China: Will partnership law be worth it?

An article (Opportunity for Domestic Funds) in the August 2008 issue of IFLR provided an overview of possible business forms for establishing onshore funds in China.

The two most prominent forms of renminbi-denominated funds (the partnership and the cooperative joint venture (CJV)) and the key legal and tax aspects of foreign investments into such funds are the subject of this article.

More than a year after China's revised Partnership Law took effect on June 1 2007, the outlook for foreign investment into renminbi, limited-partnership private-equity funds remains unclear. Legal and tax advisers are not immune from blame for this absence of progress. Designing a balanced regulatory and tax framework for the operation of foreign-invested partnerships (FIPs) conducting PE investments is a challenging task; government agencies are as in need of guidance as fund operators and potential investors. Both legal and tax professionals therefore need to engage in more effective advocacy, if onshore investment partnerships are to become more than just a topic of conversation.

Below are a few (by no means all) of the key regulatory and tax issues for forming onshore funds, as well as some solutions or at least strategies for tackling them. For reasons that will become clear, it starts with partnerships, then detours through the older, CJV form of fund operation in China and its tax treatment, and comes back to partnerships and their tax treatment towards the end.

What is the single biggest legal obstacle to the FIPs in China?

The Partnership Law provides that the State Council will issue regulations for the establishment of FIPs in China. Without such regulations, there is no organisational basis for FIPs. By the scope of its mandate, such regulations need to address FIPs generally, not just those in the investment business. (The August IFLR report appears to have neglected the general scope of the Partnership Law when it compared the "little regulatory burden" imposed by the Chinese Partnership Law with US securities regulation.)

In designing such generally applicable regulations, however, the government faces a fundamental dilemma. On one hand, assuming that FIPs may engage in all activities that are permitted for foreign-invested enterprises (FIEs), the regulation of FIPs need to be generally in parity with regulations governing other FIEs. If the regulation of FIPs is more relaxed than traditional FIE regulation, then a major transformation of the FIE landscape seems inevitable: foreign businesses, whatever line of business they operate in, will abandon the traditional FIE forms in favor of the partnership. For example, traditional FIE law (and Chinese Company Law itself) is notoriously rigid with respect to the permitted capital structure of a business: injections of and reductions in equity are difficult, debt-to-equity ratios stringently regulated, and the creation of different types or classes of ownership interests next to impossible. The Partnership Law by itself does not contain any of such restrictions.

The partnership in its simple statutory form is also characterised by flexibility in management structure and in the making of organisational changes, whereas traditional FIEs are not. Making such a form of doing business available to foreigners is therefore equivalent to punching a big hole in China's FIE regime.

On the other hand, keeping FIPs in parity with traditional FIEs would largely deprive FIPs of the attractions of the partnership form, and essentially defeat the purpose of forming partnerships.

Two draft regulations on FIPs circulated in 2007 illustrate the dilemma. A long draft published by the Ministry of Commerce in January required that all increases and decreases of capital in an FIP and other changes in capital structure be subject to government approval and that all capital contributions be made upfront. Moreover, all amendments of partnership agreements required approval, as did changes of business scope, of ownership and of a partner's status as general or limited partner.

It was as though the government itself is an indispensable partner in any FIP; it must have a say in any major partnership decision, and its power to do so, unlike the powers of other partners, cannot be contracted away ahead of time. Chinese lawyers read this draft with a sense of familiarity: the same measures applied to traditional FIEs. But the essence of the partnership form was thrown out the window.

By contrast, the State Council Legislative Affairs Office circulated a draft in September that was much shorter and required government approval only when an FIP is established and when it changes business scope. No limitations on capital structure were mentioned. The foreign business community failed to act to endorse this draft, which appeared almost revolutionary in the minimal role it gave to the government. It's not clear whether an opportunity to do so would ever reappear: to many government agencies the draft must have looked totally inadequate – it would have led to an opening in the FIE control regime, with unknown consequences.

It is not only unclear when the FIP regulations will appear, but whether they will be worth the wait. This rather large glitch in the idea of FIPs, unfortunately, also has nothing to do with private equity or the government's attitude towards it.

Will the NLPCJV form remain relevant for onshore funds?

Since at least 2003, the small number of foreign-invested VC and PE funds formed under to the Foreign-Invested Venture Capital Enterprise (FIVCE) regulations have used the non-legal person, cooperative joint venture (NLPCJV) form. Such funds enjoy important flexibility in adjusting capital structure; favourable tax rules (discussed below) were even published for them.

In a draft revision of the FIVCE rules in 2007, however, all previous references to NLPCJVs were substituted by references to limited partnerships, suggesting that the authors thought that the NLPCJV form would become obsolete and replaced by limited partnerships. They may not have been alone in this judgment, given the obscurity of NLPCJVs and the publicity received by the Partnership Law.

