The Private Equity Review: China
I General overview
The concepts of venture capital (VC) and private equity (PE)2 were first introduced to China3 in the late 1980s. Ever since the 1990s, with the rapid growth of China's economy and the unprecedented expansion of start-ups, investments, and mergers and acquisitions, China's PE/VC industry has maintained a strong momentum, and the number of PE/VC firms has grown exponentially.
In the early 1990s, foreign PE/VC firms, such as IDG, entered into the Chinese market and dominated China's PE/VC industry from the late 1990s to 2006. During that period, the majority of foreign PE/VC firms invested via offshore foreign currency-denominated funds in overseas holding companies of enterprises within the territory of China with a 'red-chip' structure.4 They reaped returns via exit in the United States or other overseas capital markets. However, as a result of growing familiarity with the PE/VC industry within China, the emergence of VC investments in China's technology, media and telecoms (TMT) industries, the development of multi-layered capital markets domestically, and promulgations or amendments of relevant laws and regulations such as the Law on Partnership Enterprises of the People's Republic of China (PRC), China's domestic PE/VC firms have been developing rapidly since 2006.
Coincident with this development, and in view of the restrictions on foreign investments and foreign exchanges that put foreign currency-denominated funds at a competitive disadvantage, as well as the freeze on shares of Chinese companies listed overseas on account of some fraud scandals, an increasing number of foreign PE/VC firms started to consider and explore schemes for forming yuan funds and exiting via the domestic capital market.
Since 2010, China's domestic PE/VC firms and yuan funds have witnessed dramatic developments, with some media describing it as 'PE fever'. By the end of December 2021, a total of 24,577 private fund managers (PFMs) managing 124,391 private investment funds (PIFs) have been registered with the Asset Management Association of China (AMAC), the self-regulatory organisation of the fund industry in China, with total assets under management of 19.78 trillion yuan.5
II Legal framework for PE/VC managers and funds
China's PE/VC legislation remains out of step with the country's burgeoning PE/VC industry and lags behind developments in this sector. VC was not written into China's legal regime until 1996,6 and for a long time there was no national law regarding the legal status of PE, and no regulation of this area or compliance requirements. Over the past few years, China has adopted a series of significant rules and regulations in relation to the PE/VC industry and a basic legal framework has begun to take shape.
In 2003 and 2005, the Ministry of Foreign Trade and Economic Cooperation (now the Ministry of Commerce) and the National Development and Reform Commission (NDRC) promulgated the Regulations on Administration of Foreign-Invested Venture Capital Enterprises and the Tentative Procedures for the Administration of Venture Capital Investment Enterprises, respectively, which established a legal regime for foreign-invested venture capital enterprise (FIVCE) and domestic venture capital enterprise.
In August 2006, the Standing Committee of the National People's Congress adopted the newly amended Law on Partnership Enterprises and introduced the concept of 'limited partnership', the most popular form of PIFs worldwide. With the growing awareness and acceptance among industrial insiders, limited partnership quickly emerged as the primary form of PE/VC funds in the markets.
In December 2012, the Standing Committee of National People's Congress amended the Law of the People's Republic of China on Securities Investment Funds (the Funds Law), in which 'non-public fundraising' is covered for the first time, and the China Securities Regulatory Commission (CSRC) is authorised to enact relevant rules in practice. The amended Funds Law entered into effect on 1 June 2013 (further amended in 2015). Although the Funds Law specifies that the CSRC oversees 'non-publicly offered' funds, Article 2 of the Funds Law also provides that the Funds Law shall apply to security investment activities by establishing security investment funds through public or non-public fundraising. Thus, controversies arose over whether the provisions of the Funds Law should apply to PE/VC funds that invest in non-publicly offered equities.
In June 2013, the State Commission Office for Public Sector Reform issued the Notice on Allocation of Administrative Authorities over Private Equity Funds that officially bestowed upon CSRC the authority for the supervision and administration of PE funds with the aim of protecting the rights and interests of investors.
As the regulator for the entire private investment fund industry, including PE/VC funds, CSRC authorised AMAC to be responsible for the registration of PFMs and record filing of PIFs, and to perform the self-regulatory function over the entire PIF industry. In August 2014, CSRC promulgated the Interim Measures for the Supervision and Administration of Private Investment Funds (the PIF Interim Measures), which established the system of registration of PFMs and record filing of PIFs, defined qualified investor and clarified non-public fundraising and disclosure requirements for PFMs. Later, AMAC released a series of self-regulatory rules, including but not limited to the Guidance of Internal Control of Private Investment Fund Managers, the Administrative Measures for Disclosure of Private Investment Funds, the Administrative Measures for Fundraising of Private Investment Funds, the Guidance on Private Investment Fund Contracts, the Administrative Measures for Service Business of Private Investment Funds (for Trial Implementation) and the Guidelines on the Administration of Investor Suitability for Fund Raising Institutions (for Trial Implementation).
Nonetheless, the level of legal authority of the existing supervisory and administrative rules remains relatively low as a whole. Against this background, in August 2017, the Interim Regulations for the Supervision and Administration of Private Investment Funds (Draft for Comments) was released by the Legislative Affairs Office of the State Council, and opinions were solicited from the industry. At the time of writing, the Interim Regulations for the Supervision and Administration of Private Investment Funds have still to be released. However, once released, as administrative regulations from the State Council, these will constitute a significant upgrade to China's private equity industry regulatory regime.
Another critical document, the Guidance on Regulating Asset Management Business of Financial Institutions (the Asset Management Guidance), was promulgated in April 2018, by the People's Bank of China together with the China Banking and Insurance Regulatory Commission (CBIRC), CSRC and the State Administration of Foreign Exchange (SAFE), and came into effect on 1 January 2022. This document aimed to provide a uniform regulatory regime for the asset management industry in China, and a series of ancillary regulatory documents have been promulgated since. Although uncertainty still exists as to its application to the private funds industry, its influence is undoubted.
