The news that China and US will likely reach a phase one agreement offered some relief (at least temporarily) to the world economy.
China seems determined to engage in further reform of its economy and part of this is to further open up to foreign investment.
On 1 November 2019, the Ministry of Justice released the Implementing Regulations for the Foreign Investment Law of the People’s Republic of China (Draft for Comment) (“Draft Regulations”) which were jointly drafted by the Ministry of Commerce (MOFCOM) and the National Development and Reform Commission.
The Draft Regulations clarify the PRC Foreign Investment Law (FIL) which will come into force on 1 January 2020.
In addition to the Draft Regulations, China’s foreign exchange control authority have also relaxed foreign exchange restrictions on foreign investment enterprises (FIEs). This should allow foreign investors greater freedom as to how they use their capital funds in China.
This article will highlight the main takeaways in the Draft Regulations as well as likely beneficial affects that will be brought about by the foreign exchange controls relaxation.
Highlights of the Draft Regulations
Sino-foreign JV can be formed with a Chinese natural person – Under the current China’s foreign investment law regime, with few exceptions, a Chinese natural person is not permitted to directly set up Sino-foreign joint ventures with foreign investors. As a result, many Chinese individuals need to set up an entity to use as an investment vehicle for a joint venture. Foreign investors have found in some cases such indirect relationship to be sub-optimal as they would prefer to have a direct relationship with their Chinese partner.
While a Chinese natural person can be a shareholder of a Sino-foreign joint venture as a result of merger and acquisition, such shareholder relationship needs to be approved by the authority.
The Draft Regulations now make it clear that foreign investors can invest jointly with Chinese natural persons.
Although this will offer some additional flexibility for both Chinese individuals and foreign investors to structure their shareholding arrangements it is unlikely to have a great impact in practice. We assume that vast majority of Chinese partners will continue to be corporate in nature.
Investment Protection – Intellectual Property protection is a key issue in the US and China trade negotiations. However, IP concerns on the part of foreign investors in China pre-date the recent trade tensions.
The FIL stresses that China will protect the intellectual property rights of foreign investors and FIEs alike. The Draft Regulations specify that China will establish a punitive compensation system to deal with infringements of intellectual property rights. China’s Trademark Law and the draft amendments to the Patent Law have all been updated to introduce punitive compensation measures. Many foreign companies will adopt a wait and see approach to see if the practical implementation matches the regulatory changes. Many would say that China’s intellectual property issues are not due to the laws but rather their enforcement. Although China’s current intellectual property protection landscape is better than the perception of most foreign businesses there is still little doubt that there is room for improvement.
A common issue raised in the past was how the Chinese authorities forced foreign companies to transfer technology to China in order to gain market access. Localization requirements span sectors from automotive to rail to aerospace. The Draft Regulations set out that Chinese government departments and their personnel shall not force, directly or indirectly, technologies transfer as part of an investment project.
The Draft Regulations also restrict Chinese government authorities and their personnel from accessing trade secrets of foreign investors or FIEs. Government departments will need to establish effective measures to protect trade secrets they obtain in the course of performing their duties and are prohibited from disclosing information containing trade secrets. Although welcome this is unlikely to be a pressing concern for many foreign investors.
Investment Management – In terms of restricted area in China’s negative list of foreign investment, the Draft Regulations state that foreign investors shall meet the restrictive requirements on shareholding ratio, senior management and other requirements as specified in the negative list.
The Draft Regulations extend the requirements on shareholding ratio in restricted area to partnership by requiring that the voting ratio of the foreign investor in the partnership agreement shall meet the restrictive provisions of shareholding ratio set forth in China’s negative list of foreign investment. Under the current negative list, a foreign invested partnership is not allowed to be established in sectors that set a maximum on the shareholding ratio of a foreign investor.
The Draft Regulations appear to be intended to relax the requirements on foreign investment partnership. However, time will tell whether such requirements can be applied to a limited partnership in which voting rights are not determined merely by the shareholding ratio between partners.
Regulatory regime change – For many years, MOFCOM or its local divisions have been the approval authority for green field investment and merger and acquisition projects, and the State Administration of Industry and Commerce (now the State Administration of Market Regulation (SAMR) ) or its local divisions have been the registration authority for the FIEs.
Starting from the pilot scheme in 2013 at the Shanghai Free Trade Zone, the Chinese government has been implementing a different approach towards foreign investors. Namely moving from a catalogue which sets out comprehensively how foreign investment is treated in specific sectors to a “pre-establishment national treatment with negative list”. Basically the negative list sets out only sectors that are restricted or off limits.
The negative list approach was introduced nationally by the publication of Provisional Measures on Administration of Filing for Establishment and Change of Foreign Investment Enterprises (the “Provisional Measures”) by the MOFCOM on October 8, 2016. According to the Provisional Measures foreign investment not falling within the scope of the negative list would only require a filing and not an approval.
