On 19 January 2015, the Ministry on Commerce issued for public comment a comprehensive draft Foreign Investment Law (the “Draft Law”), which if adopted, will radically transform the handling of foreign related investment and M&A transactions in the PRC.  The Draft Law provides for the repeal of the key legal regulatory structure that has guided foreign investment China for almost 40 years.  The Draft Law will abolish the comprehensive approval system that has been applicable to foreign investment in Chian and replace it with one that requires only limited entry permitting.  The PRC’s Sino-Foreign Equity Joint Venture Law, Sino-Foreign Cooperative Joint Venture Law and Wholly Foreign Owned Enterprise Law will be abolished upon the adoption of the Draft Law.  It will be a historic day in China’s administration of foreign investment. The Draft Law addresses the changing nature and volume of foreign investment in China and more accurately reflect China’s current economic situation compared to that which existed when China first opened its markets to foreign investment. 

The Draft Law is intended to eliminate the inconsistencies that have developed between the foreign investment regulations and domestic practice under the PRC’s Company Law and Partnership Law.  The Draft Law, if enacted, will overhaul and modernize the handling of foreign investment in China.

Definition of Foreign Investment

The Draft Law utilizes a board definition of foreign investment, which non-exclusively includes establishment of the new companies, the acquisition of real property and assets and the acquisition of company control through both equity and contractual arrangements.  The definition of foreign investment under the Draft Law is broad enough to capture VIE structures and make them expressly subject to foreign investment regulation.  The definition of foreign investment is broader than that used under the existing regulations and focuses more on the substance than the form of a transaction.

The scope of foreign investment activities subject to the Draft Law includes offshore equity transfers that have the effect of indirectly transferring an equity interest in a domestic company.  Consequently, offshore transactions that do not directly affect the registration of a domestic company will still be treated as foreign investment. 

Control Concept

The Draft Law makes use of a control concept in determining whether an investor is treated as foreign.  Pursuant to the Draft Law, in addition to considering the establishment jurisdiction, the authorities will also consider the nationality of the actual control person of the investor.  This opens the possibility that offshore registered companies controlled by PRC investors will be treated as domestic investors for the purpose of their investments in China.

The Draft Law also treats investments by domestic enterprises controlled by a foreign parties as foreign investment.  Thus, any onward investment by a foreign invested company in China would be treated as foreign under the Draft Law.

Approval Requirements

The Draft Law would replace the administrative approval mechanism currently governing foreign investment into China with a new system more focused on registration and post-investment reporting.  In most cases, approval would no longer be required for foreign investment or M&A projects.  Registration under the PRC Company Law would be required instead.  Such projects would receive national treatment, although they would be subject to more extensive reporting requirements than that applicable to domestic investments.

Approval would still be required in limited circumstances where the foreign investment fell appeared in a Special Administration Measure Catalogue which will be prepared and issued by the PRC authorities.  The Catalogue will serve as a negative list for foreign investment and should replace the existing Catalogue for existing Foreign Investment.  The negative list would set out projects that are restricted or prohibited to foreign investment.  The restrictions would be based on industry sector and the aggregate size of the investment.  The approval system set out in the Draft Law would appear to be similar to the one employed in the Shanghai Free Trade Zone.

The Draft Law sets out the criteria applicable to the review of projects falling on the negative list.  The factors to be considered include impact on national security, energy resources, environmental protection and employment among other factors.  Deal specific items are not included as specified items for approval consideration and it does not appear that transaction agreements will need to be submitted to obtain approval.  The commercial aspects of a transaction may become less important in the review process.

The Draft Law provides the approved authorities with a range of approval options for projects appearing on the negative list.  The authorities will have the option of approving the investment, approving the investment with conditions pr rejecting the investment.  The conditions that may be imposed include an obligation to divest certain assets, restrictions on the equity holding ratios, restrictions on the enterprise’s operating period, restrictions on the operating territory, local labour and work force size requirements and such other requirements as the State Council may impose.