Most recently, on 30 December 2020,7 CSRC issued Several Provisions on Strengthening the Regulation of Private Investment Funds (the PIF Provisions), which summarises relative practical experience in the field of PE funds, restates and strengthens the regulatory bottom lines in the field. Among other issues, the PIF Provisions modified the requirement of name and business scope of a PFM for its registration.
III General compliance requirements
PIFs in China are required to comply with various operational requirements. Before engaging in any fundraising activity, PFMs established in China (including PFMs with direct or indirect foreign shareholders) must register with AMAC in accordance with the regulations formulated by AMAC. After the completion of fundraising, PFMs have to register the PIFs managed by them with AMAC under the PFMs' names.
i PFM registration
Certain conditions must be satisfied to complete the PFM registration. Since February 2016, AMAC has required any PFM applying for registration to engage Chinese lawyers to conduct due diligence investigations into the PFM, to confirm its compliance in all aspects and to issue a legal opinion. A PFM will not be qualified to be registered unless the legal opinion and other application materials are accepted by AMAC. In November 2017, for the first time, AMAC clearly defined the circumstances under which PFMs will be denied registration in Q&As Related to the Registration and Filing of Private Investment Funds (Q&A No. 14), including illegal fundraising, false statement, engagement in conflicting business, being listed as enterprises with serious illegal and dishonest acts, or discredit of senior executives. In December 2018, AMAC restated the circumstances under which PFMs will be denied registration via a PFM Registration Notice, in which AMAC also listed the main requirements for PFM registration. Basic information of registered PFMs is publicised by AMAC on its official website.
In 2020, AMAC promulgated the Circular on Issues Concerning Facilitating the Application for the Registration of PFMs in February and the Circular on Issuing the List of Application Materials for Record-filing of PIFs in March, listing the materials necessary for the registration of PFMs and record filing of PIFs, which represents AMAC's effort in enhancing service efficiency, and improving the certainty extent of compliance expectation for related applications.
ii Regulations on fundraising
With the rapid growth and development of the domestic PE/VC industry, irregularities in fundraising have emerged. Therefore, regulatory authorities have issued a series of regulations on fundraising, among which the most important are the Measures for the Administration of the Fundraising of Private Investment Funds (the PIF Fundraising Measures) promulgated by AMAC on 15 April 2016, the Measures for the Administration of the Suitability of Securities and Futures Investors (the Suitability Measures) promulgated by CSRC on 12 December 2016, and the Guidelines for the Implementation of the Appropriateness Management of the Fundraising Institutional Investors (collectively with the Suitability Measures, the New Suitability Management Regulations) promulgated by AMAC on 28 June 2017.
The PIF Fundraising Measures explicitly stipulate that only registered PFMs and entities that have obtained a fund distribution licence from CSRC and a membership of AMAC are permitted to engage in private placement of fund interests. The PIF Fundraising Measures also stipulate specific rules and restrictions in fundraising, such as the guidelines on advertisement and promotion, offline or via the internet. On the basis of the PIF Interim Measures, the PIF Fundraising Measures further require due fundraising procedures and fund industry qualification of personnel engaged in fundraising. On the other hand, the New Suitability Management Regulations require managers to formulate a uniform standard to classify investors, design a hierarchical risk-control mechanism, regulate the internal management of sales organisations of fund managers and elaborate specific procedures.
iii PIFs registration
Upon completion of fundraising, PFMs must register the PIFs they manage with AMAC, which paves the way for further investment by those PIFs. AMAC places importance on the principle of professional and specialised management for a PFM. When applying for registration, a PFM may only register in one business category (e.g., PE/VC fund manager, private securities investment fund manager) and may only manage PIFs registered as a corresponding type. When registering a fund, AMAC will examine whether the PFM's fundraising activities are in compliance with relevant rules issued by AMAC, including whether the PFM has raised capital from qualified investors for the fund. If an investor is in the form of partnership or other unincorporated form and has not been registered with AMAC, AMAC will 'look through' the investor to the ultimate investors to assess whether the ultimate investors are qualified investors.
The Registration and Filing of Private Investment Funds (2019 PIF Registration Notice) issued by AMAC in December 2019 further embodies the terms under the Asset Management Guidance regarding the operation of PIFs, restating that PIFs' primary business shall not be borrowing or lending activities. According to the Notice, any PIF conducting private lending activities as its regular business, or setting up valuation adjustment mechanisms to engage in disguised loan activities (which separate the PIF's income from the profits or performance of the invested company), will not be permitted for PIF registration.8 The AMAC also requires that newly registered PFM to complete the record filing of its first PIF within six months after its registration, or the relevant PFM will be disqualified by AMAC.9 In order to support the newly registered PFM to conduct business during the period of prevention and control of covid-19, the filing period for a newly registered PFM to complete the record filing of its first PIF has been extended from six to 12 months by AMAC.10
iv Information disclosure
AMAC has promulgated several regulations regarding information disclosure by PFMs and PIFs in the past few years, among which the most important are the Regulatory Measures of Information Disclosure for Private Investment Funds and the No. 2 Guideline for Information Disclosure for PE/VC funds. PFMs are required to update both their own registration information with AMAC and the information filed for the PIFs they manage via an online system periodically or each time a material change occurs. In addition, PFMs are also required to disclose to investors information in relation to PIFs they manage according to fund documents (such as the limited partnership agreement).
v Fund liquidation
PE/VC funds have been booming exponentially since 2009. Because the typical term of a PE/VC fund is 7 to 10 years (with applicable extension), a large number of PE/VC funds will terminate in the near future. It is a significant task for a PFM to arrange an orderly liquidation of a fund. The liquidation of a PE/VC fund shall follow the stipulations under the Law on Partnership Enterprises (or the PRC Company Law for funds organised as companies) and other related regulations, as well as the terms of the fund documents.
