At September 23, 1999, the Ministry of Foreign Trade and Economic Co-operion (Moftec) and the State Administration of Industry and Commerce (SAIC) jointly issued the Regulations Regarding Mergers and Divisions of Foreign Investment Enterprises (FIEs), effective from November 1, 1999. These regulations provide specific rules for FIE related mergers and divisions. They build on broader provisions in the 1994 Company Law and for the first time address issues related to the role of Moftec in the approval of mergers and divisions of FlEs.
The regulations apply principally to mergers and divisions between FIEs, including joint ventures, wholly foreign-owned enterprises and FIES limited by shares and have limited stipulations regarding mergers between FIEs and domestic companies.
The regulations define a merger as meaning that two or more FIEs agree to merge into one company, in accordance with the provisions of the Company Law. As in the Company Law, a merger can take the form of either merger by absorption, in which one company absorbs another and continues to exist while the absorbed company is dissolved, or as a merger by the establishment of a new company, in which two or more companies are merged into a new company while the original companies are dissolved. Generally, the successor or new company is required to have a minimum of 25 percent foreign ownership in order to maintain FIE status.
?Division' refers to the process whereby an FIE, through a resolution adopted by its highest authority, is divided into two or more companies in accordance with the provisions of the Company Law.
A division of a company may take either of two forms: division with continuation or division by dissolution. Division with continuation means that a company is divided into two or more companies and the original company continues to exist, while division by dissolution means that a company is divided into two or more companies and the original company ceases to exist. Again, the successor or new company is required to have a 25 percent foreign ownership in order to maintain FIE status.
The remainder of the regulations is largely devoted to procedural matters, such as: identifying the approval authority responsible for approving a merger or division; determining the establishment date for companies formed in relation to a merger or division; documents required to be submitted to the authorities in connection with the approval of the merger or division; the mandatory provisions in a merger or division agreement; specifying the form a merged or divided company may take.
The regulations require multiple approvals. The companies that are planning to merge or divide first apply to the relevant approval authority for approval. If the merger involves the dissolution of one or more companies, approval for dissolution must be obtained before the company applies for merger approval. Within 45 days of the application for approval for merger or division, the approval authority is required to issue a preliminary reply as to whether it has agreed to the merger or division.
Thereafter, the company or companies proposed to be merged or divided must notify creditors of the companies' plans regarding debt succession in writing and by public announcement in provincial-level newspapers. Creditors have the right to request that the company amends the debt succession plans. The successor FIE(s) shall assume the rights and liabilities of the predecessor companies. After the time limits regarding the debt succession plan have elapsed, the company must submit relevant documents to the approval authority. The approval authority shall decide whether to approve the merger or division within 30 days thereafter.
Additional formalities are required after obtaining approval for the merger or division. Application must be made to cancel the approval certificates and business licences of those companies that are to be absorbed or dissolved. After this formality has been completed, application must be made to issue (in the case of the establishment of a new company) or amend the approval certificate and business license of the successor company. The contract and articles of association amended due to a merger or division are only effective from the date the approval authority amends or reissues the approval certificate. After the new business licence is obtained, the successor company must notify in writing and by public notice the creditors and debtors of the predecessor companies infonning them of the identity of the successor company. The successor company must also make corresponding amendments in its registration with the tax, foreign exchange and other relevant government departments.
The regulations reiterate the requirements found in other Chinese legislation that mergers or divisions comply with the Foreign Investment Industrial Guidance Catalogue. A merger or division is not allowed if it would result in a wholly owned foreign entity or a controlling interest in a joint venture in an industry in which foreign investors are not permitted to hold such interests.
Among other provisions, the regulations prohibit a merger or division until the investors have fully paid up their capital (or cooperative conditions) and the company's production and operation have actually commenced. The prohibition could frustrate the plans of foreign companies that pick up dormant or semi-dormant FIEs in regional or global acquisitions that are not fully capitalised. While a company may want to merge such an FIE into one of its existing FIEs, this rule would appear to make it impossible to do so.
The regulations also stipulate that Moftec, as approval authority, may exercise its own discretion to order a review of certain mergers on anti-competitive grounds. It provides that if the approval authority of a merger is Moftec, and if Moftec takes the view that the merger appears to create a monopoly in a certain industry or is likely to establish a dominant market for specific goods or services at the expense of fair competition, Moftec may call upon government departments and institutions involved in the proposed merger to hold a hearing and investigate the company and its market. Notably, equivalent merger control provisions cannot be found in legislation applicable to state-owned enterprises and other non-FIE entities.
Although certain provisions need to be ironed out, the merger/division regulations are a useful addition to the body of Chinese corporate legislation. It is hoped now, with the merger and division regime locked into place, foreign investors will have greater and more secure channels for their merger and acquisition activity in China.
Freshfields 1999. Freshfields is an international law firm. For further details, contact Lucille Barale in Hong Kong (tel: +852 2846 3400) or by e-mail (lb(' [sale@freshfields. com ) or Matthew Cosans in London (tel: +44 171 936 4000) or by e-mail (email@example.com).
The tax implications
Betty Ko, tax partner, and George Gao, senior tax manger of Pricewaterhouse-Coopers in Shanghai, look at the tax implications of the M&A regulations.
Tax attributes The Regulation provides that post-merger/division enterprises should continue to enjoy various preferential treatment available to pre-merger/division enterprise(s). This reaffirms the principle followed under Circular 71. Under this circular, post-merger/division enterprise(s) should be able to continue enjoying available tax holiday for the remaining validity period. Net operating losses brought forward can also be used for relief against profits of the post-merger/division enterprise(s) provided they have not yet expired under the five-year carry forward rule. However, where the unexpired tax holiday period or tax rates differ between the pre-merger/division enterprise(s), then income or loss of the post-merger/division enterprise(s) is required to be segregated to reflect the income or loss of the respective businesses of the pre-merger/division enterprise(s), against which the respective unexpired tax holiday or applicable tax rate should be applied.
The rationale here is that while the tax authority recognises that enterprises should not suffer adverse tax consequence as a result of a corporate reorganisation through merger or division, the enterprises involved should also not be allowed to derive additional tax benefits through a reorganisation that would otherwise not be attainable.
Circular 71 also provides an important exception to a general rule affecting all FIEs. Under the normal rule, if an HE discontinues or terminates its operation within 10 years, then the income tax previously exempt or reduced by virtue of the tax holiday entitlement will have to be refunded to the tax authority. However, Circular 71 provides that in the case of a merger or division, the dissolution of an enterprise operating for less than 10 years should not trigger the pay-back of the income taxes previously exempt or reduced under past tax holiday, provided the foreign investors concerned have not withdrawn or transferred their equity interest to the Chineseparty and that such equity stakes are maintained in post-merger/division enterprise(s). Customs The regulation provides generally that the post-merger/division enterprise should continue to enjoy similar treatment conferred upon FIEs prior to the merger/division. No specific guidelines have been provided but it is thought that these may refer to:
Duty and VAT exemption on importation of equipment within the investment limit. Presumably, after a merger the original unused quota for importing equipment free of duty would be carried over to the merged entity. For divisions, how the original quota would be divided up and inherited by the divided enterprise remain to be clarified.
Equipment imported free of duty is subject to customs supervision for at least five years. Presumably, if during the customs supervision period, a merger/division takes place and the assets are consequently transferred to another entity, it should not have caused the customs to consider that the original importer has violated the vile prohibiting transfer of the assets within the customs supervision period.