Shanghai’s foreign-invested RMB funds need reform to appeal

For this column, Shanghai foreign-invested RMB funds refer to the RMB funds collected from domestic investors by foreign-invested equity investment enterprises or foreign-invested equity investment management enterprises established in Shanghai. According to the PRC Business Partnership Law and PRC Registration of Partnership Enterprises Administrative Measures, partnership enterprises refer to general partnership enterprises – including special general partnership enterprises – and limited liability partnership enterprises established by persons, legal persons and other organisations in China.

Pursuant to the Implementation Measures in relation to the Pilot Programme for the Development of Foreign-funded Equity Investment Enterprises in Shanghai, which came into force on 24 January 2011, foreign investors of the pilot’s foreign-invested equity investment enterprises consist mainly of foreign sovereign rights funds, pension funds, endowment funds, charitable funds, funds of investment funds, insurance companies, banks, securities companies and other investors from foreign organisations recognised by a joint conference set up by the Shanghai government for the pilot programme. Foreign-invested equity investment management enterprises that have received approval to participate in the pilot project may use foreign exchange funds to make capital contributions to the equity investment enterprises that they sponsor and establish. These contributions must not exceed 5% of the total funds raised and such contributions will not alter the original attributes of the equity investment enterprises it invests in.

Domestic or foreign investment?

It is important to differentiate between domestic investment and foreign investment of RMB funds, due to existing industrial policies and restrictions in China on the access to foreign investment of certain industries. These industries are open to domestic investment – or at least partly open – but are still closed to foreign investment.

According to current international practice, whether a fund is a domestic investment or a foreign investment is unrelated to the identity of fund managers. Instead, it relates to the identity of those who are the ultimate owners of the capital. In this respect, since foreign-invested partnership RMB funds are geared to the needs of domestic investors and are collected in the form of RMB, such foreign invested RMB funds are regarded as domestic investment funds. However, if a domestic foreign invested enterprise invests RMB funds by using the identity of a limited partner, it is difficult to guarantee that such funds are 100% domestic invested funds.

Foreign interest

Since Shanghai released the implementation measures, large, foreign-invested private equity (PE) investment companies have frantically fought for “entrance licence certificates”. Up until the end of 2011, the Shanghai municipal government had already approved qualifications of qualified foreign limited partners (QFLP) for 14 PE investment companies and established Shanghai’s QFLP system.

This system refers to investors from organisations converting foreign capital into RMB capital and investing it in domestic PE and venture capital (VC) markets, after receiving qualification approvals and completing the necessary procedures for foreign exchange capital. According to Shanghai’s existing QFLP system, when foreign investors establish RMB funds, if the general partners (GPs) make contributions of less than 5% such capital can only be exchanged once into RMB and the nature of the funds will not be changed.

At the same time, if the GP is a foreign investor, this will not affect the nature of the funds. This system also exceeds the limitations of the State Administration of Foreign Exchange’s (SAFE) document No. 142. According to the rules of document 142, released in August 2008, the RMB capital obtained from the settlement of foreign-invested enterprise capital in cash exchange should not be used for domestic equity investment, unless otherwise provided.

However, since SAFE maintains a cautious attitude, those using Shanghai’s QFLP system will encounter a number of obstacles. The biggest obstacle is that the investment quota cannot be exchanged and used more than once. In fact, each investment must apply separately for its foreign exchange quota, as well as conduct an investigation into the investment industry. Prior to 1 May this year, the National Development and Reform Commission sent a Reply regarding Relevant Questions about Foreign-invested Equity Investment Enterprises to the Shanghai Municipal Development and Reform Commission to clarify that Shanghai Blackstone Equity Investment Partnership Enterprise – and such other limited liability partnership equity investment enterprises whose GPs are foreign investors and limited partners (LPs) are domestic investors – shall be administered according to foreign investment policies and regulations, and its investment projects should adhere to the Catalogue of Guidance for the Foreign Investment Industry. This reply finally clarified questions posed by foreign investment general partners in relation to domestically collected RMB funds, but also frustrated Shanghai’s QFLP system.

QFLP confusion

Shanghai’s QFLP system is also faced with legal confusion regarding the imperfections in the existing Partnership Enterprise Law, because the provisions of existing law regarding the liabilities of GPs and LPs in various partnerships are relatively general, thus leading to relatively large and uncertain risks of partnership enterprises in determining the rights and responsibilities of GPs and LPs. At the same time, according to the provisions of the existing Partnership Enterprise Law, Enterprise Income Tax Law, etc., partnership enterprises implement respective taxation by partners, leading to higher taxes for partnership enterprises in comparison with common enterprises.

Furthermore, it is rumoured that the governmental supervision and administration department will release new regulations so that tax collection and administration of domestic PE and VC will be based upon the floating profit situation of partnership enterprises over a continued period. This will not only notably increase the tax burden of partnership enterprises, but will also complicate the taxation system of partnership enterprises.

In order to accelerate the construction of Shanghai’s World Financial Centre, we recommend that reforms begin in areas such as the foreign exchange administrative system, the identity of foreign-invested RMB funds, the Partnership Enterprise Law and Enterprise Income Tax Law, and also systematic improvement of the existing QFLP system, in order to create a good policy environment and provide support for the development and expansion of foreign-invested RMB funds.

Lin Wei is the director of International Practice at Zhonglun W&D Law Firm; Zhang Zhonggang is the associate director of the firm’s Competition and Anti-trust Protection Practice