On 19 January 2015, the Ministry of Commerce of China (“MOFCOM”) released a draft version of the Foreign Investment Law (中华人民共和国外国投资法 (草案征求意见稿))  (“Draft Foreign Investment Law”) for public comments. The deadline to submit comments  is 17 February 2015.

The Draft Foreign Investment Law will replace the three existing foreign investment laws –  Sino-Foreign Equity Joint Venture Law (“EJV Law”), Sino- Foreign Cooperative Joint Venture Law  (“CJV Law”) and Wholly Foreign-Owned Enterprises Law (“WFOE Law”). It will significantly change the  existing regime of foreign investment and become the basic law regulating all foreign investment  activities in China.

Highlights of Changes

SCOPE OF “FOREIGN INVESTORS” AND “FOREIGN INVESTMENT”

Foreign Investors

One major reform introduced by the Draft Foreign Investment Law is that foreign investment will no  longer be differentiated and regulated by the form of organisation such as Sino-foreign equity  joint venture (“EJV”), Sino-foreign cooperative joint venture (“CJV”) and wholly foreign-owned  enterprises (“WFOE”), which will cease to exist as a specific form of business vehicle. Instead, the concept of “actual control” has been introduced. Under the  Draft Foreign Investment Law, foreign investors (“Foreign Investors”) not only include non-Chinese  individuals, enterprises incorporated under foreign laws, foreign government bodies and  international organisations, but also any entity which is under the actual control by these foreign  investors. In other words, a Chinese subsidiary controlled by a Foreign Investor (such as what is  currently known as a WFOE) will itself be treated as a foreign investor. Given this approach of “actual control”, investments by Chinese companies in industries restricted to foreign investment by using an offshore structure  (for instance, internet companies listed in the US) will potentially become legitimate. Equally,  going forward, foreign investment using a Variable Interest Entity (“VIE”) structure attempting to  circumvent any restriction on foreign shareholding will be expressly prohibited. Please see further  below the section on “Impact on VIE Structure”.

Foreign Investment

A broad scope of foreign investment activities are now subject to the regulation of the Draft  Foreign Investment Law (“Foreign Investment”). These do not only include (i) green-field investment  and (ii) merger and acquisition, but also (iii) provision of long-term financing (with a term of  more than one year) by a Foreign Investor to its subsidiaries in China, (iv) obtaining licence to  explore natural resources or operate/construct infrastructure project; (v) acquisition of real property; (vi) controlling, or holding interest of, a domestic entity, by  way of contractual or trust arrangements (such as VIE); and (vii) offshore transaction which results in actual control of a domestic company being transferred  to a Foreign Investor.

NEGATIVE LIST APPROACH

Another major change introduced by the Draft Foreign Investment Law is the adoption of a “negative  list” approach in respect of foreign investment approval, similar to the model adopted by the China  (Shanghai) Pilot Free Trade Zone.

Existing regulations require all foreign investors who intend to set up or acquire a company in  China to first obtain approval from MOFCOM or its local branch before business registration can be  made with the relevant Administration of Industry and Commerce (“AIC”). The Draft Foreign Investment Law fundamentally changes this requirement by limiting foreign investment approval to only those  investments listed on a negative list (“Negative List”) to be released by the State Council. The  Negative List will set out industry sectors in which Foreign Investment is restricted as well as  investment thresholds for Foreign Investment. Foreign Investment outside the Negative List will be  offered national treatment and may register with AIC directly. An information reporting procedure  is required for all Foreign Investment (please refer to the “Information Reporting System” section  below) but this may be completed after the AIC registration.

While the Negative List is yet to be published, it is generally expected that most foreign  investment projects will no longer require pre-approval by MOFCOM when the Draft Foreign Investment  Law comes into place. This will reduce the time line required for foreign investment projects and  offer parties greater flexibility in structuring their investment as relevant contracts (such as  joint venture contracts and equity transfer agreements) will no longer require MOFCOM approval.

