The game between rule loopholes and legal supervision - from backdoor listing to simple capital reduction- Zhiheng Law Firm

Author | Xinghua Lawyer

foreword

ZHI HENG LAW FIRM

Backdoor listing is an old term that used to be popular, and simple capital reduction is a new rule (also known as formal capital reduction or nominal capital reduction) created by Article 225 of the 2023 Revised Edition of the Company Law. What is the relationship between them? Where is the simple capital reduction? Why can it be simple? How to reduce it? How to pay taxes? This article will answer you one by one.The core laws are as follows:Company Law of the People's Republic of China (Revised in 2023)Article 214The company's provident fund is used to make up for the company's losses, expand the company's production and operation, or increase the company's registered capital.To make up for the company's losses, any provident fund and statutory provident fund should be used first; if it still cannot be made up, the capital provident fund can be used in accordance with regulations.When the statutory provident fund is converted to increase the registered capital, the retained provident fund shall not be less than 25% of the registered capital of the company before the conversion.Article 225After making up losses in accordance with the provisions of Paragraph 2 of Article 214 of this Law, if there are still losses, the company may reduce its registered capital to make up for losses. If the registered capital is reduced to make up for losses, the company shall not distribute it to shareholders, nor shall it exempt shareholders from the obligation to pay capital contributions or shares.Where the registered capital is reduced in accordance with the provisions of the preceding paragraph, the provisions of the second paragraph of the preceding article shall not apply, but an announcement shall be made in the newspaper or in the national enterprise credit information publicity system within 30 days from the date of the shareholders' meeting's decision to reduce the registered capital.After the company reduces its registered capital in accordance with the provisions of the preceding two paragraphs, it shall not distribute profits until the cumulative amount of the statutory provident fund and any provident fund reaches 50% of the company's registered capital.

The first part, backdoor listings -- ordinary people find huge bugs in the listing rules

ZHI HENG LAW FIRM

This starts with the famous backdoor listing case "Zheng Baiwen's case of triple restructuring", which prompted the 2005 amendment of the "Company Law" to prohibit the capital provident fund from making up losses.In 1999, the law at that time also allowed the use of capital provident funds to make up for losses. Zhengzhou Baiwen joint stock company (Zheng Baiwen) was exposed to financial fraud in its listing, and faced huge losses and the risk of delisting. Shandong Sanlian Group, as a strategic investor, proposed a restructuring plan: Sanlian invested 300 million yuan to acquire Zheng Baiwen 1.447 billion creditor's rights, and then exempted all 1.447 billion. In addition, Sanlian injected another 400 million high-quality assets in exchange for Zheng Baiwen's 50% equity, became a controlling shareholder, and completed a backdoor listing.According to the accounting rules, 1.447 billion shareholders were exempted from being included in the capital reserve. Subsequently, Zheng Baiwen used the capital provident fund to make up for the previous huge losses, turned the debt into intangible, and combined with the operating income of Sanlian's own business, he realized a turnaround in less than three years after the restructuring. The success of this restructuring case exposed the huge loopholes in the listing rules to the public, triggering widespread imitation, disrupting the valuation system of capital markets, and exacerbating the investment risks and information asymmetry of small and medium investors.To close this loophole, the 2005 Companies Act was amended with a patch banning the use of capital provident funds to cover losses.

Part II, Capital Provident Fund - Nature and Use Regulation

ZHI HENG LAW FIRM

First, the capital provident fund is the company's non-profit accumulation.Mainly from capital investment (such as shareholder premium contribution, stock premium issuance, asset appreciation, government subsidies, gifts, etc.), which is shared by all investors and cannot be arbitrarily paid to shareholders. (Figure 1: The approximate position of the capital provident fund in the composition of the owner's equity)

