The Regulations also provide a much needed legal framework for regulation of the increasing onshore lending activities undertaken by non-bank entities, and present new opportunities and structuring options for both investors and lenders.
The Regulations apply to lending activities between natural persons, corporates and other organisations, but exclude loans made by financial institutions. In this bulletin, we will focus on the provisions of the Regulations which change the legal regime on intercompany loans, and how such change may impact the way financing transactions involving PRC companies are structured.
Prior to the Regulations coming into force, the making of intercompany loans directly between PRC companies is not allowed. Article 61 of the General Rules for Loans (贷款通则), promulgated by the People’s Bank of China in 1996, prohibits any intercompany loan (whether direct or de facto). The PRC Supreme Court also confirmed, in a reply letter dated 23 September 1996, that any intercompany loan agreement should be null and void. In view of these legal restrictions, a PRC company wishing to borrow from, or lend to, another PRC company would need to enter into an entrustment loan arrangement with a domestic bank, where the domestic bank acts as the funding conduit between the two PRC companies and charges a fee.
The position is changed under the Regulations. The Regulations have made clear that, subject to limited exceptions, an intercompany loan agreement entered into for production or operating purposes is valid and will be recognised by the PRC courts. That said, the validity of an intercompany loan agreement can still be challenged if the lender (not being a financial institution) regularly carries out lending business or if money-lending activities have become its main income source, as in such cases the lender’s entry into an intercompany loan agreement may not be for production or operating purposes.
The Regulations also confirm that interest, default interests and other fees can be charged. Any interest rate on an intercompany loan not exceeding 24% per annum will be upheld by the PRC courts.
An intercompany loan agreement will be held invalid under the following circumstances:
- a lender uses funds borrowed from financial institutions for on-lending to a borrower at an "excessive" interest rate, where the borrower has prior knowledge of such arrangement or should have knowledge of such arrangement;
- a lender uses funds borrowed from other corporates or its employees for on-lending to a borrower for profit-making purposes, where the borrower has prior knowledge of such arrangement or should have knowledge of such arrangement;
- a lender makes available a loan to a borrower for funding illegal activities, where the lender has prior knowledge of such arrangement or should have knowledge of such arrangement;
- the loan arrangement is in contravention of social order and good custom; or
- other circumstances involving a breach of law or mandatory provisions of regulations.
Note that, for the purposes of paragraph (1) above, the meaning of an "excessive" interest rate is not defined in the Regulations.
Rationalising funding arrangement
Prior to an intercompany loan being legalised, as an alternative funding arrangement, a PRC company may obtain funding by way of equity, or by entering into certain "quasi" lending arrangements, such as a joint development agreement or cash pooling, in order to address its capital needs. Some funding arrangements between PRC companies may be booked as receivables and payables. Typically, those receivables and payables are not documented. Some of those arrangements seek to achieve the commercial effect of a loan but there may be some drawbacks or uncertainties.
The Regulations now provide for a legal framework for an intercompany loan to be recognised. It offers legal protection and commercial certainty to the parties. This also enhances the bankability of a financing structure if the repayment cash flow under an intercompany funding arrangement is a key part of the credit.
Security and subordination arrangement made possible
The legal recognition of an intercompany loan will now enable any properly documented intercompany loan receivable to be pledged or assigned, and a subordination arrangement to be put in place in respect of such liabilities.
Streamlining fund flows
In a structured lending transaction, lenders will typically require to closely monitor the fund flow between the borrowing vehicle and any company ultimately using the loan proceeds. The use of a direct intercompany loan without a third party entrustment bank as an intermediary enhances the ability of lenders to monitor their debt and remove any credit and performance risk of the entrustment loan bank, and also saves on transaction time and costs. This, together with the possibility to put in place any security or subordination arrangement in connection with an intercompany loan, increases structuring options for structured financing with PRC companies.
Flexibility on capitalisation
Capitalisation of a foreign invested enterprise (FIE) may be done by way of equity or debt, but in the case of a Sino-foreign joint venture enterprise, an injection of capital by the domestic joint venture party using direct debt was not possible because of the restrictions on the intercompany loan. The injection of additional equity, on the other hand, is subject to regulatory approval, which may take time to obtain. Under the new regime, a PRC domestic joint venture party may choose to lend an intercompany loan to an FIE without going through any approval in order to address any urgent funding needs of that FIE. Similarly for a domestic enterprise, the making of a direct loan by its shareholder will be a more streamlined process as any capital increase will be subject to the amendment of its constitutional documents and filings with the relevant authorities.
The flexibility in providing funding by way of debt will also be useful where a PRC sponsor has given a cost overrun funding undertaking, or a completion undertaking, in respect of the obligations of another PRC company (which is common in real estate finance or project finance transactions). With an intercompany loan being feasible, funding can be promptly made available by the sponsor to the project company by way of debt in case the relevant undertaking is being performed.
The intercompany loan structure now offers more options to put in place funding arrangements between PRC companies. For any domestic and multinational group which has multiple subsidiaries in the PRC, there is more flexibility on intra-group liquidity by way of intercompany loans among themselves without setting up a cash pool with a bank.
Impact on Cross-Border Loans
Do the Regulations apply to the cross-border intercompany loans?
The Regulations are silent on whether they apply to cross-border intercompany loans. Until any new regulation is promulgated by the relevant authorities, it could be reasonably expected that the current legal regime for cross-border lending, administrated by the State Administration of Foreign Exchange (SAFE) and the People’s Bank of China (PBOC), remains unaffected. For example, a PRC company (other than a financial institution) may not convert the foreign currency proceeds of a foreign debt it borrows to RMB for on-lending to another domestic company under the current SAFE regulations. Accordingly, notwithstanding the Regulations, a PRC company still cannot down stream the proceeds of a foreign debt to its ultimate operating companies onshore by way of intercompany loans. Similarly, the making of an intercompany loan by a PRC company to an offshore company which is not its offshore subsidiary is beyond the scope permitted under SAFE Circular 59, and is not expected to be permitted by reason of the Regulations.
Cross-border security over the intercompany loans
Now that a PRC company may pledge its receivables under an intercompany loan in favour of an onshore lender, there is no reason why a PRC company cannot pledge its receivables under an intercompany loan agreement in favour of an offshore lender, or such pledge be registrable with SAFE (if registration is required under the "neibaowaidai" regime).
The Regulations recognise the existence and necessity of intercompany lending, and provide more funding options for PRC companies. The Regulations are introduced at a time when the increasing financing needs of small and medium-sized enterprises cannot be fully satisfied by the banking system, and alternative financing solutions (including funding provided by an online peer-to-peer network, which is also covered by the Regulations) are being developed. The express recognition of intercompany loans is welcome, which provides more flexibility for a PRC company in managing its cash flow and capital structure.