FDI capital flow in China enjoys preferential treatment under the Hainan Free Trade Port Act, and its economic Master Plan encompasses the entire island province of Hainan, China. The Plan mandates regulatory liberalization and investment support for transactions and operations by using the classic FTZ model. A key question many investors have about Hainan is what changes it makes to China’s stringent regulatory and legal environment for cross-border funding and capital flows. This article will help answer those questions by explaining the national and provincial rules that apply.

In Chinese investment law, the main facts looked at by lawyers are whether the investor is Chinese or foreign, the investment structure, process, and flow of funds. For a foreign investor, this encompasses three investment models: foreign direct investment, cross-border investment by a Chinese partner (i.e. roundtrip), and cross-border M&A.

Contents

New Rules

Practical Approaches

Transaction Facilitation Accounts

New Rules Govern Transfer of Capital Funds for FDI and Remitting Funds Outside China

Circular No.28 Issued in 2023 Applies the New Foreign Investment Regime to Cross-Border Funds Transfer

A foreign-owned entity (whether wholly or partially) is capitalized using funds remitted from a foreign region in compliance with the law. A foreign-owned entity must register its FDI purpose foreign exchange at its bank and open a capital account for the venture. The law requires that the appropriate agency and the foreign exchange administration approve the foreign exchange remittance and purpose. In 2023, the National Administration for Foreign Exchange (the “Administration”) issued FOREX Circular No. 28 (2023) to implement the Exceptions List regulatory framework in foreign exchange.

Circular No. 28 was issued with an eye to the difficulties being experienced by Chinese companies listed on foreign stock exchanges such as NYSE or the Hong Kong Exchange (in particular, “red chip” SOEs). In the Hainan Zone and several other FTZs, rules for providing arm’s length loans are relaxed (this being defined as a loan to a business entity that is not an affiliate)

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Funds can be remitted out of China by following the FDI-Specific 2020 FOREX guidelines.  Section 21 of the PRC Foreign Investment Act guarantees foreign investors the right to repatriate profits and proceeds (see our English translation). The implementing regulation is found in the Capital Ventures Foreign Exchange Guidelines (2020) and requires that a foreign-owned entity remitting its profits first fill out a written application with the bank and provide a corporate resolution on profit repatriation, with an auditor report, as an exhibit supported by tax payment confirmations provided by the jurisdiction’s tax office.

You can also process cross-border remittances to local Chinese parties for a transaction reason that is not ‘profits.’  Examples of reasons not related to profit include liquidation, capital contribution reduction, capital contribution clawback, and sale of equity. In this case, three steps must be completed before funds transfers may be processed: (1) The foreign-owned entity must complete the amendment or cancellation process with its business registrar; (2) An amendment or cancellation FDI FOREX filing must be made at a bank in the jurisdiction of incorporation; (3) Tax liability settlement must be completed in accordance with the jurisdiction’s tax office requirements.

Cross-Border Capital Pooling

Cross-border capital pools are useful for multinational corporations in China because they streamline financing and accounting functions across the business. Chinese regulators began facilitating the capital pooling method under a 2012 Foreign Exchange Bureau pilot project in Shanghai and Beijing. Since then, several cross-border capital pooling methods have developed, such as a central bank-operated cross-border pool, a Foreign Exchange Bureau centralized pooling program, and a central bank program involving a consolidated RMB pool method. An essential feature of the capital pooling method is providing free flow of funds to multinational corporations within quota limits.

The cross-border pools available to multinationals under the Hainan Province free trade policy are cross-border two-way RMB pooling and a consolidated foreign/local currency pool.

Borrowing of External Debt

Special borrowing rules are available to foreign-owned entities, provided that they are correctly classified. Recall that under PRC foreign investment law, an entity is classified as such following regulatory approval and that a Supreme Court decision enables bona fide foreign companies to self-classify as Chinese-owned entities. Thus, the entity needs the foreign investment certificate in hand to qualify, merely being foreign in itself is not enough.

For these correctly classified entities, China has developed two capital control methods for foreign-owned entities to borrow foreign debt. One is to apply the difference between the registered/invested capital amounts, and the other is a macroeconomic approach. When applying the difference between registered/invested capital totals, the cumulative total medium/long-term foreign debt and the balance of short-term foreign indebtedness must be maintained within a quota based on the difference between the total actual invested and the registered capital amount.

In Chinese corporate law, the business registrar will determine a registered capital amount to be associated with the company; however, the registered capital amount can be significantly different from the amount of invested capital. A foreign-owned business may freely borrow foreign debt based on the difference between the registered and actually invested capital amounts. Under the macroeconomic approach for cross-border financing, the amount of external foreign debt permitted is determined by looking at the net worth of the foreign-owned entity. The specific finance law rule that applies is that the quota is calculated based on the weighted at-risk balance, and the balance cannot exceed an upper limit.