IV Domestic investors
i State-owned enterprises
State-owned enterprises (SOEs) are a major source of capital for PE funds, and in recent years they have also actively sought to act as the general partner (GP), either by itself or in partnership with other parties.
The participation of SOEs as the GP or limited partners (LPs) in a fund creates myriad issues. For example, SOEs are expressly prohibited from acting as the GP under the Law on Partnership Enterprises. It is unclear, however, what constitutes an SOE for the purposes of this prohibition, and different government authorities apply different standards. According to the definition by the State Administration of Industry and Commerce (SAIC), 'SOEs' refers only to wholly state-owned entities, while the NDRC used to consider SOEs to be any type of entity where the direct or indirect aggregate state ownership is no less than 50 per cent. According to Decree No. 32 of the State-Owned Assets Supervision and Administration Commission of the State Council and the Ministry of Finance, released in June 2016, the Decree mainly regulates 'state-owned enterprises, state holding enterprises, and state-controlled enterprises', and generally requires that: (1) the enterprise contains over 50 per cent state capital with the largest investor being an SOE; or (2) the enterprise contains no more than 50 per cent state capital but is controlled by an SOE investor (through agreements or other arrangements) and that SOE investor is the enterprise's largest investor.
Another important issue is the obligation of state-owned shareholders (SOSs) to mandatorily transfer (for free) up to 10 per cent of the issued shares of their portfolio company to the National Council for Social Security Fund (NCSSF) upon the portfolio company's initial public offering (IPO) (the Transfer of State-Owned Shares Regulation). Before the end of 2017, a PE/VC fund with over 50 per cent state ownership may be classified as an SOS of a portfolio company seeking an IPO, and the fund would have to transfer a portion of its shares to the NCSSF for free. In November 2017, with the promulgation of Circular Guo Fa No. 49  (Circular 49), the aforementioned Transfer of State-Owned Shares Regulation was repealed, which was a significant positive change for PE/VC funds. Circular 49 does not amend other existing regulations related to SOEs. Thus, a PE/VC fund with significant state ownership should consider in advance whether assets held by it will be deemed state-owned assets subject to extra filing, asset evaluation and equity exchange procedures for the disposition of the fund's assets under relevant rules and regulations.11
ii Government-guided funds
China's fast-growing PE/VC fundraising activities also benefit from the active involvement of government-guided funds (GGFs) (including, among others, VC investment guidance funds, governmental investment funds and government-sponsored industry investment funds, as defined in related laws, regulations or regulatory policies), which provide a quite considerable amount of capital for PE/VC funds. As most of the GGFs are funded by government-related entities or the government itself with the particular purpose of providing 'guidance', GGFs have several unique features: (1) they are usually incorporated for specific purposes, such as to promote innovation and entrepreneurship, support the growth of small and medium-sized enterprises, enhance industrial transformation and upgrading, and encourage development of infrastructure and public services; (2) they focus on a particular policy guidance feature and normally require a very low proportion of non-state-owned capital; (3) they usually attach particular investment restrictions to their capital commitments; and (4) they usually demand a higher priority in the distribution waterfall to secure the return of their investment costs by surrendering certain upside interest.
iii Insurance companies
Chinese insurance companies have been allowed to invest up to 10 per cent of their total assets in both domestic and offshore PE funds and equity of privately held companies since 2012 (at the end of September 2021, the total assets of the insurance companies amounted to 24.3 trillion yuan).12 Further, since December 2014, insurance companies have been allowed to invest up to 2 per cent of their total assets as at the end of the final quarter in VC funds. PE and VC sponsors seeking insurance LPs are required to meet two sets of somewhat differing criteria. CBIRC issued the Measures for the Administration of Equity Investments by Insurance Funds (Draft for Comments) in October 2018. Although not promulgated officially, this document shows the tendency towards giving insurance companies more discretion and space with regard to their investments in PE/VC funds. On 8 December 2021, CBIRC promulgated the Notice to Amend Certain Regulatory Documents of Law Related to the Usage of Insurance Funds to further improve the space with regard to insurance funds' investments in PE/VC funds. In particular, insurance funds are allowed to invest in funds formed by financial institutions other than insurance companies.
In addition to being permitted to invest as LPs into PE/VC funds, insurance companies are also permitted to sponsor PE funds as a GP. As at the end of August 2020, 45 insurance PE/VC funds had been registered, with total assets under management of 377.227 billion yuan.13
On 13 November 2020, CBIRC promulgated the Circular of Matters Related to Financial Equity Investment of Insurance Funds to improve the regulatory policies on equity investment with insurance funds by removing the industrial restrictions on financial equity investment with insurance funds and refining the mechanism of 'negative list + positive guidance', releasing to a certain extent the industrial restrictions on direct equity investment with insurance funds and refining the risk management of portfolio companies.14
iv Banks and the NCSSF
The tremendous wealth management funds of commercial banks have always been very attractive to PE/VC institutions. However, as the investment of such banking funds is strictly restricted, the path for PE/VC institutions to raise banking funds is not smooth. Pursuant to pertinent regulations, only wealth management funds of qualified private banks/high-net-worth clients can participate in equity investments. Therefore, for a considerable time, wealth management funds, other than those of qualified private banks/high-net-worth clients, were usually invested in PE/VC funds through trust plans or asset management plans sponsored by other non-bank financial institutions, taking advantage of the vacuum caused by separate regulation of financial institutions. The Asset Management Guidance intends to strengthen the regulation of banks' asset management business and eliminate this regulatory vacuum by requiring commercial banks to establish independent wealth management subsidiaries to detach wealth management business from other banking business. At the same time, the Asset Management Guidance also indirectly opens another door for banks to carry out broader asset management business. Since the ancillary regulations of the Measures for the Supervision and Administration of the Wealth Management Business of Commercial Banks and the Administrative Measures for Wealth Management Subsidiaries of Commercial Banks came into force successively, certain wealth management products of commercial banks have been able to invest in equity assets, including stocks listed and traded domestically, the equity of unlisted enterprises and the beneficiary rights (rights to returns) thereof. Further, a wealth management subsidiary of a bank may also select qualified PFMs to act as its cooperation organisations and invest certain qualified wealth management products in PIFs sponsored and managed by such PFMs, which is undoubtedly a piece of significantly positive news for the PE/VC industry.
