China’s Ministry of Commerce (MOFCOM) has published a draft of theForeign Investment Law (the Draft FIL) that will see a major shake-up of the country’s foreign investment regime on 19 January 2015. Public consultation for the draft law will open until 17 February. This draft law, once issued, will replace the current legal scheme regulating foreign investments in China and will have major implications for overseas investors looking to continue, expand, or begin operations in China.

Overall, the Draft FIL will grant foreign investors better and easier access to Chinese markets. However, for industries that are deemed to have national security implications, the government will impose further scrutiny.

We urge investors to review the following key points under the new draft law.

Liberalization of Market Entry

Under the current legal regime, any foreign investment into China is subject to governmental approval on a case-by-case basis (with the exception of the Shanghai Free Trade Zone).

The Draft FIL will liberalize the system so that overseas investors are not required to go through the Chinese governmental approval process. In turn, a new “Negative List” regime has been introduced, similar to the “Negative List” regime under the Shanghai Free Trade Zone. Investors will only need to seek governmental approval for investing in sectors which are classified as “restricted” on the “Negative List”.

Under the new regime, foreign investors can easily and quickly set up a business presence in China by making certain corporate secretarial filings. This will greatly simplify the process for foreign investors in setting up their business presence in China.

This provides a consistent national treatment for market entry and reflects a major step forward in liberalizing the Chinese market for overseas investors.

“Negative List”

The “Negative List” will specify two categories of industrial sectors: “prohibited” and “restricted”.

“Prohibited” category

Foreign investors are barred from investing in “prohibited” sectors, including any innovative methods such as through holding shares on behalf of nominees (“Dai Chi” in Chinese), trust, multiple-layered re-investment structures, leasing, contracting, financing arrangements, contractual control, or offshore deals. In the case of breaches, Article 149 specifically provides for administrative or criminal liabilities.  

This may have an impact on the adoption of the VIE structure (as further discussed under section 7 below).

“Restricted” category

For “restricted” sectors, the above rules apply unless pre-approvals are already obtained from the relevant authority. Otherwise, administrative or criminal liabilities may arise.

In addition, investment into “restricted” sectors will be evaluated based on the total investment amount and government approvals are only required for investments which exceed the maximum amount specified under the “Negative List”.

Under the new regime, the government will impose closer scrutiny on the total investment amount in two ways. First, all investments made in the same project will be calculated on a two-year cumulative basis. Thus the new rules will effectively prohibit large-scale investments from being split into smaller pieces to get round of approvals, as sometimes seen under the current regime. Second, financings with a one-year term or longer will be considered as part of the total investment amount. As a result, this will impact on structures which have previously sought investment by debt as an alternative.

Note that the draft “Negative List” remains to be published and it is expected to be released together with the final draft of the FIL.

Approval process

Approvals under the Draft FIL will focus on reviewing the following: the foreign investor; the actual controller of the entity; and the impact on national security, energy and resources, technological innovation, employment, environmental protection, production safety, and regional and sector developments. This differs from the current regime where the focus is on reviewing the internal corporate governance and decision-making mechanisms of foreign-invested enterprises.

Joint venture contracts and articles of association, which are heavily scrutinized under the current regime, will no longer need to seek approvals. Various transactional and investment agreements can have more commercial and flexible arrangements in the future. This will conceivably encourage more innovative ways of conducting business in China and create possibilities for foreign investors to participate in Chinese capital markets investments.

Scope of Foreign Investments

Under the current legal regime, foreign investment is primarily evaluated and estimated based on equity investment. Under the Draft FIL, foreign investments broadly include not only greenfield investments and acquisitions of shares or interests but also shareholder loans with a one-year term or longer, acquisitions of mining rights and concessions of public utilities, acquisitions of real estate assets; and obtaining controlling rights or interests by way of contractual arrangements or trust.

Such comprehensive scope may enable the Draft FIL to supersede the current law relating to mergers and acquisitions by foreign investors, e.g. the Provisions on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (the No. 10 Rules).

Definition of Foreign Investors

The Draft FIL provides that foreign investors will be evaluated based on “who is in control” rather than the prevailing regime of “who owns the equity”.

This means that a Chinese domestic company which is controlled by a foreign investor will be considered as a foreign investor; but on the other hand, the investment into China by a non-Chinese entity based outside China but “controlled” by a Chinese person may be considered as an investment by a Chinese investor.

It is worth noting that the Draft FIL may have extraterritorial effects. E.g. Article 15 provides that a foreign investor shall be considered to be investing into China if an offshore transaction results in the transfer of the actual control of a Chinese domestic entity to the foreign investor.

Such changes will have significant implications for investors when considering structuring their cross-border M&A transactions.

National Security Review

Under the new rules, where the Chinese authorities consider that a foreign investment presents a national security risk, they have the power to request that the foreign investor makes a national security review application. Detailed guidance has not yet been issued on what standards or criteria should be followed in determining whether a specific foreign investment has national security concerns.

Any final decision made on the national security review shall be immune from any judicial or administrative review.

Variable-Interest Entity (VIE) structure

The VIE structure has been widely adopted by foreign investors when making investments into certain sensitive industry sectors such as internet and telecoms, where overseas investors face regulatory barriers in China. This has been a popular structure for a number of US- and Hong Kong-listed PRC companies to attract international private equity investors. According to the market practice in this field, the VIE structure allows for foreign entity to acquire actual control of a Chinese domestic entity via certain contractual arrangements. It has been recognized that the VIE structures bear certain legal risks but to date, the Chinese authorities have not taken rigorous enforcement actions.

However, once the new rules come into effect, a VIE structure that results in foreign investors investing in “prohibited” or “restricted” sectors without obtaining pre-approvals, will be considered illegitimate and will risk triggering administrative or even criminal liabilities.

It is yet to be established how this will affect already-established VIE structures, and particularly those that facilitate the initial public offerings of Chinese companies on offshore stock exchanges. It is unlikely that the authority will treat all of the established VIE structures as illegal but may choose how to treat them on a case-by-case basis.

Regular Reporting Requirement

Regardless of whether an industry falls within or outside the “Negative List”, all foreign investors will be obliged to make regular reports to the relevant Chinese authorities in relation to operations and financial performance of their entities in China. Administrative or criminal liabilities may arise for serious breach of reporting obligations.

The reporting obligations in terms of contents and timing seem to be unduly comprehensive. In particular, certain sensitive information is required to be reported, such as the identity of the actual controller and the source of the funds of the investment. It is not uncommon for international investors to adopt complicated multi-layered structures for the purpose of optimizing their tax position. This may create practical difficulties if it isn’t be desirable for them to identify the actual ultimate controller.

Next steps

In summary, the new foreign investment demonstrates the determination of the Chinese government to open its market to overseas investors by instilling two important principles in its framework: first, to provide foreign investors with consistent national treatment extended to pre-entry stage; and second, to adopt a licensing system for market entry on the basis of the “Negative List”.

The impact of the new FIL remains to be seen as its implementation will need to rely on the effectiveness of the implementing rules, in particular for areas relating to the “Negative List”, the scope of the reporting obligations, the VIE structure, and the criteria for national security review.

Upon the expiry of the consultation period in one month’s time, MOFCOM will review public opinion and make changes to the Draft FIL. The revised FIL will be submitted to the State Council for review and then to the Standing Committee of the National People’s Congress for final approval to become law.

Companies with investments in China are advised to review their current structure and operations in light of the proposed changes and consider what steps may be necessary to comply with the new regime.