Big bang in China?


On 19 January 2015, the Chinese Ministry of Commerce (MOFCOM) published the draft Foreign Investment Law (the FI Law) for the purpose of soliciting public comments until 17 February 2015 (the Draft). 

As currently drafted, the proposed FI Law would significantly modernise the existing regime governing foreign investment and foreign invested companies in China. It would also broaden the definition of regulated foreign investment activities, notably to cover indirect changes of control of PRC companies as well as so-called variable interest entity (VIE) structures.


  • Unified foreign investment regime. All forms of foreign investment, direct and indirect (including through companies, partnerships and contract) would be subject to unified regulation under the FI Law, which would replace the separate laws currently governing different types of foreign-invested vehicles.
  •  National treatment. Separate (and generally restrictive) rules relating to the incorporation and governance of foreign-invested companies would be eliminated. Except for requiring market access approvals for foreign investments which are restricted as shown on the “Negative List” (see below), and special reporting requirements, foreign-invested companies would be established and operated in accordance with the PRC Company Law and would otherwise be treated the same as other PRC-incorporated companies.
  •  Grandfathering. In line with the principle of “national treatment”, the Draft gives pre-existing foreign-invested companies (FIEs) a grace period of three years to bring their governance structures in line with the PRC Company Law. However, any FIE that applies for an extension to its operating term within the three-year grace period will be required to complete its conversion upon the extension. To the extent any such FIE is in the form of a joint venture, it remains to be seen whether such conversion to the governance structures under the PRC Company Law will require a renegotiation of the terms of the existing joint venture agreement.
  • Pre-existing FIEs that fall within the “Negative List” (see below) would be allowed to continue their operations within their existing business scope and operating term. However, if a pre-existing FIE intends to revise its business scope or increase its investment amount to include a sector or exceed the threshold set out in the “Negative List”, it would need to apply for market access approval.
  • “Negative List”. Unlike the current system, under which prior MOFCOM approval is required for the establishment of any FIE, the FI Law would grant free market access to foreign investors unless the proposed investment exceeds the monetary threshold, or is in a sector, specified in the “Negative List”. Foreign investment approval would no longer be necessary for foreign investment which does not fall within the “Negative List”. For such investments, the investor may directly proceed to register the business with the competent Administration for Industry and Commerce (AIC), Administration of Foreign Exchange (SAFE) and Tax Bureau. 

    The “Negative List” is not included in the Draft, which contemplates that it will be published by the State Council at a later stage. It is expected to list industrial sectors in two categories: (i) the “prohibited” category in which foreign investment is completely prohibited and (ii) the “restricted” category in which foreign investment will be subject to various restrictions. Market access approval would be required for any foreign investment in a restricted sector. The Negative List is also expected to set out a monetary threshold over which investments would require market access approval regardless of sector. In accordance with the principle of “national treatment”, the Draft emphasizes that prohibitions and restrictions (rendering less favourable treatment to foreign investors compared with domestic investors) should only be imposed by laws, regulations and decisions of the State Council, and that hurdles imposed by other authorities at central and local levels should be lifted. 

    We are hopeful that the “Negative List” will take into consideration all market access commitments previously made by the PRC government (including its WTO commitments) and deliver on its promise of market opening. However, it is currently unclear how the “Negative List” under the FI Law will co-exist alongside (or possibly replace) the Foreign Investment Guidance Catalogue administered by the National Development and Reform Commission (the NDRC), an updated draft version of which was just circulated for comments in November 2014. It is also not clear how the “Negative List” under the FI Law will compare, as to its scope, with the negative list that currently applies to investments made in the Shanghai Free Trade Zone (the SFTZ) (see below), whose scope was recently reduced.

  • Extra-territorial effect. The Draft states that any transaction outside China which results in a change of control of a Chinese entity will be deemed to be a foreign investment in China. If the Draft is implemented in its current form, offshore transactions involving a direct or indirect change of control of a Chinese entity whose operations fall within the “Negative List” will trigger a foreign investment approval requirement in China. This is a significant change from the current position where only a direct change of control of a PRC entity requires MOFCOM approval.
  • Governing Law. In line with the Draft’s extra-territorial reach, the Draft also provides that investment contracts entered into by foreign investors which will be performed in China must be governed by PRC law. Depending on how broadly the terms “investment contract” and performance in China are interpreted, this may expand the list of types of contracts required to be governed by PRC law. 
  • Commercial flexibility. The current system under which MOFCOM approval is required for joint venture contracts, articles of association and equity transfer or share purchase agreements would be eliminated. MOFCOM (including its relevant local counterparts where appropriate) would grant market access approval based on application reports (which currently include information on the investors and the proposed project) as well as relevant supporting documents, the current list of which does not include transaction agreements. In a separate explanatory note in relation to the Draft, MOFCOM states that it would not scrutinize the underlying agreements (e.g. joint venture contracts, articles of association, equity transfer agreements, etc.). This may give foreign investors more flexibility to negotiate commercial terms of their investments in China (including closing conditions, price adjustment, holdback mechanisms etc.).
  • Conditional approvals. The Draft grants MOFCOM significant discretionary power in relation to restricted investments by allowing it to grant conditional approvals. Conditions listed in the Draft include divestment of assets or businesses, restrictions on shareholding percentages, limits on operating terms and geographic areas, and requirements for local employment. These conditions are similar to the types of conditions that can be imposed on certain transactions subject to the PRC merger control review which is also under MOFCOM’s jurisdiction.
  • Reporting obligations. The Draft includes comprehensive reporting obligations (both ad hoc / event-related and periodical) applicable to foreign-invested companies and, in some cases, foreign investors directly. This is consistent with the trend to introduce periodic reporting to replace the system of annual inspections (which in the case of FIEs included until recently joint inspections by AIC, MOFCOM and SAFE).
  • National security review. The Draft also proposes to incorporate into the unified FI Law China’s national security review regime under which foreign investments are scrutinized on their potential harm to national security. This review is separate and in addition to the foreign investment approval regime. Under existing regulations, the national security review regime prohibits investments in the military sector, in enterprises located near military facilities and in key domestic enterprises in sensitive sectors such as agriculture, energy and resources and infrastructure. It is still unclear which areas and industries would be affected by the national security review regime under the FI Law. The Draft also makes it clear that the government’s actions and decisions in relation to the new national security review will have judicial immunity and will therefore not be reviewable by the courts or otherwise.