(Figure 1: The approximate position of the capital provident fund in the owner's equity composition)From another perspective, the capital provident fund is also closely related to the company's operating performance, equity transactions and other activities. When a company conducts equity transactions, the amount and changes of the capital provident fund will have an important impact on the equity price. If the company's capital provident fund is relatively strong, it often means that the company has strong development potential and anti-risk ability, and its equity price may also be relatively high in the equity trading market.According to the company law after the triple reorganization Zheng Baiwen, the capital provident fund is mainly used for the company to increase the registered capital and expand production and operation. It cannot make up for the company's losses.This was a necessary and reasonable regulatory response made by the Company Law in response to the chaos in the capital markets at that time. Through the "one-size-fits-all" administrative means of "prohibiting loss compensation", fast and effective regulatory effects were achieved at that time, strengthening the principle of capital maintenance, protecting the interests of creditors, and setting important rules for truthfully reflecting the performance of enterprises. However, in a specific historical stage (three-year epidemic) and in practice, some drawbacks and limitations were also exposed. Reflected in:Restriction of dividend-paying capacity: According to the Company Law, a company must make up for accumulated losses and withdraw the statutory provident fund before distributing profits to shareholders. For enterprises with sustainable operation ability but heavy historical burden, prohibiting the use of capital provident fund to make up losses will lead to long-term inability to pay dividends and weaken investors' return expectations.Hinder refinancing: To achieve a turnaround, you can only make up for losses year by year through limited profits, and unattractive financial statements can lead to financing difficulties or even business difficulties.Disrupt the market mechanism: Some companies use various methods of disguised use of capital provident fund to make up losses to eliminate book losses. For example, disguised return of capital or cash out through "capital accumulation to increase equity + targeted reduction/equity transfer". On the one hand, it induces compliance risks, and on the other hand distorts the natural flow of market capital.A new system is on the horizon.

The third part, simple capital reduction - the big relaxation after 18 years of strong capital provident fund supervision

ZHI HENG LAW FIRM

On July 1, 2024, after 18 years of strong supervision of the capital provident fund, in order to cope with the fluctuations of the economic cycle and truly "reduce the burden" for troubled enterprises, the state conditionally opened the capital provident fund system. The newly effective revised version of the "Company Law" not only allowed the capital provident fund to make up for losses conditionally, but also added "simple capital reduction" in the way of company capital reduction. Activated the substantive function of capital reserves and solved the dilemma of the traditional capital reduction procedure for enterprises.There are two ways to reduce the company's capital. The first is to reduce the paid-in capital and refund the shareholder's capital base proportionally in the case of actual payment; the second is to reduce the amount of capital subscribed by the shareholder in the case of non-actual payment. In both cases, because taking capital from the company or reducing the company's future capital expectations has caused the company's solvency to be reduced, which touches the interests of creditors. At the same time as reducing capital, the following three procedures should be completed: 1. Within 10 days from the date of the shareholders' meeting making the resolution of capital reduction, notify all known creditors in writing (such as EMS, mail, etc.), clearly informing the situation of capital reduction and the rights of creditors. 2. Within 30 days from the date of the resolution, publish the announcement of capital reduction in newspapers or through the "National Enterprise Credit Information Publicity System". The announcement period is 45 days. 3. Creditors have the right to demand that the company pay off its debts or provide corresponding guarantees within 30 days from the date of receipt of the notice, or within 45 days from the date of the announcement.The basis of the new third "easy capital reduction" is based on the fact that in the accounting statements, when calculating the total of owners' equity, the only "undistributed profit" item that can be negative is added to all other items, the book is hedged, resulting in aVisual makes up for the loss(Figure 2: Specific items under "Owner's Equity" in the annual audit report of a listed company.)(Figure 2: Specific items under "owner's equity" in the annual audit report of a listed company.)However, "allowing to make up losses" from a legal perspective is a rule empowering, and this permission only applies to "surplus reserve (optional provident fund + statutory provident fund) ", "capital reserve (capital provident fund) " and "share capital (paid-up capital) " in the entries of the accounting statements after July 1, 2024. When the company's losses are hedged with the surplus reserve and capital reserve in sequence, and there are still losses that need to be hedged with the share capital, the company can choose to make a "simple reduction" of the paid-up capital of the shareholders in the industrial and commercial registration office.This flat-account type of capital reduction method does not require the actual withdrawal of paid-in capital from the company, nor does it reduce the company's future expected capital, but only reduces the registered capital and paid-in capital of the industrial and commercial registration simultaneously. The reduction of registered capital, without affecting the business threshold and qualifications, is only related to the company's commercial reputation and external image, does not affect the company's actual solvency, does not touch the interests of creditors, and does not need to perform procedures to protect creditors. Only within 30 days from the date of the shareholders' meeting making a resolution to reduce the registered capital, it can be announced in newspapers or the national enterprise credit information publicity system.After a simple capital reduction, the company unloads its debt burden, holds beautiful financial statements, and regains market financing vitality. The company's surplus reserves are increasingly abundant, and shareholder dividends are just around the corner.

