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China is now allowing contribution of share rights (equity) in a China registered company as capital that may be contributed to another China registered company.

This new rule, the Administrative Measures on Registration of Capital Contribution of Share Rights (Order No. 39), went into effect March 1, 2009. Crafted as part of China’s response to the global financial crisis, it may save multinational companies time and cost in reorganizing their Chinese subsidiaries if those subsidiaries need to be moved under the umbrella of a holding company in China.

New Rule Fills Gap

In the past, China’s company law has left some room for contribution of non-cash assets, which would have included share rights (equity). However, in practice, such allowable forms of non-cash asset capital contribution were limited to intellectual property rights, land use rights and in-kind property. No rules existed that would make the contribution of share rights a feasible option.

Order 39, issued by the State Administration for Industry and Commerce, fills that gap.

Highlights of Order 39

Qualified share rights: Share rights in a China registered limited liability company or joint stock company can qualify for contribution as capital in another China registered limited liability company or joint stock company, as long as the contributed share rights are considered to have an unambiguous, complete ownership and can be assigned according to the law.

The following are excluded:

1) Share rights in a company where the registered capital has not been fully paid;

2) Share rights on which a pledge is established;

3) Share rights that are not assignable under law;

4) Share rights that are not assignable under the Articles of Association;

5) Share rights where an assignment requires approval under law and the approval has not been obtained

6) Other circumstances where assignment is prohibited.

Usage: The share rights can be contributed as capital both for purposes of establishing a new company and increasing the capital in an existing company.

Cap: The sum of the contributed share rights plus other non-cash asset capital cannot be more than 70 percent of the registered capital of the accepting company.

Valuation: The contributed share rights must be valued by a China registered appraisal firm.

Approval and Registration: Depending on the situation, various approval and registration procedures must be completed in connection with a capital contribution. These relate to establishing a new company or increasing the capital in an existing company, transferring share rights, changing shareholders, or changing the paid-up capital.

Capital Verification: In connection with the contribution of shares as capital, the accepting corporation shall carry out a capital verification.

A Significant Boon for Foreign Investors

Order 39 makes it possible to leverage existing capital to set up new companies or increase the capital in existing companies without resorting to bank loans or other financing.

In particular, it is a significant development for foreign investors. It allows them to directly assign the share rights in a Chinese subsidiary to another Chinese subsidiary without going through a cash round-trip (receiving money for the sale of the share rights in one company and then making capital contribution of the same money into another company).

Regulatory Procedures and Tax Consequences

Please note that, because Order 39 is brand new, some practical concerns are not yet resolved. Before contribution of share rights can become fully operational, the relevant regulatory authorities need to take concurrent action. These authorities include the approval authority (the Ministry of Commerce or its local counterparts) and the foreign exchange authority as well as the tax authority.

For example, under current tax rules, the contribution of in-kind property would be treated as a taxable event. It would first be regarded as a sale of the contributed property at the fair market value and then as a contribution of the sales proceeds as capital.

We expect the Chinese tax authority will issue rules clarifying whether the contribution of share rights shall be regarded as a taxable event or may be deferred for tax purposes.

In addition, it remains to be seen how the contribution of share rights would impact the accepting company’s business scope. For example, is the accepting company required to have a business scope allowing it to make investment in other companies? Some foreign exchange registration and approval procedures also need to be clarified.

In addition, the new rule theoretically makes it possible for an investor to acquire an interest in a Chinese domestic company by using the equity investment in one Chinese subsidiary as consideration--i.e., a share-for-share acquisition. However, the current 2006 M&A rules governing foreign investors’ acquisition of Chinese domestic companies only permit using the share rights in an offshore listed company as a special form of consideration. Foreign investors will not be able to use their share rights in a Chinese subsidiary to acquire a Chinese domestic company until the 2006 rules are amended.