Government policymakers also observed that early-stage technology startups would be unreasonably disadvantaged by low ceilings calculated based on their small net worth totals, and, to remedy the disparity, issued the Supplemental Rules for FOREX in the Yangpu Zone in 2021.
The Supplemental Rules allow low net worth companies in a pilot program access to foreign debt as needed, up to $5 million US Dollars. There are five qualifying conditions that must be met: (1) Be located in the Yangpu Zone pilot program area; (2) Be registered within the Yangpu Economic Zone; (3) Have ownership of intellectual property rights; (4) Have advanced technological capabilities; and (5) Have good business prospects. Under Circular No. 28 (2023), a $10 million USD foreign debt quota is provided to small and medium businesses in a financial pilot project area, which specifically includes innovation or technology-oriented companies in Hainan Province (recall as noted above, the entire Province is now defined as a “Free Trade Port”). Other businesses that meet those requirements but are in other jurisdictions are entitled to a $5 million USD borrowing quota.

In addition to the existing Circular No. 28, several 2023-2024 regulations provide for simplified government filings when processing foreign loans. In December 2023, the Foreign Exchange Bureau issued the Circular on the High-Quality Trade & Investment Liberalization Pilot Project.

The Circular extends to Hainan Province and five other pilot project zones, enabling companies in these regions to take out foreign loans by filling out the appropriate forms at their bank (note that the Circular excludes financial firms from participating in the program). In February 2024, Hainan issued its own Supplemental Rules under Circular No. 28. The Supplemental Rules add that companies using the macroeconomic approach (i.e., total net worth) to determine their foreign debt quotas may complete foreign debt filings at the local office of the Hainan Foreign Exchange Bureau.

Below, we’ll cover the practical approaches corporate lawyers in China are using to structure financial transactions routed through Hainan. However, a common stumbling block with cross-border transactions in China is a poor strategic fit between counsel’s legal decisions and overall business goals due to miscommunications caused by language barriers and unfamiliarity with Chinese practice. Therefore, make sure to have English versions of all Chinese legal memoranda properly translated by professional translators, rather than in-house staff, freelancers, or other unprofessional workers, to ensure that both local and international collaborators can clearly understand the plan and rationale. If it sounds awkward, it’s probably misleading.

Practical Approaches to Cross-Border Finance via Hainan

FDI by a Domestic Business Entity Through an Affiliate or SPV

Chinese entities investing outside China must complete filings to cover their venture with both the Development and Commerce ministries, and then make foreign exchange applications at their registered bank.

Several key tax-related elements must be assessed for these international ventures. The PRC business income tax policy applies a 25% tax rate to dividends from a foreign entity to a China entity, while also applying generally accepted foreign tax crediting principles. This means advice from a tax lawyer or accountant in the foreign jurisdiction should be translated into Chinese so that the investment incentive policy described below can be applied correctly. Under the Hainan Tax Administration’s 2020 Business Tax Incentive Circular, qualifying Hainan entities in the tourism, modern services, and technology innovation sectors making outbound FDI qualify for a business tax exemption. The initial expiration date runs through the end of 2024 but is subject to renewal.

Direct Participation of Domestic Residents in Offshore Investments

China’s legal framework currently does not contemplate its resident citizens directly owning offshore investments. The system provided by Circular No. 37 (2024) is for a Chinese citizen residing in China to form a domestic entity to hold an interest in a foreign business entity after making filings with the Foreign Exchange Bureau. The domestic entity can then serve as a special purpose vehicle (SPV) used to participate in a foreign business venture into China. For example, several American business partners could use the SPV structure to allow shareholding by a Chinese resident in a foreign venture into China.

A Circular 37 filing is required for a China resident to make subsequent profit and dividend repatriation remittances. An SPV used for offshore equity financing is subject to Chinese regulations on foreign debt for foreign investors and must also comply with the foreign exchange filing requirements described above, which apply broadly to FDI. There are also capital control restrictions when using the typical operating agreement-based structure—for example, the funds cannot be provided as a loan to an entity that is not an affiliate. These are the same capital control restrictions described in the earlier discussion on Circular No. 28 (2023). As a general principle, the same rules applicable to foreign investors will apply when involving a local Chinese citizen as an investor or partner in a venture or using an SPV to gain foreign investor status for a Chinese resident, and many ordinary Chinese business practices will be prohibited.

Cross-Border Mergers and Acquisitions

China’s foreign investment laws use many different procedures for cross-border M&A depending on if the foreign party is the purchaser or seller. To make the legal distinction clear, we can classify Chinese M&A filings into two scenarios:

1. Foreign Purchaser: A Chinese-owned China business entity’s equity is acquired from a local Chinese company; or
2. Foreign Seller: A foreign-owned China business entity’s equity is purchased by a local Chinese company.

China’s foreign investment law is extremely unintuitive and changes almost half of the Western USMCA/BIT principles. So, if you find this at all confusing at any point you can find clear answers, including explainers and regulatory translations, in CBL’s dedicated Foreign Investment Law section.

This confusing legal regime is mixed with China’s highly complex and restrictive capital controls regulation, which makes simultaneous equity assignment and payment impossible, and is a lot different from many other familiar cross-border M&A contexts. Below, we’ll cover what happens in both scenarios, whether the foreign party is on the purchaser or seller side.

