On 19 January 2015, the Ministry of Commerce ("MOFCOM") published the draft PRC Foreign Investment Law (the "Draft") along with an explanation paper (the "Explanation"), and called for opinions from the public. The Draft represents a complete revamp of the legal regime that has applied to foreign investment in China for more than three decades, and importantly lifts a significant number of restrictions/requirements that foreign investors are currently required to meet when investing in China. Although many aspects of the future PRC Foreign Investment Law remain to be clarified, we have summarised below our understanding of the main points covered in the Draft:
Overview of the Draft
The Draft consists of 11 chapters (170 clauses in total), addressing the following key issues:
definition of "foreign investors" and "foreign investment";
regulation of foreign invested projects subject to an "entry permit";
provision for national security review of foreign invested projects;
an information reporting system for foreign investment;
promotion and protection of foreign investment and coordination and handling of complaints in relation to foreign investment; and
liabilities for breaches.
Foreign Investors and Foreign Investment Under the Draft, the definitions of "foreign investors" and "foreign investment" are extended to cover a wide range of investment vehicles and investment activities.
The definition of "foreign investors" is not limited to foreign nationals or foreign incorporated entities, but also covers enterprises incorporated in China and "controlled" (a defined term under the Draft, which we discuss below) by foreign investors.
The definition of "foreign investment" goes beyond the traditional methods of foreign investment activities in China: for instance, in addition to greenfield projects, the establishment of foreign invested entities, the acquisition of shares or equity interests in enterprises incorporated in China, the definition also covers the holding of certain rights/interests over assets owned by, or voting rights, in a domestic enterprise.
More specifically, "Foreign investment" under the Draft refers to any of the following investment activities conducted, directly or indirectly, by foreign investors:
establishing domestic enterprises, which are enterprises incorporated in China in accordance with Chinese laws, which can either be enterprises with foreign investment, or wholly domestic owned (referred to as "Domestic Enterprises"); acquiring shares, equity interests, certain rights/interests over assets, voting rights or other similar interests and rights in a Domestic Enterprise; financing, with a term of one year or more in any Domestic Enterprise in which one or more foreign investors hold an interest or right described in the point above; obtaining the concession rights to explore or develop natural resources in China, or obtaining concession rights to construct or operate infrastructure facilities in China; acquiring land use rights, ownership of buildings and other real property rights in China; and "controlling" or holding interests or rights in any Domestic Enterprise through contract, trust or other arrangement.
Interestingly, it is specified that overseas transactions that result in the transfer of the actual control over a Domestic Enterprise to a foreign investor shall be deemed as a foreign investment in China.
The Draft has a broad and detailed definition of "control". "Control" of an enterprise under the Draft means the controlling party's:
direct or indirect holding of 50% or more shares, equity interests, certain rights/interests over assets, voting rights or other similar interest or right in such enterprise; or
direct or indirect holding of less than 50% shares, equity interests, certain rights/interests over assets, voting rights or other similar interest or right in such enterprise, but
being entitled to, directly or indirectly, appoint over half of the members of board of directors or similar decision-making body in such enterprise; being capable of nominating over half of the candidates and secure such candidates' directorship in the board or membership in similar decision-making body in such enterprise; or holding sufficient voting rights to materially influence on the shareholders' meeting, board of directors or similar decision-making body of such enterprise; or
de facto control of the management, financial matters, human resources or technologies of such enterprise through contract, trust or other arrangement.
The definitions of "foreign investors", "foreign investment" and "control" as stipulated in the Draft expressly include the contractual control of Domestic Enterprises by foreign investors. In this regard, the Draft covers and regulates the practice of variable interest entities ("VIE") that has been widely adopted as an investment structure in certain restricted or prohibited foreign-invested sectors in China.