INFORMATION REPORTING SYSTEM

Under the Draft Foreign Investment Law, Foreign Investors and their subsidiaries in China are  required to fulfil a number of reporting obligations via an online reporting system to be set up by  MOFCOM.

An initial information report is required for any Foreign Investment, which should be completed  either before the implementation of or within 30 days after the implementation of the transaction  (which is the business registration date if the transaction requires registration, or the closing  date if the transaction does not require registration). Information to be disclosed in the report  includes, among others, basic information of the Foreign Investor (including its actual controlling  shareholder) and its subsidiary, and information on the investment (including sources of  investment). Joint venture contracts and articles of association are not required to be submitted  for this purpose.

An updated information report must be submitted within 30 days after any change to the matters  stated in the initial investment report occurs. Furthermore, any enterprise with foreign investment must file an annual report to MOFCOM disclosing various operation information. For an enterprise   with large business scale (total assets, sales income or revenues exceeding RMB 10 billion per  annum in China, or having more than 10 subsidiaries in China) which is controlled by foreign  shareholders, an additional obligation to report information on a quarterly basis is also in place.  However, it is not entirely clear whether the above threshold for quarterly reporting obligation is  calculated on a group basis.

NATIONAL SECURITY REVIEW

Compared with the existing regulations, the Draft Foreign Investment Law expands the scope of  matters that are subject to national security review. Any Foreign Investment that damages or may  potentially damage national security is subject to a unified national security review regime,  regardless of industry sector or whether it is controlled by a Foreign Investor. This is a very  broad coverage, and even though the Draft Foreign Investment Law highlights a number of areas that  are subject to particular review attention (such as national defence, key infrastructure and key  natural resources), this expanded regime still raise much uncertainty to foreign investors.  Guidelines on national security review will be promulgated separately, which hopefully may provide  more detailed clarifications.

  • It is also worth noting that Foreign Investors may not withdraw their applications of national  security review without MOFCOM’s prior consent, and administrative reconsideration and  administrative litigation are not available for any decision of  national security review.

IMPACT ON EXISTING FIEs

The Draft Foreign Investment Law will no longer regulate corporate governance issues for  enterprises with foreign investment; instead, they should follow the same requirements as domestic  enterprises under the Company Law, the Partnership Law and the Law on Individual Proprietorship  Enterprises etc. The Draft Foreign Investment Law gives existing EJVs, CJVs and WFOEs (“FIEs”) a  three-year transitional period to conform with these laws. The following are some of the potential  changes to existing joint venture contracts and articles of association:

  • changing the highest authority of an EJV from the board of directors to the shareholders’ meeting according to the Company Law;
  • changing the legal status of an unincorporated CJV to either a limited liability company or a foreign-invested partnership; the highest authority of a CJV should no longer be the board of  directors or the joint management committee, it should either be changed to the shareholders’  meeting according to the Company Law or follow the provisions in the Partnership Law;
  • changing the profit distribution ratio of an EJV since profit sharing among shareholders is not  required to be proportionate to equity ratio under the Company Law; and
  • amending the pre-emptive right requirement so that selling shareholders of an EJV or a CJV  will only need to obtain consents from more than half of the non-selling shareholders (rather than  all  the non-selling shareholders according to the EJV Law or CJV Law). This is particularly  favourable to the selling shareholders of an EJV or a CJV which has multiple partners.

IMPACT ON VIE STRUCTURE

The Draft Foreign Investment Law expressly makes VIE structure subject to the same regulatory  regime of Foreign Investment.

At present, VIE structure falls within a “grey” area and is often used by foreign investors to  invest in Chinese entities that are restricted to foreign investment. It is a critical question on  how to deal with these existing VIEs. The explanatory note that accompanies the Draft Foreign  Investment Law (“Explanatory Note”) introduces three options for public comments:

  • Option 1: to grandfather any existing VIE that files a record with MOFCOM to confirm that its  actual controlling shareholders are Chinese investors;
  • Option 2: to grandfather any existing VIE that applies to and obtains approval from MOFCOM confirming that its actual controlling shareholders are Chinese investors; or
  • Option 3: MOFCOM to decide and approve on a case-by-case basis whether to grandfather any  existing VIE upon its application.

