Positive experiences with recent experiments have encouraged China’s lawmakers to publish a new law on foreign investments. It is not yet clear when and in what form this new law will enter into force, but the text that is now available for public consultation suggests a major change in China’s attitude towards foreign investments. The replacement of the current approval regime by a reporting regime for non-restricted industries will make it much easier for many foreign companies to do business in China. The new law may also have a big impact on the use of VIE structures. Due to the introduction of “effective control” as one of the identifying criteria for foreign investment, domestic Chinese companies that are subject to contractual foreign control will be classified and regulated as foreign investments.
Foreign investments in China are currently structured primarily through either an equity joint venture, or a contractual joint venture, or a wholly foreign-owned enterprise (WFOE). Separate laws govern each of these three structures, which are together referred to as foreign invested enterprises (FIEs). All FIEs are subject to a strict regulatory regime, built on a case-by-case approval system. In practice, this means that both the establishment of an FIE and any subsequent material changes – capital increase or reduction, amendment of articles of association, mergers and acquisitions, etc. – require prior government approval, regardless of the FIE’s size, nature or industry. FIE regulations are currently scattered and sometimes inconsistent. Many foreign companies spend a lot of time and monetary resources on figuring out where to obtain what approval. This effectively raises the cost of foreign investment and, to some extent, hinders free competition.
On 19 January 2015, the Ministry of Commerce (MOFCOM) released a new draft Foreign Investment Law for public consultation. This new law intends to abandon the three existing structures for foreign investment and to integrate them into the Company Law, which applies to domestic companies. Existing FIEs will be given a three-year period to make their corporate governance compliant with the Company Law instead of the specific laws that currently govern FIEs.
More importantly, the case-by-case approval regime for foreign investments will be replaced by a reporting regime. Foreign investors will only need to file reports when they make an investment or effect material changes to an existing investment. Prior governmental approvals will no longer be required unless the activities fall under a negative list to be released by MOFCOM. A foreign investment can be restricted because it is in a particular industry or exceeds a certain financial threshold. The negative list will also include those industries that are closed to foreign investment. This negative list approach was first introduced in September 2013 in the Shanghai Free Trade Zone. The proposed negative list is not part of the draft law, so it remains unclear whether the list for the Shanghai Free Trade Zone will be implemented nationwide or whether a separate list will be introduced. The negative list will replace the existing catalogue on foreign investments which was recently updated (see In context December 2014).
A significant element of the draft law is its impact on VIE (variable interest entity) investment structures. A VIE structure enables foreign investors to participate in and receive economic benefits from certain activities in China, through a series of contractual arrangements rather than through a majority stake. VIEs are typically used if a foreign investor cannot acquire equity in an entity operating in a particular industry in China or if the acquisition would be subject to approvals difficult to obtain. Many Chinese companies active in the internet industry and listed in the US use VIEs as part of their corporate structure, including Alibaba, Tencent and Baidu. The draft law introduces an effective control test: Chinese companies controlled by overseas investors qualify as foreign and those controlled by Chinese investors qualify as domestic, regardless of country of incorporation. The good news for foreign investors is that the draft law seems to acknowledge the validity of VIE structures, which is highly debatable under current law. The bad news is that companies operating in sensitive sectors and controlled by foreign investors through a VIE structure are no longer considered domestic and will therefore require approval from MOFCOM. The general expectation is that existing VIEs will be grandfathered, but it will be interesting to see whether they actually will be. It is not clear how this would correspond with the national security review provisions included in the draft law.
China already has regulations relating to the review of foreign investments, based on national security concerns, similar to the CFIUS review in the United States. But the draft law includes more detailed provisions, most notably that decisions regarding national security will not be subject to administrative or judicial review.
The draft Foreign Investment Law and previous reforms of laws governing inbound and outbound investments show that the Chinese government is relaxing its scrutiny of activities that it does not consider a risk to national interests and, at the same time, it is increasing its grip on activities that it considers sensitive. For foreign investors investing in activities which are not deemed sensitive, we believe the new draft Foreign Investment Law will reduce their administrative burden and help to create a level playing field between domestic and foreign companies.
The new law is not expected to enter into force before 2016.