015) and Announcement of the State Administration of Taxation on Issues Concerning the Withholding of Non-resident Enterprise Income Tax at Source 2017 (国家税务总局关于非居民企业所得税源泉扣缴有关问题的公告).)

If EIT is due on an indirect transfer of China taxable assets under Tax Bulletin 7/2015 but is not paid (or withheld) as required, the competent tax authority may impose a number of penalties:

•          Against the withholding agent. A penalty of 50% to 300% of the unpaid tax (Article 69, Law of the People’s Republic of China on the Administration of Tax Collection 2013). This penalty may be reduced or waived if the withholding agent reported the transaction within 30 days after the date on which the sale and purchase agreement was executed.

•          Against the seller. Interest on the unpaid tax. The interest period starts to run on 1 June of the year following the year that the tax is due and continues until the date on which the tax is paid. The interest rate will be:

•          the benchmark interest rate, if the seller reported the transaction within 30 days of the date of execution of the sale and purchase agreement or has paid the tax in a timely manner; and

•          the benchmark interest rate plus five percentage points, if the seller fails to report and pay the tax on time.

For more information on the implications of Tax Bulletin 7/2015.

Buying an offshore entity

If buying an offshore entity, the following points apply:

•          The buyer has a withholding obligation (where EIT is payable under Tax Bulletin 7/2015), and may be imposed a penalty of 50% to 300% of the unpaid tax.

•          Treaty-based preferential withholding tax rates are difficult to apply for under the Notice of the State Administration of Taxation Concerning the Meaning and Determination of the Identity of “Beneficial Owner” in Tax Treaties 2009 (2009 Tax Circular 601).

In an asset sale, any gains from the sale will be subject to a 25% EIT. The sale of fixed assets and inventory will also trigger value added tax (VAT), although VAT is generally just a cash flow issue and not a real cost as it can be used as a credit by the buyer. If the assets include any intangible property, including goodwill, the sale will trigger a 5% business tax, which is a true cost for the seller.

China-specific issues arising under typical global transaction structures

Offshore global share acquisition including indirect acquisition of China business

An offshore global share acquisition usually involves a simple acquisition of the shares of the offshore parent target company. Ownership of the China subsidiaries will transfer to the offshore buyer as part of the acquired group of companies as set out in the following diagram.

Transfer to ownership in offshore global share acquisition: scenario 1

In this scenario, ownership of the registered capital interests in the China WFOE and JV will remain registered in China in the name of the offshore target company, so no change in ownership will need to be registered at the China level.

Due diligence will need to be conducted on the China entities consistent with standard practice. Provided no serious irregularities are discovered through due diligence and no restructuring of the China business operations is required for commercial purposes, no further changes will be required at the China level.

Merger control filings will be required if the relevant thresholds are met. Under Tax Bulletin 7/2015, the seller must pay taxes in China on any gain from the sale relating to the China assets at a rate of 10% if the offshore holding company does not satisfy the “reasonable commercial purpose” .

For background information on share acquisition documents.

Offshore global asset acquisition or hive down including direct or indirect acquisition of China business

Where the offshore buyer intends to acquire only part of the global business of the target company, the overall transaction may take the form of an asset acquisition or hive down. For the purposes of illustration, the example below assumes that the China WFOE is to be included in the business units to be acquired, while the China JV is not. To make the presentation simpler, it is structured as a hive-down transaction.

The starting point for the target company group structure, before the hive down, is the same as in Diagram 1: Transfer to ownership in offshore global share acquisition: scenario 1 above (before the transfer of the shares in the target company).

There are two principal ways for the buyer to acquire the target business operations and assets under this hive-down arrangement. First, as shown in the following diagram, the target company can, as a pre-closing condition, divest the business assets and operations that are not to be acquired. The buyer can then purchase the shares of the target company.

Transfer to ownership in offshore global share acquisition: scenario 2

In this scenario, the transfer of the registered capital in the WFOE and the JV originally held in the name of the target company to offshore holding companies 1 and 2, respectively, will required a MOFCOM approval or record-filing (where appropriate) and an update registration with the local AMR. Where MOFCOM approval is required, executed equity transfer agreements and unanimous board resolutions approving the equity transfer will need to be submitted, together with amendments to the relevant constitutional documents and other miscellaneous documentation. In the case of the transfer of the registered capital in the WFOE, all such documentation will be within the sole control of the target company management, while in the case of the JV it will also be necessary to obtain waivers of pre-emptive rights from the JV partners and partner consents to the amendments to the JVC and articles of association. Where only a record-filing is required, the corporate governing documents and transaction documents do not need to be submitted.