For first-tier PE/VC sponsors in China, another deep-pocketed LP to go after is the NCSSF. Since May 2008, the NCSSF has been permitted to allocate up to 10 per cent of its assets to domestic PE funds (investments in offshore PE funds are not yet permitted). By the end of 2020, the total assets of the NCSSF were 2,922.661 billion yuan, including 1,014.653 billion yuan of direct investment assets, accounting for 34.72 per cent of the total assets of the NCSSF;1,908.008 billion yuan of entrusted investment, accounting for 65.28 per cent of the total assets of the NCSSF; 2,639.312 billion yuan of domestic investment, accounting for 90.31 per cent of the total assets of the NCSSF; and 283.349 billion yuan of overseas investment, accounting for 9.69 per cent of the total assets of the NCSSF.15
V Foreign investors
The form of fund with foreign participation (either as a GP or investors or both) has evolved over the years.
i Foreign-invested venture capital enterprise
Before the advent of the limited liability partnership (LLP) in China, foreign fund sponsors primarily formed onshore funds in China in the form of an FIVCE under the Administrative Regulation for Foreign-Invested Venture Capital Enterprises (the FIVCE Regulation) promulgated on 30 January 2003. An FIVCE may be set up either as a 'non-legal-person Sino-foreign cooperative joint venture' (non-legal-person FIVCE) or as a limited liability company (LLC or corporate FIVCE). A corporate FIVCE is typically used by one or more foreign fund sponsors to set up an onshore fund exclusively with foreign currency capital, whereas a non-legal-person FIVCE was the popular form for a foreign fund sponsor to pool onshore and offshore capital together, often in partnership with a Chinese fund sponsor.
An FIVCE (whether in non-legal-person or corporate form) is required to have a 'requisite investor' that plays a role similar to a GP to a partnership fund. The requisite investor is required to satisfy certain requirements, including but not limited to having VC investment as its main line of business; having cumulative capital under management of at least US$100 million (or 100 million yuan in the case of a Chinese investor acting as the requisite investor) in the previous three years; and subscribing for and contributing at least 1 per cent (in the case of a non-legal-person FIVCE) or 30 per cent (in the case of a corporate FIVCE) of the total size of the FIVCE.
An FIVCE is required to have a minimum fund size of US$5 million or the yuan equivalent (in the case of a corporate FIVCE) and US$10 million or the yuan equivalent (in the case of a non-legal-person FIVCE). Each investor other than the requisite investor is required to invest at least US$1 million or the yuan equivalent.
The non-legal-person FIVCE was very popular before the advent of the LLP because it was the legal form closest to an LLP. The FIVCE Regulation allows the investors of a non-legal-person FIVCE to agree that the requisite investor assume joint liability to the FIVCE and the other investors to assume limited liability up to their capital commitments (in contrast, all investors of a corporate FIVCE enjoy limited liability protection). A non-legal-person FIVCE was also allowed to be treated as a tax pass-through entity, similar to a partnership, in which case the income of the FIVCE would not be taxed at the fund level but would be allocated and directly taxed in the hands of its investors. The tax pass-through treatment, however, was not well understood by many local tax authorities, causing many non-legal-person FIVCEs to be unable to enjoy the tax pass-through status in many local jurisdictions. As the LLP form was made available to foreign-invested PE funds in 2010, and the provision granting tax pass-through status to non-legal-person FIVCEs was officially repealed in 2011, the FIVCE became a much less desirable legal form for foreign-invested funds in China.
ii Qualified foreign limited partner and renminbi-qualified foreign limited partner
As discussed in Section II, the Law on Partnership Enterprises was amended in 2006 to permit the LLP form, which spurred the growth of domestic LLPs (DLPs). As foreign investment and foreign exchange is tightly regulated in China, however, foreign fund sponsors and investors had not been able to avail themselves of the new LLP structure until the SAIC promulgated the Administrative Regulations on the Registration of Foreign-invested Partnership Enterprises in 2010 and Shanghai released trial regulations on its qualified foreign limited partner (QFLP) pilot programme in January 2011.16 The pilot programme opens the door for foreign sponsors to set up onshore funds in China in the form of LLPs and brings clear advantages over the traditional FIVCE or offshore fund model. In particular, in contrast to an FIVCE, which is now subject to a 25 per cent Enterprise Income Tax (EIT), a QFLP fund as a partnership enjoys tax pass-through treatment at the fund level. In addition, an offshore fund has to go through the time-consuming approval process with SAFE for each of its investments into China, and the portfolio company, which would receive foreign currency capital from the fund, must seek SAFE approval for foreign exchange settlement on each occasion that it needs to use such capital. In contrast, SAFE approval for a QFLP fund is done at the front end (namely, at the time of the fund formation), and foreign currency capital may be converted into yuan directly with the custodian bank in a prompt manner (typically close to one week), thus avoiding the lengthy SAFE approval process for each investment and also saving the portfolio company the trouble of having to seek SAFE approval for foreign exchange settlement. With the promulgation, by SAFE, of Circular Hui Fa  No. 19 (Circular 19) in March 2015, Circular Hui Fa  No. 16 (Circular 16) in June 2016 and Circular Hui Fa  No. 28 (Circular 28) in October 2019, the previous stringent payment-based foreign exchange settlement system for foreign-invested enterprises (FIEs) has been replaced by a foreign exchange settlement system for FIEs where FIEs are allowed to settle foreign exchange-registered capital at their discretion and then make equity investments with renminbi (yuan). Circulars 19, 16 and 28 are intended to put the rest of the country on the same level playing field as the QFLP pilot areas. However, in practice, the QFLP pilot areas are still considerably ahead of the rest of the country in terms of the implementation of these foreign exchange regulations and thus remain the preferred location for foreign PE/VC firms contemplating QFLP fund formation at this time.