But the judgment seems rash in light of the inherent tension in the FIP concept discussed above. That tension may indefinitely delay the issuance of regulations on the organisation of FIPs, making NLPCJVs valuable in the interim. The tension may also be resolved by conforming the treatment of FIPs to traditional FIEs, in which case it will no longer be clear why people would switch to using FIPs (both NLPCJVs and partnerships are largely contractual creatures and what is adopted by one could normally be adopted in the other). And if, to the contrary, FIPs are truly allowed to operate like partnerships, it won't just be the NLPCJV form, but most traditional FIEs, that will be obsolete.

Some onshore funds have been formed recently using the partnership form, where foreigner investors indirectly participated through wholly owned domestic entities (the partnerships are thus not "foreign-invested" because all partners are domestic). This raises the old regulatory question of whether domestic businesses that FIEs invest in should be subject to similar rules, such as sectoral restrictions and approval requirements, imposed on FIEs themselves. The answer has been yes for corporate targets of FIEs, and if the answer is different for partnerships, regulatory loopholes analogous to those averred earlier would emerge.

From the perspectives of tax and corporate finance, investing in a Chinese partnership through domestic corporate entities eliminates most of the theoretical advantages of partnerships: single-level taxation and flexibility in adjusting capital structure. So without truly generous dispensations by local governments, it's unclear that the new fund structure presents any true advantage over the traditional NLPCJV.

The answer to the question is "probably yes", which leads us on to questions regarding the status of certain tax rules applicable to NLPCJVs.

Will NLPCJVs continue to be treated as transparent entities under the new Enterprise Income Tax (EIT) Law?

Before the EIT Law took effect this year, China's tax law explicitly provided that NLPCJVs are to be taxed at the entity or at the owner level, but not both. They were thus transparent in the sense of not being subject to two layers of tax, as companies are. The EIT Law omitted such explicit provisions, which has led some to suggest that NLPCJVs may no longer be deemed transparent.

However, there is no legal or policy rationale that would justify so big a change, which would also be inconsistent with the government's previous acknowledgement, in connection with tax rules issued for partnerships in 2001, that a range of similar business forms should all be treated as transparent. Of course, to the extent that the EIT Law's omission creates unnecessary uncertainty, tax practitioners should urge the government to eliminate that uncertainty, instead of speculate about the demise of a reasonable rule.

Will previous tax treatments favourable to foreign investors in VC funds taking the NLPCJV form continue to be available?

In 2003, Chinese tax authorities issued a circular describing conditions under which foreign investors in a FIVCE taking the NLPCJV form might obtain favourable tax treatment. If the fund does not have a management office in China, and if it delegates all management activities to an external entity, then foreign investors in the fund, regardless of whether they bear limited or unlimited liability, would not be deemed to have "establishments" in China. This means that income received by investors through the fund would only be subject to withholding tax, instead of net-income taxation at a generally higher rate. As a result, many foreign-invested VC funds adopted the external manager structure. Whether such a structure remains sufficient, under the EIT Law, to insulate foreign investors from net-income taxation is open to question.

Uncertainty arises not just because authorities have not confirmed the continued validity of the 2003 circular. If one thinks of the favourable rule it contains not in isolation but as derived from general principles, then the following must be considered. In general, a foreigner's "establishment" in China can take the form either of a physical presence (a business office) or a business agent. Under corporate (non-tax) law, the investors in a NLPCJV own the assets and rights of the business and are principals of its agents. Therefore any business office or agent of the fund itself would be deemed, for non-tax purposes, to be the office or agent of the fund's investors.

Under the 2003 circular, tax authorities seemed to assume, in the scenario where favourable tax treatment was made available, that the fund does not have its own business office in China (whether the office of the external manager should be attributed to the fund was not considered). And even if the external manager is an agent of the fund and its investors, under prior law, only business agents engaged in the trading of goods were deemed to give rise to "establishments" for tax purposes. Interpreted in this way, the 2003 circular offered a technically interesting approach that both provided foreign investors with favourable results and stayed consistent with general tax and corporate legal principles.

Under the EIT Law, however, the business agent category of establishment has been broadened to include all agents carrying out business activities. Questions can now be raised: why isn't the external manager a business agent of the fund and its investors? If it is, why don't the foreign investors have a business agent establishment through the manager? As troublesome as these questions seem, they are also inevitable. The continued validity of the 2003 circular should probably not be taken for granted.

Besides technical consistency, what other reasons might tax authorities have for reconsidering the previous tax treatment of VC funds?

