China's Latest Partnership Investment Vehicle for Foreign Investors

China's foreign invested partnership enterprise (FIPE) has caused a stir in the business community. It is the latest of China's investment vehicles for foreigners, and reports have emerged of FIPEs being established in several cities around China. But the FIPE enabling regulations do not answer some important questions: Are FIPEs more attractive to foreign investors than traditional FIEs? What are FIPE pros and cons? Are Chinas legal and tax regimes sophisticated enough to administer FIPEs?

We provide answers to some of these questions by offering a short background summary and an analysis of the important legal and tax considerations affecting FIPEs. China's 1997 Partnership Law has always envisaged the FIPE. But the government did not enact rules to govern their administration, until recently the State Council issued the Administration Regulations on Establishing Partnership Enterprises by Foreign Enterprises or Individuals in China on 25 November 2009 and the State Administration of Industry and Commerce (SAIC) issued the Administration Measures on the Registration of Foreign Invested Partnership Enterprises on 29 January 2010. These are collectively known as the FIPE Regulations. The FIPE Regulations effectively bring to four the number of legal forms available to a foreign invested enterprise in China. The other three are the wholly foreign owned enterprise (WFOE), the Chineseforeign equity joint venture (EJV) and the Chinese-foreign cooperative joint venture (CJV) (collectively FIEs). With a few exceptions FIEs are limited liability companies with independent legal person status.
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Legal Considerations for FIPEs

More market entry restrictions, not less
Chinese law requires FIPE investors to comply with Chinas industry

Theoretically CJVs can be set up as entities without legal person status.

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policies for foreign investment, i.e. the Guidance Catalogue of Industries for Foreign Investment (Catalogue) , issued by the Ministry of Commerce (MOC) and National Development and Reform Commission (NDRC) in 2007 and subject to amendment by these authorities from time to time. Previously, the Catalogue applied only to FIEs. Now Chinese law prohibits a FIPE from the following Catalogue industries: Any industry that is prohibited to foreigners; Any industry which is only opened to EJVs and CJVs; Any industry which is only opened to a project with absolute controlling Chinese shareholder(s) or with relative
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controlling Chinese shareholders; and Any industry which requires a specific shareholding ratio of foreign investor(s) in a project. Therefore, generally FIPEs are subject to more restriction in the Catalogue than CJVs and EJVs. A foreign investor may find it is not allowed to set up a FIPE in the industry it intends to enter into after checking the Catalogue.

FIPE as equities investment vehicle: no clarity

The FIPE Regulations provide no clear guidance on setting up FIPEs for equity investment, i.e. funds. Following verbal consultation with SAIC we understand that a FIPE fund can be registered if its set-up is supported by local regulations. However, State Administration of Foreign Exchange (SAFE) still have no specific rules on how FIPE fund could convert its capital to RMB for equity investment purpose. This may restrict or even prohibit FIPE funds from making equity investments in China. In any event, foreign investors should consult the relevant local branch of SAFE to check how they will treat FIPE funds before specific rules are issued by SAFE. Furthermore, according to the FIPE Regulations and our verbal discussion with SAFE, a FIPE fund is deemed a foreign investor if it invests in another enterprise in China. Thus the FIPE fund investor should follow the current approval and registration requirements under

The current version of the Catalogue divides industries for foreign investment into three (i.e. encouraged, restricted and prohibited) categories. Those industries which are not listed in the Catalogue are generally permitted for foreign investment without special requirement.

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the existing FIE and FIPE regimes, depending on which type of enterprise it wishes to invest in.

