In this issue:

Feature Articles

  • Follow up on the Reform on the Segmented Share Structure of the PRC
  • Employee Share Plans for Listed Companies
  • New Venture Capital Measures Reflect Policy to Cultivate Onshore Venture Capital Industry
  • Notarization Law of the People's Republic of China

Other Recent Developments

  • Electric Power Market
  • Banking
  • Taxation
  • Foreign Exchange
  • Trade
  • Environment
  • Sports
  • Patents
  • Media and Advertising
  • Direct Sales

Feature Articles

Follow up on the Reform on the Segmented Share Structure of the People’s Republic of China

In the July 2005 and November 2005 issues of the China Law Bulletin, we reported that the China Securities Regulatory Commission (the "CSRC") had begun reforming the segmented share structure system of PRC listed companies (the "Reform") with the promulgation of the Administrative Measures for the Reform of the Segmented Share Structure of Listed Companies. Other government authorities have issued related regulations facilitating the Reform, including the Ministry of Commerce ("MOFCOM") and the CSRC issuing on October 26, 2005 the Notice on the Administration of Foreign Investment Relevant to Reforms of the Segmented Share Structure of Listed Companies ; the "Notice"). This comment discusses the Notice and recent developments of the Reform.

The Notice addresses issues concerning foreign invested joint stock companies with A shares listed on domestic stock exchanges ("FIJSC") in connection with the Reform. Two points in the Notice are particularly worth noting:

(i) Filing with and obtaining approval from MOFCOM. PRC foreign investment laws give MOFCOM the power to regulate all foreign investment-related matters. As such, before a FIJSC implements its reform plan it must make a filing with and obtain approval from MOFCOM; and
(ii) Preferential treatment. PRC foreign investment laws provide that if foreign investors own at least 25% of a listed company's shares, the company is eligible for various preferential treatment including tax exemptions and/or lower income tax rates for a period of time. The Notice provides that if a foreign investor's holdings in a FIJSC drop below 25% as a result of the Reform, in principle the preferential treatment enjoyed by the FIJSC will remain unchanged. However, if the foreign investors sell their shares after gaining trading rights for their non-tradable shares and such sale results in foreign ownership dropping below 25%, the preferential treatment may be revoked.

Subsequently on November 4, 2005, the State-owned Assets Supervision and Administration Commission (the "SASAC") issued the Measures Concerning Approval Procedures for Financial Shareholders of State-owned Shares of Listed Companies to Participate in Reform of Segmented Share Structure, which set out procedures for obtaining SASAC approval of reform plans affecting State-owned shares. The Approval Measures further strengthen SASAC authority to determine the price for State-owned shares that become tradable as a result of the Reform.

Employee Share Plans for Listed Companies

The China Securities Regulatory Commission (the "CSRC") has taken a significant step forward in relation to regulation of employee stock schemes through issuance of the Measures on the Administration of Stock Incentive Plans of Listed Companies, which became effective on January 1, 2006.

The Incentive Measures apply to domestic companies listed on the Shanghai and Shenzhen Stock Exchanges. The recipients of share incentive benefits under the measures include directors, supervisors, senior management, personnel possessing key technology and other individuals specified by the company. However, the Incentive Measures exclude:

  • independent directors;
  • individuals who:
    • have been publicly sanctioned or declared as an inappropriate candidate by the securities exchange within the previous three years;
    • have received administrative punishment from the CSRC within the previous three years for any material violation of laws and regulations; or
    • fall within one of the categories of individual stipulated under the Company Law of the PRC as being ineligible to act as a director, supervisor or senior management of a listed company.

Companies are also restricted in the number of shares that can be made available under incentive plans. The number of shares allocated to a plan may not exceed 10% of the company’s total share capital and no more than 1% of the company’s total share capital may be issued to a single individual, unless otherwise approved through special resolution. The source of shares made available under a plan are limited to the following three sources:

  • issued stock directed to plan participants;
  • repurchased stock; or
  • other methods as permitted by laws and administrative regulations.

Note, shares pooled under a Chinese company’s plan are all issued outstanding shares, a feature that is different from a plan commonly seen in the U.S. or other common law jurisdictions. Other common features of an incentive plan in such jurisdictions may not readily be available in China given the registered capital system under China’s corporate law regime.

