The Year of Boar testifies to feverish interest in the Chinese venture capital community in something called renminbi fund. But what is a renminbi fund and what are the key issues that a foreign sponsor needs to take into consideration when forming and structuring one?

Renminbi funds may be broadly construed to include any legal entity formed under PRC laws that purports to make renminbi-denominated private equity investments in China.

Private equity funds have been established in various legal forms in China, including trusts, limited liability companies and limited partnerships (only recently made available to domestic sponsors). Certain alternatives have also been used, such as investment management agreements (for a start-up sponsor with a relatively small number of investors) and holding companies (for defined pool investment ideas). From time to time, sponsors that do not yet have a sufficient record also raise equity on a deal-by-deal basis. But this will not be discussed here.

For a foreign sponsor, the easiest vehicle to use under the current regulatory regime is a foreign invested venture capital investment enterprise (a FIVCIE or Fund) established under the Rules on Administration of Foreign Invested Venture Capital Investment Enterprise promulgated by five central government agencies in 2003.

This is because: (i) China does not yet have a national foreign investment partnership law that incorporates a legal form of limited partnership; and (ii) the FIVCIE Rules create a legal form that resembles a limited partnership in international norms. In this connection and for ease of discussion, terms such as Fund, General Partner (GP), Limited Partner (LP), manager and partner are used purely as functional and not legal descriptions.

Why bother with renminbi funds?

A renminbi fund has a number of appealing attributes. For instance, portfolio investments are subject to a streamlined approval process: if they are in "encouraged" or "permitted" industries, they only need to be filed with the local Ministry of Commerce (Mofcom). A renminbi fund also enables foreign investors to repatriate principal and capital gains together when exits from portfolio companies are achieved.

However, with too much money chasing too few onshore deals, the most attractive feature of a renminbi fund vis-à-vis an offshore fund (with all of its capital parked outside the border) probably lies in the ability to get a term sheet signed, regulatory hurdles cleared and the deal done far more efficiently. More often than not, the presence of a Chinese partner makes a renminbi fund more accessible to the management of the portfolio companies (and in many cases the local government as well).

This often gives the renminbi fund a niche position when time comes for an A-share IPO. Earlier entry can mean shorter lock-ups and better multiples.

This has been particularly true given the fundamental change for offshore exits brought about by regulations since September 2006. Under a conventional private equity model, domestic founders and offshore fund investors would set up an offshore holding company, which would take over the domestic assets through a so-called round trip investment, and then get listed on an international capital market on a consolidated basis. The process is known as red chip listing.

The M&A Rules published on September 8 2006 made it almost impossible to repackage domestic companies into red chips. First of all, approval must be received from Mofcom before an offshore SPV can be established. After that, a separate approval must be sought, within one year, from the China Securities Regulatory Commission (CSRC) for the overseas listing. Despite rumours to the contrary, Mofcom has not rendered a single approval since the promulgation of the M&A Rules.

Furthermore, Safe Notice 106 created onerous filing requirements for every possible situation. Incidentally, under 106, any filing by a renminbi fund under Safe Notice 75 may only need to be made at the local Safe level.

From the regulator's point of view, China has enormous capital surplus and it makes no sense to raise money abroad for investing in China. This policy change, together with the appreciation of the renminbi and the surge of the A-share market, apparently gives foreign sponsors enough incentive to seriously consider onshore fund raising and domestic listing as an alternative to (if not a substitute for) the orthodox offshore play.

Structuring the Fund

Under the FIVCIE Rules, the Fund can be structured as either a legal person in corporate form or a non-legal person in the form of a Sino-foreign cooperative joint venture.

China normally considers each investor in a Chinese cooperative joint venture as having a permanent establishment in China, by virtue of that joint venture. Any items of income, gain, loss and deduction attributable to the joint venture would be subject to enterprise income tax (EIT). A 2003 tax circular sets forth a different basis for taxation of foreign investors in a non-legal person Fund.

If properly structured, a non-legal person Fund outsourcing all of its investment management functions to a separate manager would be deemed as a foreign entity without a permanent establishment in China, and would be able to enjoy pass-through tax treatment. That is, there will be no EIT liability at the Fund level; and distributions to the foreign investors of the Fund will be subject to a 10% withholding tax rate, reduced by any more preferential tax treaty benefits that may be available to individual investors. Moreover, there will be no EIT against the investor's share of items of income, gain, loss or deduction of the Fund. In this respect, the non-legal person form prevails over the legal person form.

It is uncertain whether this could still hold under the amended PRC Enterprise Income Tax Law and its Implementing Rules, which become effective on January 1 2008. Under the Implementing Rules, an agent that conducts operations in China on behalf of a foreign entity would be deemed a permanent establishment and thus subject to EIT. The tax authorities that we have consulted are unable to reach a consensus in this regard.

The landscape is made more complex by the release of a circular by the State Administration of Taxation in early 2007. Under the circular, certain venture capital investment companies are entitled to an EIT deduction of up to 70% of total investment in a qualified small and medium hi-tech company. There is uncertainty about whether this tax holiday applies to a non-legal person Fund at all, as it is not a company as defined.