Where MOFCOM approval is required, once the documentation is in proper form and submitted to MOFCOM, the approval should be obtained within 30 days (where only a record-filing is needed, MOFCOM is required to complete the filing within three working days). Update registrations with the local AMR typically can be completed within five days.

Related due diligence, merger control filing and tax issues and considerations will be substantially the same as in the global share acquisition structure outlined in Diagram 1: Transfer to ownership in offshore global share acquisition: scenario 1 above.

The second way in which the buyer can acquire the targeted assets and business operations in the hive-down arrangement is for the buyer to acquire the shares of the offshore holding company number 1, into which all of the targeted assets and business operations globally, including the targeted China assets, will be transferred. This is shown in the following diagram.

Transfer to ownership in offshore global share acquisition: scenario 3

All of the China considerations discussed in relation to the first hive-down transaction structure described in Diagram 2: Transfer to ownership in offshore global share acquisition: scenario 2 also apply here.

China-specific structuring issues and strategies

Structuring, documentation and approvals for spin-offs of bad assets

For background information on offshore holding structures.

A typical deal structure for the spin-off of bad assets in the China operations of the target company is set out below. For simplicity, only a single China subsidiary is shown, which takes the form of a WFOE.

Transfer to ownership in offshore global share acquisition: scenario 4

The main procedural steps in connection with the spin-off of bad assets at the China level typically include the steps set out below.

This sample deal structure assumes that the target company directly holds the equity interests in the original China WFOE, rather than indirectly through an intermediary holding company subsidiary.

The first step is for the target to set up a new company, or NewCo (in this example in the form of a WFOE). The main procedural steps for this are for the target to:

•          Obtain MOFCOM approval or record-filing (where appropriate) for the establishment of NewCo, if required.

•          Complete registration with the local AMR and obtain NewCo’s business licence.

•          Open a foreign exchange bank account for NewCo.

•          Complete other post-establishment formalities.

For more information.

The second step is for the transfer of the registered capital (equity) of the original WFOE from the target as seller to a domestic company as buyer. The main procedural steps are for the:

•          Target and domestic buyer to sign an equity transfer agreement transferring 100% of the registered capital in the original WFOE from the target to the domestic company.

•          Target and domestic company to instruct the original WFOE to obtain the MOFCOM approval or record-filing (where appropriate) for the change in shareholder of the original WFOE and the conversion of the original WFOE into a purely domestically owned enterprise.

•          Target and domestic company to instruct the original WFOE to complete update registration of the change in shareholder and the entity conversion with the local AMR and to obtain the original WFOE’s new business licence reflecting the same.

•          Domestic company to obtain tax clearance from relevant Chinese tax authorities, confirming either that the target company had no gain from the sale of the equity in the original WFOE (so that no CGT is owed in China) or that all relevant CGT has been duly paid by or on behalf of the target company.

•          Domestic company to remit payment of the equity transfer price to the target company offshore through a domestic bank in China, which will be responsible for reviewing the equity transfer agreement, the related MOFCOM approval or record-filing (where appropriate), the SAMR updated registration and the tax clearance certificate to confirm that the remittance is legitimate on its face.

The third step is for the original WFOE to complete other post-conversion formalities, that is:

•          Cancellation of foreign exchange registration certificate.

•          Cancellation of foreign exchange basic account (foreign exchange capital account may be preserved).

•          Cancellation of financial registration.

•          Change of tax registration.

•          Change of organisation code certificate.

The final step is the transfer of the good assets and related employees from the original WFOE to NewCo, consisting of the following main steps:

•          The original WFOE and NewCo to enter into an asset transfer agreement, under which the original WFOE conveys to NewCo all of the tangible and intangible property comprising the good assets for agreed consideration.

•          The original WFOE to terminate (or accept the resignations of) all employees to be transferred to NewCo, and NewCo to enter into new employment contracts with each employee transferred, in which case either:

•          the original WFOE pays such employees the required statutory severance (and the severance calculation period at NewCo restarts from the date of the transfer of such employees) or

•          NewCo assumes responsibility for the previous service periods of the transferred employees for purposes of calculation of severance and all other purposes (in which case the original WFOE is not required to pay severance upon the transfer of the employees).

