The legal concept of a demerger (in Chinese: 分立1) in the People’s Republic of China (“PRC” or “China,” which, for purposes of this article, excludes Hongkong, Macau, and Taiwan) involves the separation of a company into two (or more) corporate entities pursuant to the resolutions adopted by the company’s highest authority, i.e., the shareholders’ meeting.2 In general, there are two types of demerger: a split (in Chinese: 解散分立), in which a company is split into two new companies while the original company is dissolved, and spin-off (in Chinese: 存续分立), whereby a new company is spun off from the original company. Spin-offs are more frequently encountered than splits, as the former does not require dissolution of the original company, which is a lengthy process in China. This article is intended to review the legal issues associated with China-based demerger transactions in the life sciences industry.
In recent years, we have observed an increasing number of demergers in the pharmaceutical and medical devices sectors. The reasons why demerger has become a popular corporate restructuring mechanism include (a) businesses featuring innovative drugs or medical devices are more likely to be successfully listed on national or international stock exchanges if operated on a standalone basis than being commingled with other auxiliary businesses; (b) core businesses, if owned and managed separately, may have better growth prospects and thus can attract higher valuations; (c) acquirors choose demerger as part of the target’s pre-closing restructuring in order to remove unwanted assets from the framework transaction; and (d) demerger can be accomplished in a tax-free or tax-efficient manner if certain criteria are met. Another tax benefit for life sciences companies is that a demerger can rationalize business units by separating R&D-heavy segments from those that focus on low-margin manufacturing or distribution business, thereby positioning the R&D business as a High and New-Technology Enterprise which can enjoy a 15 percent corporate income tax rate (versus the standard 25% percent tax rate).
Demerger is not a risk-free proposition. For example, it must follow a set of prescribed procedures. Under the revised PRC Company Law which will take effect on July 1, 2024, a procedural requirement for demerger is that, within 10 days of passing a resolution approving the demerger, the company must notify its creditors and publish an announcement in the press or via the National Enterprise Credit Information Publicity System within 30 days. Some companies may be sensitive to public disclosure of demerger plans.
Despite its growing popularity, demerger transactions are still less common than equity acquisitions or asset purchases in China, mainly because the process of completing a demerger is complex, especially in regulated sectors such as pharmaceuticals, biotech and medical devices. The level of complexity depends on a broad array of factors, including commercial strategies behind the separation, the degree of interdependencies before the demerger, whether the demerger is part of a larger M&A deal (often a closing condition), the extent of the continuing relationships after the deal and the tax authority’s attitude towards the tax efficiency of demergers.
We identify below some key (but non-exhaustive) corporate and regulatory issues that may arise in demergers of life sciences companies and highlight several challenges in China-based transactions. Each demerger deal is unique, so the relevance and applicability of the issues examined below may vary on depending on the specific circumstances surrounding each matter. In short, there is no one-size-fits-all approach to handling a demerger in China.
Alternative structures
Before settling on the demerger option, it is common for life sciences companies to consider other separation options. A popular alternative structure is setting up a new company (“NewCo”) and transferring in-scope assets from the original company to NewCo (in Chinese:资产转让). This constitutes a typical asset purchase transaction. However, the main downside of doing so compared to a demerger is that the shareholders will need to inject capital into NewCo to purchase the assets, whereas in a demerger, the shareholders do not need to fund the transaction. Also, depending on the category of transferred assets, a range of tax implications would arise, including deed tax, land appreciation tax, value-added tax and stamp duty.
Another tax-efficient structure is asset assignment (in Chinese: 资产划转), whereby a company establishes a wholly owned subsidiary—NewCo—and assigns assets to NewCo in exchange for an increase in the registered capital of NewCo based on the assets’ book value. But to qualify for special tax treatment, the asset assignment needs to meet a plethora of requirements, including a one-year freeze on M&A activity after the closing, i.e., the substantive operations underlying the assigned assets must remain unchanged for at least 12 months following the closing.
In the initial planning stage, it is important to set priorities and weigh the pros and cons of various separation options before determining the optimal structure to accomplish the strategic and financial objectives.
Shareholding and capital structure
In a demerger, the original company (“BaseCo”) is separating out a piece of its business and giving it to its shareholders via a new company (“SpinCo”), as opposed to selling it to a buyer. This means that shareholders have a great degree of latitude in deciding how the original registered capital (i.e., the amount of capital subscribed by the shareholders) and paid-in capital (i.e., the amount of capital actually paid by the shareholders) of BaseCo is allocated between BaseCo and SpinCo, as long as the total registered capital and paid-in capital of BaseCo and SpinCo after the demerger are equal to the corresponding amounts before the demerger. Note that such flexibility is subject to tax, solvency and financial considerations. In general, the assets that are grouped into SpinCo should be proportional to the registered capital allocated to SpinCo.
