On 1 January 2020, the new Foreign Investment Law of China (FIL) and its implementation regulations came into effect, which overhauled the decades old regime for foreign invested enterprises (FIEs) in China. The new regime will have a profound impact on foreign investment in China. In this e-bulletin we highlight the key areas of the FIL and the implementation regulations and analyse the practical implications of these for foreign investors in China.
Highlights of the new FIL and the implementation regulations
Negative list and national treatment
China adopts a negative list regime restricting foreign investment in sectors listed in the negative list. According to the latest 2019 negative list jointly published by the National Development and Reform Commission (NDRC) and the Ministry of Commerce (MOFCOM), there are 40 sectors with restrictions on foreign investment, including media, telecommunications, education and medical institutions. Recently the Chinese government has announced that the negative list will be shortened further in 2020, in particular to open up services sectors such as financial services, medical institutions, telecommunications and education. For industries outside the negative list, foreign investors will receive national treatment, meaning that they will be subject to the same qualifications and requirements as applied to a Chinese investor.
In addition, the NDRC and MOFCOM have also jointly published an encouraged industry catalogue (the latest version being the 2019 version) which lists sectors encouraged for foreign investment in specific provinces, especially in the western regions of China.
According to the FIL and the implementation regulations, if a local government makes promises to foreign investors on any preferential treatment, or enters into any contracts with foreign investors, the local government must honour those promises, notwithstanding any adjustments to the administrative region or government function, or government elections or staff changes. Where the local government has to modify those promises due to national or public interest concerns, it must follow the specified legal procedures and pay fair and reasonable compensation to the foreign investors who suffer losses as a result.
Streamlined process for FIE approval and registration
Under the old foreign investment regime, foreign investors wishing to invest in a sector listed in the negative list were required to first obtain approval from MOFCOM. This MOFCOM approval regime has been repealed by the FIL and the implementation regulations.
The implementation regulations provide that the competent authorities are responsible for reviewing whether a foreign investment project falls under the negative list and meets the relevant requirements, such as any restriction on foreign shareholding ratio. On 31 December 2019, the State Administration for Market Regulation (SAMR) issued a notice clarifying that it will review whether a foreign investment project falls under the negative list and meets the relevant requirements when it reviews an application for registration. However, where a foreign investment project is subject to pre-approval by a sector-specific regulator under sector-specific regulations (such as those for the banking, telecommunications and education sectors), the relevant sector-specific regulator will be responsible for the review rather than SAMR. MOFCOM approval will, therefore, no longer be required for foreign investment projects falling under the negative list. Based on our enquiries with a number of local MOFCOM branches, this streamlined process has been implemented since 1 January 2020.
While streamlining the FIE approval and registration process is a welcome change, we expect that it will take time for SAMR and the sector-specific regulators to get themselves familiar with handling foreign investment projects, given that MOFCOM has been the centre for FIE administration for decades. It is also likely that SAMR and the sector-specific regulators will take a more cautious approach at least in a transitional period. Foreign investors should be prepared that during the transitional period, there may be procedural uncertainties at the execution level at the local branches of SAMR and sector-specific regulators, which may prolong the registration timetables for foreign investment projects.
MOFCOM information reporting regime
Under the old foreign investment regime, foreign investment falling outside the scope of the negative list was required to go through a record-filing process with MOFCOM.
The FIL introduces a foreign investment information reporting regime which replaces the old regime. Foreign investors and FIEs must now report investment information to MOFCOM through the Enterprise Online Registration System and China’s National Enterprise Credit Information Publicity System (each administered by SAMR). The content, scope and frequency of such reporting are determined by MOFCOM and SAMR on the basis of actual needs and in the spirit of minimising the burden on foreign investors and FIEs.
In connection with the above, MOFCOM and SAMR have released new measures setting out the detailed procedures and requirements for such information reporting, including:
- Foreign investors and FIEs will need to make online reports through the Enterprise Online Registration System upon establishment and when there is any change to the reported information. FIEs are also required to submit an annual report through China’s National Enterprise Credit Information Publicity System, to be filed between 1 January and 30 June each year.
- The information submitted will be shared by SAMR with MOFCOM and other governmental bodies.
- MOFCOM will name and shame those foreign investors and FIEs which have non-compliance records on its Foreign Investment Information Reporting System.
The information to be reported under the new regime is largely the same as that previously required under the MOFCOM record-filing regime, including the basic information on the FIE, its investors and ultimate controlling shareholder(s). The good news is that the implementation regulations require the different authorities (such as SAMR and MOFCOM) to share information among themselves to avoid repeated information requests and ease the administrative burden on foreign investors and FIEs.
