China's Revised Company Law: A Guide to Capital Reduction for Foreign Investors

by Mei Zhang & Jonathan Pfister

The recent revisions to the Company Law of the People’s Republic of China (“PRC”), which were formally approved on 29 December 2023 and will go into effect on 1 July 2024 (“New Company Law”), ushered in a range of new changes to China’s corporate law regime. Among the most significant is Article 47, which requires that the subscribed capital of a Chinese limited liability company (“LLC”) must be fully paid up by the company’s shareholders within five years from the company's establishment. Under the previous Company Law amended in 2018 (“Previous Company Law”), there was no time limit on the contribution of capital into an LLC.

The requirements of Article 47 apply not only to newly established LLCs, but to existing ones as well: Article 266 of the New Company Law requires existing LLCs to “gradually adjust” their capital subscription period to within the period stipulated in Article 47. Although the New Company Law provides no specific deadline for completing the “gradual adjustment”, the recently released Draft Regulations on the Implementation of the Registered Capital Registration Management System of the Company Law (“Draft Regulations”), issued on 6 February 2024 by the State Administration for Market Regulation (“SAMR”), provide for a three-year transition period starting from 1 July 2024 and ending on 30 June 2027 for existing LLCs to comply with Article 47. If the Draft Regulations are adopted in their current form, then within the transition period, any existing LLCs with capital contribution periods of longer than five years after 1 July 2027 will need to modify their articles of association and publish such information through National Enterprise Credit Information Publicity System so that all subscribed capital of the LLC is required to be contributed within such five-year period. As a result, 30 June 2032 would be the deadline by which the registered capital of all existing LLCs would need to be fully contributed.

As a result of these requirements, many overseas investors are nonetheless now faced with the decision to either commit to paying in any outstanding registered capital by the deadline in the New Company Law, or undertake a capital reduction. While the former is relatively straightforward, a capital reduction entails a complex and lengthy process that many foreign investors are unfamiliar with. For a foreign-invested entity (“FIE”), separate processes will need to be completed with each of: (1) the competent branch of the State Administration for Market Regulation (“SAMR”), the corporate registry in the PRC, (2) the competent tax authority, and (3) the FIE’s designated bank. These steps typically take three to eight months to complete, although longer periods are common in complex situations; the tax and bank processes can be particularly unpredictable.

In this article, we will discuss each of these key steps in detail to provide a general overview of the capital reduction process for FIEs.

Initial Legal Matters and SAMR Filing

A capital reduction is more substantial than other corporate changes, such as an address change or personnel adjustments, as it could impact an FIE’s solvency. Therefore, before a capital reduction can be registered with the SAMR, an FIE must fulfill specific requirements mandated in the New Company Law. First, the FIE must formulate a balance sheet and a detailed inventory of assets, and its shareholders must pass a resolution approving the capital reduction. After passing the shareholders’ resolution, within ten days the FIE must inform its creditors of the planned capital reduction, and within 30 days the FIE must make an announcement in a local newspaper or in the National Enterprise Credit Information Publicity System (a government-operated online corporate registration system). Within 30 days of receiving a notice, or 45 days of the public announcement date (if no notice was received), the FIE’s creditors will then have the right to claim full repayment of any debts that are due or request a corresponding guarantee from the FIE.

After the notice periods, the required corporate change documents can be submitted to the local SAMR. If the documents are in order, the local SAMR will accept and review the application and provide a response within five working days. If approved, the FIE will be notified to collect its renewed business license within 10 working days.

The capital reduction process with the SAMR can be complex, and if not handled properly, could result in delays or even warnings or fines from the SAMR. Some of the more commonly encountered issues are as follows:

1. If the FIE does not follow the requirements mandated under the New Company Law, it could be deemed to have undertaken an illegal capital reduction, and receive warnings or fines of RMB 10,000 to RMB 100,000 from the SAMR. Under the New Company Law, if a company decreases its registered capital in violation of the New Company Law, the shareholders must return any funds received, and the decrease in the shareholders’ contributions will be reinstated. If the company incurs any losses, the shareholders, any directors, supervisors, and senior officers responsible for the violation will be liable to compensate the company.