It seems the Draft Regulations provides that the SAMR will take over all “approval” and “filing” roles for foreign investment including the incorporation or changes in registration (whether included on the negative list or not). This approach seems to have been confirmed in the draft Guidelines on Better Handling Foreign Investment Enterprises Registration that was issued by SAMR on 6 November 2019. 
VIE remain largely safe – One of the breakthroughs under the Draft Regulations is that a VIE structure may not be needed for Chinese investors’ round-trip investment arrangement in the circumstance where a Chinese investor (i.e. a Chinese individual, company or other organization) uses its wholly-owned enterprise established outside China to facilitate round-trip investments into China and approval is obtained from the State Council for the exemption of application of negative list. In other words, the Draft Regulations treat such round-trip investment (not all round-trip investment) as domestic investment and therefore restrictions or prohibitions set out in the negative list for foreign investment will not apply.
Notably, and consistent with the terms of the FIL, the Draft Regulations do not question the legality of VIE structures established in China by foreign investors which wish to circumvent restrictions on their investments. More details with regard to the necessity and application of VIE arrangement can be referred to our previous article at China: VIEs Alive and Well.
Unresolved issues – The Draft Regulations provide working guidelines ahead of the FIL’s coming into effect in January 2020. However, much remains unclear or unresolved. An example includes the treatment of FIEs’ reinvestments in China – neither the FIL nor the Draft Regulations provide a clear definition whether such reinvestment should be treated as foreign investment or domestic investment. Another example involves how many foreign investment related regulations will remain in force or be amended or repealed after the FIL and Draft Regulations come into effect.
Foreign exchange relaxation
Foreign exchange depletion has been a major concern for the Chinese government in recent years.
The new regulations finally show some good news on this front as China inches towards relaxing (slightly) its foreign exchange controls.
Coupled with free inbound and outbound capital remittance promise made by FIL and the Draft Regulations, measures have been recently announced by the State Administration of Foreign Exchange (SAFE) to facilitate foreign investment and cross-border transactions.
Restrictions on foreign exchange transfers has been always a grave concern for foreign investors. A few years ago the already restrictive regulations were tighten by additional practical policies such as requiring banks to balance their foreign exchange which complicated transfers or setting caps on transfers or requiring payments to be made in tranches. The complications were (and are) especially frustrating for foreign investors trying to exit their China projects.
The FIL is unequivocal in advocating free inbound and outbound capital remittance, stipulating that the capital contributions, profits, capital gains, income from the disposal of assets, royalties of intellectual property rights, compensation or indemnity lawfully obtained, liquidation income and other income of foreign investors within the territory of China shall be freely remitted into or out of China in CNY or foreign currencies in accordance with the law.
The Draft Regulations reiterate and further clarifies that it is illegal to impose restrictions on the currency, amount or frequency of inbound and outbound capital remittance so as to provide clear legal grounds for FIEs to challenge if the capital remittance process is hindered by relevant authorities. It also specify that legitimate income earned by foreign employees of FIEs shall be freely remitted abroad in accordance with the law after tax has been paid under China’s tax laws and administrative regulations.
Historically the capital account of FIEs have been much more strictly controlled than the current account. One frustration for FIEs (except for foreign invested holding companies) has been the prohibition on using funds on the capital account from being used for domestic equity investments.
As FIEs have matured in the China market and have become large enterprises in their own right it has been a source of frustration that financing on-shore China M&A project is complicated and ties up fresh capital even though there may be funds available that just sit idly in the buyer’s capital account.
Following by the introduction of discretionary settlement system, the SAFE opened a window for FIEs to use its capital funds to make equity investment within its business scope. At the same time, it still shut the door to 99% of FIEs whose business scope does not include “investment”.
On 23 October 2019, the SAFE has released the Notice on Further Facilitating Cross-Border Trade and Investment (“2019 SAFE Notice”), where all the FIEs, whatever their business scope are able to use capital funds for equity investment purposes, provided that the investment project is authentic and complies with the foreign investment negative list.
The Draft Regulations coupled with a slew of regulations in respect of foreign exchange are largely positive for foreign investors looking at or already in China. Indeed, in theory, the relaxation in respect of foreign exchange remittance may be helpful for foreign investors looking to leave China. The relative slowdown in China coupled with over ambitious expansion plans in the early 2000s means that many foreign investors have excess capacity which they need to reduce. The provisions should ease the transfer of funds overseas.
However, the operative word is “should”. There is a lot positives in the Draft Regulations – more level playing field; better IP protection; great ease in transmitting funds overseas; tacit acknowledgement of the VIE structure etc. However, the main issue is whether the actual implementation on the ground will match the ambition of the regulations. Most decisions are made locally – it is unclear whether the local authorities will support the greater flexibility afforded under the Draft Regulations or will they continue in their old ways. Time will tell.