As for the shareholding structure, the shareholders generally prefer to replicate BaseCo’s ownership structure in SpinCo, although they are allowed to modify their shareholding percentages in SpinCo (but this is rarely seen in practice).
From a company law perspective, BaseCo will undergo a capital decrease in the demerger process while SpinCo will be newly established. As such, there is no single set of company registration formalities in China that applies solely to demerger transactions. Instead, the registration will be a combination of a capital decrease transaction by BaseCo and registration of formation of SpinCo. Clients are advised to consult with the local company registration authority regarding the filing documentation requirements as soon as the steps plan is finalized.
Land and manufacturing facilities
It is common for pharmaceutical or medical devices companies in China to operate multiple plants on a single plot of land with some plants dedicated to one business line and others to discrete but related businesses. Usually, demerger requires those companies to identify and place into SpinCo the manufacturing facilities dedicated to the business to be spun off. However, this is challenging to implement in practice, because ownership of manufacturing plants is not easily transferrable in China if they are constructed on the same plot of industrial land supported by a single Real Property Title Certificate.
In China, transferring real property automatically entails the transfer of the land use rights underlying such real property. In a demerger, transferring plants to SpinCo would mean dividing the land into two pieces—one piece being owned by BaseCo and the other by SpinCo. Such division is often prohibited or restricted by the land use right grant contract entered into between BaseCo and the local land authority who may have reservations about granting any derogation, for fear of being seen as supporting land speculation. Nonetheless, based on our informal discussions with various authorities, some local governments support land division as part of a corporate demerger strategy, provided certain criteria will be met, such as SpinCo commits to an investment intensity target or a tax contribution target post-closing. These are designed to head off any alternate plan for the land, but also create pressure on SpinCo’s management especially if the market changes.
If physically separating out manufacturing facilities into a freestanding plot is not practicably feasible, SpinCo would need to (a) lease the production facilities from BaseCo or (b) engage BaseCo as its contract manufacturing organization. It is worth noting that China has recently tightened up the regulation of outsourcing manufacturing by pharmaceutical marketing authorization holders. Therefore, regulatory advice should be sought to analyze the long-term viability of the outsourcing approach.
Permitting issues
Demerger impacts the regulatory licenses or permits or marketing authorizations (“Permits”) held by BaseCo in a variety of ways. Depending on the specific Permits at issue, BaseCo would typically need to conduct a change of registration with the approval authorities such as the National Medical Products Administration (“NMPA”). For example, if BaseCo holds a Drug Manufacturing Permit (in Chinese: 药品生产许可证), as a result of the demerger, it should seek approval from NMPA regarding changes to production site (e.g., if the demerger requires BaseCo to reduce the size or capacity of its site, so that certain parts of the site can be spun out to SpinCo) or change of manufacturing scope (e.g., if BaseCo produces three drugs before the demerger and, after the demerger, produces only two drugs with the other drug being manufactured by SpinCo). In addition, such change would trigger the change of qualify management system (“QMS”) and the related documents per the Good Manufacturing Practices.
Some changes resulting from the demerger must be registered with the governmental authorities before the closing, while others (e.g., change of quality manager or production manager) can be done post-closing.
With respect to marketing authorization (the “MA”), for drug products, the MA cannot be transferred from BaseCo to SpinCo; rather, it would constitute a material change subject to prior approval by NMPA. As a first step, SpinCo will need to obtain a Drug Manufacturing Permit covering the separated out products and then file a supplementary application with the Center for Drug Evaluation of NMPA. This is a complex process, and regulatory advice should be sought and prior consultation with NMPA should be conducted during the planning phase of the demerger.
For medical devices, there is no legal pathway for BaseCo to transfer the MA to SpinCo. This means SpinCo needs to apply for a new MA in its own name for the medical devices that will be spun off from BaseCo and undergo substantial product technical review and onsite QMS inspection by NMPA. The practical implication is that SpinCo cannot operate until all the Permits required to engage in the carved-out business have been obtained. Consideration should be given as to whether this would lead to a manufacturing “gap” and how this would affect the relationships with suppliers and customers (who will be contracting with SpinCo) as well as the financial impact given the time required to get SpinCo up and running.
Management and employee matters
While SpinCo must maintain the same company type as BaseCo (if BaseCo is a limited liability company, SpinCo must be a limited liability company after the spin), it does not need to adopt the same corporate governance structure as BaseCo. For example, if BaseCo has a board of directors made up of three directors, SpinCo can have a board made up of five directors or appoint an executive director in lieu of the board.