Note, further, the Incentive Measures do not address the offering of stock benefits to employees in China by foreign companies. Relevant securities, foreign exchange and other issues must be considered carefully before a foreign company offers stock benefits to its employees in China.

For a full copy of the Incentive Measures in Chinese or English please feel free to contact our Hong Kong office.

New Venture Capital Measures Reflect Policy to Cultivate Onshore Venture Capital Industry, but Meaningful Adoption Will Require Further Definition and Corporate Law Reform

Overview

The Interim Measures for the Administration of Early-Stage Venture Capital Enterprises were promulgated by the National Development and Reform Commission, the Ministry of Science and Technology, the Ministry of Finance, MOFCOM, the People’s Bank of China, the State Administration of Taxation, the State Administration for Industry and Commerce, the China Banking Regulatory Commission, the CSRC, and the State Administration for Foreign Exchange and approved on November 11, 2005 by the State Council and take effect as of March 1, 2006.

The Venture Capital Measures reflect a broad governmental policy to cultivate China's venture capital industry, particularly in the technology sectors. Among other things, the Venture Capital Measures contemplate that investment funds will be established to invest in onshore venture capital firms and that preferential tax policies will be adopted to support these onshore venture capital firms. However, the ability of the Venture Capital Measures to meaningfully advance China's onshore venture capital industry is unclear, as regulations enacting the specific tax and legal benefits contemplated by the Venture Capital Measures have not been promulgated. Furthermore, the requirement that onshore venture capital firms only directly invest in Chinese legal entities departs from existing practice and is unlikely to spur additional investment activity under the current Chinese corporate law regime. Nevertheless, the Venture Capital Measures are a positive step in the development of China's onshore venture capital industry.

Flexible Internal Eligibility Requirements

The Venture Capital Measures apply to both domestic and foreign-funded venture capital enterprises registered and established in the PRC ("Venture Capital Enterprises") and have flexible eligibility requirements with respect to a Venture Capital Enterprise’s permitted scope of business, minimum capital contributions, investor criteria and management experience.

Ease of Incorporation

Incorporation procedures are streamlined. Specifically, Venture Capital Enterprises need only be registered with the applicable administrative department for industry and commerce (city, provincial or national, as applicable) by filing certain documents, including charter documents, industrial and commercial registrations, business licenses, investor and capital commitment information, and disclosures on management structure, qualifications and compensation, followed by a post-registration filing process with the applicable administrative authority in charge of Venture Capital Enterprises. (Note, however, that foreign-invested Venture Capital Enterprises are subject to additional formalities provided under separate legislation.) As with other limited liability companies in China, Venture Capital Enterprises are subject to annual reporting requirements and annual inspection by the applicable administrative department of industry and commerce

Substantive Investment and Tax Benefits are Yet to Be Defined

The Venture Capital Measures contemplate that national and local governments may establish investment direction funds to invest in or provide guarantees for Venture Capital Enterprises. Moreover, they indicate that the national government will adopt preferential tax policies to support Venture Capital Enterprises. While these are positive signs for the development of the venture capital industry in China, specific guidance for the establishment of government-sponsored investment direction funds and tax benefits are not yet available. The actual efficacy of the Venture Capital Measures in promoting the venture capital industry in China will depend in large part on the specific measures that are yet to be defined.

Limitation on Direct Investments in Private Companies Registered in China Does Not Reflect Current Practices in Venture Capital Industry

