The issuance volume of PRC-related offshore bonds hit a record high of approximately US$103 billion in the year of 2016 and remained strong in the first quarter of 2017.1 Due to a variety of regulatory restrictions imposed by the PRC government in relation to offshore bond offerings, different types of transaction structures have been developed to comply with such restrictions. Understanding the major differences among the transaction structures is necessary to effectively structure transactions in a manner that best fits different circumstances and needs of issuers.
Transaction Structures and Factors Affecting Choice of Transaction Structures
Major transaction structures for PRC-related offshore bond offerings can be largely categorised into four types, namely, (i) issuance by offshore entities with downstream credit enhancement (mainly in the forms of cross-border guarantee (“Cross-border Guarantee”) and keepwell and equity interests purchase undertaking (collectively, “Keepwell”)) provided by onshore parent companies; (ii) direct issuance by onshore parent companies (“Direct Issuance”); (iii) direct issuance by offshore “red-chip” issuers (“Red-chip Issuance”), and (iv) issuance with standby letter of credit (“SBLC Issuance”). Certain major factors which should be taken into consideration for choice of transaction structure are set out below:
Due to its wide jurisdiction, the requirement of registering offshore bond offerings with the National Development and Reform Commission of the PRC (“NDRC”) is one of the most critical factors for PRC-related issuers.
On 14 September 2015, NDRC promulgated Notice on Pushing Forth Administrative Reform for Filing and Registration for Incurrence of Offshore Debt by Enterprises (“NDRC Notice”), which provides that PRC enterprises and any offshore enterprises or branches controlled by PRC enterprises which incur offshore debt with a maturity term of longer than one year shall complete registration with NDRC before incurrence of such debt (“NDRC Pre-registration”), and shall further complete filing with NDRC within 10 working days of each incurrence of offshore debt (“NDRC Post-incurrence Filing”, collectively with NDRC Pre-registration, “NDRC Registrations”). Furthermore, according to the interpretation by NDRC, the requirement of NDRC Registrations also applies to “red-chip” issuers which are controlled by PRC nationals.
Procedure of Application for NDRC Registrations
Applicants should submit applications for NDRC Pre-registration to NDRC through provincial NDRC branches which supervise such applicants, except for (i) applicants which are supervised by the six local branches to which NDRC has delegated administrative authority of NDRC Registrations and (ii) “red-chip” applicants, which are not supervised by any provincial NDRC branches and therefore can directly submit applications to NDRC.
Although NDRC Pre-registration was initially designed as procedural review, NDRC has subsequently implemented more substantive review in relation to NDRC Pre-registration, which usually prolongs the review process and brings about more uncertainty on execution of offshore bonds projects. In addition, NDRC may from time to time impose more stringent review standards on applicants in certain industries in accordance with relevant national industrial policies or guidance. According to NDRC Notice, NDRC will decide whether to accept an application within five working days of receipt of such application, and will issue a registration certificate of offshore bonds with specified quota and validity period within seven working days of acceptance of the application. Nevertheless, due to the prolonged review process, the aforementioned timeframes are usually not strictly followed by NDRC. Therefore, it is advisable for applicants to budget enough time for their applications for NDRC Pre-registration accordingly. Subsequently, after each issuance of offshore bonds, applicants should complete NDRC Post-incurrence Filing, which is generally considered as procedural rather than substantive, within 10 working days.
Impact on Choice of Transaction Structure
For Direct Issuance structure, NDRC Notice superseded the previous requirement of case-by-case approval, and replaced it with the more relaxed NDRC Registrations. Due to NDRC Registrations, Direct Issuance has become a more accessible transaction structure than before for PRC-related bond offerings and have since been frequently capitalised on by PRC-related issuers.
It is worth noting that, although choice of transaction structures generally has limited impact on NDRC Registrations, NDRC or its local branches may from time to time provide window guidance on choice of transaction structures in the course of their review for NDRC Pre-registrations.
Offshore bond offerings with Cross-Border Guarantee structure are subject to registration requirement imposed by the State Administration of Foreign Exchange of the PRC (“SAFE”).
New SAFE Rules
On 12 May 2014, SAFE promulgated the Provisions on the Administration of Foreign Exchange for Cross-Border Security and the Administration of Foreign Exchange for Cross-Border Security Implementation Guidelines (collectively, “New SAFE Rules”). Under the regime of New SAFE Rules, a PRC parent company can provide guarantees for bonds issued by an offshore entity without any prior approval from SAFE, provided that the PRC guarantor shall have an equity interest in the offshore issuer. After entering into a cross-border guarantee agreement, a PRC guarantor which is a non-bank financial institution or enterprise shall register the cross-border guarantee (“SAFE Registration”) with the local SAFE branch within 15 working days of the date of the guarantee agreement. Although it is generally believed that local SAFE branches will only conduct procedural review for SAFE Registration, it is advisable for PRC guarantors to consult with local SAFE branches prior to entering into cross-border guarantee agreements, as certain local SAFE branches may have limited experience in processing SAFE Registration.
Impact on Choice of Transaction Structure
Prior to the introduction of SAFE Registration, PRC guarantors were required to obtain prior approvals from SAFE for Cross-Border Guarantee for offshore bond offerings on a case-by-case basis. SAFE Registration, which only requires registration with the local SAFE branch after entering into a guarantee agreement, renders the Cross-Border Guarantee structure more accessible for PRC-related issuers. Nevertheless, as SAFE Registration does not apply to upstream cross-border guarantees under “red-chip” structure (ie, guarantees provided by PRC subsidiaries to their offshore parent companies), “red-chip” issuers cannot benefit from the easier accessibility of SAFE Registration.