For those fund sponsors that have not previously managed onshore funds, a QFLP fund could also bring certain reputational and other intangible benefits. To date, dozens of foreign sponsors have received QFLP licences for their PE funds in Shanghai, including leading PE firms such as Blackstone, Carlyle, TPG, 3i Group, Hony Capital and SAIF.
Over the past few years, three main models have emerged for QFLP funds: (1) the DLP model, where the foreign fund sponsor sets up a wholly foreign-owned enterprise (WFOE) to act as the GP or management company of a DLP and raises capital solely from domestic investors in yuan (as exemplified by the Blackstone QFLP fund); (2) the co-GP–joint venture foreign limited partnership (FLP) model, where the foreign fund sponsor partners up with a Chinese fund sponsor to set up a joint-venture management company and raises capital from both domestic and offshore investors (as exemplified by the Carlyle–Fosun QFLP fund); and (3) the wholly foreign-owned FLP model (as exemplified by the Fidelity QFLP fund). QFLP funds and their management companies are required to include 'equity investment' and 'equity investment management' in their company names and business scope. Additionally, both the New Shenzhen QFLP Rule, released in September 2017, and the Zhuhai QFLP measures, released in January 2019, explicitly permit a 'domestic manager managing foreign capital' model (the New Model), by which a pure domestic fund management institution, subject to certain requirements, may raise funds from offshore investors to establish a foreign-invested equity investment enterprise.
The nature of a QFLP fund as a domestic or foreign fund is also an important issue. Under Chinese laws, it is very clear that QFLP funds under the above-mentioned models (2) and (3) and the New Model are deemed to be foreign investors in terms of their investments and are required to go through the same foreign investment process as an offshore fund (except for the differences in the foreign exchange approval and conversion process as described earlier). However, the nature of a QFLP fund under model (1) above is less than clear. According to a written reply from the NDRC to its local counterpart in Shanghai on the classification of the Blackstone QFLP fund in April 2012, it was made clear that the investments by such funds still have to comply with the Catalogue for the Guidance of Foreign Investment Industries (the Foreign Investment Catalogue) (e.g., with respect to the prohibition against and restrictions on certain industries, such as the TMT industry and the culture and entertainment industry), even where the fund is issued a business licence as a DLP rather than as an FLP and the portfolio company is not required to be converted to an FIE. Furthermore, the New Shenzhen QFLP Rule explicitly provides that foreign-funded equity investment enterprises are required to directly invest in portfolio companies in compliance with the Foreign Investment Catalogue. Since the Foreign Investment Law came into force on 1 January 2020, the foreign investment management regime based on the examination and approval system has been completely removed and replaced by the ex post reporting regime for foreign investment, greatly simplifying the foreign investment procedure.
It is very common for foreign sponsors to seek to raise yuan capital exclusively from Chinese investors, namely, under model (1) above. To avoid the time-consuming process of applying for a QFLP licence and foreign investment restrictions, foreign sponsors often choose to set up a pure DLP free from any foreign investment restrictions. To our knowledge, one approach used by certain market participants to structure a pure DLP is to use Chinese nationals (e.g., Chinese members of the team or family members of the relevant principals) to set up a purely domestic LLC and to put a series of contractual arrangements in place between the GP and the WFOE management company. Careful advance legal and tax planning is required to ensure that such contractual arrangements provide effective control over the GP and are enforceable under Chinese laws, and that the economics of the fund (e.g., carried interest and management fee) are structured in a way consistent with the commercial intentions of the fund sponsor.
Another variation of the QFLP fund is the renminbi-qualified foreign limited partner (R-QFLP) fund, where offshore yuan as opposed to foreign currency capital is used to set up the fund. The R-QFLP pilot programme has been less successful, partly because it is subject to additional regulation by the People's Bank of China with respect to the use of offshore yuan by the fund.
VI Structuring of outbound investment funds
i Outbound direct investment
In 2016, China witnessed huge growth (an increase of 44 per cent) in outbound direct investment (ODI), even though the Chinese government has significantly tightened the ODI and other outbound investment filing and approval channels on account of significant concerns about capital flee and foreign exchange imbalance. The year 2017 witnessed a significant drop in ODI activities as the government was determined to crack down on the illegal transfer of domestic assets offshore through such activities. Since late 2017, however, with the gradual improvement of the foreign exchange imbalance, the government appears to have been cautiously reopening the door for ODI activities, but at the same time it has also significantly raised the disclosure requirements for ODI approval and record filing by means of a series of new rules from the NDRC in late 2017 and early 2018. These rules include Order No. 11, promulgated by the NDRC on 26 December 2017 and effective since 1 March 2018, which strengthened the supervision of channels for outbound investments by detailing the sensitive industries to be regulated and clarifying the requirements regarding ODI application materials. The competent departments involved in the ODI process are mainly the NDRC, the Provincial Development and Reform Commission (PDRC), the Commerce Department, the Provincial Bureau of Commerce and SAFE. Generally, ODI in sensitive projects17 must be approved by the NDRC, and for ODI in non-sensitive projects, records must be filed with the NDRC or PDRC or disclosed to the NDRC identifying investors and detailing the method of investment and the investment amount. In addition, in a regulatory first, Order No. 11 places ODI activities by PRC individuals through overseas enterprises under the PRC individuals' own control and those by enterprises in Hong Kong, Macao and Taiwan within the scope of supervision, which means such ODI activities shall be subject to the approval and record-filing requirements mentioned above.