Venture Capital Enterprises are limited to making equity investments in privately held startup enterprises registered and established in the PRC. While the Chinese government’s desire that such investments be made onshore is understandable given earlier attempts to regulate offshore investments1, the onshore investment requirement is inconsistent with the current practices in the international venture capital community, where investments in Chinese companies are typically structured through offshore holding companies incorporated in the Cayman Islands or the British Virgin Islands. While this offshore structure is driven in part by tax planning measures, it is also necessitated by limitations in China’s current corporate law regime. For example, equity interests in private Chinese enterprises are held in the form of registered capital, with no differentiation amongst equity holders other than the amount of registered capital held. The lack of a share-based equity system in China prevents an investor from obtaining special economic rights such as liquidation preferences, anti-dilution adjustments and other rights that are fundamental to the financial mandates of venture capital investors. Furthermore, limitations on the transferability of Chinese equity interests are viewed as overly restrictive by many venture capital investors. Until the Chinese corporate legal system provides investors with, among other things, the flexibility to define special economic rights for their equity interests and free transferability, the adoption of Venture Capital Enterprises under the Venture Capital Measures is likely to be limited. Notwithstanding the foregoing, the Venture Capital Measures are a positive sign that the PRC government is seeking to create a more attractive environment for venture capital investors and the start-up companies in which they invest.

Notarization Law of the People’s Republic of China

On August 28, 2005, China’s National People's Congress promulgated the country’s first law governing notary qualifications and notarization procedures - the Notarization Law of the People's Republic of China. The Notarization Law will go into effect on March 1, 2006.

Prior to the enactment of the Notarization Law, the State Council’s Interim Regulations for Notarization had been the primary regulation governing notarization activities. The new law includes statutory provisions governing the following areas:

1. Notarial Office:
  • The Notarization Law clearly defines the term "notarial office" - "a non-profit certification institution that is lawfully established and independently exercises the notarial functions and bear corresponding civil liabilities."
  • One or more notarial offices may be established in one city. The following requirements must be satisfied: (i) having its own name; (ii) having a fixed place; (iii) being staffed with 2 or more notaries; and (iv) having necessary funds.
2. Notaries:
  • Key criteria for qualifying as a notary include having PRC citizenship, and successfully passing the National Judicial Examination.
3. Notarization Procedures:
  • The Notarization Law stipulates detailed procedures for notarization. Any notarization request can be made to a notarial office in the place where the applicant is domiciled or habitually resides, or where the relevant act is committed, or where the relevant fact occurs. Notarization of documents related to real property shall be done by a notarial office where the real property is located.
4. Effect of Notarization:
  • Once a specific act, fact or document has been notarized, such will be considered as accurate unless proven otherwise by evidence. Anyone who contests the contents of the notarial certificate may file a civil suit in the People’s courts.

Other Recent Developments

Electric Power Market

In early December, China took a major step in the continued reform of its electric power market. Three major regulations promulgated by the State Electricity Regulatory Commission (the "SERC") took effect on December 1, 2005: the Measures for the Supervision of the Electric Power Market promulgated on November 7, 2005, the Basic Operating Rules for the Electric Power Market promulgated on November 7, 2005, and the Provisions on the Administration of Electric Power Business Licenses promulgated on October 13, 2005.

The Supervision Measures establish a foundation for China’s electric power market. All participants in the Market such as power generation enterprises, power distribution, and power supply enterprises, and consumers are subject to this regulation. The SERC is empowered with specific authority to serve as supervisor and arbitrator.

Detailed operating processes of China’s electric power market, including power generation, power transmission, power supply, power trading, and auxiliary activities such as maintenance of the grid, are regulated by the Operating Rules. Participation in the electric power market requires all participants to obtain necessary licenses. The Administration Provisions establish the qualifications and procedures for participants and legal consequences of non-compliance.

These regulations provide the SERC with the supervisory tools to implement far-reaching reforms of China’s power sector. Commentators anticipate that the SERC will have significantly greater market influence on the pricing and allocation of power.

Banking

Guidelines on Electronic Payment

The Guidelines on Electronic Payment promulgated by the People’s Bank of China on October 26, 2005 and took effect as of the date of promulgation.

The Guidelines establish certain rules for electronic payment activities which guard against payment risks and create a secure environment for conducting electronic payment transactions under the Electronic Signature Law, which was promulgated in August 2004 and took effect in April 2005. The Guidelines also impose caps on electronic payments by individual customers of RMB 1,000 for a single transaction and RMB 5,000 for the cumulative daily amount. These caps do not apply for transactions employing security methods, such as digital certificates, electronic signatures, and other security authentication methods.