Typically, SAMR officials will check to ensure that an FIE has posted the necessary public notices before processing a capital reduction application. FIEs should therefore strictly adhere to the time requirements for notifying creditors and publishing public notices. The balance sheet and detailed inventory of assets, although they will not need to be submitted for SAMR’s review, should nevertheless be prepared in accordance with the New Company Law, as they may need to be provided to tax officials or presented in the event a creditor challenges the capital reduction process.

2. An FIE should use a broad definition of “creditors” when identifying who to notify. In the past, the term “creditors” in Article 177 of the Previous Company Law – which is almost identical to a provision in Article 244 of the New Company Law – generally has been interpreted broadly by judicial authorities. For example, in a case decided by the Shanghai High People's Court[1], the term “creditors” was interpreted to include not only the creditors of the company at the time the shareholders’ resolution to undertake the capital reduction was passed, but also all creditors that arose up until the capital reduction filing with the SAMR was submitted. Parties were deemed to qualify as creditors, even if their claims had not yet matured or the amount of their claims had not yet been verified

3. When preparing the SAMR submission, any documents to be signed by an FIE representative should be signed by the authorized signatory filed with the SAMR. If that person no longer works at the company or is otherwise unavailable to sign, then a new authorized signatory will need to be registered. Registration will be time consuming, as the registration documents will need to be apostilled before being submitted to the SAMR. Even if the authorized signatory is available, he/she should take care to ensure that his/her signature matches that filed with the SAMR to the greatest extent possible, to avoid the documents being rejected.

4. An FIE should ensure that sufficient shareholder approval is obtained to complete the capital reduction. A resolution adopted at a shareholders’ meeting by holders representing at least 2/3rds of all equity in an FIE is generally needed to complete a capital reduction under the New Company Law. However, if a written resolution is used in lieu of convening a shareholders’ meeting, the written resolutions should be unanimous. In addition, if an FIE wishes to reduce the capital of its shareholders on a non-proportional basis, then approval of all FIE shareholders will be required.

5. When undertaking a capital reduction, an FIE should be sure not to lower its capital below any minimum required amount. For example, companies engaged in certain industries, such as international transportation and labor dispatch services, must maintain a minimum required registered capital. Entities having special qualifications, such as “regional headquarters”, may need to maintain a minimum registered capital as well. An FIE should determine at the outset any registered capital requirements that it is subject to.

Tax Treatment

Some foreign investors may be surprised to find that the proceeds from a capital reduction may be subject to PRC taxes. Under the Announcement of the State Administration of Taxation on Several Enterprise Income Tax Issues, funds distributed to shareholders from a capital reduction may be subject to three different tax treatments, each with different tax implications:

• the portion that is equivalent to a shareholder’s initial investment in the FIE will be recognized as recovered investment, and will not be subject to PRC Corporate Income Tax (“CIT”);
• the portion that is equivalent to accumulated undistributed profits and accumulated surplus reserves and attributed to such shareholder’s reduced capital will be recognized as dividend income, and will be subject to CIT at a rate of 10% (or an applicable preferential treaty rate); and
• any additional portion will be recognized as income from the transfer of investment assets, and will be subject to CIT at a rate of 10% (or an applicable preferential treaty rate).

Under PRC law, an FIE should act as the withholding agent for any taxes owed through a capital reduction and make any declarations and payments to competent tax authorities. Moreover, when a non-resident taxpayer enjoys a preferential tax rate, it will need to determine whether it is eligible for treaty benefits. If it is, then an application (specifically, the Reporting Form for Entitlement to Treaty Benefits for Non-resident) will need to be filed to receive such benefits. All tax-related materials should be retained as well, for tax authorities’ future reference.

Following the tax filing, if any single outbound remittance of the capital reduction proceeds will equal USD 50,000 or more, the FIE will be required to file a record of outbound remittance with the competent tax authority. Once completed, the FIE will obtain a tax record filing form or serial number, which will be required by its bank to process the foreign exchange payments.

Although the above-mentioned regulations are relatively clear on the tax treatment of capital reduction proceeds, various issues arise in practice. Some of the most common are as follows:

1. In principle, the capital reduction amount distributed to each shareholder should be based on the shareholder’s share of net book assets. If the consideration for a capital reduction is unfairly priced, it may be subject to adjustment by the tax authorities.
2. If the funds received through the capital reduction were previously subject to tax benefits (such as tax deferrals for reinvestments by overseas investors), back taxes may be owed.
3. A disproportionate capital reduction – whereby one or more shareholders’ equity percentages are reduced by a greater amount than the other shareholders – could attract the attention of PRC tax authorities, who may question whether the capital reduction should actually be treated as an equity transfer. FIEs should consult with tax professionals to assess this risk and determine whether the capital reduction should be restructured as an equity transfer.
4. FIEs should further confirm whether a capital reduction can make up for serious losses incurred by an FIE, and if so, how it should be handled from a tax perspective.