Abolition of Existing Laws on Foreign Investment
According to the Draft, the existing PRC Sino-foreign Equity Joint Venture Law, PRC Sino-foreign Cooperative Joint Venture Law and PRC Wholly Foreign Invested Enterprises Law will be abolished upon entry into force of the PRC Foreign Investment Law (and presumably all the related regulations as well).
Under the "national treatment" principle applicable to all Foreign Invested Enterprises (as explained below), all existing foreign invested enterprises shall adapt their corporate forms to the requirements, where relevant, of the PRC Company Law, PRC Partnership Law, PRC Law on Enterprises Wholly Owned by Individuals and other PRC laws applicable to companies or enterprises in China.
This will have significant implications for all existing foreign investment enterprises currently incorporated in China. For illustrative purposes, the main consequences of this abolition of the existing laws of foreign investment are expected to include:
the disappearance of the notion of "total amount of investment" vs. registered capital;
the adoption of the corporate governance structure provided under the PRC Company Law, e.g. shareholders' meeting, Board of Directors and Supervisory Board; and
the abolition of the preferential treatment for foreign investors previously provided under Sino-foreign cooperative joint ventures, and more specifically the priority return on investment that was available under specific circumstances.
A New Entry Permit System To Replace the Previous Approval and Registration Procedures National Treatment
Under the existing foreign investment law regime in China, all foreign investment projects are subject to the prior approval of MOFCOM (or its local or provincial counterparts), before registration of the concerned foreign investment company in China.
Under the Draft, foreign investors will now benefit from the "national treatment" principle and as a result will no longer require approval from MOFCOM (or its local or provincial counterparts) unless they invest in the prohibited or restricted sectors, in which case they will be subject to the special administrative measures described below. The Draft does not address whether the current requirement to submit a Project Application Report (or Feasibility Study Report) to the National Development and Reform Commission (“NDRC”, or its local or provincial counterparts) will still stand, as this derives from regulations promulgated by NDRC.
Catalogue of Foreign Invested Projects Subject to Special Administrative Measures
Under the Draft, all restrictions on foreign investors and foreign investment and all treatments applicable to foreign investors and foreign investment that differ from the "national treatment" principle and standards shall be stipulated in relevant laws, regulations or decisions of the State Council. These specific restrictions and treatments will also be stipulated in the catalogue of foreign invested projects subject to special administrative measures to be promulgated by the State Council (the "New Catalogue"). This new Catalogue is understood to be replacing the current Foreign Investment Industries Guidance Catalogue that has been governing foreign investments since 1995 (under its various updated versions).
The New Catalogue will be divided into two categories: prohibited category and restricted category. As a general principle, a Domestic Enterprise in which foreign investors directly or indirectly hold shares, equity interests, certain rights/interests over assets or other interests, rights or voting rights, is not allowed to invest in the sectors listed in the prohibited category.
If a foreign invested project falls into the restricted category, an "entry permit" will need to be obtained from MOFCOM (or its provincial counterparts – note that local counterparts will not have approval power, only provincial-level MOFCOMs will). The restricted category will cover two types of restrictions:
restriction by investment amount: any foreign investment in one particular project exceeding the amount limit set forth by the State Council, regardless of industrial sector, in which the project is; the detailed mechanism under which this restriction by investment amount remains yet unclear; and
restriction by industrial sector: foreign investment in certain named sectors that are subject to restrictions listed in the New Catalogue, regardless of the foreign investment amount.
The entry permit will normally be delivered within 30 days from the submission of the entry permit application (unless an additional 30 days period is added for complex cases).
Entry Permit with Conditions
In the restricted sectors, MOFCOM (or its provincial counterparts) may also impose one or more conditions for granting an entry permit. Such conditions may include for example restrictions on the shareholding proportion of the foreign investor(s), divestment from certain assets or businesses, limited duration of the concerned Domestic Enterprise, geographic restrictions for the operations, requirements on certain percentage of local employment. It is still unclear how these conditions may be determined and imposed by MOFCOM.