ii Qualified domestic limited partnership
The qualified domestic limited partnership (QDLP) pilot programme, which originated in Shanghai and was further developed in Beijing, Chongqing, Tianjin, Qingdao, Jiangsu, Hainan and Guangdong, allows qualified foreign-invested overseas investment fund management enterprises to raise capital from qualified domestic investors to set up overseas investment funds for outbound investments. Approval for the QDLP pilot programme was materially suspended from September 2015 until the end of 2017 following changes in regulatory policies on cross-border flows of foreign exchange. On 24 April 2018, SAFE officially announced the expansion of quotas for the QDLP pilot programme in Shanghai to US$5 billion, and on 8 December 2020, SAFE further approved an increase in Shanghai's QDLP quotas to US$10 billion. Since the resumption of approval of the QDLP pilot programme at the end of 2017, a number of institutions have successively obtained QDLP quotas. In addition, Beijing was approved by SAFE to increase the QDLP quotas to US$10 billion as well. The QDLP pilot programme in Beijing launched in January 2020 has attracted much attention since then. By the end of 2020, two well-known international asset management institutions (Oaktree Capital and Amundi Group) successfully achieved QDLP licences and quotas in Beijing. As the new QDLP pilot provinces, Hainan, Guangdong and Jiangsu also followed suit in adopting their own versions of the QDLP in 2021 and each obtained QDLP quotas of US$5 billion.
iii Qualified domestic investment enterprise
The qualified domestic investment enterprise (QDIE) pilot programme, which was promulgated in Shenzhen, allows qualified overseas investment fund management enterprises to raise capital from qualified domestic investors to set up overseas investment funds for outbound investments. By the end of 2015, QDIE quotas had been granted to more than 40 enterprises since the implementation of the QDIE pilot programme in 2014, with quotas increasing from the initial US$1 billion to US$2.5 billion.
However, approval for the QDIE pilot programme was gradually withdrawn and then materially suspended in 2016. The QDIE pilot programme subsequently appeared to resume at the beginning of 2018. On 24 April 2018, SAFE officially announced the expansion of quotas to US$5 billion for the programme in Shenzhen, matching the quotas for the QDLP pilot programme in Shanghai. In December 2020, SAFE further approved the expansion of QDIE quotas to US$10 billion. According to the statistical data disclosed in Instructions on Revising the Administrative Measures for Carrying Out the Pilot Program of Outbound Investment by Qualified Domestic Investors (Draft for Comment) by Shenzhen Local Financial Supervision Administration, by the end of 2019, a total of 48 entities, including several licensed asset management institutions, subsidiaries of fund managers, securities companies, fund companies and other types of entities, have been qualified for the QDIE pilot programme, with total quotas of US$1.551 billion.
Tax is critical to the fund structuring process in China. As tax rules with respect to PE/VC funds and their partners are less settled, the room for tax planning and the downside for lack of or inappropriate tax planning may be significant.
As in the United States, Hong Kong and a number of other jurisdictions, the tax status of carried interest received by the GP remains less than clear. In the United States, for example, legislative proposals have been raised from time to time to try to redefine carried interest from capital gain to ordinary income since 2006. The risk of carried interest being taxed as service income appeared fairly remote in China until early 2017, when a major New Third Board-listed private equity firm was penalised by a local tax authority for having failed to pay value added tax (VAT) on carried interest. Prudent advance tax structuring during the fund formation process thus became extremely important in this respect.
Under Chinese tax law, dividend income between two LLCs is exempt from EIT to avoid double corporate taxation (inter-LLC dividend exemption). For the same reason, dividend income from a corporate PE/VC fund to an investor that is an LLC (a corporate investor) is also exempt from EIT. Because a fund typically receives most of its income from the disposition of portfolio interests, which is then allocated and distributed to its partners, for a corporate investor it makes no significant difference whether the fund is an LLC or an LLP as far as EIT is concerned, because only one layer of EIT will be incurred, either at the corporate PE/VC fund level or at the corporate investor level.
On the other hand, the form of the fund greatly concerns individual investors. An LLC fund is generally subject to EIT and an individual investor in the fund is generally subject to individual income tax (IIT) at a rate of 20 per cent with respect to investment returns from the fund (i.e., two layers of taxes will be incurred). For an LLP fund, no EIT occurs at the fund level because an LLP is treated as a tax look-through entity in China. However, for a long time now it has been less clear in practice whether investment returns from private funds received by an individual investor are subject to the 20 per cent rate or a progressive rate of IIT ranging from 5 to 35 per cent. The promulgation of Circular Cai Shui  No. 8 (Circular 8) in January 2019 makes it clear for the first time how IIT will be calculated for individual investors in venture capital investment enterprises (VCIEs) in the form of an LLP. Circular 8 stipulates that a VCIE may choose to apply either 'single portfolio accounting', by applying a fixed rate of 20 per cent IIT, or 'annual income overall accounting', by applying a rate ranging from 5 to 35 per cent IIT. Because a fund in LLC form would be subject to an additional layer of tax (EIT) on its income from the sale of portfolio interests, LLP funds are clearly more tax-efficient for individual investors that directly or, through income-tax-transparent vehicles (such as a fund of funds in LLP form), indirectly invest in the funds. With the nationwide advancement of VAT reform in China since 2016, the financial industry has been included in the scope of this reform. Subject to different types of investment targets, VAT may be imposed on PE/VC funds on the basis of VAT taxable income (e.g., the bond interest income, and income derived from trading in financial instruments, such as stocks and bonds). Considering that contractual funds have no legal personality and do not require any tax registration, there were uncertainties as to how the VAT scheme would apply to contractual funds in practice. In 2017, a series of guidance regulations were issued by the Ministry of Finance and the State Administration of Taxation (SAT), which clarified that asset managers are VAT taxpayers for the VAT imposed on asset management products, and a simplified VAT calculation method will apply to the VAT taxable income of those asset management products (including contractual funds) at a rate of 3 per cent, effectively as of 1 January 2018. However, for PE/VC funds in the LLP or LLC form that were subject to clear VAT rules (i.e., 6 per cent) prior to the issuance of these documents, there is still uncertainty as to whether the simplified VAT calculation method at the rate of 3 per cent for asset management products applies.
