Why Is China's QFLP So Popular With Foreign Investors

The pilot Qualified Foreign Limited Partners private Equity Fund System (QFLP) is a powerful attempt to continue to open up the capital market and accelerate the internationalization of RMB under the condition that China's foreign exchange management and RMB are not fully convertible. Through the QFLP system, foreign investors can convert foreign exchange funds into RMB and directly invest in the equity of non-listed companies in China (some pilot areas have been expanded to non-public offering of listed companies and non-self-use real estate). It is the core goal of the policy to attract more foreign capital to enter the Chinese market and enhance the vitality and competitiveness of the market.

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As an attempt of China's continuous opening-up, QFLP has its unique institutional values, including but not limited to:

1. Simplify the foreign exchange registration burden of overseas investors: one-time approval, no separate FDI registration for each investment;

2. Reduce the burden of the investee enterprises: the investee enterprises do not need to open a separate foreign exchange account, and experience the friendliness, which is almost the same as that of Chinese domestic investors;

3. QFLP has a low tax burden. Generally speaking, there is no double tax burden for foreign-invested companies (in the case of not being identified as having a permanent establishment);

4. QFLP can jointly initiate and set up sub-funds in China together with GFS in China;

5. QFLP can help foreign managers raise RMB funds in China (commonly known as "offshore management");

6. If QFLP is put on record in AMAC, it will be included in the management scale of the manager, laying a foundation for the subsequent raising of insurance funds;

7. QFLP can carry out certain structure design overseas (such as S fund and private debt) to better achieve business goals.

01 Main paths for foreign participation in domestic equity investment in China

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There are three main ways for foreign investors to participate in domestic equity investment in China:

Path 1: Foreign investors invest directly in China, namely Foreign Direct Investment (" FDI ");

Path 2: overseas investors set up domestic subsidiaries in China and invest in domestic enterprises in China through domestic subsidiaries in China;

Path 3: Foreign investors participate in QFLP funds established in China and invest in Chinese domestic enterprises through QFLP funds.

3.1 Practice and problems of Path 1 (FDI)

FDI is the most traditional and common way for foreign investors to participate in China's domestic equity investment. Foreign investors (such as US dollar funds) directly invest in Chinese domestic investee enterprises and are registered as shareholders of Chinese domestic investee enterprises at the industrial and commercial level.

In the past project implementation process that the author participated in, there may be the following main problems:

(1) It causes operational burden to the investee enterprises

In the project transactions that the author has participated in in the past, when the investee enterprises in China can choose RMB fund or US dollar fund, they are more inclined to accept RMB fund investment. One of the core reasons is that overseas subjects directly become shareholders, which will cause certain operation and management costs to the invested enterprises.

If the invested enterprise accepts direct investment from overseas investors, its enterprise nature will change from "domestic company" to "sino-foreign joint venture", which will have the following effects:

(i) Foreign exchange burden: the invested enterprise shall specially open a "foreign exchange settlement pending payment account or capital account" to receive the investment of US dollar fund. If the invested enterprise uses the aforementioned funds to make further overseas investment, the subsidiary and Sun Company shall register the information of "receiving domestic reinvestment" and open a "foreign exchange settlement account to be paid or capital account".

(ii) Filing with the Commerce Commission: The investee shall register with the Commerce Commission for accepting foreign investment.

(iii) Industrial and commercial registration: It takes several weeks and certain communication costs for foreign investors to register with industrial and commercial enterprises.

(2) Affecting the certainty of delivery

At the time of investment, as the premise for the foreign investor to pay the investment money to the account of the invested enterprise, the foreign investor shall complete the notarization of the overseas entity, and the invested enterprise shall complete the opening of the bank account and other procedures. These lead-up processes can take weeks or even more than a month and have an impact on the certainty of delivery.

More importantly, when the foreign investor transfers the equity and exits, the buyer cannot directly pay the consideration, but needs to complete the tax withholding and payment, tax filing of external payment and foreign exchange payment procedures in advance before the purchase price can be paid to the foreign investor's account. In exits where opportunity is more important than price, delivery certainty costs are not to be underestimated.

2. Practice and problems of Path 2

For one US dollar S fund management institution that entered China earlier, it adopted the way of setting up a foreign investment company in China.

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However, the US Dollar S fund investment institution obtained the qualification of China's domestic manager in 2021, raised China's domestic government guidance funds and other institutional investors, adopted QFLP structure for follow-up investment (" offshore management "), and gave up the dual-tier structure.