National Security Review
Under the Draft, the existing national security review will be integrated into MOFCOM's review of a foreign investor(s) application for an entry permit. If MOFCOM (or its provincial counterparts) considers that a proposed foreign invested project that requires an entry permit may jeopardize national security, MOFCOM will be entitled to suspend the entry permit review and require the foreign investor(s) to submit an application for national security review:
Authority in charge of the New National Security Review
The State Council will set up an Inter-ministry joint meeting for national security review (the "Joint Meeting"), which is understood to be jointly set up by NDRC and MOFCOM.
Process of National Security Review
The review of the Joint Meeting will be a two-step approach:
General review (within 30 working days): to decide whether the proposed foreign investment is likely to jeopardize national security. If yes, the Joint Meeting will proceed to the next step. Special review (within 60 working days): to examine in details and decide whether the proposed foreign investment will or may jeopardize national security.
New Information Reporting Requirements
All foreign investors or their invested enterprises in China (regardless of whether they fall in the restricted category or not, referred to as "Foreign Invested Enterprises") are required to submit an information report to MOFCOM before proceeding with any investment in China, or within 30 days of making such an investment. An update report must also be submitted within 30 days after the occurrence of any corporate change affecting the foreign investor(s) or the Foreign Invested Enterprise. In other words, transactions such as change in registered address, capital increase, equity transfer or pledge and other changes affecting a Foreign Invested Enterprise or its foreign investors will no longer require MOFCOM's prior approval as under the current regime, but only the filing of an update report. If certain changes however affect terms relevant to the entry permit, an new entry permit application shall also be filed.
Foreign Invested Enterprises will also be required to submit an annual report to MOFCOM before April 30 of each year.
Certain Foreign Invested Enterprises will be subject to an additional quarterly reporting requirement, namely:
any Foreign Invested Enterprise with a total assets, sales amount or revenue exceeding RMB10,000,000,000; or
any Foreign Invested Enterprise having ten or more subsidiaries (in China or elsewhere).
Round Trip Investment
The Draft adopts a principle of "actual/ultimate control" to determine whether an enterprise incorporated in China is a Foreign Invested Enterprise.
A Chinese Investor is defined as being any of the following persons/entities:
a natural person with Chinese citizenship;
the Chinese government and its subordinate departments or agencies; and
a Domestic Enterprise under the control of the persons or entities mentioned in the above points.
If a Chinese Investor controls a foreign investor, which in turn invests in China in a restricted category, such foreign investor can file an application to MOFCOM for recognizing its investment in China ("Round Trip Investment") as being an investment actually made by Chinese Investors. This application is to be filed together with the application for the entry permit in the restricted category. MOFCOM (or its provincial counterparts) will determine whether to recognise such investment as a "Round Trip Investment" and therefore grant the entry permit.
However, if an individual holding Chinese citizenship has obtained an overseas citizenship (which would normally require such Chinese individual to abandon his Chinese citizenship as dual nationality is not possible under PRC laws), his/her investment in China will be regarded as that of a foreign investor and the provisions regarding foreign investment will apply.
Impact on VIE Structures
VIE structures have been widely adopted in certain sectors (and in particular in the context of overseas listing) to circumvent restrictions on foreign investment in some restricted/prohibited sectors in China under the current foreign investment catalogue and other regulations (e.g. the telecommunication, internet, education and healthcare, etc.).
The Draft contains provisions that are aimed at dealing with two different VIE scenarios, namely:
VIE Structures + Round Trip Investment
If a Domestic Enterprise involved in a VIE structure is controlled by a foreign investor, which is in turn actually/ultimately controlled by a Chinese Investor, the investment in the Domestic Enterprise is a VIE structure coupled with a Round Trip Investment. As mentioned above, a Round Trip Investment can be treated as investment by Chinese Investors subject to its recognition by MOFCOM. In that case, the VIE structure can be regarded as a legal arrangement even if the Domestic Enterprise falls into the restricted category.
