In the past, foreign direct investments in China mainly took the form of Sino-foreign equity joint ventures, Sino-foreign contractual joint ventures and solely foreign-owned enterprises. Following the deepening of reform and open policies in recent years, merger and acquisition (M&A) of Chinese enterprises have become a new form of foreign investment in China. Foreign businesses interested in M&A should note the following fundamental legal issues.

Catalogue for Foreign Investment

To provide better directions to foreign-invested enterprises (FIEs) in their ventures, Beijing published the "Provisional Rules on the Guidance of Foreign Investment Industries" and the "Catalogue for the Guidance of Foreign Investment Industries" in 1995. The Catalogue was subsequently revised in 1998. Under the provisions, foreign investment projects are classified into four categories: encouraged, permitted, restricted and prohibited. Those under the encouraged, restricted and prohibited categories are listed in the Catalogue whereas those under the permitted category are not. The Catalogue also contains a list of foreign-invested projects where state-owned assets must hold a controlling or dominant stake and are not to be acquired or merged by FIEs. In light of this, FIEs interested in acquiring or merging with Chinese enterprises should refer to the Catalogue, which provides information on which sectors are open to M&A by foreign investors and what preferential treatment is offered.

Assessment and Pricing

In China, the price for M&A is not solely determined by the parties involved. It is subject to many external restrictions. According to the relevant provisions on state property administration, the sale of state-owned assets and state-owned shares (including the assignment of the Chinese party's contribution of state-owned assets to the investment in an FIE) must be assessed by a qualified assessment body and the results confirmed by the National Administration of State Property. The assessed price upon confirmation will be the basis for pricing. For the sale of state-owned shares, the transfer price must not be lower than the net asset value per share, and must be determined by a combination of factors such as the net asset return rate, actual investment value, recent market price and reasonable P/E ratio.

Approval Procedure

Like traditional foreign investment, the M&A of Chinese enterprises by FIEs is subject to examination and approval by relevant government authorities. The sale of state-owned enterprises (SOEs) normally requires the approval of state property administration departments, industry administration departments, State Economic and Trade Commission, and MOFTEC. Acquisition of a shareholder's contribution to the investment in a FIE (including the non-listed shares of a limited liability FIE) must be subject to the prior approval of the board by resolution, the approval of other investors and the approval of the relevant authorities (MOFTEC or local foreign economic and trade departments). If the acquired enterprise is to be converted to solely foreign-owned and its business is in an industry where the establishment of FIEs is restricted under Article 5 of the "Rules for Implementation of Solely Foreign-owned Enterprises", the acquisition must also be approved by MOFTEC.

Taxation

M&A may entail complicated taxation issues. In general, income tax is chargeable on the assignment of assets and shares; value-added tax is chargeable on the assignment of machinery and equipment; business tax is chargeable on the assignment of intangible assets; and stamp duty is chargeable on the assignment of shares. Concessions may be granted by the taxation authorities to specific projects, especially the acquisition of SOEs.

There are special legal provisions on income tax on the merger and acquisition of FIEs. In April 1997, the State Administration of Taxation published a set of interim provisions governing income tax chargeable on the restructuring of FIEs by way of merger, split-off, share restructuring and asset assignment. The interim provisions cover detailed rules on the restructuring (including M&A) of FIEs, including continuity of business operations, valuation of assets, preferential tax treatment, and settlement and transfer of losses. In short, if the business of the acquired/merged enterprise meets the conditions of the "Income Tax Law for Foreign-invested Enterprises and Foreign Enterprises" and its "Rules for Implementation", the enterprise can continue to enjoy the preferential tax treatment applicable to its predecessor.