Shorter set-up procedure, with potential to lengthen

Setting-up an FIE first requires the approval of the Ministry of Commerce (MOC) or its local counterparts followed by registration with SAIC or one of its local branches (collectively, Registration Authority). The whole set up process may take at least three months, depending on the FIEs investment and business, etc. However, MOC approval is not required to set up a FIPE. The investor or their agents only need to submit application documents to the Registration Authority who must then decide whether to register the FIPE on receipt of a complete set of application documents, or within 20 days after accepting the application. In some cases the Registration Authority will ask for opinions from other authorities in charge in writing within 5 days after accepting the application, and will decide whether to register the FIP within 5 days after receiving the written opinions from the authorities in charge. These cases are: Advance approval from the authorities in charge, if the FIPE is engaged in a prescribed industry such as pharmaceutical production, mining, and dangerous chemicals production; Approval from the National Development and Reform Commission (NDRC) or its local counterparts, if the FIPE will conduct real estate construction after it is established ; Opinions from the MOC or its local counterparts if the FIPE will engage in a restricted category industry under the Catalogue. Therefore, the FIPE registration timeline is prolonged if SAIC considers that additional approvals/opinions should be obtained before it registers the FIPE. A FIPE's investors should establish good
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communication with the Registration Authority and other authorities involved to ensure control of the set up timeline.

Partnership barred with state and public companies

Foreign investors should note that Chinese law prohibits any of the

3 Local NDRC divisions may have different opinions on which projects are subject to their approvals.

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following entities from being a general partner (GP) in a partnership enterprise: a wholly state owned company; a state-owned enterprise; a listed company; and a public welfare institution or social entity.

Foreign investors should exercise caution when accepting a subsidiary of a state-owned enterprise as GP, since this may still have the risk violating Chinese law. In this case the foreign investors may consider requesting the subsidiary to take the role of limited liability partner (LP) in the FIPE, or obtaining clarification from the competent authority, such as the local state-owned assets administration commission.

No registered capital requirement; more capital flexibility

FIEs face a minimum registered capital requirements in practice, normally USD 100,000 depending on its business plan. If it pays registered capital in installments, Chinese law requires its investors to contribute 15% of the registered capital within three months and the remainder within 2 years from the date on which the FIEs business license is issued. The investor may contribute cash, assets in kind, intellectual property and land use right, etc. as registered capital. However, investors may not contribute assets of which the value cannot be appraised, e.g. labor. Also the contribution in cash should be a minimum of 30% of the registered capital. A FIPE does not need to have registered capital. Neither does it have a mandatory timeline for capital contributions. An investor may contribute to the FIPE cash, assets in kind, intellectual property, land use or other proprietary rights, for which an appraised value is not necessary. Labor contributions are allowed subject to the following restrictions: An LP cannot make a labor contribution; A foreign partner may be unable to make a labor contribution .
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4 This is mainly because a foreign partner may be unable to obtain a work permit in China by contributing his/her labor to a FIPE.

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Therefore, an investor generally enjoys more flexibility when it makes a capital contribution to a FIPE than to a FIE.

Cash trap risk decreased, capital decrease unrestricted

An FIEs after tax profits should be used to make up for the accumulated losses of previous years. For any remaining after tax profit the FIE must allocate to the statutory reserve fund 10% of after tax profits until the fund amount reaches 50% of the FIEs registered capital. (This may create cash trap problem for some foreign

investors.) The FIE may distribute dividends to its investors in their agreed ratio (different from shareholding ratio). A capital decrease is usually difficult as there are mandatory procedures that must be observed, including a public announcement, and provision of guarantees to creditors. approval by the authorities. A FIPE is not required to make up for its accumulated losses or to allocate to reserve funds from its profit. Partners of a FIPE may agree on a mechanism to distribute profits and share losses in their partnership agreement, except that a general partnership enterprise can neither distribute all of its profit nor allocate all its losses to some of its investors. (While a limited partnership enterprise has the Also the capital decrease is subject to

freedom to distribute all of its profit to some of its investors to the extent the partnership agreement permits.) Also Chinese law does not restrict a capital decrease for a FIPE.

Facilitating management control

Under the FIE regime, if a foreign investor sets up a CJV or EJV with a Chinese investor, it may still fail to control the company even if it has an absolute majority shareholding. This is because Chinese law requires the Chinese investor to appoint at lease one director to the board of directors, and some important matters of the company are subject to the unanimous consent of directors from both parties, e.g. amendment to the articles of association of the company, capital increase and decrease of the company. The company is vulnerable to deadlock if a single investor does not consent to these matters. However if a foreign investor is cooperating with a Chinese investor in a FIPE, it may act as a GP, requiring the Chinese investor to be a LP. Chinese law prohibits a LP from representing the partnership, or managing partnership matters. However, an LP still has some rights

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to partnership matters, e.g. decision on adding new GP or a GPs retirement, suggestions on the management of the partnership business, and reviewing audit reports of the partnership. Therefore, though a FIPE may not eliminate battles for control, it appears better for a foreign investor to cooperate with a Chinese investor under the FIPE regime rather than the FIE regime.