VIE Structures without Round Trip Investment
If a Domestic Enterprise under a VIE structure is actually/ultimately controlled by a foreign investor and such Domestic Enterprise falls into the restricted category, such VIE structure will be illegal if the investment in the Domestic Enterprise does not obtain the entry permit.
Complaints Coordination and Handling
A national complaints coordination and handling centre will be established, which will be responsible for coordination and handling of disputes and complaints between foreign investors and Foreign Invested Enterprises on the one hand and Chinese governmental authorities on the other hand in relation to foreign investment in China. Local governments may also set up their complaints coordination and handling centres to deal with local claims and disputes. This mechanism aims to offer, as one of the measures to promote and protect investment, a channel for foreign investors to resolve their disputes with Chinese governmental agencies with respect to their investment in China. The Draft does not address whether this new complainst coordination and handling mechanism is a compulsory requirement before foreign investors can file a petition for administrative review or litigation, which are the existing options available to foreign investors - under the current legal regime - to resolve their disputes with Chinese governmental agencies. However, it is understood that this mechanism does not apply to the resolution of disputes among foreign investors, or between a foreign investor and its Chinese partners or Domestic Enterprises, or to other disputes to which Chinese governmental agencies are not a party. In these latter cases, foreign investors will be able to continue to use courts or arbitration bodies to resolve their disputes.
Impact on Other Regulations
Whilst the implications of the Draft on other regulations are yet to be fully assessed, two major areas of law are expected to require significant changes:
As the Draft contains an expanded definition of "foreign investment" and "foreign investors" and introduces a new information report mechanism for foreign investment, it is expected that several existing foreign exchange regulations will need to be amended.
With the intended generalisation of national treatment rules to all foreign investors, it is expected that the existing preferential tax treatments applicable to certain foreign invested enterprises (e.g. exemption of customs duties and value-added tax applicable in certain sectors under the encouraged category) will be significantly revamped or possibly cancelled.
The Draft provides that, within three years after entry into force of the future PRC Foreign Investment Law, all existing foreign invested enterprises will have to make the necessary changes to their corporate forms and corporate governance structures in order to adopt the requirements set forth under (as applicable) the PRC Company Law, PRC Partnership Law, PRC Law on Enterprises Wholly Owned by Individuals and other applicable PRC laws and regulations. This is expected to bring about substantial changes to the corporate forms and corporate governance structures of all existing wholly foreign owned enterprises, Sino-foreign equity joint ventures and Sino-foreign cooperative joint ventures.
Whilst the timing of the entry into force of the future PRC Foreign Investment Law remains unclear, foreign investors would be well advised to start taking into consideration the provisions of the Draft in the structuring and negotiations of their upcoming projects, and perhaps assess the possible adjustments that will be required to their existing foreign investments in anticipation of the work that will be required during the three-year transition period.
 The existing review is regulated by the Regulations of MOFCOM on the Implementation of the Security Review System for Merger with and Acquisition of Domestic Enterprises by Foreign Investors, and currently undertaken by MOFCOM.
 VIE structures have been adopted by certain investors in industries of China where foreign investment is banned or restricted ("prohibited/restricted industries"). Under a typical VIE structure in China, a company held by Chinese citizens (the "VIE Co") is set up in China to conduct business in the prohibited/restricted industries, with capital contribution made by the Chinese citizens to the company coming directly or indirectly from the foreign investors. The foreign investors (the "Controlling Party") sign a set of "controlling" agreements with the Chinese citizens, under which the Chinese citizens acknowledge that they actually hold the equity of the VIE Co on behalf of the Controlling Party. In some occasions, the "controlling" agreements will also include service contracts, consultancy contracts or trademark license contracts, etc. between the Controlling Party and the VIE Co under which almost all revenues of the VIE Co are paid to the Controlling Party as service fees or royalties.