The fourth part, the practical points of simple capital reduction and tax related

ZHI HENG LAW FIRM

First, the four main points of simple capital reduction(1) Start of simple capital reduction:It is necessary to first use any provident fund and statutory provident fund through the provisions of Article 214 of the new "Company Law"; when there is insufficient compensation, the capital provident fund can be used; finally, if there is still a loss, the registered capital (paid-up capital) can be reduced to make up for it.(2) When a simple capital reduction is made, the owner's equity cannot simultaneously flow out.Simple capital reduction has strict applicable conditions (such as it must be used to make up for losses, cannot distribute funds to shareholders at the same time, and cannot exempt shareholders from capital contribution obligations at the same time). If an enterprise undertakes "substantial capital reduction" in the name of "simple capital reduction" (such as disguised withdrawal of capital), resulting in improper reduction of the company's liability property, it will still damage the interests of creditors and face compensation liability for illegal capital reduction.(3) Only need to make an announcement, no creditor protection system:The company shall keep the balance sheet, income statement (which proves that the enterprise has a huge loss and negative net assets) and tax treatment instructions on the date of the resolution to reduce the registered capital, and the date of the shareholders' meeting to reduce the registered capital as the base date, to ensure that the accounting treatment is consistent with the tax declaration, and to avoid the risk of tax inspection due to "false capital reduction" or "fictitious financial data". However, it shall be announced in newspapers within 45 days from the date of the shareholders' meeting to reduce the registered capital or through the national enterprise credit information publicity system.(4) Future dividends are limited:Compared with the ordinary capital reduction, although there are two fewer procedural requirements, strict restrictions are imposed on the subsequent profit distribution, that is, after the company has reduced the registered capital in accordance with regulations, the company shall not distribute profits to shareholders until the cumulative amount of the statutory provident fund and any provident fund reaches 50% of the company's new registered capital.II. Simple capital reduction tax-related(1) Tax treatment of shareholders:The amount of investment recovered by individual shareholders is 0, which is less than or equal to the original actual capital contribution amount, and no personal income tax is incurred. Investment losses of individual shareholders shall not be deducted before tax from personal comprehensive income, wages and salaries. Losses can only be borne by themselves, and cannot be offset against other income taxes.Corporate shareholders do not generate actual capital inflows in taxation, and do not incur tax obligations for value-added tax or corporate income tax. However, losses cannot be confirmed for the time being, and final settlement must be made when they are completely liquidated/withdrawn. If there are losses, equity investment losses can be made, and corporate income tax can be deducted before tax.In short, the institutional changes of the capital provident fund to make up for losses, from the comprehensive prohibition of the "Company Law" in 2005, to the conditional liberalization officially implemented in 2024, to the creation of the "simple capital reduction" model, are essentially the static projection evolution of rule loopholes and legal supervision under dynamic social and economic conditions. This evolution is not a simple binary switch between "ban" and "release", but the result of legislators' repeated trade-offs between the principle of capital maintenance and the efficiency of corporate financing: the 2005 ban responded to the capital credit crisis triggered by the "Zheng Baiwen" case, aiming to build a solid bottom line for creditor protection; while the 2024 liberalization accurately adapted to the development needs of enterprises under the distress of the economic cycle. Through the order limit of "surplus reserve first and then capital reserve" and the simplification of the procedure of simple capital reduction, the balance between "revitalizing stock capital" and "maintaining market order" was achieved.As a legal practitioner, I must present the risk points in practice at the end of this article: Do not believe in tax avoidance suggestions that take the side of the sword through the special status of the capital provident fund. Do not implement corporate affiliates (such as controlling shareholders, actual controllers, directors, supervisors, and senior executives and their affiliates) to use the name of "simple capital reduction" to maliciously damage creditors. Such improper operations not only involve the consequences of illegal penalties and illegal compensation, but may face criminal liability in serious cases. Enterprises should pay attention to the boundaries between law-abiding and flexible governance in the process of corporate governance, and hire professionals to conduct compliance assessments when necessary.

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