Governing law can be non Chinese law

The shareholders agreement and/or AoA are constitutional

documents of a FIE. Under Chinese law, these documents (and their amendments) are valid only after the competent authorities approve them. The shareholders agreement must be governed by Chinese law. The partnership agreement is the constitutional document of a FIPE. This agreement only needs to be filed with SAIC and no approval from the Chinese government is required. Chinese law does not insist that the partnership agreement be governed by Chinese law. According to our verbal consultation with SAIC, it seems that SAIC accepts the filing of a partnership agreement governed by a foreign law.

Investing in other domestic investments through a FIPE: not clear

If a FIE intends to invest in another enterprise in China which is permitted or encouraged under the Catalogue, it need only apply to/file with SAIC or its local branches. But if the enterprise is a restricted industry, approval from a provincial level MOC counterpart is needed . Chinese law is still silent on the requirement for domestic investments made by FIPEs, except for those whose main business is making investment in other projects and enterprises, i.e. a FIPE fund. (See Section 2.2) Anyway, FIPEs other than funds should consult their relevant local authorities and wait until the regulations or practice is clearer before they decide to invest in any enterprise in China.
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5 Interim Regulations on the Domestic Investment by Foreign Invested Enterprises

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Tax Considerations for FIPEs

Tax transparency for partnerships; partners to pay taxes
Tax rules for partnership enterprises are scattered in a number of tax circulars. They are mainly Circular Guo Shui Fa [1997] No. 43 (Circular 43), Circular Cai Shui [2000] No. 91 (Circular 91) and Circular Cai Shui [2008] 159 (Circular 159). It has been clarified that a partnership enterprise is tax transparent. Enterprise Income Tax Law and its implementation rules (EIT Laws) are not applicable to partnership enterprises. A partnership should calculate its taxable income and then allocate the taxable income to its partners accordingly. The partners should pay individual income tax (IIT) (see Section 3.3) or enterprise income tax (EIT) ) (see Section 3.4) on this taxable income.

No preferential EIT treatment; at least until regulation appears

EIT Laws provide preferential treatment (including tax exemption, reduced tax rate, super deduction) to enterprises in certain encouraged activities or businesses .
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For example, a high-tech

product manufacturing company may enjoy reduced EIT of 15%. However for a partnership enterprise doing the same business, when its tax income (from the high-tech business) is allocated to its partners, it is unclear if its partners may enjoy the 15% EIT for such income. We suspect the tax authority will not allow the FIPE partners to enjoy preferential treatment under EIT Laws until a specific regulation is issued.

Tax on individual FIPE partners

Circular 91 requires an individual partner to pay IIT on the taxable income from a partnership enterprise at a progressive rate from 5%35% as if it is business income of individual industry and commerce household . One exception is for a partnerships dividends or interest allocated to individual partners, in which case an individual partner can pay 20% EIT as if it was his/her own dividends or interest income . It is unclear if these tax circulars will be applicable to foreign partners.
6 E.g. software and integrated circuit production; high-tech products manufacture; R&D; environment protecting, energy/water saving, safe production. 7 Under this tax item, if the taxable income is higher than RMB 50,000, the applicable tax rate is 35% with a quick deduction of RMB 6750. 8 Guo Shui Han [2001] No. 84

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At State level, there is no law to specify if an individual partner will be subject to capital gain tax when it transfers its partnership interests. In practice some tax authorities may impose 20% IIT on the capital gain of individual partner. However the way to calculate capital gain is unclear. There is also no official interpretation on how to impose capital gain article in tax treaties on foreign partners. Nevertheless, a certain level of clarity is provided by local regulations, promulgated mainly to encourage developing equity investment funds in respective local regions. For instance, according to a local regulation of Shanghai
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, for taxable income allocated from a

partnership fund, an individual GP should be subject to the 5-35% IIT; while an individual LP only need to pay 20% IIT under dividends and interests tax item. However a local regulation of Beijing
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allows all

individual partners be subject to 20% IIT for taxable income of a partnership fund. Nevertheless only partners in funds may enjoy the treatment under these local rules. We consider that because of the FIPE Regulations, SAT should issue circulars to clarify the ambiguity and inconstancy of taxing the foreign individual partners.