Taxation

Reply of the State Administration of Taxation Concerning Relevant Issues of Tax Refund in Connection with Re-Investment by Foreign Investors

The Reply of the State Administration of Taxation Concerning Relevant Issues of Tax Refund in Connection with Re-Investment by Foreign Investors was issued by the State Administration of Taxation ("SAT") and took effect on November 17, 2005. The Reply clarifies the availability of a refund of Foreign Enterprise Income Tax ("FEIT") when a foreign investor acquires equity in a foreign invested enterprise and reinvests retained earnings produced before the equity transfer. According to the Reply, a tax refund may not be available in these circumstances.

A foreign investor who acquires equity from an affiliated entity as part of a tax-deferred internal reorganization is exempted from application of the Reply and a reinvestment of retained earnings, even if produced before an equity transfer, continue to be eligible for an FEIT refund.

Foreign Exchange

The Circular of the State Administration of Foreign Exchange on Improving the Administration of Foreign Debts was promulgated on October 21, 2005 by the State Administration of Foreign Exchange and took effect on December 1, 2005.

In accordance with the Circular, the following activities are subject to foreign debt registration:

  1. Import contracts newly concluded by domestic entities as of December 1, 2005, with the unpaid amounts exceeding US$200,000, and the agreed or actual deferred payment time limit exceeding 180 days, in which case an import enterprise shall, within 15 working days of customs declaration, go to the local bureau of the State Administration of Foreign Exchange to handle registration of the deferred payments.
  2. Domestically registered transnational corporations using funds from overseas affiliated companies within the territory of China.

The Circular also clarifies foreign debt management rules for domestic loans with foreign guarantees as well as foreign debt management rules for certain types of foreign-invested enterprises, such as enterprises in which the foreign investor’s investment is less than 25%, total investment is equal to registered capital or else is unclear, and in situations involving foreign investment holding companies and foreign investment leasing companies.

Trade

New Measures for Export Processing Zones to Facilitate Industry Upgrade

MOFCOM promulgated the new Interim Administrative Measures of Processing Trade of Export Processing Zones on November 22, 2005, and effective January 1, 2006.

Processing trade here refers to transactions whereby a foreign party sources raw materials and components in a foreign market and then has a manufacturer in China make the final goods, or alternatively has raw materials and components processed on a consignment basis in China.

The new Measures are intended to streamline the administrative procedures and enhance the processing trade. These Measures supersede the measures issued in 2001. Major changes from the previous measures include the administration of processing trade in Export Processing Zones (the "EPZs"), entry and exit of goods from/to the EPZs, and transferring goods outside the EPZs for further processing. Key provisions of the new Measures include:

  • prohibiting high energy-consuming and polluting businesses in contravention of industrial policy;
  • prohibit the establishment of new labor intensive enterprises which are of low standards or low value-add in the eastern coastal areas;
  • encourage businesses that offer local characteristics or businesses that are transferred from the eastern coastal areas to the central-western area of China;
  • set a time limit of 10 business days for the administrative committee to approve and issue the license for the trade-processing operations;
  • prohibit the dismantling and revamping of businesses;
  • permit the operation of repair and maintenance businesses inside EPZs for electromechanical products, which are manufactured and exported from China; and
  • implement new measures regulating the transfer of goods outside of EPZs for further processing, and prohibit the transfer of bonded materials that have not been substantially processed out of EPZs.

MOFCOM Circular on Administration of FIEs Import & Export Quotas

The Circular on Relevant Issues Concerning the Adjustment of the Commodities Subject to Import & Export Quota Licenses Administration for Foreign-Invested Enterprises in 2005 and the Application Quantity of that in 2006 was promulgated by the MOFCOM on October 27, 2005, and became effective on the same date.

In the Circular, MOFCOM requires the provincial branches to verify actual usage of import and export quotas by foreign-invested enterprises, and to make a filing of the unused portion before November 15, 2005 so as to permit reallocation of the unused quotas. Applications for 2006 quotas need to be submitted to MOFCOM before November 15, 2005.

