The People’s Republic of China’s (the “PRC”) Ministry of Commerce (the “Ministry”) has recently released a draft foreign investment law (“Draft Rules”) to ease restrictions on foreign investors, unify regulations on foreign investments in China, and to start regulating the variable interest entities (“VIE”) that are used to get around foreign-ownership restrictions. If enacted, the Draft Rules would streamline bureaucracy by abolishing the local and central government’s pre-approval system for foreign investments and normalize foreign investment practices with developed countries. This overhaul of existing foreign investment laws could mark the biggest change since 1978 to the way global companies do business in the country. The Ministry, on its website, is accepting public feedback until February 17, 2015.

What is the current law?

The Draft Rules, will replace the current obscure and controversial legal regime that is the Sino-foreign Equity Joint Venture Law, the Wholly Foreign-owned Enterprise Law and the Sino-foreign Contractual Joint Venture Law. Wholly foreign-owned enterprises, foreign-invested equity joint ventures and contractual joint ventures will no longer have separate legal regimes but instead be captured by the Draft Rules as the one and only authority for foreign investments.iAs expected, the three current laws governing foreign companies’ investment and operation in the PRC will be obsolete once the Draft Rules comes into force.

Why the change?

The Draft Rules, a brainchild of the Shanghai Free Trade Zone is used to cut excessive red tape. Under the current regulatory system, all foreign-invested enterprises must obtain pre-approval before making any material changes to its capital structure. This regulatory approach, a necessary instrument for the early years of market reform, is now a drag on free competition and the liquidity of capital markets. The Draft Rules will scrap decades old joint venture laws in favour of a modern streamlined system for foreign investment.

What’s New?

  1. Pre-established National Treatment

The Draft Rules will give pre-established national treatment to foreign investors, putting foreign investors on the same legal footing as domestic PRC entities. However, as explained below, all foreign investors will still be required to produce “information reports” to the Ministry.

  1. New Definitions of investor, investment, and control

Foreign enterprises will now be defined as enterprises with foreign control, rather than merely foreign ownership. According to Article 11 of the Draft Rules, the definition of “foreign investor” is an investor who is:

  1. a natural person that is not a Chinese national;
  2. corporation registered according to foreign laws;
  3. a foreign government body; or
  4. international organizations.  

While a “Chinese investor” is defined as:

  1. an investor who is a Chinese national;
  2. the Chinese government and its entities; or
  3. domestic enterprises controlled by the preceding entities.

Article 15 defines “foreign investment” as investment activities that directly or indirectly:

  1. establish a domestic enterprise;
  2. acquire shares, equities, interest in assets, voting rights or other similar rights and interests of domestic enterprises;
  3. provide financing for one year or more to a domestic enterprise referred to in the preceding paragraphs;
  4. acquire interest or rights to the exploration, mining or extraction of natural resources, or to acquire interest or rights to the operation of such undertakings within China’s administrative jurisdiction;
  5. to acquire interest or rights to land use, real property or immovable property within China;
  6. control domestic enterprises or its rights through contracts, trusts, or any other way.

Any other foreign agreements that causes the actual controller of a domestic enterprise to become a foreign investor shall be deemed a foreign investment.

According to Article 19, “actual controller” means a natural person or corporation who directly or indirectly controls a foreign investor or foreign-invested enterprise. This differs from the current foreign investment law which defines “Chinese companies with any foreign ownership” as “foreign-invested enterprises.” These new definitions will have a profound impact on VIEs.

  1. Introduction of the “Negative List”

The Draft Rules will relax controls on foreign investment by only requiring pre-approvals on such investments into restricted industries. These restricted industries will be grouped together into a negative list (“Negative List”), replacing the existing “Foreign investment Industrial Guidance Catalogue.” The Negative List contains industries in the prohibited and restricted sectors including defense, technology, vital infrastructure, communications and network security, energy and food security, public interest and public order, among others. The Negative List is open ended and the State Council may investigate other factors it deems necessary.  If a foreign investment falls under the Negative List, a pre-approval process is initiated. The State Council, via a joint ministerial tribunal, will carry out a national security review on the proposed foreign investment. Following the review, the State Council may pre-approve the foreign investment, set conditions, or prohibit the investment. Interestingly, the national security review mechanism is borrowed from Canadian and Australian foreign investment legislations. Similar to the Investment Canada Act, foreign investors may proactively apply for a national security reviewHowever,All State Council decisions are final.

  1. Foreign investment comprehensive information reporting system

Under the Draft Rules, foreign investments outside of the Negative List will follow the comprehensive information reporting system and no longer require pre-approval from the State Council. The information reporting system is a substantial relaxation of foreign investment control. The information reports are divided into investment implementation report, investment change reports, annual report and quarterly reports.ii Fraud, and non-compliance will result in severe fines and or criminal liability to the reporting company and management.

That said, the breadth of reporting obligations and the threshold are potentially more stringent than similar provisions in the Investment Canada Act. For instance, the Draft Rules requires disclosure of the ultimate source of investment and the actual controlling identity of the foreign entity. This goes beyond the disclosure requirements of current PRC foreign investment laws. Additionally, there are still redundancies created by the comprehensive information reporting system and the registration requirements for foreign-invested business. These may prove burdensome on potential investors.

How will it Impact VIEs?

Although there is no clear prohibition against the VIE structure in the PRC, there is also no express endorsement of it. VIEs have always been a gray area in the Chinese legal system. So what happens to existing enterprises with a VIE structure, such as Alibaba, Baidu or Tencent?

The Ministry has stated that VIEs will be subject to the Draft Rules, including the Negative List which will restrict VIEs from certain industries. For existing VIEs operating under the Negative List of industries, there may be three possible outcomes:

  1. first, if a Chinese national is the ultimate controller to the foreign party of a VIE structure, a filing stating such facts would be sufficient to continue operations;
  2. second, notwithstanding the filing, the same controller may be required to apply for a Ministry approval of their Chinese controlling status, following which operations may be resumed; and
  3. third, the VIE would have to apply to the Ministry for a full blown assessment of whether among other factors, the nationality of the ultimate controllers are Chinese, before operations may resume.

Accordingly, VIEs such as Alibaba, Baidu and other companies that have dual-class share structures or similar arrangements to keep its Chinese founders in control may suffice its compliance by mere filing. In any case, the litmus test seems to be whether the offshore portion of the VIE is Chinese controlled.

Some investors see the Draft Rules as double edged because while it encourages foreign investment, it may also create a system that concentrates voting power in the hands of Chinese executives. On that note, the Ministry said it will further refine its approach to VIEs after “broadly listening to social opinions” on the matter, recognising the sensitivity of global investors to this new legislation. In the meantime, the Draft Rules is still open for public feedback before being approved in the plenary session of the National People’s Congress expected to convene in March 2015, which means it could come into force in the first half of 2016.