A Foreign Purchaser Buys a Chinese-Owned Company in China

When the foreign party is on the purchaser side, the transaction will involve a share assignment that establishes an investment in China. In the context of PRC foreign investment law, this means following the investment reporting procedures to avoid the possibility of the transaction being blocked under national security principles. The Ministry of Commerce provided a plain language explanation of the reporting filing process (see CBL’s English translation), and you can find an English translation of reporting rules for foreign investments here.

A fairly unique point for the LLC (or LP) being transacted is that the foreign-owned entity classification must be converted to the Chinese-owned classification. The foreign purchaser will also pay a purchase price for the shares being assigned, which implicates the basic rules for foreign investment currency exchange (see CBL’s English translation). A breakdown of the flow of funds is explained below, assuming compliance with China’s foreign investment law. In this kind of transaction, the target company will have to make the foreign exchange filings, and then provide its business registration certificate to the seller to open an account to receive the proceeds of the sale. The target company will also have to file an equity assignment amendment with its business registrar office before any foreign exchange filings can be completed.

A cooperation agreement can be used as a framework for each step of the equity transaction, which generally involves the following steps:

1. Execute a share purchase agreement;
2. Complete closing checklist items, with special attention to the equity assignment amendment to be filed with the business registrar;
3. Target company completes foreign exchange filings (described above);
4. The local Chinese seller opens a separate bank account to receive the share purchase price;
5. The Foreign Purchaser remits the share purchase price into China at the designated account.

Law Firms in China have Lobbied the Government to Offer Special Transaction Facilitation Accounts

Before describing this policy solution, let’s look at the problems entailed by cross-border M&A under China’s historical capital controls. Observe that in the above sequence of steps in the share purchase agreement, there can be a significant delay between when the purchase price is paid and when the equity is assigned.

In addition to the substantial red tape involved with the China foreign exchange process, additional local bank processes will likely be required if the foreign purchaser uses an SPV to purchase the target company. Many popular SPV jurisdictions have tightened their KYC rules recently, and bank due diligence for this can be time-consuming.

Hainan Province introduced a policy solution it calls a “Free Trade Account” to remedy the above problems, therefore achieving compliance with the Foreign Investment Act’s mandate to provide foreign investors with the national treatment standard. The first Free Trade Accounts were piloted by Shanghai, and Hainan’s equivalent to the system was launched in 2019. Foreign legal entities and other qualifying organizations are eligible to apply for a Free Trade Account. In 2023, China’s central bank published draft regulations proposing a new type of account called an “Electronic Fence Account” to be offered in Hainan, which will allow further convenience in making foreign exchange transactions within a designated free trade port zone.

A Foreign Seller of a Chinese Company to a Chinese Purchaser

In this type of transaction, a foreign party owns a business entity that is registered in China and wants to sell its company to a Chinese purchaser. A well-known example of this kind of M&A is when Uber sold its subsidiary to its local rival, Didi, and exited the Chinese market. In this example, Uber USA is the “Foreign Seller” and the target company, Uber China, is the “Chinese Company.” Under foreign investment law, this involves converting the foreign-owned entity to a Chinese-owned classification. Remitting the funds from China across the border to the foreign jurisdiction requires the target company itself to make a foreign exchange filing, and for the Foreign Seller to complete tax withholding payments for the share purchase price. The next steps in the process are similar to the Foreign Purchaser scenario, with a few tax-related differences. The target company will also have to file an equity assignment amendment with its business registrar office before any foreign exchange filings can be completed.

A cooperation agreement can be used as a framework for each step of the equity transaction, which generally involves the following steps:

1. Execute share purchase agreement;
2. Complete closing checklist items, with special attention to the equity assignment amendment to be filed with the business registrar;
3. Target company completes foreign exchange filings (described above);
4. Tax withholding transfer processed by the purchaser in China;
5. The purchaser in China makes cross-border remittances to pay the purchase price.

Observe that in the above sequence of steps in the share purchase agreement, there can be a significant delay between when the purchase price is paid and when the equity is assigned.

In contrast with the intra-national M&A context that allows for a great deal of flexibility in structuring the transaction, cross-border M&A transactions must be carefully structured to comply with the complex regulatory system China has established for foreign investment and foreign exchange.

Conclusion

China’s system for completing cross-border M&A transactions in the context of its relatively recent foreign investment law regime is extremely complex, whether involving a spin-off transaction or cross-border restructuring. In this complex system, China has adopted legal policies at crucial control points to ensure that this complex system can produce outcomes desirable to international business.

In this context, the Hainan Free Trade Port policy framework, covering the entirety of Hainan Province, provides a cost-effective method for completing cross-border M&A transactions for business operations in China.

FURTHER READING

Get authoritative insights about Chinese foreign investment law from CBL’s English translations of official government guidance:

• How Foreign Investment is Regulated
• Investment Information Reports for National Security

For a general overview of this topic, see also CBL’s Foreign Investment FAQ.