VIE and round-trip issue
The Variable Interest Entity (VIE) model has been used in China for decades. Simply put, this model uses contractual arrangements (rather than equity ownership) to control operating entities in China, notably in sectors where foreign investment is prohibited or restricted, so that the Chinese founders will be able to raise offshore funds or achieve a listing offshore. In connection with the VIE model, Chinese founders would usually use a round-trip investment structure, by setting up an offshore holding company which will invest back into China. Despite the popularity of the VIE model, the PRC government has never officially recognised its legality or passed any laws to regulate it (except in a few specific sectors).
The round-trip issue was touched upon in the draft version of the implementation regulations released for public comment in November 2019. The draft provided that if a foreign investment is made by an offshore entity which is wholly owned by Chinese individuals or entities, then subject to approval by the State Council such investment may be exempt from the restrictions under the negative list. The draft clause was widely commented on as being an attempt by the Chinese government to tackle the VIE and round-trip issue. However, due to the controversy around the VIE and round-trip issue, the exemption was eventually deleted from the final version of the implementation regulations.
It is likely that the Chinese government is only deferring the regulation of VIEs. The FIL makes it clear that the foreign investment covered by the FIL includes both direct and indirect investment, which leaves room for the government to regulate VIEs (as a form of indirect foreign investment) in the future.
Conversion of existing FIEs
The existing corporate governance structure of FIEs is based on decades old FIE laws which have become increasingly inconsistent with the PRC Company Law. For example, under the law on Sino-foreign joint ventures, the board of directors of a Sino-foreign joint venture functions as its highest authority with board seats allocated in proportion to each joint venture partner’s capital contribution and certain fundamental matters (such as amending the articles of association, changing the registered capital, mergers or dissolutions) requiring unanimous board approval. However, under the PRC Company Law, the highest authority for a company is its shareholders’ meeting with certain fundamental matters requiring the approval of more than two-thirds of the voting rights.
The FIL requires that within a five-year transitional period, existing FIEs shall reform their corporate governance structures (including decision-making mechanism, voting, quorum and management nomination) to comply with the PRC Company Law requirements. The implementation regulations further provide that, after the expiry of such five-year transitional period (i.e., 1 January 2025), if an FIE fails to convert its corporate governance structures, SAMR will reject any other registrations by the FIE and will publicise the non-compliance in China’s National Enterprise Credit Information Publicity System.
We expect that converting existing FIEs to comply with the PRC Company Law requirements is likely to present a major challenge to foreign investors with joint ventures in China. While the FIL will have limited impact on the corporate governance of wholly foreign-owned enterprises (as their organisational form and corporate structure have been governed by the PRC Company Law since 2006), it will have a major impact on existing joint ventures. Converting the corporate governance structure of a joint venture will involve changes to, among other things, the decision-making mechanism, voting, quorum and management nomination provisions, which will likely open the door for joint venture partners to seek to renegotiate and could have a major impact on the dynamics of their relationship. Joint venture partners should evaluate their positions in the joint venture and get themselves ready for the changing landscape.
Under the current regime, there are a few special types of FIEs, including foreign invested partnership enterprises, foreign invested joint stock companies and investment companies established by foreign investors. These are regulated under separate regulations, which may not be entirely consistent with the new regulatory regime. According to a recently issued MOFCOM notice, the regulations on foreign invested joint stock companies were abolished on 1 January 2020. However, it is unclear what transitional measures (if any) will apply to existing foreign invested joint stock companies and whether the special regulations which apply to other types of special FIEs will also be repealed or amended to reflect the FIL requirements. For foreign investors who have established these special types of FIEs in China, you should keep a close eye on the legislative developments, and be prepared for possible changes in the near future.
Practical implications for foreign investments in China and our observations
The FIL together with the implementation regulations and supporting rules demonstrate China’s determination and efforts to level the playing field for foreign investors and attract more foreign investment. To this end, the State Administration of Foreign Exchange (SAFE) has also recently issued rules to liberalise the foreign exchange control regime, which will offer more alternative investment and funding options for foreign investment in China (see our e-bulletin China liberalises its foreign exchange control rules for foreign investment and cross-border trade).
All these will have a profound impact on foreign investors’ future investment strategies and structures in China. It is crucial for foreign investors to review their China business, assess the practical implications and get prepared for the new era. We would be happy to work with you to ensure a smooth transition of your China business to the new regime. We can help by:
providing bespoke training sessions to legal and business teams on the implications of the new regime to your China business;
advising on the overall strategy and execution plan for FIE conversion;
using standardised process and technology driven solutions to help review, amend and populate documents to assist with the FIE conversion;
assisting with your discussions with your JV partners during the FIE conversion process; and
advising on M&A and investment strategy and deal structuring options under the new regime.
Finally, in the short term we expect a flurry of more new rules and regulations in the first half of 2020 to implement the FIL and to repeal the old legal regime. During this transitional period, we expect uncertainties and inconsistency of practices among various local government authorities (including local MOFCOM, SAMR, SAFE and the banks) under the new regulatory regime. Foreign investors should be prepared for potential disruption or delay to their China projects during this period.