News + Events
China Advisory: Partnerships Open Further to Foreign Investors in China
January 5, 2010
Edward J. Epstein
Partnerships are not new to China. In 1986, partnerships were first adopted in the General Principles of Civil Law (中华人民共和国民法通则, "GPCL"). In 1997, the first Partnership Enterprises Law (中华人民共和国合伙企业法, "Partnership Law") was promulgated. However, in practice, partnerships were not popular. The reasons for this are complex but there were some key factors. For example, according to the GPCL and the Partnership Law, only individuals could be partners. Before 2000, the partnership enterprises established based on the Partnership Law were still subject to the enterprise income tax ("EIT"), which means these partnerships could not enjoy the tax pass-through treatments. Moreover, before the Partnership Law was amended in 2006, limited partnerships were not allowed, and foreign investors could not be partners of a domestic partnership enterprise.
All these restrictions limited the development of partnerships in China. Therefore, unlike their wide use in real estate development, entertainment, research & development, private equity ("PE") and venture capital ("VC") in western countries, Chinese partnerships have generally been limited to small business or professional industries, such as law firms, real estate broker firms, accounting firms, etc.
With the amendment of the Partnership Law in 2006 and the development of local PE/VC markets, partnerships are becoming more and more important and popular. According to the new Partnership Law issued in 2006, partnerships can enjoy tax pass-through status, and legal persons (such as enterprises) can be partners. Limited partnerships are also allowed. However, although the new Partnership Law allows foreigners to set up partnerships in China, it did not truly facilitate the process.
On December 2, 2009, the State Council published the long awaited Administrative Measures on the Establishment of Partnership Enterprises by Foreign Enterprises or Individuals (外国企业和个人在中国境内设立合伙企业管理办法, "Measures"), which will take effect on March 1, 2010. These Measures are recognized as a new step in encouraging foreign investment because they allow foreigners more easily to use partnerships as a vehicle for doing business in China.
The final Measures have made using partnerships more accessible to foreign investors by lowering the thresholds and simplifying the set-up process. The Measures are not detailed and we believe that subsequent legislation will be forthcoming.
Partnership Forms and Investors – Foreign Invested Partnerships (FIPs) under the Measures refer to general or limited partnerships(1) established in China by foreign enterprises or individuals or by foreign enterprise(s) or individual(s) together with Chinese investor(s). Foreign enterprise(s) or individual(s) may also join existing domestic partnerships, which will be converted into foreign-invested partnerships. There are no special requirements for foreigners to become partners of FIPs established under the Measures.
Based on these rules, foreign investors are allowed to establish wholly foreign-owned FIPs or Sino-foreign FIPs. Foreign investors may also convert a domestic partnership into a FIP through M&A, which will provide a wide access to the China market.
General Policy - Partnerships incorporated in China by foreign enterprises or individuals shall abide by the Partnership Law and other relevant laws and regulations, and they shall also be in compliance with the industry policies(2) for foreign investment. Foreign enterprises or individuals with advanced technology and management experience are encouraged to establish partnerships in China. It is expected that China will provide relevant incentive policies in the near future.
The Measures only supplement the Partnership Law so most of the clauses under the Partnership Law will also apply to FIPs. Current foreign investment industry policies, such as the Guideline Catalogue of Industries for Foreign Investment ("Catalogue"), are based on the regime of foreign invested enterprises ("FIE"); and therefore, how such policies will be applied to FIPs will be a problem that will be left to practice. For example, under the Catalogue, many industries limit foreign investment to "equity joint venture[s] or cooperative joint venture[s]". As such, whether Sino-foreign FIPs may also enter into such industries is an open question. In addition, some industries require that the "Chinese party must be the majority shareholder", and this restriction raises the questions as to how it is applied to a FIP and how "majority shareholder" should be defined in a FIP.