Among these three options, Option 1 should have the least effect on existing VIE structures since  it only requires a filing with MOFCOM, while Option 3 gives MOFCOM a huge discretion on whether an existing VIE structure shall be continued. However,  these options are intended to legitimise VIE structures with Chinese controlling interest and do  not assist “actual” foreign investors who have adopted the VIE structures to avoid restrictions on  foreign shareholding in Chinese companies.

Questions to be Answered

There is no doubt that the Draft Foreign Investment Law will, when promulgated, bring fundamental  changes to the foreign investment regulatory regime in China. While the Draft Foreign Investment  Law is seen as a very positive sign of Chinese government’s determination to relax restrictions on  foreign investment, some questions remain unanswered and need to be clarified.

RELATIONSHIP WITH EXISTING INVESTMENT CATALOGUES

Currently, the Catalogue of Industries for Guiding Foreign Investment (“Foreign Investment  Catalogue”), jointly published by MOFCOM and NDRC is the key legal investment guide on industry  sectors to foreign investors. With the adoption of the Negative List approach by the Draft Foreign  Investment Law, whether foreign investment is subject to MOFCOM’s approval and at which level will  depend on the industry sectors and thresholds set out in the Negative List. Logically, the Negative  List should replace the Foreign Investment Catalogue. The NDRC (and MOFCOM) published a revised  draft of the Foreign Investment Catalogue for comments in November 2014. It remains to be seen  whether the Negative List will be a mere copy of the restricted and prohibited sectors in the  Foreign Investment Catalogue or whether it will further relax the current restrictions. The status  of the State Council’s Catalogue of Investment Projects subject to Government’s Verification, which  also applies to foreign investment, also needs to be clarified.

TOTAL INVESTMENT AND REGISTERED CAPITAL

The long-existing concepts of total investment and registered capital are unique mechanism of FIEs.  As the difference between the total investment and registered capital represents the foreign loan  quota of FIEs, the mandatory ratio between the two restricts the FIE’s ability to get foreign  financing. Whether such financing quota still applies to enterprises with foreign investment after the Draft Foreign Investment Law enters into effect remains unanswered in the draft law. If it applies, whether  short-term foreign shareholders’ loans (with a term of one year or less) will be subject to such  quota is also unclear.

INTERACTION WITH OTHER FOREIGN INVESTMENT REGULATIONS

While the Explanatory Note made it clear that the Draft Foreign Investment Law will repeal the EJV  Law, CJV Law and WFOE Law, it did not clarify how the Draft Foreign Investment Law may interact  with other foreign investment regulations, in particular the Provisions on the Merger and  Acquisition of Domestic Enterprises by Foreign Investors (“M&A Regulations”) and various  regulations by the State Administration for Foreign Exchange.

For foreign acquisition currently subject to the M&A Regulations, although the relevant approval  regime will be overhauled by the Draft Foreign Investment Law, whether other regulatory  restrictions in the M&A Regulations, such as the three-month payment deadline and MOFCOM’s approval  on round-trip investment, will be retained is a question for the legislators to clarify.

REPORTING OBLIGATIONS

The Draft Foreign Investment Law establishes a comprehensive information disclosure mechanism for  Foreign Investors and their subsidiaries in China, ranging from the initial report, the updated  report to the annual report, and for large enterprises controlled by Foreign Investors, an  additional quarterly reporting is in place. The burden incurred by these multiple layers of disclosure obligations is considerable. Further, the information to be  disclosed to MOFCOM overlaps to a great extent with what is required by AIC under its annual  reporting system. If the two systems are not on an integrated platform, it will create extra  administrative burden for investors.