The most fatal problem with this structure is the "double tax burden". When a foreign investor withholds the invested enterprise in China: (1) the domestic subsidiary of the foreign investor in China shall pay the first line of 25% corporate income tax. (2) When the subsidiary makes distribution overseas, it shall further pay 10% withholding income tax. This is the central shortcoming of Path two.

What problem does 02QFLP solve?

Based on the discussion in the first part, the main problems encountered in the above two paths are briefly summarized:

(1) The investee has burdens (additional foreign exchange registration, separate bank account opening, filing with the Commerce Commission and industrial and commercial change, etc.)

(2) Affect the certainty of delivery (no matter at the time of investment or withdrawal, pre-approval must be completed before payment can be made, resulting in uncertainty)

(3) Double tax burden (25% corporate income tax +10% withholding income tax)

The QFLP essentially solves the problem of making dollar funds invest in China as well as renminbi funds.

In 2019, a managing partner of a leading dual-currency fund manager left to start his own firm, which raised a new fund of hundreds of millions of dollars. The agency has completed a number of domestic equity investments in China by setting up QFLP to use US dollar funds "as" renminbi funds.

1. QFLP solves the problem of FDI and the burden of invested enterprises

① At the level of foreign investors, the QFLP system is equivalent to the pre-approval of a package of multiple foreign investments in China in advance. In contrast, under the FDI path, each investment needs to be registered separately for FDI, and each time the overseas subject needs to be notarized, and the pre-approval process is long and time-consuming.

(2) At the level of the investee, its shareholders are Chinese domestic entities (rather than foreign capital entities). According to the QFLP policy, the investee does not need to open a separate account for foreign exchange settlement to be paid, nor does it need to file with the Commerce Commission separately. Through the QFLP system, the "user experience" of the invested enterprises receiving investment from foreign investors is basically the same as that of accepting investment from RMB investors.

2. QFLP solves the delivery certainty problem

Under the original FDI path, (1) at the time of investment, the invested enterprise needs to open a separate bank account of "foreign exchange settlement to be paid" before it can accept the investment payment from overseas investors; (2) At the time of withdrawal, the buyer shall go through the procedures of withholding and payment, tax filing and external foreign exchange payment to the overseas investor in advance before the consideration can be actually paid. So in both cases, the front-end process will affect the certainty of delivery and collection.

However, under the QFLP system, ① at the time of investment, since the QFLP is a domestic enterprise in China and the foreign exchange settlement has been completed at the level of the QFLP, the invested enterprise does not need to further open a bank account or put on record by the Commerce committee, and the QFLP can directly pay the investment funds to the bank account of the invested enterprise; (2) At the time of withdrawal, the withdrawal receiver is QFLP, a domestic enterprise in China. The buyer has no withholding obligation, and the purchase consideration of the buyer can be paid to the account of QFLP. The precondition is simplified, which greatly improves the certainty of delivery and collection.

3. QFLP does not have the problem of double taxation

Under the original path 2, the US dollar fund reinvests in the investee company by setting up a domestic subsidiary in China, which results in the foreign investor bearing a double tax burden when exiting (see analysis above). However, under the QFLP system, the QFLP has a clear advantage of single-tier tax burden.

For overseas investment subjects (foreign partners of QFLP), if they do not set up institutions or sites in China, they will pay corporate income tax at the rate of 10% on their income derived from China.

It should be noted that if the overseas investment subject is identified as having established an institution or site in China, it will pay corporate income tax at the rate of 25%. Therefore, in terms of governance mechanisms such as QFLP structure, partnership agreement and voting meeting, professionals should be invited for advice and planning in advance to avoid adverse consequences.

4. QFLP cooperated with government guidance fund raising

According to the author's experience in GGF projects, the upper limit of GGF's investment in sub-funds is generally 30% or 50%, that is to say, the manager needs to raise 50%-70% of the funds separately in order to smoothly accept the GGF investment.

In this context, if the manager has overseas funds or foreign investors, the problem of capital sources other than the government guidance fund can be solved through QFLP. For example, if the manager has managed a US dollar fund, the US dollar fund can further set up a QFLP and jointly establish a sub-fund with the government guidance fund and other domestic funds in China for domestic equity investment in China.

5. Combined with S fund /S trading, etc

The QFLP system provides convenience for foreign investors to participate in S transactions of China's domestic funds.

Through the above analysis, the author understands that QFLP, as an innovative cross-border investment mechanism, not only provides a convenient investment channel for overseas capital to invest in China, but also simplifies the process and burden for the transaction itself. It helps to promote the further opening and internationalization process of China's capital market, and promotes the effective docking and mutual benefit of domestic and foreign capital.

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