The above analysis of the 2003 circular interprets it as delivering a favourable tax result that taxpayers could perhaps have discovered themselves. By contrast, some might see the circular as a concession made by the tax authorities to the policy need of encouraging onshore venture capital. In this latter view, a favourable rule for foreign investors in onshore VC funds need not be derivable from general tax principles. As a piece of preferential policy, it can be an exception to the general principles. But why should the government have chosen the external manager structure as the right way of making an exception?

Even though, under the fund structure spawned by the 2003 circular, business tax is imposed on management fees received by the external manager, and the latter is itself subject to income tax, the government is probably not deriving much revenue from either tax. In the Chinese context, it's still rare for the same management entity to provide service to multiple funds. More often, as is the case elsewhere, the bifurcation of manager and GP (in the FIVCE context, the equivalent of a GP is called the "mandatory investor") is made for tax purposes. If use of an external manager does not serve genuine business purposes and is adopted merely so that fund investors can qualify for the benefit of the 2003 circular, then the fee paid to the manager is likely to be much lower than the typical rate of 1% or more of the committed capital of the fund. If the promoters and investors of the fund are all offshore, the bulk of the management fee could be arranged to be paid offshore to another entity.

Arguably, therefore, the fund structure encouraged by the 2003 circular is distortive without raising revenue for the government. Yet another reason to reconsider the circular is the following: suppose that, somehow, the impediments for onshore funds to adopt the partnership form are removed. Then, in order to offer foreign investors similarly favourable tax treatment as VC funds previously received, rules must be designed so that the foreign partners of a fund partnership can be treated as having no establishment in China. In this completely new context, to import the requirement that the partnership must not have its own business office and must delegate all its management tasks to an external manager will seem bizarre and lacking any connection with the logic of partnerships.

What alternative approaches might Chinese tax authorities take to provide foreign investors with similar benefits as under the 2003 circular?

Once it is assumed, as it sometimes has been, that FIP funds will be viable in the future, and when, on that basis, it is further discussed how foreign partners might avoid being treated as having an establishment in China, one intuitive approach is to differentiate between general and limited partners.

The intuition is that the limited partners are passive and removed from active management. Whatever the general partners and other agents of the partnership do, the limited partners have little say and cannot be understood as doing business through them. Therefore even if foreign general partners would be deemed to have establishments in China, foreign limited partners should not be.

This approach has the merit of dispensing with the artificial fund structure described in the 2003 circular. If applied, by analogy, to funds that adopt the NLPCJV form, it would deem those investors with limited liability for the fund to be establishment-free, while investors with unlimited liability would be subject to net-income basis taxation on income derived from the fund. While this is not as favourable as the 2003 circular, where all investors can be deemed establishment-free if the external manager fund structure is adopted, once investors are on notice, they can restructure the allocation to the unlimited liability investors so that there is little additional tax burden.

The intuition, however, may be unreliable. Under regulations governing funds taking the NLPCJV form, for example, there is little restriction on the ability of limited liability investors to control management. And in the partnership context, exactly how passive a limited partner must behave to remain a limited partner is a fundamental issue yet to be explored in practice.

Does Chinese partnership law treat limited partners differently when it comes to attribution of assets and activities?

Besides the intuition that limited partners are necessarily passive, certain legal doctrines may support a distinction between general and limited partners for determining whether an establishment should be found. For example, it is well known in US partnership law that limited partners do not have ownership interest in specific partnership assets, and that general partners are not agents of limited partners and cannot bind them as principals. Some taxpayers have invoked these doctrines to argue in the US (although unsuccessfully) against the attribution of permanent establishments of partnerships to their foreign limited partners.

However, such doctrines are absent in Chinese partnership law. While the statute is silent, scholars believe that in a Chinese general partnership, the partners jointly own the specific assets of the partnership. There is no indication in either the Partnership Law itself or in its scholarly exegesis that general partners have property rights that limited partners do not. By inference, then, even limited partners might be deemed to own specific partnership assets. Likewise, the Chinese law of agency (as contained in the Civil Law) is quite primitive, but given what it does say, one cannot conclude that a limited partner cannot be a principal with respect to a general partner's actions.

Nonetheless, there is no fundamental reason why tax law should hew to partnership or other commercial law. It has its own set of considerations (administrability, fairness, protection of government revenue, and minimisation of economic distortions) for designing rules. Arguably, the external manager fund structure contemplated by the 2003 circular is a distortion. Although, for purposes of determining whether foreign investors in Chinese VC or PE funds have establishments in China, differentiating between general and limited partners (or unlimited-liability and limited-liability investors) is not a perfect alternative, it might nonetheless prove to be less distortive, while remaining benign to the development of foreign-invested funds.

