After a long wait, on 19 January 2015, China's Ministry of Commerce (MOFCOM) released the draft Foreign Investment Law for public comment. The draft Foreign Investment Law represents a significant step forward in China's continuing reform and opening-up. Upon effectiveness, the Foreign Investment Law will replace the current three main laws on foreign-investment enterprises (i.e., the Law on Wholly Foreign Owned Enterprises, the Law on Equity Joint Ventures, and the Law on Cooperative Joint Ventures), and introduce various other changes.
Comments on the draft Foreign Investment Law will be accepted till 17 February 2015. It is unclear when the Foreign Investment Law will be finalized and issued.
China's current foreign investment laws were first issued around thirty years ago. They introduced the existing foreign investment approval system, but have fallen behind the rapid economic development of China.
Various issues have emerged over the years, including a lack of transparency during approval processes, giving rise to inconsistent practices, and unpredictability. Conflicts between the Company Law and the various foreign investment laws also exist.
MOFCOM requested public comments in late 2013 with the intention of thoroughly revising China's foreign investment laws.
Set out below are various significant changes introduced by the draft Foreign Investment Law.
- Expanded scope of foreign investment
The draft Foreign Investment Law provides for broad definitions of “foreign investor" and “foreign investment". The concept of ‘‘actual control" is introduced to the definition of foreign investor. As a result, domestic enterprises that are directly or indirectly controlled by foreign investors will be deemed as foreign investors. On the other hand, if a foreign investment is directly or indirectly controlled by Chinese investors, such investment in China will be deemed as being made by Chinese investors.
In addition to greenfield investment, the draft law also governs foreign investment through merger and acquisition, financing to PRC-incorporated enterprise in which foreign investors own any equity interest, voting rights or other interests or rights of similar nature for over one year, obtaining land use rights and real estate ownership, obtaining concession rights for exploration and development of natural resources or construction and operation of infrastructure facilities, and controlling domestic enterprises through contracts, trust or other arrangements.
Offshore transactions that result in the transfer of actual control to foreign investors will be deemed as investment in China by foreign investors.
- National treatment and negative-list approach
The draft Foreign Investment Law intends to repeal the existing approval system, and introduce a new regulatory system based on a catalogue for special administrative measures (Catalogue). The Catalogue will set out restricted and prohibited sectors for foreign investment, and certain investment amount thresholds specified by the State Council. For investment in restricted sectors or exceeding the investment amount thresholds, foreign investors will be required to obtain approval to invest in China.
Foreign investment in sectors not listed in the Catalogue does not need approval under the draft law; rather, the establishment of a foreign investment enterprise (FIE) in such sectors will be subject only to registration.
As outlined in the draft Foreign Investment Law, the focus of the approval authority will be on the foreign investor and its investment activities (and not simply on the articles of association and related corporate documentation). The approval authority may solicit public opinions during the review process, and is required to publish its decision after the review (unless the publication is otherwise prohibited by law).
Under the new system, most foreign investment will no longer be subject to approval. Establishment time will also be shortened.
- Information reporting
The draft Foreign Investment Law sets up an information reporting system for foreign investors and FIEs. The information to be reported covers implementation of foreign investment (i.e., completion of registration or completion of a deal), change of foreign investment and periodical reports (including annual reports and quarterly reports).
Information required to be disclosed in the annual report includes information regarding:
- the foreign investor, FIE and investment;
- the business operations, finances and accounting;
- investment and trading activities with affiliates; and
- major litigation and administrative/criminal penalties.
Quarterly reports are also required for FIEs with total assets, sale volume or operating revenue exceeding RMB10 billion, or which own more than 10 subsidiaries in China. The quarterly report includes information regarding the FIE‘s business operation and financial status.
The new reporting obligation will impose an extra burden on FIEs. This is particularly the case because the new reporting obligations would be in addition to disclosure requirements under the existing information-disclosure system with the Administration for Industry and Commerce. FIEs, especially those within a large MNC group, would need to spend additional time and cost to comply with these new reporting obligations.