Tax on company FIPE partners

Like the situation with a foreign individual partner Chinese law is unclear on how to tax a foreign company partner. The following provision under Circular 61, which is applicable only to foreign invested venture capital enterprises (FIVCEs), gives some indication: a foreign investor should be regarded a foreign tax resident with establishment in China to pay EIT. However if the FIVCE has not set up a management organization to directly engage in management and consulting of venture capital business but authorize another management company or FIVCE to operate its business, the partner of this FIVCE can pay EIT as if it is a foreign enterprise without establishment in China. If the principles implied here are adopted by Chinese tax authorities for FIPEs, a foreign partner (whether LP or GP) might be taxed as a permanent establishment (PE) in China, unless it can prove it has not formed a PE under an applicable tax treaty. In this sense, we analyze both senarios:
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Hu Jin Rong Ban Tong [2008] No. 3 Jing Jin Rong Ban [2009] No. 5

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A company partner taxed as a PE

Under the various tax treaties that China has signed a PE must calculate its taxable income as if it is tax resident in China. If there is no special treatment for a PE partner in a FIPE, it should calculate its own tax income after deducting expenses and costs, and pay 25% EIT.

A company partner taxed as a non PE

If the Chinese tax authorities confirm that a partner not a PE in China, and if there is an applicable tax treaty, the partner may be required to pay only tax on passive income derived from China. Such income includes dividends, interest, royalties and capital gains. In view of the principles implied in Circular 61, the tax authorities might require a non-PEs income allocated from a FIPE to subject to withholding tax at 10% or lower determined by an applicable tax treaty.

We set out a comparison of the tax consequences for the same foreign investors in different legal forms, i.e. WFOE and FIPE. For easy comparison, we assume that: The WFOE or FIPE has earned USD 1,000,000 business profit; The foreign investors shareholding ratio in the WFOE or FIPE is 50:50, on which dividend distribution or taxable

income allocation will be based; For Model A, business profits and dividends attract 25% and 10% EIT respectively; and For Model B, PE partners income allocated from FIPE attracts 25% EIT with no deduction. Non-PE partners income allocated from FIPE attracts 10% EIT.

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Model A

Model B

Investor A Investor A Investor B (PE) After tax profits (25% EIT): USD 375,000

Investor B (non-PE) After tax dividends (10% EIT rate): USD 450,000

After tax dividends (10% EIT): USD 337,500

After tax dividends (10%EIT): USD 337,500 After tax profit (EIT rate 25%): USD 750,000

WFOE

Profit: USD 1,000,000

FIPE

Profit: USD 1,000,000

Under Model A, where two foreign investors set up a WFOE in China, the profit is first subject to 25% EIT. When after tax profit is distributed to the investors, the dividends attract 10% EIT. So the total tax burden under this model is USD 325,000. Under Model B, where we assume that one investor creates a PE while the other does not, the profit is not taxed at FIPE level. When the profit is allocated to the PE investor, it attracts 25% EIT, but when the profit is allocated to the non-PE investor, only 10% EIT applies. So the total tax burden under this model is USD 175,000. Model Bs total tax burden in China is lighter than Model A, mainly because one layer of taxes is omitted due the nature of the FIPE . Please note that this analysis is purely based on our own assumptions (listed above) and our understanding of certain tax circular principles (Circulars 61 and 159) which may not be totally applicable to FIPEs. We do not know if the future FIPE tax rules will accord with these principles. Furthermore, in Model A, when the investors transfer their shares in the WFOE they will normally be subject to 10% EIT, subject to the relevant capital gain provisions under an applicable tax treaty. Under
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Taxation in the investor's home country must be considered in order to make an overall assessment of either model.