Mainland and Hong Kong Closer Economic Partnership Arrangement ("CEPA")

Supplementary Agreement No. 2 on Mainland and Hong Kong Closer Economic Partnership Arrangement

On October 18, 2005, the Mainland and Hong Kong reached agreement on the third phase of further trade liberalization measures (CEPA III) relating to trade, services and investment by Hong Kong companies in China. Key provisions of CEPA III include:

(a) Trade in Goods
Effective January 1, 2006, all products of Hong Kong origin except for prohibited articles (such as used or wasted electrical machinery and medical/surgical products, chemical residual, municipal waste, tiger bone and rhinoceros horn), are eligible for duty-free treatment upon application by the local manufacturer and compliance with CEPA rules of origin ("ROOs"). CEPA III added 261 new products to the ROOs list in addition to the 1,108 tariff free products already covered in the first two phases of CEPA. For products that have no agreed ROOs, Hong Kong manufacturers may apply and request to include their products in subsequent ROOs discussions which will be held twice a year (instead of once a year as previously).
(b) Trade in Services
Further liberalization measures apply to 10 service areas, namely legal, accounting, audiovisual, construction, distribution, banking, securities, tourism, transportation and individually owned stores. For instance, in the audiovisual services sector, Hong Kong service suppliers can establish wholly-owned companies in the Mainland, each of which may build and operate more than one cinema theatre at more than one location; and in the tourism sector, lower turnover thresholds apply to Hong Kong travel agents setting up travel agencies in the Mainland. Overall, the liberalization permits earlier access for Hong Kong service suppliers to the Mainland market, ahead of China’s World Trade Organization timetable.
(c) Trade and Investment Facilitation
CEPA III emphasizes that trade and investment facilitation play a crucial role in successfully implementing CEPA. Accordingly, measures have been devised to enhance trade and investment between the Mainland and Hong Kong under CEPA III. Two notable examples include:
  • Exempting from Mainland’s export duty textile and clothing products under Hong Kong’s Outward Processing Arrangement when they are re-imported to Hong Kong; and
  • Permitting certain types of Mainland securities and futures companies to establish operations in Hong Kong.

Environment

Regulations Governing the Approval Procedures for Environmental Impact Evaluation Documents for Construction Projects

On November 23, 2005, the State Environmental Protection Administration ("SEPA") issued the Regulations Governing the Approval Procedures for Environmental Impact Evaluation Documents for Construction Projects, and the Regulations went into effect on January 1, 2006.

The Regulations govern the environmental impact evaluation documents ("EIA Documents") that fall within the approval authority of SEPA. Such documents include a full EIA report, a simplified EIA form and an EIA registration form.

Depending on the type of construction project, the applicant must file the relevant EIA Document prior to:

  • submission of the feasibility study for a project requiring examination and approval;
  • submission of project application report for a project requiring review and approval; and
  • after completion of recordal procedures and prior to commence of construction for a project requiring recordation.

The approval procedures consist of three steps: (i) application and acceptance, (ii) examination, and (iii) approval.

After SEPA accepts the application, a technical evaluation and expert review may be required for a project that SEPA determines requires such evaluation and review. A hearing may be required for a project that may cause serious environmental impact to local residents or a project for which major differences of opinion exist.

The relevant EIA Document must be submitted for re-examination if the project is not constructed within five years of SEPA approval.

Sports

Administrative Measures on Sports Service Certification

The Administrative Measures on Sports Service Certification were jointly promulgated on November 10, 2005 by the Certification and Accreditation Administration ("CNCA") and the General Administration of Sports ("Sports Bureau") of the PRC and became effective as of January 1, 2006.

The Sports Measures establish a unified system for the certification of "sports services", including the organization and promotion of sports venues and sporting activities, such system to be administered by the CNCA and the Sports Bureau.

The Sports Measures include provisions governing the qualifications of entities applying to be sports services certification units as well as the qualifications of their personnel. They also contemplate the CNCA and the Sports Bureau formulating sports service certification rules.

Patents

Measures Governing the Compulsory License of Patent Implementation Related to Public Health

On November 29, 2005, the State Intellectual Property Office of China ("SIPO") issued the Measures Governing the Compulsory License of Patent Implementation Related to Public Health pursuant to the Patent Law of People’s Republic of China ("Patent Law"). The Patent Measures went into effect on January 1, 2006.