- National security review
The draft Foreign Investment Law sets out a unified security review system for foreign investment. The draft generally follows the current review procedures, including general reviews and special reviews, but also makes various changes.
Notably, compared with the existing regulation (which covers foreign-invested acquisitions of military enterprises, and foreign-invested acquisitions that would result in the foreign investor(s) gaining control over domestic enterprises in key sectors, such as agriculture and energy), the draft Foreign Investment Law expands the scope of national security review by providing that any foreign investment that harms or may harm the national security will be subject to review. There is no further definition of ‘‘harm". Therefore, any foreign investment may potentially be caught by the national security review on the authority's discretion.
The draft Foreign Investment Law states that national security decisions are not subject to administrative review or appeal.
- Variable interest entity (VIE) structures
Historically, VIE structures have facilitated offshore listings of Chinese companies and enabled foreign investors to indirectly invest in restricted or prohibited sectors in China.
The draft Foreign Investment Law would now expressly include a VIE structure as foreign investment. This is done by including as an FIE any domestic entity that is contractually controlled by a foreign investor.
The draft Foreign Investment Law does not provide a solution for existing VIE structures. However, the explanatory note issued with the draft proposes three options:
- filing with MOFCOM a declaration that an entity contractually controlled under a VIE structure is actually controlled by Chinese investors; this would preserve the existing VIE structure;
- applying for confirmation from MOFCOM that an entity contractually controlled under a VIE structure is actually controlled by Chinese investors; again, this would preserve the existing VIE structure; or
- applying to MOFCOM for approval to invest; if approved, the entity will be classified as an FIE.
We will circulate a separate e-bulletin specifically on the implications for VIE structures under the draft Foreign Investment Law.
- Investment protection and dispute resolution
The draft Foreign Investment Law provides that compensation will be granted upon the expropriation of foreign investment. Foreign investors or FIEs are also expressly permitted to claim damages from the state for losses caused by illegal acts of government authorities or officials.
Consistent with international practice, China will establish a mechanism to coordinate and address investment disputes among foreign investors/FIEs and administrative authorities.
- IP and foreign exchange
The draft sets out general principles for the protection of intellectual property rights of foreign investors and FIEs. It also includes principles for the free inflow and outflow of capital contributions, profit, legitimately obtained compensation and other legitimate assets of foreign investors.
The extent to which these principles will be implemented will largely depend on amendments to a range of other regulations.
- Transitional period arrangement
Existing FIEs will have three years from the effectiveness of the Foreign Investment Law to ensure compliance of their organizational forms and corporate governance related matters. The draft specifically notes the need for compliance with the Company Law, Partnership Enterprise Law and Individual Proprietorship Enterprise Law.
This may well require changes to the constitutional documentation for many FIEs. For instance, it will mean that equity joint ventures will need to recognize the shareholders' meeting (rather than the board of directors) as the highest governing authority. In addition, matters to be unanimously approved by the board of directors will no longer be mandatorily required.
The range of changes required may well re-open negotiations between shareholders of FIEs. Depending on their current corporate documentation, this may well cause particular issues for Sino-foreign joint ventures.
- Consequences for non-compliance
The draft Foreign Investment Law specifies several types of legal consequences for violations. These include orders to cease implementation of the foreign investment, dispose shares or other assets, confiscate illegal gains, cancel approvals, and other penalties.
The draft Foreign Investment Law is a big step forward for foreign investment regulation in China. It embraces various innovative systems and principles as well as advanced experience from in China and abroad.
There remain, however, lots of issues that will still need to be addressed. For example, the draft does not give the details of how the new negative-list review system will work. The draft also still appears, in practice, to leave governmental authorities with significant discretionary power to review foreign investment.
Various aspects of the existing M&A rules are inconsistent with the draft law, and it is likely that the M&A rules will be revised for compliance with the Foreign Investment Law. While this might introduce greater flexibility, the revision might also introduce more reporting requirements.
Finally, we note that the draft Foreign Investment Law only sets out the general regulatory framework and certain principles. A lot more legislative work will be required before the full details of the system emerge. It is going to be an interesting year.