China’s current legal framework on foreign investment mainly includes laws governing the three basic forms of foreign-invested enterprises (“FIE”): wholly foreign-owned enterprises (“WFOE”), equity joint ventures (“EJV”) and cooperative joint ventures (“CJV”), and their implementation measures, ancillary regulations and other stipulations found in different laws.

Due to China’s rapid growth in recent decades, the Draft FIL aims to accommodate the ongoing development of China’s investment environment, which has long been considered over-regulated. MOFCOM is now requesting public comments on the Draft FIL, and when the draft is officially enacted, it will become China’s first integrated legislation relating to foreign investment.

The Draft FIL significantly restructures  the current regulatory framework of foreign investment in China, as follows:

1. Definition of foreign investors and foreign investment

The Draft FIL states that domestic enterprises controlled by foreign individuals, foreign enterprises, foreign governments or international organizations investing in Mainland China must be identified as foreign investors and fall within the scope of the Draft FIL.

The Draft FIL broadens the definition of foreign investment to include (1) establishing domestic companies; (2) carrying out various forms of mergers and acquisitions; (3) providing financing to domestic companies with terms exceeding one year; (4) investing in real property; (5) obtaining concessions to explore or exploit natural resources, and carry out construction projects or operate infrastructure; and (6) controlling domestic companies, directly or through contracts, trusts or in other ways.

2. Definition of “control” and “actual controller”

To avoid uncertainties when determining whether domestic enterprises are controlled by foreign entities and thus identified as foreign investors, the Draft FIL defines “control” comprehensively, specifying the circumstances under which a party would be considered to have control over an enterprise:

  1. A party directly or indirectly holds at least 50% of the shares, equity, property shares, voting rights or similar rights and interests in the enterprise.
  2. A party directly or indirectly holds less than 50% of the shares, equity, property shares, voting rights or similar rights and interests in the enterprise, but:
    1. is entitled directly or indirectly to appoint at least half of the members of the enterprise’s board of directors or similar decision- making body;
    2. can ensure that its nominated people can obtain at least half of the seats on the enterprise’s board of directors or similar decision- making body; or
    3. the party’s voting rights are enough to have a material impact on the resolutions of the enterprise’s shareholders meetings, general meetings, board of directors or similar decision-making bodies.
  3. A party can have a decisive influence on the enterprise’s transactions, finance, personnel and technology, through contracts, trust or in other ways.

The Draft FIL also introduces the concept of “actual controller” for the first time in terms of foreign investment, relating to individuals or enterprises directly or indirectly controlling foreign investors or FIEs.

The new definition may significantly affect the validity of variable interest entity structures, designed to avoid the legal restrictions on the entry of foreign investment in some restricted sectors.

3. Administration of market entry

To grant national treatment to foreign investors, the Draft FIL adopts a negative list regime to manage market entry of foreign investment.

Under this regime, used on a pilot basis by the Shanghai Free Trade Zone since September of 2013, foreign investment is no longer subject to restrictive and case-by-case approval requirements, unless it affects sectors on the negative list.

Under the Draft FIL, all foreign investment projects not specified on the negative list must to go through record-filing procedures and submit information reports to the relevant authorities through a centralized information reporting system for foreign investment.

The negative list, which the State Council has not yet published, will be divided into two catalogues: prohibited sectors and restricted sectors, depending on the scale of investment and the invested industries. When the negative list is enacted officially, it will replace the Industry Catalogue Guidance for Foreign Investments, one of the most important legal documents in the current approval regime for foreign investment entering the market.

4. National security review system

The Draft FIL, also for the first time, codifies the national security review system, applying it to any foreign investment that harms or is likely to endanger national security. An inter-ministerial joint conference will be established to carry out security reviews based on the standards and procedures in the Draft FIL.

These standards and procedures will include scrutinizing the investment’s impact on the nation’s defense security, the research and development capacity of national security’s key technology, the nation’s leadership in national security technology, the nation’s information and network security, and whether the investment is controlled by foreign governments.

The Draft FIL  exempts national security review from administration reconsideration or litigation. Therefore, although it relaxes market entry administration, the inter-ministerial joint conference discretion in this process may lead to a lack of transparency. It is expected that detailed interpretation or standards will be published soon.

5. Information reporting mechanism

The new information reporting mechanism requires foreign investors to report the completion of and any change to foreign investment projects within specific periods and to report certain information on existing foreign investment regularly.

Although the Draft FIL significantly relaxes market entry administration for foreign investment, it establishes more restrictive information reporting obligations and consequences for non-compliance. Under the new information reporting mechanism, the actual controller’s identity and the source of investment funds must be disclosed and failure to disclose this could result in a penalty of up to 5% of the investment amount, depending on the circumstances.

The information reporting platform is yet to be launched and implementing measures are expected after the Draft FIL takes effect.

The Draft FIL also regulates investment promotion, investment protection and measures for handling FIE-related complaints.

Date of issue: January 19, 2015. Deadline for public comments: February 17, 2015.