A Fund is also desirable for non-tax reasons. For instance, capital calls can be made on a committed basis instead of being paid upfront under a registered capital system. In addition, admission of new LPs and transfer of Fund interests are permitted, without further governmental approvals, if provided for in the original approved fund agreement.

Many statutory matters that are usual in a common law jurisdiction must be spelt out in the fund agreement, because of the lack of a foreign investment partnership law. These issues include fiduciary duties, inter-partner liabilities, the status of a defaulting partner and the assignment of fund interests.

Structuring the GP

A GP only needs to contribute 1% of the registered capital of the Fund, and is jointly liable, together with the Fund, for its debts. A GP can be either an onshore or an offshore entity, provided that it or its affiliate meets a variety of statutory qualification requirements as set out below. If an offshore GP is used, though, the GP should ideally be structured as a passive entity, so that the carry can receive favourable tax treatment.

Known as a requisite investor under the FIVCIE Rules, the GP (or its affiliate) has to meet the following qualification requirements:

• Venture capital investment must be its main line of business;
• In the three years before the application it must have had cumulative capital under its management of not less than $100 million, of which at least $50 million was used for venture capital investments. For an onshore entity, the cumulative capital must be Rmb100 million ($13.3 million) of which at least Rmb50 million was used for venture capital;
• It must have at least three professional management personnel who possess at least three years' experience in venture capital; and
• Neither the GP nor its affiliate (as defined below) can have been prohibited from venture capital investments or investment consultancy, or been subject to penalties for fraud by a judicial authority or any other relevant regulatory authority in its home country.

For the purposes of these requirements, an affiliate means an entity that controls, is controlled by, or is under common control with the party concerned; and a party is controlled by another party if the controlling party owns more than 50% of the voting power in the controlled party.

Until recently, a foreign investor was exempt from withholding tax on dividends received from a foreign-invested enterprise deemed to have a permanent establishment in China (an FIE). After January 1 2008, when the amended PRC Enterprise Tax Law takes effect, a 20% withholding tax may be levied. Investors will need to pay careful attention to low-tax investment vehicles and locations that have tax treaties, and balance their considerations in this area carefully.

The manager

The FIVCIE Rules clearly recognise that a fund manager may manage a Fund on a day-to-day basis under a separate contract. In principle, if an offshore GP is used a separate manager is preferred, to preserve the passive status of the GP.

If a separate manager is used, it can be either an onshore or an offshore entity (but with an onshore presence as required). In either case the onshore management function is subject to various Chinese taxes including a turnover tax of 5%. Careful tax planning is critical to minimise the tax exposure of the management fee.

LP issues

A Chinese investor is desirable and in a non-legal person Fund it is required. Foreign sponsors need to be careful, though, if they expect funding from a state-owned enterprise (SOE). In the presence of an SOE LP, the National Development and Reform Commission (NDRC) may deem your Fund as an "industry investment fund" that falls into its jurisdiction, despite the fact that a regulation in this respect is still not in place. Furthermore, with an SOE LP, each exit event may involve special procedures that are designed to protect state assets from being siphoned.

Although the FIVCIE Rules state that the liability of an LP is capped to its capital commitment, it is not clear that this limitation would hold in a Chinese court. Foreign investors should thus invest through an offshore feeder fund or through individual single purpose subsidiaries.

What's new?

Under the draft amendments to the FIVCIE Rules, which are expected in early 2008, a Fund will be able to engage in business broader than conventional venture capital. This is a natural evolution of the pragmatic approach adopted by Mofcom (or more accurately the department in charge of approval of Funds). Even under the current FIVCIE Rules, a number of Funds have been approved with investment scopes limited to neither venture capital nor hi-tech portfolio companies.

Under the proposed amendment, a Fund will be allowed to invest in listed companies as a "strategic investor", so long as the investment is not more than 20% of the total capital of the Fund (though it is unclear if it is meant to be committed capital or contributed capital). The Fund may also be able to borrow to invest, which is now prohibited.

A foreign investment partnership law is also expected, along a similar timeline. From the draft we reviewed, it seems to open the door for foreign investors adopting limited partnership structures that are otherwise similar to domestic ones, subject to any existing restrictions or limitations on foreign investments. Therefore, we think that this law may codify current practice under the FIVCIE Rules in many aspects, including the pass-through status of the Fund and the limited liabilities of LPs.

However, the draft, is not completely in line with international private equity norms. For instance, it provides that all capital contributions have to be paid in full upfront within 90 days of the issuance of an approval certificate by Mofcom or its local counterparts.

We are optimistic about domestic fund formation and deployment in general. However, organising a fund in China is much more complicated than under Delaware or Cayman Islands law. For one thing, a Fund's partnership agreement, as well as any fund management agreement, will be subject to Chinese government review and approval. Experienced counsel should be consulted to ensure that the Fund is properly set up. Anecdotal evidence testifies to abandoned investments and troubled IPOs resulting from structural defects. Several renminbi funds have had to go through a painful restructuring process to get back on a level playing field.

By Richard Guo, partner at Fangda Partners in Beijing