The taxation of an FLP, or more specifically, its offshore partners, remains unclear. One school of thought among the Chinese tax community was that the withholding tax (WHT) at a rate of 10 per cent applicable to foreign invested enterprises in the form of LLC should apply to dividend income from the FLP to an offshore partner, including carried interest to the offshore GP; the WHT could be reduced to 5 per cent if the offshore partner could avail itself of the reduced WHT pursuant to a tax treaty between China and the jurisdiction of formation of the foreign partner (unless the offshore partner was deemed to have a permanent establishment in China, in which case it would be subject to the 25 per cent EIT). This school of thought, however, has not been accepted by Chinese tax authorities, and efforts of tax advisers to negotiate and convince local tax bureaus to accept a 10 per cent WHT have had little success to date. In practice, given the lack of clear guidance on the taxation of offshore partners of an FLP (such as a QFLP fund), some local tax bureaus have been requiring a 25 per cent WHT on dividend income before it may be repatriated to its offshore partners (without distinguishing between the GP and LPs).
VCIEs that are duly registered with the NDRC or AMAC and angel investment individuals enjoy special preferential tax treatment in several pilot areas18 pursuant to Circular Cai Shui  No. 38 (Circular 38),19 with effect from 1 January 2017. If they hold investments in qualified seed or early-stage technology enterprises for a period of at least two years, they are permitted to apply 70 per cent of their total investment amount in the qualified enterprises to offset their taxable income, with any excess carried forward to subsequent years. In the case of VCIEs formed as LLPs, the 70 per cent tax benefits could be passed along to their corporate or individual LPs. Circular Cai Shui  No. 55, effective since 1 July 2018 and superseding Circular 38 enabled the rest of the country to enjoy the same VCIE tax treatment policies as the several pilot areas listed in Circular 38.
Based on China's commitment to the mutual exchange with other jurisdictions of financial account information of foreign tax residents,20 the Administrative Measures on Due Diligence Checks on Tax-Related Information of Non-residents' Financial Accounts (Announcement 14) was promulgated on 9 May 2017, marking the localisation of the Common Reporting Standard in China. Pursuant to Announcement 14, as from 2018, financial institutions, including PFMs and PIFs, shall identify the tax-resident identity of the holder or relevant controlling person of any account, identify non-resident financial accounts,21 and report account-related information to the SAT.
VIII Secondary fund
Secondary fund investment was a niche market and unfamiliar to the PFMs over a long period of time and, even now, is still at an early stage of development in China, but the benefits it offers have attracted much attention in recent years, the secondary fund investment market in China has grown and has been evolving over the past few years. The new breakthrough of the secondary fund investment in China is that, on 10 December 2020, the CSRC approved the pilot programme regarding the transfer of interests of the PE/VC fund at Beijing Equity Transaction Center which is the first officially recognised platform for transaction of PE/VC fund interests. Thereafter, the Beijing Equity Transaction Center has promulgated business rules (including a valuation mechanism) to regulate the transfer of the interests of the PE/VC fund. By January 2022, the size of the deals traded on the Beijing Equity Transaction Center exceeded 1 billion yuan, and the size of pipeline deals has exceeded 40 billion yuan.22
As a concept learned from the Western world, the PE/VC market in China has grown at a phenomenal rate over the past 20 years and has helped create many of the leading Chinese companies and global technology giants, such as Tencent and Baidu. At the same time, this phenomenal rate of growth has also caused myriad business and legal issues, some of which are unique to China. As more and more Chinese laws and regulations have been promulgated, the whole regulatory system has continued to lag seriously behind the development of the industry in many respects and has remained characteristically vague in relation to many other aspects of this sector. Regulators are working hard to play catch-up while protecting their own turf. It is a most dynamic market – one in which the law changes much faster than it does in other developed countries, and in which great opportunities and great challenges coexist.
1 James Yong Wang is an investment fund expert at Jingtian & Gongcheng. The author acknowledges the assistance of his current team members, including but not limited to Yurui (Peter) Lu and Yanfang (Rita) Zhang in preparing this chapter, and the contribution of his former colleagues Zhiwei (Charles) Liu, Xue Qiu, Qingwei (Grace) Gu, Yao (Ally) Hu, Xiao (Shawn) Ding, Chenchen (Cici) Jiang, Shiyi Lin and Wei (Abby) Mei.
2 Opinions vary in respect of the relationship between VC and PE. Some argue that VC refers to investments in start-ups or enterprises at their early stages while PE refers to merger and acquisition investments in privately offered equities of non-listed enterprises and listed enterprises. Some argue that PE covers all investments in non-publicly offered equities and thus VC is a branch of PE. However, rules differ in terms of the regulation of PE and VC and the regulatory authorities tend to make a distinction between the two. For instance, the Asset Management Association of China, the self-regulatory organisation of the fund industry in China, divides private funds into securities investment funds, PE funds, VC funds, etc. Thus, in this chapter, unless otherwise mentioned, we distinguish between VC and PE and use PE/VC to describe investments in non-publicly offered equities.
3 For the purposes of this chapter, the People's Republic of China or China does not include Hong Kong, Macao and Taiwan.