By Wei Cui, associate professor, China University of Political Science and Law

On January 1 2009 some changes to the German Foreign Trade and Payments Act (Außenwirtschaftsgesetz, AWG) will come into effect that are likely to have a significant impact on foreign investors wishing to invest in German target companies. Under the new regime, any such acquisition by foreign investors may trigger the right of the German Federal Ministry of Economics to investigate and even prohibit the transaction.

The reform

Who is affected?

Under the Foreign Trade and Payments Act, investors from non-EC countries that do not belong to the European Free Trade Association (EC plus Switzerland, Norway, Iceland and Liechtenstein) and that acquire shares representing 25% or more of the voting stock of a German company may have their acquisition investigated by the Federal Ministry of Economics. Shares held by companies controlled by the acquirer (by holding at least 25% of the voting stock) are treated as if they were held by the acquirer itself. Shares that are subject to voting agreements are also assigned to the acquirer.

If the Ministry comes to the conclusion that Germany's public order or national security are threatened by a transaction, it may prohibit the acquisition. Unfortunately, the Act does not contain any definition of public order or national security, so the Act brings a certain degree of uncertainty about which transactions fall within its scope. If the Ministry decides that a transaction falls within the scope of the Act, it may order that the acquisition (which may already be consummated) be reversed. The Ministry may also choose only to prohibit the exertion of voting rights of shares held by the foreign investor, thus restricting the investor's influence on the German target.

How long does it take to reach a decision?

Foreign investors are under no obligation to file their transaction with the Federal Ministry of Economics. However, they may do so after signing and will, in that case, receive a final decision on whether the transaction will be prohibited within one month. If the transaction is not filed with the Ministry, it may start an investigation on its own account within three months after the consummation of the transaction, with the effect that the transaction is put under the condition precedent of the Ministry's approval. The Ministry will immediately inform the investor of its decision to investigate the acquisition, which triggers the acquirer's obligation to provide the Ministry with data. The acquirer will be informed about the specific data required by the Ministry through an announcement in the Federal Gazette (Bundesanzeiger). The investigation must be completed within two months of receipt of the transaction data.

Aims and criticism

The reform seeks to protect sensitive branches of German industry such as the energy, telecom and military sectors. Potential threats are perceived to come from state-controlled funds (in particular from China, the Emirates and Russia) that may be used to influence German politics via investments in German key enterprises. State-controlled foreign corporations have also been classified as potentially dangerous.

The reforms have attracted much criticism. For example, the new powers granted to the Ministry of Economics are suspected of infringing the freedom of capital movement as guaranteed by Article 56 of the EC Treaty. The European Commission is planning to examine the Act for its reconcilability with Article 56 and the freedom of establishment (Article 49). Also, the scope of the Act is considered to be unreasonable because it not only restricts investment from foreign countries, state-owned funds or state-controlled corporations but foreign investors in general. Any private equity investor wishing to invest in Germany may find his transaction being investigated by the Federal Ministry of Economics.

The problem for foreign investors

The main problem is the legal uncertainty for foreign investors. If an investor has successfully completed a transaction, it may still be subject to investigation for a period of three months after the closing date. A further two months may pass until the Ministry has completed its investigation. The result may be that the transaction is prohibited and the acquisition must be reversed. This uncertainty is unacceptable for the seller, buyer, target, financing banks and employees of the target company.

Recommended course of action

Foreign investors wishing to acquire 25% or more of the voting stock of a German company should therefore adhere to the following guidelines.

Informal enquiry before signing

A foreign investor can contact the Federal Ministry of Economics before he signs a share purchase agreement on a confidential and informal basis in order to find out if the Ministry will investigate the transaction. A similar approach is generally taken if a bidder wishes to know the position of the German Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin) on a takeover process. There are no guidelines on how such an informal approach should be made, though any informal contact bears the risk that information may be leaked. A seller is therefore unlikely to agree to such contact.

Filing for investigation after signing

Therefore, a foreign investor should voluntarily file the transaction with the Federal Ministry of Economics immediately after signing a share purchase agreement. He should refrain from filing only if he and the seller are in no doubt that the transaction does not qualify for an investigation by the Ministry. If the investor intends to file the transaction, the share purchase agreement should contain a clause that makes the clearance of the acquisition by the Ministry a condition precedent for the obligation of the parties to consummate the transaction. After the Ministry has received all relevant data, it has one month to decide whether it will prohibit the consummation. In order to speed up the process, the investor should agree with the Ministry on which information it needs in order to come to a decision as quickly as possible. It appears likely that an investor will, in most cases, be able to get a decision before the German Federal Cartel Authority (Bundeskartellamt) has cleared the transaction. Therefore, the filing of the acquisition should not lead to delay in most cases.