Capital Contributions – According to the Partnership Law, partners may make capital contributions to the partnership in cash, in kind, by labor, by intellectual property, by land use rights or by other property rights. There is no restriction on the capital contributions by foreign partners under the Measures. The Measures only states that the monetary contributions by foreign partners to the partnership will be convertible currencies or lawfully earned RMB. It is not clear whether foreign partners may also make capital contributions in the same manner as their Chinese partners but this issue will most likely be clarified in practice.
The Measures are also silent on the minimum capital required as well as the minimum ratio for monetary contribution. As such, whether partners of a FIP may freely agree on capital contribution amounts in its partnership agreement will be another practice issue. Moreover, there is also no time limit for contributions stated in the Measures. It is unclear whether the partners must make full contributions when setting up the FIP or not.
Regulatory Authority – Unlike foreign-invested enterprises, the incorporation, amendment registration and termination of FIPs will be governed by the State Administration of Industry and Commerce ("SAIC") and its local counterparts without the need for approval from the Ministry of Commerce ("MOFCOM"). However, the partners are required to submit a statement to SAIC when establishing a FIP to confirm that the pending partnership complies with relevant foreign investment industry policies. If the pending partnership is subject to any specific government pre-approval, it will go through the relevant approval procedures.
The approval process for a FIP is significantly different from the current approval process for FIEs. Traditionally, most foreign investments are subject to MOFCOM's review and approval, and SAIC will then follow MOFCOM's decision and act as a registration center. The Measures provide SAIC with the approval authority regarding FIP investment. According to the statement of the Legal Affairs Office of the State Council, the purpose of this arrangement is to simplify the approval process and encourage foreign investment. At this time, it is unclear how SAIC will exercise this power and interact with MOFCOM.
Private Equity ("PE") Investment - The Measures state that FIPs which mainly engage in the investment business shall comply with "other relevant rules", which indicates that China may adopt special rules in the future on foreign-invested PEs which use a FIP as their investment vehicle. Because of the Legal Affairs Office of the State Council’s lack of experience with PEs using a FIP structure, the government is uncertain whether stricter regulations will be adopted. Due to this uncertainty, some argue that the Measures allow FIPs to engage in the investment business immediately until further detailed restrictions are provided, while some others believe that investors need to wait for further detailed rules. The local governments of Beijing, Shanghai and Tianjin are also considering the issuance of more detailed rules concerning foreign-invested PEs based on the Measures, which may resolve this uncertainty at the local level and provide more practical ways for FIPs to engage in the investment business.
Foreign Exchange, Tax and Other Issues - The Measures do not provide detailed rules on more complex issues such as foreign exchange, tax, accounting and customs. The Measures only state that all these issues shall be dealt with according to the “relevant laws, regulations and other rules”. However, many relevant rules relating to foreign investment are based on the FIE structure and cannot be easily applied to a FIP structure. For example, the current foreign exchange rules on foreign investment are based on the concept of “total investment amount” and “registered capital”, but there is no “total investment amount” rules for FIPs. Another example deals with taxes. The current tax regulations state that a partnership enjoys tax pass-through and that it is taxed at the partners’ level. However, foreign partners bring more questions: (1) Should foreign partners be taxed at the EIT rate of 25% or at the general withholding tax rate? (2) How should the partners be taxed when they sell their partnership interests in FIPs? (3) Whether the taxable losses of FIPs can be carried forward into the following tax years? Although all these issues may be clarified in practice, we expect that the relevant authorities will issue detailed rules accordingly.
In conclusion, although the Measures are broad, leaving several issues still unclear, the Measures have lowered thresholds and simplified the setup process to allow foreign investors who understand the risk to take advantage of this opportunity. We believe that FIPs will become a popular vehicle for foreign investment and will facilitate the further opening of China's markets to foreign investors.
(1) The Measures do not address whether FIPs can be both general partnerships and limited partnerships, and whether foreign investors can be general partners or limited partners, but the Measures should generally follow to the Partnership Law, which allows different types of partners and partnerships.
(2) Foreign investment industry policies are mainly contained in the Guideline Catalogue of Industries for Foreign Investment and other regulations.