4 The red-chip structure adopted by enterprises within the territory of China is a special transactional structure that is established for the purpose of overseas financing and initial public offerings. Usually, shareholders of enterprises within China establish overseas holding companies in offshore jurisdictions such as the Cayman Islands, and make the overseas holding companies acquire, directly or indirectly, equities of enterprises within China held by shareholders. In this way, ownerships of enterprises within China are transferred overseas.
5 See Overview Report of PFM and PIF Registration (2021) released by AMAC, available at www.amac.org.cn/researchstatistics/report/zgsmjjhysjbg/ (accessed on 6 January 2022).
6 See Law of the People's Republic of China on Promoting the Transformation of Scientific and Technological Achievements (promulgated and entered into effect in May 1996).
7 The Several Provisions on Strengthening the Regulation of Private Investment Funds were released to the public on 8 January 2021.
8 For more information on the 2019 PIF Registration Notice, see the following Jingtian & Gongcheng legal commentary: www.jingtian.com/Content/2019/12-26/1453291876.html (in Chinese).
9 According to Article 13 of Interim Regulations for the Supervision and Administration of Private Investment Funds (Draft for Comments), AMAC will also cancel the registration of any PFM who fails to complete the record-filing procedure within 12 months after the liquidation of all PIFs under its management. If the Interim Regulations come into effect in the future, AMAC will also cancel the registration of shell or 'zombie' PFMs that fail to maintain the continuous fundraising activities.
10 See Notice on the Work Arrangement Concerning Registration and Filing of Private Funds During the Period of Prevention and Control of COVID-19, available at www.amac.org.cn/aboutassociation/gyxh_xhdt/xhdt_xhtz/202002/t20200201_6561.html.
11 These include, but are not limited to, the Law of the People's Republic of China on the State-Owned Assets of Enterprises, the Interim Regulation on the Supervision and Administration of State-owned Assets of Enterprises, the Measures for the Supervision and Administration of the Transactions of State-Owned Assets of Enterprises, the Rules on the Evaluation and Management of State Assets, and the Interim Measures for the Administration of Assessment of State-Owned Assets of Enterprises.
12 For more information, available at www.cbirc.gov.cn/cn/view/pages/ItemDetail.html?docId=1018542&itemId=915&generaltype=0.
13 For more information, available at www.iamac.org.cn/cpzc/zcsj/202109/t20210922_7468.html.
14 For more information, see the following Jingtian & Gongcheng legal commentary: www.jingtian.com/Content/2020/11-17/1737231057.html (in Chinese).
15 Please see the Annual Report on National Council for Social Security Fund (2020) available at www.ssf.gov.cn/portal/jjcw/sbjjndbg/webinfo/2021/08/1632636003310029.htm.
16 Beijing, Tianjin, Chongqing, Shenzhen, Qingdao, Guiyang Free Trade Zone, Pingtan, Zhuhai, Guangzhou, Suzhou, Xiamen, Hainan, Liaoning Pilot Free Trade Zone (Shenyang Area) followed suit in adopting their own versions of the QFLP pilot programme, which were all modelled on the Shanghai version. Of all the cities with a QFLP pilot programme, the Shanghai programme is by far the most successful while the Tianjin programme is more time-efficient. Shenzhen released Circular Shen Jin Gui  No. 1 (New Shenzhen QFLP Rule) in September 2017, which improved the QFLP pilot programme it had formed in 2012. On 29 January 2021, Shenzhen Local Financial Supervision Administration promulgated the Measures of Shenzhen Municipality for the Pilot Program of Foreign-invested Equity Investment Enterprises, which further increases the flexibility of the pilot programme of Shenzhen QFLP pilot programme comparing to New Shenzhen QFLP Rule. On 10 October 2020, Hainan QFLP Rules were promulgated, making new breakthroughs comparing with other QFLP pilot programmes, including but not limited to: (i) no minimum access threshold for the establishment and registration of relevant entities in Hainan; (ii) non-discriminatory treatment for both domestic and foreign investors; and (iii) no restriction upon the scope of investment for Hainan QFLP funds except the industries set forth in the negative list.
17 According to Order No. 11, Article 13, sensitive projects shall include: (1) projects involving sensitive countries and regions; and (2) projects involving sensitive industries. For the purpose of these Measures, sensitive countries and regions shall include: (1) countries and regions that have not established diplomatic relations with China; (2) countries and regions where war or civil unrest has broken out; (3) countries and regions in which investment by enterprises shall be restricted pursuant to the international treaties, agreements, etc., concluded or acceded to by China; and (4) other sensitive countries and regions. For the purpose of these Measures, sensitive industries shall include: (1) research, production and maintenance of weaponry and equipment; (2) development and utilisation of cross-border water resources; (3) news media; and (4) other industries in which outbound investment by enterprises has to be restricted pursuant to China's laws and regulations and related control policies. According to the Notice of the National Development and Reform Commission on Promulgating the List of Sensitive Industries for Outbound Investment (2018 Edition), sensitive industries shall include: (1) real estate; (2) hotels; (3) cinemas and theatres; (4) the entertainment industry; (5) sports clubs; and (6) the setting up of equity investment funds or investment platforms with no specific industrial project overseas.
18 The pilot areas include Beijing, Tianjin, Hebei, Shanghai, Guangdong, Anhui, Sichuan, Wuhan, Xi'an, Shenyang and Suzhou Industrial Park.
19 Circular 38 has since been abolished by Circular Cai Shui  No. 55.
20 These commitments were made by China when signing the Multilateral Competent Authority Agreement on Automatic Exchange of Financial Account Information in tax matters with the Organisation for Economic Co-operation and Development in December 2015.
21 'Non-resident financial accounts' refers to the financial accounts opened or maintained by China's domestic financial institutions and held by non-residents or passive non-financial entities with non-resident controllers.
22 For more information, available at https://www.bjotc.cn/content/details_38_1138063.html.