•          NewCo to pay the asset transfer consideration to the original WFOE in RMB, typically by way of domestic inter-bank electronic funds transfer.

•          The original WFOE and NewCo to complete related registrations for the transfer of certain categories of assets, including:

•          patents;

•          trade marks;

•          registered software copyrights;

•          motor vehicles;

•          land use rights; and

•          building ownership rights.

•          To effect these changes in registrations, separate written agreements of transfer should be entered into.

•          The original WFOE and NewCo to enter into assignments of contracts relating to the transferred business operations. In cases where NewCo is to assume the performance obligations of original WFOE under the assigned contracts, the original WFOE will obtain the written consent of the contract counterparties. The assignment of obligations requires the consent of the obligee, as does the assignment of obligations and rights together (Articles 84 and 88, Contract Law of the People’s Republic of China 1999 (1999 Contract Law)). In contrast, the assignment of rights alone requires only giving written notice to the contract counterparty and does not require obtaining written consent (Article 80, 1999 Contract Law).

Approval and timing issues in spin off of bad assets

Proper co-ordination of the timing of each of the above steps and with the overall closing schedule for the global transaction is critical. In cases involving concerns regarding serious prior non-compliant business conduct by the target company’s entities in China, it is common to require that all the steps listed above be completed before the closing of the global acquisition to ensure that the offshore buyer can avoid any related taint or potential liability arising from these activities. This requires the parties to allow sufficient time to complete all steps in proper order, which typically will require up to three to four months or longer. In most cases, these steps cannot be initiated until the global SPA is signed, so the time required to complete them must be factored into the overall closing schedule.

In practical terms, the NewCo entity will need to be set up, its bank accounts opened and sufficient registered capital funded before NewCo can sign and perform its obligations under the asset transfer agreement or enter into employment contracts with the transferred personnel. The target company and the domestic company can enter into the equity transfer agreement in parallel with the establishment of NewCo, but the parties will need to take into account several considerations (including tax, cash flow and liability) to determine whether the equity transfer approvals, registrations and payments of the transfer consideration should precede or follow the transfer of assets and employees to NewCo.

IP assignments and other asset transfers

For assignments of intellectual property (IP) such as patents, trade marks and registered software copyrights, separate registrations are required to effect the transfer. Written transfer agreements are required for all such transfers, but the effective date of the transfers varies by category. Consequently, related timelines will need to be taken into account.

Patent transfers are effective as of the date of registration with the patent authority. Transfers of registered software copyright are effective on the execution of the agreement by the parties. These transfers should not therefore affect the overall timeline.

However, trade mark transfers are effective only as of the publication date by the trade mark authority, which as a practical matter may take up to six to eight months from the date of application. In most cases, only the submission of the application for the trade mark transfer registration is made a condition precedent to closing, as the publication by the trade mark authority is seen as a perfunctory administrative matter that does not introduce additional risks. Similarly, to the extent that changes in registrations of title in other assets (such as land use rights, building ownership rights and motor vehicle title) require additional time, the parties will need to assess the risks and benefits of managing these as conditions precedent to closing instead of post-closing matters.

Tax implications

There are important tax implications to consider in connection with this spin-off transaction structure. In most cases in accordance with China’s tax policy, the target company will have to pay CGT in connection with the sale of the equity interests in the original WFOE even if the stated equity transfer price is the same as the original amount of the registered capital contributed by the target company. The tax authority can levy CGT on the transfer price at a rate of 10% based on the balance sheet value of the original WFOE for the month immediately preceding the equity transfer.

While in theory it may be possible to delay the closing of the original WFOE equity transfer and take steps to manage the accounts to minimise the book value of the original WFOE, in practice there usually is not sufficient time in the context of the overall global deal timeline. Therefore, to keep within the timeline of the overall transaction, the target company may have no choice but to pay the full amount of the CGT calculated based on the original WFOE book value to obtain the tax clearances. This in turn may result in a corresponding adjustment to the final purchase price to be paid by the buyer to the seller at closing of the global deal.

These capital gains cannot be avoided by either:

•          Having the domestic company pay the equity transfer price from an offshore account.

•          Substituting an offshore purchaser in lieu of the domestic company in the example structure.