Reporting Requirements

While the approval system for foreign investment will largely be abolished under the Draft Law, a new comprehensive reporting system will be put in place which will require both investment and periodic reporting.  A report will be required when a foreign investor makes an investment in China or when a significant change in the investment occurs.  Reporting will also be required on an annual basis and in some instances on a quarterly basis of large foreign investors.  A more extensive range of reporting will be required than that applicable to domestic companies.  It is not clear how these reporting requirements will interact with the requirements of State Administration of Industry and Commerce.

VIE Structures

The Draft Law brings the VIE structure within scope of regulated foreign investment.  Contractual control is recognized as a form of foreign investment, and consequently a VIE structure controlled by a foreign party will be deemed a foreign investment.  The Draft Law provides that foreign companies controlled by Chinese investors may apply for the domestic treatment of their investments in China, creating the possibility that VIE structures ultimately controlled by Chinese investors will receive domestic treatment, while VIE structures controlled by foreign investors will be treated as foreign and subject to the approval process if the investment appears on the negative list.  The foreign investment reporting obligations would in any event be applicable with respect to a VIE structure controlled by a foreign investor even if the investment does not appear on the negative list.

The treatment of existing VIEs is not yet clear.  The section of the Draft Law dealing with existing VIE structures has been left blank with the text reserved.  The explanatory note accompanying the Draft Law explains the possible treatments.  However, all treatment option focus on whether the VIE structure is controlled by Chinese investor.  It is not clear how a VIE structure controlled by foreign investors will be treated or whether it will be possible for the structure to continue to operate without ceding control to a Chinese investor.

National Security Review

The Draft Law also elevates the national security review process to the level of a law.  The Draft Law requires foreign investors going through the approval process to explain the national security implications of the investment. Foreign investors are given the option of voluntarily submitting their projects to the national security review process.  Unlike in its current formulation, no guidance provided on what types of project would be deemed to pose a national security risk.  Any form of foreign investment in any industry sector may be subject to a national security review.  The scope of application appears broader than under current practice.  The Draft Law also permits a wide spectrum of interested parties to raise national security concerns for any foreign investment project.  Projects subject to approval may be elevated for a national security review by the approval authority.  A foreign party that does not submit a project to national security review which subsequently deem a national security risk would be subject to related penalties.

Support and Supervision for Foreign Investment

The Draft Law provides for the establishment of policies to support foreign investment and includes provision that specifically protect foreign investments from expropriation.  The Draft Law also provides for the dispute resolution mechanism pursuant to which investors may appeal decisions made by administrative approval authority.  The Draft Law also contains extensive monitoring provisions with respective to foreign investment activities.  The Draft Law also sets out the penalties for failing to adhere to its requirements.

Repeal of the FIE Laws

The Draft Law provides for the abolition of the three major foreign investment laws, the Sino-Foreign Equity Joint Venture Law, Sino-Foreign Cooperative Joint Venture Law and Wholly Foreign Owned Enterprise Law.  Companies that have been established under the prior foreign investment laws will have a three-year period in which to register as a Company under the PRC Company Law or partnership under the PRC Partnership Law.  The three primary foreign investment laws will presumably still be applicable to some extent during this three year transition period.  The regulations supporting the primary foreign investment regulation will also presumably be repealed.

Financial Sector

The Financial Sector is not currently directly impacted by the Draft Law.  The regulation of the Financial Sector, including with regard to investment banks, securities companies and insurance companies, will continue to be handled the competent industry regulator, which will be responsible for any new regulations.

Conclusion

The Draft Law potentially represents a major overhaul in the handling of foreign investment in China.  The support of other government agencies for the Ministry of Commerce’s proposed law however remains to be seen.  When the Draft Law is adopted in its final form, it should provide China with modern system for handling foreign investment that reflects the significant strides that have been made in the Chinese legal system and economy since China first open for foreign investment in the late 1970s.