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Model B we consider that subject to an applicable tax treaty, 10% capital gain tax might only apply to the non-PE partner when it transfers it FIPE interests in Model B. However this needs to be clarified by later tax laws with the development of FIPEs in China.

Better tax planning opportunities

The specific character of a FIPE offers investors more tax planning opportunities from these points: First, Chinese law allows investors to agree on the allocation ratio in the partnership agreement (see Section 2.6). A limited partnership enterprise may allocate all profits to some of the investors (Special Allocation), subject to tax authority restrictions ; they may adjust the allocation ratio when calculating the taxable income of partners. Moreover, partnership losses can be carried forward and offset against the partnerships income in the next five years . These losses may not be allocated to any partner to offset the partners own profit. When the partnership has profits but the partner has losses, the profits allocated to the partner can offset the partners loss . By using this rule and the Special Allocation abovementioned, the partner has room for tax planning. This will, however, increase the possibility of being challenged by tax authorities. In the future FIPE tax rules, we are interested to see if various types of income (e.g. business operation income, capital gains, dividends, interests) of a FIPE will be taxed differently at the level of its partners. For example, would the dividend income of the FIPE continue to be taxed as dividend income of its partner, or as business profit of its partner? Would equity transfer income of the FIPE be regarded as a partner's capital gains? We consider that China tax authority will answer these questions as they are necessary to continued, stable FIPE development. answers will definitely affect FIPE tax planning. The
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Circular 159 states that partners must not agree in a partnership agreement that all of a partnership enterprises profits allocated to one partner. 13 Circular 91 14 Circular 159

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Conclusion
The long awaited FIPE Regulations reflect the Chinese governments policies to further encourage foreign investment. Compared with traditional FIEs, the legal procedures for setting up a FIPE are simpler and easier to implement. Substantive laws necessary to operate FIPEs are generally available, but detailed rules (such as foreign exchange regulations for FIPEs) need to be enacted or clarified. The current ambiguities surrounding these rules may prevent FIPE funds from being developed in China. FIPEs create more tax planning opportunities than FIEs, and due to their tax transparent nature and other specific characters, may reduce an investor's tax burden in China. Before the relevant tax rules are issued, we suggest that FIPEs closely monitor the tax developments and establish good communication channels with their local tax authorities.

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Contacts
Yun Wei Of Counsel, Head of China Tax Practice Group Yun Wei is Of Counsel in Salans' Shanghai office. She is head of the China Tax Practice Group. As qualified CPA and Chinese lawyer with tax expertise, Mrs. Wei specializes in providing integrated tax and legal advice on tax planning, cross border investment, group restructuring and M&A transactions. Mrs. Wei also advises clients on various tax issues including tranfer pricing and disputes. Mrs. Wei frequently publishes articles on the development of Chinas tax field and has been instrumental in building the firms China tax practice group.
T: +86 21 6103 6000 E: ywei@salans.com

Dr. Bernd- Uwe Stucken Greater China Managing Partner Dr. Bernd-Uwe Stucken is the Greater China managing partner working from Salans' Shanghai office. He has lived and worked in China for over 20 years and has extensive experience advising on foreign direct investment (FDI), mergers and acquisitions and enterprise restructuring, including strategic business and tax.

T: +86 21 6103 6000 E: bstucken@salans.com

Matthias Mueller Managing Partner, Beijing Office Matthias Mller heads Salans Beijing office. He specializes in all aspects of corporate law and foreign direct investment, including mergers and acquisitions and restructuring foreign invested enterprises as well as the tax aspects of M&A and operations of foreign invested enterprises in China. Mr. Mueller also focuses on the leasing business and lease finance in China.

T: +86 10 6535 1700 E: mmueller@salans.com

This alert does not constitute legal advice with respect to any matter or set of facts and may not be relied upon for such purposes. Readers are advised to seek appropriate legal advice before entering into any transaction, making any determination or taking any action related to matters discussed herein. No part of this alert may be copied or quoted without the prior written consent of Salans. 2010. All rights reserved.

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