Overview

2008 was a year of extremes for China – from the disastrous Sichuan earthquake to the euphoric Olympic Games to the scandalous nationwide recall of dairy products, and from feverishly combating hot money in real estate at the beginning of the year to introducing the largest fiscal stimulus package the country has ever seen in November. It was challenging to maintain stability in such volatility. As a result, in addition to steadily promulgating regulations to implement the groundbreaking Anti-Monopoly Law, Enterprise Income Tax Law, Labor Contract Law, and improving longer term efficiency of its administration, the Chinese government also made swift adjustments to deal with a worldwide economic slowdown.

Anti-Monopoly

For international investors, perhaps one of the most high-profile regulations in 2008 was the Regulation on Notification Thresholds of Concentration of Undertakings (Concentration Regulation) which, together with the Anti-Monopoly Law that came into effect on August 1, level the playing field between Chinese and foreign parties to mergers and acquisitions (M&A) by expanding the merger control regime to cover M&A activities between domestic companies as well as between foreign and domestic companies.

The Concentration Regulation simplified notification thresholds by removing (i) the transaction volume test (i.e., acquired more than ten enterprises in the relevant industry within one year); (ii) the 20% pre-acquisition market share test; and (iii) the 25% post-acquisition market share test. In addition, a “two-party revenue test” replaced the traditional “one-party revenue test” – notification is now required only if the revenue of at least two parties each exceeds RMB400 million (US$58 million). As a result, many acquisitions or investments by larger investors in smaller companies no longer trigger notification requirements, and the process is streamlined.

The Concentration Regulation, however, still leaves many questions unanswered – for example, the market continues to try to ascertain what minority shareholder rights would constitute “decisive influence” or “control” over a company to trigger notification, or the extent of extraterritorial application of the Concentration Regulation and the Anti-Monopoly Law. As the market watched with intense interest Coca Cola’s application to acquire Huiyuan Juice with intense interest, the restrictions on future acquisitions that the Ministry of Commerce (MOFCOM) imposed on InBev in connection with its approval of InBev’s acquisition of Anheuser-Busch stirred foreign investors’ concerns.

MOFCOM Reorganization

Throughout 2008, we perceived a trend for MOFCOM to delegate its review responsibility and approval authority to its provincial branches (COFTECs). In June, MOFCOM issued Circular 23 to delegate review responsibility over filings of real estate foreign invested enterprises to provincial COFTECs and in August, MOFCOM issued Circular 50 to delegate its approval authority for certain foreign invested enterprises (FIEs) and foreign invested joint stock companies, again to provincial COFTECs. Then, in September, MOFCOM issued Circular 51 to further delegate its authority to approve establishment of foreign invested commercial enterprises (FICEs, which would include retail and wholesale enterprises) and changes to existing FICEs. Such delegation signaled to us a quiet reorganization that would free up MOFCOM to focus on more “national” matters such as roundtrip investments, outbound investments, real estate investments and anti-monopoly review, while improving overall efficiency in the review and approval process for foreign investments.

Onshore Investment Vehicles

Throughout spring and summer, “hot money into real estate” remained a major concern. In mid-August, the People’s Bank of China (PBOC) and the China Banking Regulatory Commission (CBRC) jointly issued a Notice on Promoting Economical and Intensive Land Use by Financial Means to restrict loans to various real estate projects. Then, at the end of August, the State Administration of Foreign Exchange (SAFE) issued Circular 142 to further restrict foreign investors’ use of FIEs to further invest in other companies (such as real estate project companies). In November, the national SAFE, in a letter response to Shanghai SAFE, explicitly carved out from Circular 142 investments by foreign invested venture capital enterprises (FIVCEs, which are formed under specific regulations to make investments in certain companies), and described the conditions and currency conversion procedures for such investments.

M&A Loans

As the economy slowed, the State Council confirmed its “Nine Policy Measures” at its meeting in early December for the financial sector to promote economic development and listed “M&A loans” as one of the permitted ways to raise capital. Several days later, CBRC issued guidelines on how all banks incorporated in China (whether foreign or domestically owned) may extend loans for the acquisition of equity interests (including outbound acquisitions) by Chinese enterprises, including FIEs. There are still ncertainties – not only with respect to how the CBRC guidelines reconcile with the general principles issued by PBOC in 1996 prohibiting banks from making loans for acquisition of equity interests, but on various operational details as well. Although we do not expect the guidelines to generate a leveraged buyout market in the near future, the guidelines have generated much market excitement, and banks and investors alike will likely keep a close watch on this development in the coming year.

Enterprise Income Tax

The Enterprise Income Tax Law and its Implementing Regulations (Income Tax Regulations), which came into effect on January 1, generally reduce enterprise income tax from 33% to 25%, but restructure tax incentives from preferences based on foreign ownership or geography to preferences based on industries – enterprises engaged in agriculture, forestry, husbandry, fishery, or infrastructure construction, as well as those engaged in environmentally-friendly or energy-saving projects, all enjoy new benefits. The Income Tax Regulations increase the number of years during which income taxes for such enterprises are exempted or reduced by half, and provide criteria for enterprises to qualify for such preferential tax treatments.

For foreign investors, the most significant change wrought by the Income Tax Regulations is that the profits/dividends of FIEs distributed to foreign investors are subject to a 10% withholding tax – a significant change, as China had exempted such profits from any income tax for the last 15 years. Withholding tax rate may be lower if China entered into a tax treaty or other tax arrangement with such tax jurisdiction.

Labor Contracts and Slowing Economy

Although the Labor Contract Law came into effect on January 1, the State Council did not issue the Implementing Regulations of the Labor Contract Law (Employment Regulations) until September. While the Employment Regulations shed light on issues such as penalties for failing to execute a written contract, termination of employment relationship where an employee refuses to sign a contract, grounds for termination of employment contracts, training expenses and automatic extension of employment contract, and calculation of severance, many ambiguities remain. As the economy slowed, the government announced that it would encourage the local labor authorities not to increase the minimum wage and some local governments have frozen or reduced the contribution levels to the social insurance schemes.

Outbound Investments, Foreign Invested Partnership and Foreign Invested Venture Capital Enterprise

Despite intense interests from foreign investors, investment funds and even governments, China has not issued any new rule to permit foreign participation in Chinese partnerships, to amend the FIVCE regulations to increase flexibility for investors, or to greatly expand outbound investments in other countries. These remain closely watched by the international investment community.

New Investment Guidelines

In late December, MOFCOM issued new guidelines on foreign investments. These guidelines include detailed application procedures, submission documents, approval timeline and foreign equity ownership limits for foreign investments in certain industries in China. In addition, the new guidelines also include a list of industries for which pre-approvals from industry regulators are required.

Looking Ahead

As we review the 2009 legislative calendar of the People’s Congress, from a foreign investment point of view, we would focus on new laws on asset appraisal (and its impact on M&As), city real estate administration and land administration (and its impact on real estate investments), value-added tax, consumption tax and business tax, telecommunications, and energy and alternative energy. As the world economy slows, we also anticipate administrative measures that may in general encourage more foreign investments.

Maurice Hoo is a partner in Paul, Hastings, Janofsky & Walker's Private Equity Group. Maurice has been recognized as a leading private equity lawyer in the region by a number of independent legal directories such as Chambers Asia, IFLR and Practical Law Company, and has been an integral part of the practice that was awarded Asian Law Firm of the Year (Transactions) by Private Equity International in 2008.