Impact on VIE structures

  • Under the Draft, the definition of “foreign investment” now expressly includes control by other means in addition to equity ownership. Therefore, de facto control by foreign nationals or entities over a PRC company whose equity is 100% Chinese-owned would under the Draft be treated as a foreign investment. This proposed expanded definition of foreign investment could have a severe impact on VIEs - domestic companies whose shares are nominally held by Chinese nationals or entities, but are de facto controlled by foreign nationals or entities through contractual arrangements. The controlling foreign entity could itself be controlled by Chinese and/or foreign investors and may be listed on a stock exchange outside China. VIEs have historically been used to enable foreign investment in prohibited or restricted sectors under the Foreign Investment Guidance Catalogue, such as value-added telecommunications.
  • The Draft expressly states that any investment within the “prohibited” category of the Negative List made through a VIE structure will be viewed as a prohibited foreign investment. Potential legal consequences of a foreign investment within the “prohibited” category include: 
    • an order to cease business;
    • an order to dispose of the shares or assets;
    • confiscation of illegal earnings; and/or
    • a fine of between RMB 100,000 and RMB 1 million or up to 10% of the illegal investment.
  • The Draft leaves a placeholder on how pre-existing VIEs will be treated. In an explanatory note published by MOFCOM together with the Draft, MOFCOM acknowledges that there have been different views on how pre-existing VIEs should be treated, namely:
    • Notification. Any pre-existing VIE controlled by “Chinese investors” would be allowed to continue to operate its business under the VIE structure after it notifies MOFCOM of the VIE structure.
    • Notification and confirmation. As with the first option, this involves a notification to MOFCOM, but the VIE would only be able to continue to operate its business under the VIE structure after the Approval Authorities confirm that the business is controlled by “Chinese investors”.
    • Approval. All pre-existing VIEs would need to seek foreign investment approval and the Approval Authorities would give (or withhold) their approval based on all relevant facts including the identity of the de facto controller of the VIE.
  • Based on the above, the underlying assumption seems to be that a VIE ultimately controlled by a Chinese person would be allowed to continue by being deemed to be a domestic entity and falling outside of the FI Law (which is likely to give to some comfort to China’s foreign-listed technology businesses), but that otherwise the authorities plan to close the loophole. This is particularly alarming to those foreign investors who control, through a VIE structure, a business in China which is in a sector on the “Negative List”. The explanatory note asks for public comments on this particular issue to help MOFCOM decide on the details.
  • In this context, it is worth noting that China has recently allowed foreign investors to own 100% of the equity of companies operating e-commerce businesses in the SFTZ as part of a pilot scheme. Currently, foreign investment in the e-commerce sector outside of the SFTZ is only possible with a PRC joint-venture partner. Under the new SFTZ pilot scheme, e-commerce businesses currently structured by way of VIEs could technically be moved to the SFTZ and then be transformed into WFOEs. If this could be efficiently implemented and operated in practice within the SFTZ, it could offer a solution for legalising current VIE structures in the e-commerce sector.

Conclusion and outlook

MOFCOM has made clear its intention to modernise China’s foreign investment regulations and provide greater clarity to foreign investors. If the Draft is implemented in its current form, it will make foreign investment into China more akin to foreign investment in other mature markets where the focus is on substance rather than form of investment.

For pre-existing VIEs controlled by foreign investors, the potential impact of the proposed FI Law may be quite severe. However, MOFCOM has made it clear that it is keen to receive suggestions on how it should deal with existing VIEs. Grandfathering them all does not look like a realistic option, but it is also not clear that MOFCOM is necessarily ready to force all pre-existing VIEs controlled by foreign investors to be unwound. We are ready to help our clients formulate suggestions on how to deal with pre-existing VIEs and submit those suggestions – on a no-names basis – to MOFCOM within the consultation period.

It will likely take several rounds of consultations between different ministries and interest groups, and perhaps multiple further drafts, before the FI Law is finalised and comes into effect. In addition, important details which foreign investors need to assess the real impact of the FI Law on their PRC activities, such as the scope of the “Negative List” (including threshold amounts as well as restricted and prohibited sectors) and the interaction of the “Negative List” under the FI Law with the NDRC’s Foreign Investment Guidance Catalogue, still need to be provided.