After lengthy legislation procedures, which took more than two years, the State Council finally promulgated on November 25, 2009, the Measures on Establishment of Partnership Enterprises by Foreign Enterprises and Foreign Individuals (“Measures”). The Measures, which will become effective as of March 1, 2010, have been long-awaited in particular by the foreign private equity (“PE”) and venture capital (“VC”) community in China, since they are believed to principally open the gate for foreign investors to use limited partnerships as investment vehicle to set up RMB funds in China.

The People’s Republic of China has long been a promising, but also difficult place for foreign PE and VC investments. Growth rates of this industry have been impressive, in particular since 2005, but foreign investors found it difficult to fully access this market due to the lack of sufficiently suitable investment vehicles available under the PRC legal regime which allow investment structures to be as flexible as those in other jurisdictions. Limited partnerships have long been the preferred vehicle among PE and VC firms in the U.S. and in Europe, given its high flexibility in terms of internal organisation and tax efficiency. China’s current approval regime in relation to foreign investment projects (including any establishment, change, withdrawal from and restructuring of the project vehicle) further adds complexity.

As such, in the past foreign PE/VC investors often set up their investment vehicles off-shore in order to enjoy greater freedom to structure these vehicles, despite the portfolio investment made by the offshore fund in China still being subject to China’s foreign investment regime. However, offshore funds are less accessible for Chinese investors due to China’s tight foreign exchange regime.

Acknowledging the benefits of foreign financial investors providing funds to the domestic industry, in particular the start-up financing by venture capitalists, the Chinese government has made efforts to attract foreign PE and VC funds. In 2003, five ministries of the Chinese government jointly created a tailor-made vehicle called Foreign Invested Venture Investment Enterprise (“FIVIE”) which allows foreign venture capital investors alone or together with Chinese enterprises (but not Chinese individuals) to invest into domestic non-listed high-tech companies. However, the establishment of a FIVIE still requires lengthy governmental approval procedures. In addition FIVIEs are not permitted to utilize debt financing for their portfolio investments which has been a problem for many investors in the past.

On the local level, the local governments in Tianjin, Shanghai, Beijing and other cities in the past two years have issued various local rules promoting the formation of onshore PE funds and foreign-invested fund management companies. The decisive liberalisation the foreign PE and VC community has hoped for, however, had been missing so far: The permission of foreign investors to establish limited partnerships in China. This step has been taken now by the promulgation of the Measures.

The promulgation of the Measures is a response to the PRC Partnership Enterprise Law which was amended on August 27, 2006. The PRC Partnership Enterprise Law directly allows the establishment of partnership enterprises by domestic partners only, and provides that partnership enterprises established by foreign investors shall be subject to separate regulations to be issued by the State Council. Compared with a previous draft published by the Ministry of Commerce (“MOFCOM”) in January 2007, the Measures have been significantly simplified and contain only principal provisions under 16 articles. The Measures, however, still include the following important contents:

(i) Under the Measures, foreign enterprises or foreign individuals alone or together with Chinese individuals, legal persons and other organizations may establish partnership enterprises in China, which means Chinese individuals are allowed to participate in  foreign invested partnership enterprises (“FIP”) as partners. This is a significant change because, as a general rule, Chinese individuals so far were not allowed to enter into joint ventures together with foreign investors.

(ii) The establishment and subsequent changes of a FIP are only subject to registration with the competent Administration of Industry and Commerce (“AIC”). The AIC upon the registration will internally communicate and file record with MOFCOM, the foreign investment watchdog of the Chinese government. In contrast hereto, the establishment of other forms of foreign investment enterprises (“FIE”) requires prior approval of MOFCOM or its delegated branches. Accordingly, it appears that the corporate documents of the FIP (e.g. partnership agreement) do not require government approval to become effective. However, during the registration process AIC will still check, whether the FIP complies with the foreign investment related industry policies of China.

(iii) The Measures indicate that further implementing rules addressing institutional investors (e.g. PE/VC funds) will be issued.

(iv) The Measures provide that the Chinese government encourages foreign investors with advanced technology and management experiences to set up FIP in order to promote the modern services industry.

It is too early to cheer though! The Measures in its current sketchy nature still lack clarity and guidance as regards practical implementation, e.g. financing, accounting, taxation, foreign exchange, customs and personnel immigration etc. The available rules in many of these areas do not always seem to fit to the specific nature of a FIP. For instance, one has to see how the existing SAFE rules restricting the foreign debt financing capacity of FIEs apply to FIPs.  Whereas in many jurisdictions FIP structures are often chosen due to their favourable tax implications, the PRC tax implications of a FIP in China are still unclear. According to the current tax rules, the taxable income of a partnership should be computed on the partnership’s level but then be taxed on the partner’s level. However, a lot of questions remain open, such as whether any income of the FIP would automatically pass through to the foreign partner(s) or what would be the applicable tax rate which the foreign partner(s) would be subject to.

Given the above it is therefore foreseeable that further implementing regulations will be issued, hopefully before March 1, 2010 in order to clarify how FIPs may provide a viable alternative investment vehicle in particular for foreign institutional investors.