The SIPO issued the Patent Measures to implement China’s commitment under the Doha Declaration on the TRIPS Agreement and Public Health, adopted by the WTO Ministerial Conference in November 2001. The objective of the Patent Measures is to help solve China’s public health problems (e.g., infectious diseases, AIDS, tuberculosis, malaria and drug addiction), promote access to medicines for such diseases as well as help other countries or regions dealing with public health problems.

The Patent Law only permits compulsory license of patents for very limited purposes, such as "public interest" or "State emergencies". The Patent Measures provide that the manufacturing, sale import and export of drugs for the following purposes will be deemed as "public interest" or "State emergencies", and therefore qualified to apply for compulsory patent licenses:

  • prevention and control of infectious diseases (public interest); and
  • infectious diseases causing public health crisis (State emergencies).

The Patent Measures requires the licensees (e.g., drug manufacturers) to pay reasonable compensation to the patent rights holders.

Media and Advertising

New Development in the Administration of Newspaper and Periodical Publication

The General Administration of Press and Publication promulgated the Provisions on the Administration of Periodical Publication (Decree No. 31) and the Provisions on the Administration of Newspaper Publication (Decree No. 32) on September 30, 2005 and effective December 1, 2005. The Periodical Provisions and the Newspaper Provisions formalize "interim" measures that had been used to administer newspaper and periodical publication for over a decade.

The following developments under both the Newspaper Provisions and Periodical Provisions are notable:

(1) For the first time, a "publication entity" is required to be established to be responsible for the publication of a periodical or newspaper. A "publication entity" must be an independent legal entity and assume liability for the relevant periodical or newspaper. It is necessary to undertake the same approval procedures to establish such a "publication entity" as obtaining approval for publication of the relevant periodical or newspaper.
(2) Newspapers and periodicals are subject to strict geographic scopes of publication.
(3) Post-publication review, quality appraisal, annual review and staff professional qualification requirements have been instituted.
(4) Newspapers and periodicals are expressly permitted to publish their contents on-line, subject to the "publishing entity" being held responsible for verifying the accuracy of such information and complying with applicable online publication regulations.
(5) A compulsory de-registration mechanism has been implemented for a newspaper which ceases publication for more than 180 days or a periodof more than 1 year.

Direct Sales

MOFCOM promulgated the Administrative Measures on the Vocational Training of Direct Sales Personnel, the Administrative Measures on Depositing, Payment and Use of Earnest Money of Direct Selling Enterprises and the Administrative Measures on Information Reporting and Disclosure by Direct Selling Enterprises on November 1, 2005. These provide additional clarification and implementing procedures for the Regulations on the Administration of Direct Selling (the "Regulations") promulgated by the State Council of China on August 23, 2005. The above Measures all took effect on December 1, 2005 and impose detailed requirements for the training of direct sales personnel, security deposit payment and disclosure obligations on direct selling enterprises. Key provisions include:

Direct Sales Personnel Training: A direct selling enterprise is required to hold training sessions and examinations for new recruits. The contents of the training programs and examinations need to be filed with competent authorities. An individual who passes the examinations should be issued a Direct Sales Personnel certificate. The direct sales person is required to wear the certificate during his/her work.

Security Deposit Payment: Enterprises need to enter into an agreement with a designated bank to deposit RMB 20 million, in cash, as a security deposit in a newly opened special account before being approved by MOFCOM to operate a direct selling business.

Disclosure: A direct selling enterprise is required to set up a website which provides information on the direct selling enterprise such as its legal name, a list of direct sales personnel and its internal direct selling policies.

MOFCOM also made three announcements immediately after the issuance of the Regulations, further clarifying detailed requirements and closing potential loopholes in the Direct Selling Regulations. Among them, Announcement No.72 currently limits permitted products for direct selling ("Products") to cosmetics, health foods, hygiene products, health care equipment, and kitchen appliances. Announcements No.74 and No.75 stipulate the form of direct Sales Personnel certificates and direct selling trainer certificates which direct selling enterprises are required to issue to qualified direct sellers and direct selling trainers.

Footnotes

1. See SAFE Circular 75 – The Key Provisions of Circular 75 and What They May Mean for Investors, November 2005: http://www.mofo.com/news/updates/files/update02094.html

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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