On 19 January 2015, the PRC Ministry of Commerce (“MOFCOM”) published a draft Foreign Investment Law (“Draft FI Law”) together with an explanatory note (“Explanatory Note”) for feedback from the general public. The Draft FI Law will replace the Wholly Foreign Owned Enterprise Law, the Sino-Foreign Equity Joint Venture Law, and the Sino-Foreign Cooperative Joint Venture Law (collectively, the “Three Foreign Invested Enterprise Laws”) once it is finalised and after being adopted and approved by the National People’s Congress of the PRC. This Update summarises the key changes set out in the Draft FI Law.
“Foreign Investment” Redefined
Test of “ultimate control”
Currently, under the Three Foreign Invested Enterprise Laws, “foreign investment” is, in general, defined as equity investment in China by a foreign registered company or a foreign national. It does not consider the foreign investor’s source of funds or its actual controller. The Draft FI Law takes a different approach and introduces a new standard which includes a test of “ultimate control”. Accordingly, a Chinese company which is ultimately “controlled” by a foreign individual or a foreign entity may be deemed to be a foreign investor for the purposes of the Draft FI Law.
What amounts to “control”
The Draft FI Law further provides that an individual or entity will be deemed to “control” another entity (“target entity”) if he/it:
- directly or indirectly holds more than 50% of the equities, shares, or voting rights of the target entity; or
- has the power to appoint more than half of the directors or members of similar decision-making bodies of the target entity or has the ability to exert significant influence on such bodies of the target entity; or
- may exert significant influence upon the target entity by contract, trust, or otherwise.
What amounts to “foreign investment”
The Draft FI Law also substantially expands the scope of “foreign investment” to include the following:
- green field investments;
- acquisition of PRC registered companies;
- obtaining of assets, shares of assets, voting rights, or similar rights of a PRC company;
- long term (i.e., more than one year) financing to the Chinese subsidiaries of the foreign investors;
- obtaining rights to explore and/or exploit resources or to construct and/or operate infrastructure;
- real estate purchases; and
- obtaining control of Chinese companies by contractual arrangements and/or trusts.
The Draft FI Law also expressly states that if an offshore transaction results in the control of a PRC company being transferred to a foreign investor, then the foreign investor will be deemed to be making an investment in China.
Negative List and Access Permit
Foreign investment industry catalogue
Currently, the PRC has a foreign investment industry catalogue which categorises industries into “prohibited”, “restricted”, “permitted” and “encouraged” categories. A foreign investor is not allowed to invest in a “prohibited” industry and is encouraged to invest in an “encouraged” industry. Investments in a “restricted” industry are subject to greater scrutiny by the relevant PRC authority and it may be more difficult and time consuming to get approval for the investment. Any industries not categorised as “prohibited”, “restricted”, or “encouraged” are deemed to be “permitted”. Regardless of whether the industry being invested in is classified as “prohibited”, “restricted”, “permitted”, or “encouraged”, approval from the MOFCOM is required.
Negative list approach
The Draft FI Law adopts a new approach by introducing a negative list (to be separately enacted by the State Council in due course). Any foreign investment not on the negative list will no longer require approval from the MOFCOM or its local branch, and the foreign investor may proceed to register its investment with the local State Administration for Industry and Commerce. On the other hand, if a foreign investment is in an industry found on the negative list, the foreign investor will be required to obtain an access permit (“Access Permit”) from the MOFCOM.
Information reporting requirements
Although prior government approval for foreign investment will not be required for most foreign investment, the Draft FI Law does impose an administrative information reporting obligation on all foreign investors which must be complied with prior to or within 30 days of the investment. Information reporting is also required if there are material changes to the foreign invested enterprise (“FIE”), such as a shareholding transfer, pledge of capital, or capital increase. Furthermore, foreign investors will need to comply with annual report filing obligations and the following foreign investors will be required to submit quarterly reports:
- an FIE with total assets, sales, or revenues of more than RMB 10 billion; and
- an FIE with more than 10 subsidiaries in China.
The Draft FI Law also introduces penalties for failure to comply with the reporting obligations in time. In addition to the imposition of a fine on the FIE, the persons responsible may also be held criminally liable.
National Security Review
Enterprises requiring a review
Since 2011, foreign investors have been subject to a national security review process when investing in industries that “may have an impact on the national security of China”. The current regime only provides broad guidelines in this regard and does not specify a list of industries covered by this rubric. Generally, however, acquisition of any of the following enterprises by foreign investors, where the acquisition may result in foreign investors acquiring actual control of the domestic enterprise in question, will be subject to a national security review:
- domestic military manufacturing and related ancillary enterprises;
- enterprises in the vicinity of key and sensitive military facilities;
- other enterprises related to national defence; and
- enterprises related to national security in industries involving important agricultural products, important energy and other resources, important infrastructure, important transportation services, key technologies, and major equipment manufacturing.
Review process set out
The Draft FI Law (Chapter 4) sets out a national security review process and provides for a reviewing commission (“Reviewing Commission”) to be set up by the MOFCOM, the National Development and Reform Commission, and several other ministries. The Reviewing Commission will be in charge of the review of any foreign investment. It may carry out such a review on its own initiative or upon the application of the foreign investor or the relevant authorities, associations, or companies. The decisions made by the Reviewing Commission may not be judicially reviewed.
Variable Interest Entity
The Draft FI Law also expressly deals with the Variable Interest Entity (“VIE”) structure (also known as “SINA model”) which is popular in China for foreign investment in industries in which majority foreign shareholding is not allowed (for example, the value-added telecommunications industry). A typical VIE structure will allow foreign investors to finance Chinese businesses in such industries by owning and using a wholly foreign-owned enterprise to control the Chinese entity that possesses the coveted industry license, thereby receiving its economic benefits by contractual arrangements.
Significant penalties to be imposed on the VIE structure
Article 149 of the Draft FI Law proposes to impose significant penalties on contractual schemes that circumvent Chinese foreign investment restrictions, and it is widely understood to be targeting VIEs. It is not clear whether the Draft FI Law (once adopted and approved) will apply retrospectively. If so, it will effectively put some of the existing VIEs in danger of termination. The Explanatory Note states that the MOFCOM may take one of the following approaches in dealing with the existing VIEs:
- The parties concerned may declare the business to be controlled by Chinese investors and the VIE structure may remain;
- The MOFCOM may certify the business as being controlled by Chinese investors and the VIE structure may then remain; or
- If the business is actually controlled by foreign investors, an Access Permit may be required from the MOFCOM and the MOFCOM may grant or reject the Access Permit after a consideration of all relevant factors.
The Draft FI Law represents a significant change in the current regulation of foreign investment. It is still, however, under review and its provisions may be amended after a consideration of feedback provided. What its final form will be remains to be seen, and we will keep you updated of further progress on the matter.