Banking and Foreign Exchange Issues

As many overseas investors know, China maintains strict foreign exchange management policies. To convert RMB funds into foreign exchange and remit them outside of China, complex applications and supporting materials are often needed and at least one on-site visit to the bank is necessary. The entire process often takes days (or weeks) to complete.

The same applies to any capital reduction funds that need to be exchanged for foreign currency and remitted outside of China to foreign investors. Typically, two steps will need to be completed with the FIE’s bank: (1) registration of the capital reduction, and (2) completion of the foreign exchange payment process. Details on both processes are set out below.

1. Registration of Capital Reduction

After registering the capital reduction with the SAMR, completing any tax filings and settling any related taxes, an FIE should register the capital reduction with its local bank. The FIE’s bank will require a number of documents and information to complete this process, typically including the FIE’s business registration certificate (业务登记凭证, a SAFE registration document issued to the FIE), and capital reduction registration forms, among others. The volume and scope of documents required may also depend on whether only the subscribed (but not paid-in) portion of the FIE’s registered capital will be reduced, or if any portion of the paid-in portion will be reduced.

2. Completion of Foreign Exchange Payment Process

Once the capital reduction has been registered with its bank, the FIE can proceed with the foreign exchange payment procedures. To do so, the FIE will need to provide documents and materials not only evidencing the proper completion of the capital reduction processes, but also required to fulfill its bank’s "know your client", "know your business", and "due diligence" requirements. The FIE will assume all liability for examining and approving the authenticity and compliance of any supporting materials, and will be required to retain such materials for five years. In addition, the FIE will be permitted to remit the capital reduction proceeds to its direct overseas shareholders only; its bank will not permit any capital reduction funds to be paid to a shareholder’s affiliate or parent company, or to any third party.

Ultimately, the information and documents requested may vary depending on the FIE’s bank. However, at its core, the review will focus on verifying the authenticity and legitimacy of the capital reduction and the foreign exchange payments. In addition, as the PRC maintains a closed capital account, the exchange and remittance outside of China of capital reduction proceeds can be unpredictable and may be subject to delays that are outside of the bank’s control. Therefore, we suggest preparing the necessary materials well in advance, and responding to all requests and inquiries in a timely and prudent manner to ensure a smooth and efficient capital remittance process.

Conclusion

Under the New Company Law, if an overseas investor chooses to undertake a capital reduction of its FIE, it will need to complete a relatively complex process, involving a number of government authorities, multiple rounds of review, and various documents and information. Moreover, these processes and documents differ from place to place, from city to city, and from branch to branch. As many different risks may arise, investors should analyze and deal with them according to local conditions and based on their FIE’s particular situation. We therefore recommend carefully considering the legal, tax, and foreign exchange implications that may be involved in the design and implementation of capital reduction plans, and introduce professional assistance when necessary to reduce the impact of the capital reduction on the FIE to the extent possible.

Footnotes

[1] See Shanghai Boda Data Communications Co., Ltd. (“Boda”) vs Meisi Information Technology (Suzhou) Co., Ltd. (“Meisi”) ((2020) Huminzai No. 28), where the shareholders meeting of Meisi resolved to undertake a capital reduction on 15 September 2015, and Meisi completed the capital reduction process and obtained a new business license from the SAMR on 8 August 2016. Meisi and Boda entered into three sales contracts on 8 October 2015, 11 November 2015, and 5 January 2016, respectively. Meisi claimed that it had no obligation to notify potential creditors during the capital reduction period and refused to pay Boda for debts owed under the sales contracts. According to the decision of the Shanghai High People's Court, however, the contracts gave rise to debts, so the signing date of the sales contracts should determine when the creditor-debtor relationship between Meisi and Boda arose. Boda therefore was entitled to demand that Meisi pay the amounts owed under the contracts, as Boda was a creditor of Meisi. The fact that the Boda’s claims had not yet matured or the amount of the claim had not yet been clarified did not affect Boda’s creditor status .