In the first scenario, Chinese government authorities typically require the domestic company to make this payment from an onshore account, as this is a domestic investment in what will be a domestic company following conversion. In the second scenario, under Tax Bulletin 7/2015, the seller, buyer or the target company may report the equity transfer transaction to Chinese tax authorities, even if the transfer is one level up involving only the transfer of the shares of an offshore holding company with no change at the China level. More importantly, the buyer is required to act as the withholding agent for any tax payable. Failure to pay or withhold taxes as required may trigger a number of penalties against the withholding agent and the seller as well. This clear duty on the buyer to withhold taxes, together with clear penalties for a seller that fails to report the transaction, gives buyers a firm basis for withholding and empowers them to report the transaction if the seller is reluctant.

A more tax efficient alternative structure is sometimes available in which the original WFOE directly transfers to the domestic company buyer the bad assets to be spun off as illustrated by the following diagram.

More tax efficient alternative structure

This alternative structure works best where only a smaller portion of the original WFOE assets and business operations need to be spun off. Moreover, if original WFOE has outstanding contracts relating to the business operations to be spun-off together with the bad assets and it has not fully performed those contracts, counterparty consents to the assignment of the contracts to the domestic company will be required. If the counterparties to these contracts do not agree to the assignment, then this alternative structure cannot be used. In addition, there may be other circumstances that dictate that the target company set up a clean NewCo entity to accept only the good assets to put as much distance as possible between the offshore buyer and the prior bad acts that may give rise to continuing liability on the part of the original WFOE, even with the disposal of the bad assets that may otherwise be imputed up to the offshore buyer post-acquisition.

Transfers of assets under any of the spin-off structures outlined above are subject to VAT and business tax, depending on the type of asset. The asset transfer price should be set at fair market value, and the seller of the assets may also be subject to tax on any gain from the sale.

Remedying regulatory non-compliance in China operations: timing and process management considerations

In certain cases, due diligence discloses that the China operations of the offshore target company are not in compliance with applicable regulatory requirements in China. In many of these cases, the non-compliant conduct will need to be remedied as a condition precedent to closing the global transaction. However, the non-compliance does not require a spin-off of bad assets and related business operations.

Although in most of these scenarios the remedial work to be undertaken will not be as extensive as in the case of the spin-off of bad assets, the amount of time, resource and effort required should not be underestimated. China compliance often is comprised of a series of sequential steps, each of which consists of its own specific pre-conditions and timeframes. As a result, this can impact the overall deal closing schedule if not addressed adequately early in the process.

Other categories of non-compliance can be managed on a post-closing basis. However, in China it is not always simple to delineate between matters of regulatory non-compliance that should be cleaned up before closing and that can be addressed after closing. This is because almost all China operations involve some degree of technically non-compliant conduct that is tolerated (or even tacitly acknowledged) by the relevant government authorities as acceptable in practice. This is a matter for careful evaluation in consultation with experienced Chinese legal counsel.

Each category of regulatory non-compliance has its own special characteristics. However, some of the more common issues include:

•          Incomplete corporate registrations.

•          Tax issues.

•          Defects in IP right registrations or other IP infringement problems.

•          Failure to comply with labour law requirements.

•          Discrepancies in land use rights and building ownership registrations.

•          Failure to comply with related procedural requirements in connection with land and buildings.

While these issues more commonly arise for domestic Chinese enterprises, they can also arise for FIEs, particularly for minority foreign-owned EJVs or CJVs managed by Chinese parties.

FIE approved scope of business

Of more concern in connection with the China operations of foreign target companies are circumstances in which the FIE exceeds the approved scope of business set out in its business licence. All legal entities in China have a limited scope of business. An FIE’s scope of business is typically restricted to a specific category of manufacturing or services, and the business scope set out in the business licence is controlling over the business scope set out in the FIE’s constitutional documents. The business scope set out in the business licence must conform to operational categories included on a list maintained by the local AMR. For more information on FIEs.

Typically, the approved scope of business in the business licence is stated in general terms, and companies are usually given some freedom in their actual operations as long as there is a reasonably close relationship between the business activities undertaken and a good-faith understanding of the categories of permitted operations set out in the business licence. In many cases, ultra vires business conduct can be remedied by a relatively simple application to expand the original approved business scope to include an additional category of permitted operations. For certain types of expanded business scope categories, such as value-added telecommunications services (VATS) or real estate development, a further project application report (PAR) and related feasibility study report may need to be submitted and additional capital injections may be required to meet statutory minimums. In other situations, only a simple application supported by amendments to the articles of association and (for Sino-foreign joint venture companies) the JVC and a unanimous board resolution will be sufficient.

