Chinae BusinSeptember-Octoberess 2010 Review The PRC Partnership Enterprise Law permits foreign investors to establish general or limited partnerships. Introducing the Foreign-Invested Partnership There’s a new option for structuring foreign investment in China, and it may offer companies greater flexibility. Paul McKenzie, Thomas Chou, Adam Kearney, and Charles Coker oreign investors have pursued establishing joint (FIP measures) and the Administrative Provisions on the ventures (JVs) and, later, wholly foreign-owned Registration of Foreign-Invested Partnership Enterprises (FIP enterprises (WFOEs), since the inception of registration procedures), both of which took effect March 1, China’s foreign-investment boom more than 30 2010, there is a new structure to consider: the foreign-invest- years ago. Now, with the recent release of the ed partnership (FIP). Administrative Measures on the Establishment of Partnership The FIP option and its implementing regulations repre- FEnterprises in China by Foreign Enterprises or Individuals sent the culmination of PRC government efforts over the chinabusinessreview.com September–October 2010 1 FOCUS: INVESTMENT VEHICLES past three years to expand the scope of foreign-investment nized capital contributions compared to the more restrictive legislation to include partnership entities under the 2006 rules for EJVs, CJVs, and WFOEs. In addition to cash and PRC Partnership Enterprise Law. These developments, in-kind contributions, labor services may also be contributed though monitored most closely by the private equity and to a partnership, provided that the contributor is not a limit- real estate investment community, suggest new investment ed partner. In practice, services are often contributed by one structure options for a broad range of foreign investors and or more partners, particularly in a limited partnership where businesses in China. In fact, the first FIP to be registered the general partner manages cash contributions of the limited under the new regulations, the Jiangsu-based Kunshan Sun partners. Partnerships are also exempt from the 70 percent City Gardening Center, involves plant nurseries and gar- cap on the contribution of non-cash assets applicable to dening supplies rather than the fund for- foreign-invested enterprises (FIEs) and mation activities that have been widely Quick Glance other domestic companies under the PRC anticipated by foreign observers. Company Law—a key consideration for ■ China’s new investment high-tech start-ups, where intangibles often A closer look at FIPs option—foreign-invested represent the bulk of a venture’s assets. The basic contours of a partnership in partnerships—generally provides Finally, unlike the situation for corporate China are similar to partnership structures more flexibility than cooperative or FIEs, the payment of contributions in a in other countries, though China may pass equity joint ventures. partnership is not subject to statutory time legislation to clarify certain details in the ■ The related Partnership limits, which in turn facilitates “just-in- coming years. Broadly speaking, a partner- Enterprise Law guides investors on time” deployment of capital contributions. ship provides more structural flexibility partnership forms, capitalization Observers expect this feature to be critical than equity joint ventures (EJV), coopera- requirements, profit and dividend for investment fund partnerships as a means tive joint ventures (CJV), and other invest- distribution, management of enhancing the capital efficiency of fund ment vehicles (see p.14). The law provides structure and governance, and tax operations and internal rates of return. guidance in five critical areas. treatment. Beyond investment funds, the flexible ■ PRC regulations are unclear capitalization rules for partnerships may Partnership forms about the new structure’s approval prove useful for small enterprises for which The Partnership Enterprise Law pro- processes and downstream corporate FIE forms can be ill-suited and vides for two basic forms: general partner- investment options, however. cumbersome. The first batch of registered ships under which all partners undertake FIPs, in March 2010, included not only unlimited liability for the debts of the investment funds and managers, such as the partnership; and limited partnerships consisting of at least Fosun-Carlyle (Shanghai) Equity Investment Fund and one general partner and one or more limited partners. Softbank-affiliated Shanghai Xinchuang Equity Investment Limited partners generally do not participate in the daily Management Co., but also small and medium-sized non- management of the entity’s affairs and are liable for debts of financial enterprises such as plant nurseries and consultancies. the partnership only to the extent of their capital contribu- tions to the partnership. Accordingly, limited partnership Flexibility of profit and dividend distribution vehicles may be particularly relevant for forming invest- In some ways, the FIP structure is more flexible than the ment funds, with the fund sponsor assuming the role of JV structure. A key aspect of EJVs is the rigid linkage general partner and passive financial investors taking inter- between capital contributions and profit distribution. Each ests as limited partners. Certain early renminbi (RMB) investor is entitled to a pro rata share of profits strictly in fund test cases have made use of the limited partnership accordance with their pro rata contribution of equity. option, though others have been set up in the form of a Foreign investors requiring more flexibility have formed general partnership. CJVs, which permit the investors, subject to foreign invest- Interestingly, the Partnership Enterprise Law also provides ment approvals, some discretion in adjusting the linkage for “special” general partnerships for professional services between capital contributions and profit shares. Though firms such as law firms and accountancies. Preliminary indica- originally used principally for natural resource development tions suggest that additional legislative and regulatory devel- projects, the CJV has become increasingly popular in recent opments on professional services partnerships are pending. years for real estate-related investments. In addition, several onshore venture capital funds set up under the PRC Capitalization Ministry of Commerce’s (MOFCOM) foreign-invested Partnerships, including FIPs, are not subject to statutory venture capital enterprise (FIVCE) scheme have made use minimum capitalization requirements. The Partnership of the non-legal person CJV, given the unavailability of a Enterprise Law provides for a more liberal scope of recog- limited partnership vehicle. 2 September–October 2010 chinabusinessreview.com Though CJVs have served as a workable solution in Pass-through tax treatment some cases, provided that requisite foreign investment The Partnership Enterprise Law exempts partnerships approvals are forthcoming, a limited partnership affords from income tax at the enterprise level; partnerships are investors the ability to structure their interest-sharing rela- subject to pass-through taxation, whereby each partner is tionship without any reference to capitalization. This flexi- responsible for income tax on its share of the partnership’s bility is critical to setting up the kind of carried-interest income instead. Currently, entities with legal person status, arrangements that are typically the centerpiece of invest- such as FIEs that may be established as general partners of ment-fund structures. It may also come into play for other an onshore partnership, are subject to a 25 percent enter- closely held businesses where value-added strategic relation- prise income tax, while individuals are subject to a graduat- ships play an important role. ed income tax. Neither the Partnership Enterprise Law nor A limited partnership affords investors the ability to structure their interest-sharing relationship without any reference to capitalization. Management structure and governance the FIP measures address the question of how a foreign All FIPs require the preparation and registration of a part- limited partner’s interest in an FIP is to be taxed in China. nership agreement that sets out the governance arrangements Under general tax rules applicable to foreign taxpayers, of the partnership, as well as other key details. Though the withholding tax would apply. Partnership Enterprise Law requires certain specified coverage The venture capital and private equity community has in a partnership agreement, including governance provisions, welcomed the additional clarity provided by the Partnership the law offers a great deal of flexibility in structuring these Enterprise Law on pass-through taxation. In practice, exist- provisions. For example, Article 31 enumerates certain mat- ing onshore venture capital funds established under the ters as subject to unanimous partnership consent but pro- FIVCE regime in non-legal person CJV form have in many vides for an opt-out under which a partnership agreement cases been able to obtain pass-through taxation on a case- may provide for alternative procedures. A similar approach by-case basis with special approval. The legal basis and applies to other vital matters such as profit distribution and availability of such treatment has been a murky area, how- admission of new partners. At the same time, the Partnership ever. The PRC State Administration of Taxation and Enterprise Law provides partners with