Can goodwill be used for capital contributions to a company?

The first paragraph of article 27 of the Company Law stipulates that: “Shareholders may make capital contribution in currency or in non-currency property that may be valued in currency and transferrable according to the law, such as physical objects, intellectual property and land use rights, except for property that may not be used as capital contribution according to the laws or administrative regulations.” As one of the increasingly important factors in market competition for enterprises, can goodwill be used as a form of shareholders’ capital contributions to the company?

Goodwill (i.e., business reputation) refers to a trust relationship formed in the frequent exchange of goods by business entities, which may originate from a superior geographical location, good reputation, favorable business position, advanced technology, or scientific and effective management, etc.

From the perspective of social or value judgement, goodwill is the public’s positive assessment of a particular business entity’s production and management capabilities, operation status, credit status, and quality of goods and services, among others, which often enables the business entity to earn higher profits than the average profit level in the industry over a long period of time.

In market transactions, goodwill is directly reflected as the exceeding portion of a business entity’s overall value to the sum of its individual values (fair value). China’s Accounting Standards for Enterprises No. 20 – Business Combination, also makes this clear: “The acquirer shall recognize the positive balance between the combination costs and the fair value of the identifiable net assets it obtains from the acquiree as business reputation.”

Dilemma of regimes

China does not directly negate goodwill contributions from the legal aspect, but there are clear prohibitive provisions in specific administrative regulations. For example, article 14 of the Regulations on the Administration of Company Registration clearly states that, “Means of contribution by shareholders shall comply with the provisions of article 27 of the Company Law, and no shareholder may make any contribution with capital that evaluated from labour, credit, name of a natural person, goodwill, franchise, or properties to which any guarantee has been made.”

From the perspective of China’s company law system, in order to protect the stability of the company’s capital, the shareholders’ contributions should meet at least two criteria: First, they can be valued in currency; second, they are transferable according to the law.

While the attributes of goodwill are well known, goodwill is intangible and cannot be quantified through tangible objects or certain rights. Moreover, goodwill is dependent and cannot exist independently from the business entities. The above characteristics determine that there are practical difficulties in determining the valuation of goodwill and in effecting legal transfers.

Feasibility analysis

From the legislative perspective, common law countries generally do not restrict the form of shareholder contributions, while civil law countries including Germany, France and Japan have recognized the effectiveness of goodwill contributions. In China, the continuous development and innovation of the market economy have led to a clear understanding and affirmation of the attributes of goodwill.

In practice, there have also emerged some alternative methods of goodwill contributions, such as: (1) considering goodwill as the connotation of a trademark or brand name, thereby effecting the transfer of the value of goodwill by transferring the trademark or brand name to the target company; or (2) realizing the transfer of the value of goodwill through purchasing at a premium in M&A by attaching it to the target company in the overall evaluation and accounting.

In addition, the current Company Law recognizes the shareholders’ autonomy, such as making capital contributions at a premium or receiving/distributing dividends not in proportion to their respective capital contribution, which also leaves a certain space for the contribution of goodwill.

The consideration for Chinese legislators to temporarily restrict goodwill contributions is clearly worthy of affirmation, for reasons of corporate capital and market economic stability. But with the continual development of the market economy, more and more complex transaction models are accepted and used, and the forms or carriers of capital are becoming more varied. The restrictions on the goodwill contributions should also be gradually relaxed, or even eliminated.

The authors believe that the feasibility of the contribution of goodwill should be based on the following supporting regimes: (1) improving the goodwill evaluation mechanism to ensure that goodwill obtains a fair value in the market within a certain range; and (2) clarifying the liabilities that shareholders with goodwill contributions should bear.

For example, the shareholders with goodwill contributions are liable to guarantee the valuation of goodwill within a certain period of time; shareholders with goodwill contributions should assume the liability of continuing to make contributions when the value of goodwill is depreciated due to their fault. If shareholders with goodwill contributions cancel the authorization, or set up barriers to its use, resulting in the target company’s inability to make reasonable use of the goodwill, the shareholder shall assume the liability of withdrawing capital contribution, etc.

The establishment and improvement of the above-mentioned supporting regimes can, to a certain extent, ensure that shareholders make goodwill contributions at a fair market value, and fulfill the corresponding delivery obligations and accompanying obligations or legal liabilities after delivery, thus ensuring the stability and credibility of corporate capital.

The transformation of the Company Law from the paid-up capital to the subscribed capital regime has obviously increased investors’ enthusiasm. The authors believe that the contribution of goodwill, as another form of lifting the restriction on capital requirements, can also further stimulate market vitality.

On the basis of fully demonstrating the feasibility of the contribution of goodwill and ensuring the stability of the market economy order, consideration can be given to appropriately relaxing the restrictions on forms of capital contributions to the company, to adapt to the transformation of the new economic pattern with the new trend of economic development.

Wang Kun and Yan Lantao are associates at Tiantai Law Firm