M&A in China

Overview

Investors who intend to purchase a company in China should differentiate between an indirect acquisition and a direct acquisition. In an indirect acquisition, the foreign investor takes control of the target company in China by acquiring shares in a foreign parent company. Indirect acquisitions are relatively common. Although the entity acquired is offshore, the transaction may trigger Chinese tax obligations.

More extensive Chinese legal provisions govern the direct acquisition of a company, in other words, acquiring shares in a Chinese company directly. The so-called M&A Provisions play a key role in the legal framework for such transactions. In accordance with the M&A Provisions, foreign companies can acquire shares in government-owned Chinese companies and private companies, including foreign-invested enterprises (“FIEs”), both joint ventures (“JVs”) and wholly foreign-owned enterprises (“WFOEs”).

The ramifications of the transaction will differ depending on whether it is an asset deal (acquiring assets in a company) or a share deal (taking over shares).

Memorandum of Understanding

The parameters of the transaction as understood by the purchaser and the shareholders of the target company should be recorded in a Memorandum of Understanding ("MoU"). The most important aspects to be regulated in the share purchase agreement should be set forth in the MoU, which should be used to:

  • establish a schedule for the transaction;
  • prepare the course of the pending due diligence review; and
  • determine a licensed Chinese valuation expert.

Investors often underestimate the difficulty of negotiating contracts for M&A transactions in China. Some Chinese negotiating partners, for example, are unfamiliar with common expectations surrounding the process of an M&A transaction conducted by professionals. Likewise, main contractual points may not be raised until near the end of lengthy negotiations, and matters that already seem resolved may be re-introduced at a later stage. 

Due Diligence

There is often a substantial lack of transparency surrounding target companies in M&A transactions in China. In addition to undertaking due diligence on finance, tax, and legal matters, some transactions require an in-depth review of technical, commercial, and environmental areas. In any event, investors should at the very least conduct a "red flag" due diligence investigation with regard to financial, tax and legal aspects to identify major dangers and risks.

Further important aspects are, for example, whether the target company: has the licenses and permits required to carry out its business activities legally; has made necessary tax registrations and tax declaration filings; actually holds the land uses rights it claims to hold; and has retained employees in compliance with laws that cover labor and social insurance.

Knowledge gained through the due diligence process can be applied to the matter of structuring the M&A transaction, and may lead to a share deal being turned into an asset deal or vice versa. A careful review of the transaction involves understanding the merits of both types of sale, especially in the context of tax treatment.

Government approval

Chinese government entities have broad authority when it comes to approving M&A transactions. This means that the contractually agreed transaction only becomes legal and, thus, effective, when the relevant government authority issues the necessary approval. This is usually the local Bureau of Commerce or, for larger transactions, its supervisory body, the Ministry of Commerce. Registration with other authorities is also required, notably, the local tax authorities and the commerce authorities ("Administration of Industry and Commerce").

Special conditions

The M&A Provisions require that the purchase price be paid within one year after completion of formalities with the authorities. The result is that earn-out clauses, which are common in Western purchase agreements, are not possible in their customary form in China. As a result, a success-based payment can be created by withholding the transfer of a portion of shares and subjecting this transfer to a call option.

Another possibility is to use an existing Chinese production subsidiary for the purchase. In this situation, the M&A Provisions do not apply. Chinese law has allowed a Chinese subsidiary to use stated capital for acquisitions since 2015.

A purchase is more complex if the Chinese target is owned by the government. In this case, a specially qualified accountant must issue a valuation report. The valuation and the project must then be submitted to the State-Owned Assets Supervision Administration Commission ("SASAC") and the transaction must then be publicly tendered. Although this theoretically allows competitors to bid on the company and endanger the transaction, in our experience this does not normally occur. There are also exceptions to the tender requirement that can be negotiated with the SASAC.