In more flagrant cases of ultra vires conduct, certain business activities could be considered illegal and related contracts could be considered invalid and unenforceable. However, enforcement of business scope restrictions is inconsistent and depends on the policy posture of the relevant local government departments. Serious legal consequences generally arise only in situations involving the most flagrant violations, particularly where there are additional elements of political sensitivity. In most cases, rectification steps are permitted and additional penalties can be avoided.

Non-compliance with approved scope of business

Categories of non-compliance by China subsidiaries of foreign target companies that may result in more serious consequences typically involve the failure to obtain requisite operating licences for the particular industry sector. This most often occurs in sectors in which foreign investment and participation is restricted or prohibited, such as VATS, publishing and education.

The two common ways in which FIEs attempt to circumvent the restrictions on foreign investment and participation in a particular industry sector are:

•          Through a form of nominee shareholder arrangement.

•          By ignoring the legal restrictions and proceeding with the business activities without the proper licences, usually based on a biased interpretation of what conduct is permitted and what is restricted or prohibited.

For issues relating to the nominee shareholder arrangement. For FIEs in the second bullet above, for the seller to be able to provide clean warranties relating to the compliance status of the target company at closing, the licensing issue must be rectified either:

•          Through discontinuing the ultra vires business conduct, by obtaining the necessary licences.

•          By finding an alternative structural solution through co-operation with another entity that possesses the proper licences.

It may be impossible to obtain the requisite licences within the contemplated closing schedule not only because of the time required to apply for and receive the relevant licence, but also because it may not be possible for the China subsidiary to put its house in order to qualify for the licence (if the company can even qualify under applicable rules).

The problem is further complicated if the ultra vires business activities involve commercial commitments to China-based customers, in which case simply discontinuing the illegal business conduct will result in a breach of contract. Work around solutions, such as subcontracting arrangements with properly licensed entities which will nominally provide the product or service, require customer consents which also may be difficult to obtain.

In many cases there is no single solution, only different processes to be put together to achieve an interim arrangement that:

•          Permits the seller to give clean warranties under the SPA at closing.

•          Puts the China subsidiary on a path to a more stable and sustainable business model from a regulatory compliance perspective.

All these solutions require sound commercial and legal judgment from the buyer’s business team and external advisors. It is also necessary to scope out the risks and issues early on and then design a work plan with realistic timelines to incorporate into the overall closing schedule.

Nominee shareholder arrangements: risks and remedies

One popular structure used to work around restrictions on foreign investment and participation in certain industry sectors in China is a nominee shareholder arrangement, sometimes referred to as a variable interest entity (VIE) structure. These arrangements are commonly used by foreign investors in industry sectors in which foreign investment is restricted (such as VATS operations), to circumvent those restrictions and operate a local company as a captive partner. Investors have used the VIE structure for many years, particularly for offshore listings of companies operating in restricted sectors (for example, Sina Corp and Sohu, Inc.).

The typical arrangement is for a domestic company to hold the necessary operating licences, in accordance with Chinese law, but for the foreign party to set up a WFOE in China. The WFOE then enters into a series of agreements with the domestic company and its shareholders, by which the foreign party assumes effective corporate, operational and financial control of the domestic operating company. These arrangements carry legal and practical risks that must be carefully evaluated by a prospective foreign buyer. In recent years, various Chinese government regulatory authorities have made a series of public comments that cast doubt on the stability of this structure. However, to date, no systematic action has been taken to end these arrangements.

Risks associated with VIE

The risks associated with a VIE structure include both regulatory risks and partner risks. A regulator could view the overall set of contractual relationships and, notwithstanding that each individual piece is lawful on its face, declare that arrangement is an illegal attempt to circumvent the restrictions on foreign investment in the sector. Partner risks include domestic partner control of the company chop (seal) and bank accounts and the risk of partner default. For more information on the risks of VIE structures and strategies to mitigate them.

In general, the best course is to conduct the business in China without the use of a VIE structure and have the FIE subsidiary of the target company conduct the business directly in its own name with the proper licences, if it is possible to do so. Where there is an existing VIE structure in place but a plausible path to a non-VIE structure, it is important to consider the relevant timelines to complete that transition as well as the regulatory and commercial risks and benefits of doing so (or not doing so) when deciding whether this is to be done as a closing condition or after closing.