Since credit ratings have direct impact on the marketability and financing cost of offshore bonds, implications of transaction structures on credit ratings should also be taken into consideration for choice of transaction structures.
For a SBLC Issuance, the credit rating of the bonds is generally tied to the credit rating of the commercial bank providing the standby letter of credit, which is usually higher than the credit rating of the issuer or its parent company. For an issuance with Cross-Border Guarantee, a Direct Issuance or a Red-chip Issuance, the credit rating of the bonds is generally tied to the credit rating of the parent company. However, for a bond issuance with Keepwell, due to reasons such as the uncertainty on the effectiveness of the Keepwell structure, the credit rating of the bonds may be one or two notches lower than the credit rating of the parent company, subject to the package of Keepwell covenants.
Use of Proceeds
Whilst use of proceeds is a key factor for offshore bond offerings due to various restrictions and window guidance imposed by PRC government which may conflict with the needs of issuers, the government has put forward a trend of liberalisation on this matter.
SAFE Circular No. 3
On 26 January 2017, SAFE promulgated Notice on Improving the Check of Authenticity and Compliance to Further Promote Foreign Exchange Control (“SAFE Circular No. 3”), which allows offshore issuers to directly or indirectly repatriate proceeds of offshore bond offerings with Cross-Border Guarantee structure to onshore entities through means such as loans or equity investments (excluding investments in securities).
Prior to the promulgation of SAFE Circular No. 3 and under New SAFE Rules, issuers of offshore bond offerings with Cross-Border Guarantee structure were restricted from repatriating proceeds of offshore bond offerings to onshore entities. On the other hand, as Keepwell is generally not recognised as guarantee under New SAFE Rules, bond offerings with Keepwell structure were not subject to the abovementioned historical restriction on Cross-Border Guarantee. Therefore, prior to the promulgation of SAFE Circular No. 3, Keepwell structure were utilised as an alternative credit enhancement structure for issuers with an intention to transfer proceeds from offshore bond offerings to onshore entities.
Impact on Choice of Transaction Structure
SAFE Circular No. 3 largely supersedes the abovementioned restriction on use of proceeds and rendered the Cross-Border Guarantee structure more favourable for PRC-related issuers with an intention to transfer the proceeds to onshore entities.
It is also worth noting that use of proceeds of offshore bond offerings may be subject to window guidance by NDRC and/or SAFE and their local branches from time to time. Therefore, it is advisable for PRC-related issuers to consult with NDRC and SAFE or their local branches regarding use of proceeds beforehand, especially when any cross-border transfer of funds is or will be involved in relation to the offshore bonds.
A variety of PRC-related taxes, such as Enterprise Income Tax (“EIT”), Individual Income Tax (“IIT”) and Value-added Tax (“VAT”), may potentially have an impact on the overall financing cost of offshore bonds.
EIT and IIT
Pursuant to EIT Law and IIT Law of the PRC and the relevant implementation regulations, interest and/or premium on bonds paid by PRC residential enterprises to non-PRC residential enterprise or individual bondholders is subject to EIT or IIT. Therefore, for Direct Issuance structure, where the issuers are located within PRC and are regarded as PRC residential enterprises, interests and/or premium on the bonds paid by the issuers to non-PRC residential enterprise or individual bondholders may be subject to EIT or IIT (including applicable tax treaties). For bond offerings with other transaction structures where the issuers are located outside PRC and not regarded as PRC residential enterprises due to “de facto management bodies” located in PRC, interests and/or premium on the bonds paid by the issuers to non-PRC residential bondholders will not be subject to EIT or IIT.
On 23 March 2016, the Ministry of Finance and the State Administration of Taxation of the PRC jointly promulgated the Circular of Full Implementation of Business Tax to Value-added Tax Reform, which replaces business tax with VAT in relation to revenue derived from the provision of financial services. Therefore, interests and/or premium on bonds under Direct Issuance structure may be subject to VAT, because the issuers are located within PRC and the bondholders’ purchase of the bonds may be regarded as provision of financial services. For bond offerings with other transaction structures, if the issuers are located outside of the PRC and are not regarded as PRC residential enterprises due to “de facto management bodies” located in PRC, interests and/or premium on the bonds will not be subject to VAT.
Impact on Choice of Transaction Structure
It is usually provided in the terms of offshore bonds that, subject to certain exceptions, issuers shall assume PRC-related tax costs on the bonds. Such terms of the bonds may potentially increase the Issuer’s cost of servicing the debt, if any of EIT, IIT and VAT applies. Therefore, Direct Issuance, to which EIT/IIT and VAT usually apply, may be less favourable for the issuers from a PRC tax perspective. On the other hand, for other types of transaction structures where the issuers are outside PRC, EIT, IIT or VAT may also be incurred for transactions among the issuers and its related parties in relation to use of proceeds and funding for repayment of the bonds, which may in turn increase the issuers’ overall financing costs.
Issuers should take into consideration major factors such as NDRC Registrations, SAFE Registration, credit rating, use of proceeds and PRC taxation for choice of transaction structure of PRC-related bond offerings. The chart below sets out such factors and the implications of these factors on different transaction structures. As the regulatory restrictions imposed by the PRC government continue to evolve, the implications of such factors may change accordingly, which in turn will affect the decision-making on transaction structure of PRC-related offshore bond offerings.
1. For the purpose of this article, the term PRC excludes Hong Kong Special Administrative Region, Macao Special Administrative Region and Taiwan.