When carving out divisions that will operate independently, shareholders usually prefer a different roster of managers whose responsibilities are solely focused on the spun-off business, rather than transferring or allowing existing managers to concurrently oversee the retained business. Ultimately, the composition of the management team of SpinCo will be affected by business need as well as the wishes of the individual managers (to the extent they can be accommodated).
With respect to employees, one of the biggest advantages of choosing demerger over asset purchase is that transferring employees from BaseCo to SpinCo for the demerger does not require the employees’ consent. Under Chinese law, SpinCo will inherit the employees relating to the separated divisions by operation of law, along with the relevant employment contracts, prior years of service and employee benefit plans.
If BaseCo has a labor union before demerger, its labor union will not be automatically carried over to SpinCo. Nonetheless, as demerger is likely considered to be a major operating matter, BaseCo should consult with its labor union before closing the transaction, though the labor union does not have power to veto the demerger.
Consent requirements
Based on the assets to be separated into SpinCo, material contracts should be reviewed to determine whether consents from counterparties are required, whether demerger would trigger or accelerate debt repayment obligations or have other contractual consequences and whether SpinCo needs to enter into new agreements with the counterparties. It is worth highlighting that counterparties do not have a statutory right to terminate the agreements simply because of a demerger, unless the agreement has express provision giving the counterparty a contractual termination right (which, in our experience, is unusual).
Under Chinese law, the debts incurred by BaseCo prior to the demerger will be borne by BaseCo and SpinCo on a joint basis after closing, unless BaseCo has separate agreements with creditors regarding debt repayment. For demergers that are part of a wider M&A transaction, the buyer will normally cherry-pick the liabilities that should be assumed by SpinCo. This will require advance negotiation with the counterparties to modify the original agreements, so that all other liabilities will be assumed by BaseCo after the demerger, rather than being jointly shared by BaseCo and SpinCo, which is the default position.
Subsidiaries
For life sciences companies with an extensive network of subsidiaries, careful planning is required with respect to how subsidiaries and interests in joint ventures or other partnerships should be allocated between BaseCo and SpinCo.
Wholly owned subsidiaries of BaseCo will need to update their shareholder register if they have been allocated to SpinCo in the demerger. As for joint ventures in which there are shareholders other than BaseCo, if the demerger involves SpinCo holding stakes in such joint ventures, depending on the terms of the shareholders agreements or joint venture contracts, prior consent from the other shareholders may be required.
Transition services
As with other divestitures, SpinCo in a demerger transaction will often need BaseCo to continue ongoing business relationships or provide common support functions on a transitional or long-term basis (e.g., legal, marketing, finance functions) until SpinCo has all the people, infrastructure and processes to operate on a standalone basis. A seemingly innocuous transition services arrangement can get complicated if both parties (BaseCo and SpinCo) end up providing services to each other.
A transition services agreement is essentially a related-party arrangement. Hence, pricing of the transition services, as well as the period (normally 6 – 24 months), should be evaluated from a tax as well as a commercial perspective. For example, if related party transactions are not carried out on an arm’s length basis, the competent PRC tax authority has the right to make reasonable adjustments.
Conclusion
We expect demerger transactions in the life sciences sector to continue to offer compelling opportunities in 2024 and beyond. While the benefits are significant, demergers also require a significant amount of effort, advance preparation and all-hands-on-deck implementation. It is important to gauge likely reactions of creditors. In our experience, to minimize the risk that transactions may need to be abandoned later, companies will do better if they involve advisors early on to develop a comprehensive step plan and map out the myriad of legal, regulatory, real estate, employment, intellectual property and tax issues before pulling the trigger. Choosing experienced advisors who have a proven record of executing demergers and calibrating structures to address concerns is equally important. More so in China than anywhere else, obstacles to demergers are best addressed by a multidisciplinary deal team featuring regulatory specialists who are adept at navigating China’s regulatory framework governing the life sciences and healthcare sectors. Well-planned and executed demergers can, in the best case scenario, be key drivers of value creation, but in the worst can tie up management in a drawn out and expensive process that fails to deliver the promised benefits.
Authored by Andrew McGinty, Wensheng Ren, and Jessie Xie.
References
1 Some legal practitioners in China may also refer to 分立 as a spin-off, split or carveout.
2 Article 4, Provisions on Merger and Division of Foreign Investment Enterprises (关于外商投资企业合并与分立的规定), promulgated on November 22, 2001 and last amended on October 28, 2015.
