Draft Foreign Investment Law open for comment until 17 February 2015

Practical Law UK Legal Update 9-596-4525 (Approx. 10 pages)

Draft Foreign Investment Law open for comment until 17 February 2015

by Practical Law China

Features of the draft

The Draft Law significantly changes the regime governing foreign investment into China that has been in place since the early 2000s:

The existing foreign investment laws that apply to FIEs (that is, the Wholly Foreign-owned Enterprise Law, the Sino-Foreign Equity Joint Venture Enterprise Law and the Sino-Foreign Co-operative Joint Venture Enterprise Law, collectively, the FIE Laws) will be repealed and replaced with a unified law regulating foreign investment into China. To the extent that the changes will have a negative impact on existing FIEs, some aspects of their current business and operations can be grandfathered (see Grandfathering protection for further details of this).
Foreign investors will no longer be subject to a different regulatory regime from domestic Chinese investors (that is, foreign investors will enjoy "national treatment"), except in certain industrial sectors that are specified on a negative list (see Negative list approach).
The model for government to manage foreign investment will shift from requiring FIEs to obtain prior approval, often via licenses from a range of governmental authorities, to a model of "limited licensing plus comprehensive reporting" (see Reporting obligations).
The scope of the national security review procedure for foreign investments will be expanded and decisions will explicitly receive immunity from judicial or administrative review (see National security review).

The stated intention of the Draft Law is to facilitate and protect investments with a view to creating a stable, transparent and predictable investment environment.

Negative list approach

The Draft Law introduces the concept that foreign investment in China will receive "national treatment" (that is, be regulated in the same way as domestic investment instead of under a separate and more restrictive regime). However, this welcome change will be subject to a "negative list" of industrial sectors to which national treatment will not apply (this may sound familiar to practitioners used to reading the foreign investment catalogues that China has published in the past).

The Draft Law does not contain a draft of the negative list, which will be promulgated and released by the State Council at a later stage.

The general rule is that industries appearing on the list are areas in which foreign investors will not be offered national treatment. Foreign investments in these areas will be prohibited outright or subject to specified restrictions and will continue to require prior approval from MOFCOM (or its local counterparts), as is the case under the current regime. For industries not appearing on the list, foreign investors will be able to establish a business the same way as domestic investors, that is, by applying directly to the country's business registration authorities.

The negative list will retain the concepts that exist under the existing regime of industrial sectors in which foreign investment is "restricted" or "prohibited".

In prohibited industries, no foreign investment in any form (including through any variable interest entity (VIE) structure or through any intermediary domestic company) will be allowed.

In restricted industries, foreign investment will require the investor to obtain an "entry license". The negative list will specify the limitations and conditions that will apply to obtaining such a license for each industrial sector. These may include:

A threshold amount for foreign investment into specific industrial sectors. Foreign investment by a particular investor exceeding such investment cap will require prior MOFCOM approval. The relevant threshold amounts will be set by the State Council. The Draft Law expressly prohibits foreign investors from splitting a large investment into smaller ones to circumvent the approval requirement. For example, if the cumulative investment amount by the same investor on the same investment projects or items within in two years reaches the approval threshold, MOFCOM approval will be required. Debt investments with a term of more than one year will also count towards ascertaining whether the investment from a particular investor has reached the approval threshold.
Specific conditions to investment in that industry sector, such as:
- divestiture of certain assets or business lines;
- limitation on the foreign-to-domestic shareholding ratio;
- specified term of operation;
- limitation on the geographical scope of the investment;
- local hiring ratio or hiring quantity requirements; or
- other conditions required by the State Council from time to time.

The negative list approach was first implemented in the China (Shanghai) Pilot Free Trade Zone (Shanghai FTZ) in October 2013. The Draft Law shows the government's determination to extend the reform nationwide.

Broad scope of "foreign investors" and "foreign investment"

Scope of "foreign investors"

The Draft Law defines foreign investors to include:

Individuals who are not Chinese citizens.
Any enterprise incorporated under foreign laws.
Any organ of a foreign government.
International institutions.
Any domestic entity which is controlled by any of these.

This means that any domestic entity controlled by a foreign entity, such as nominally independent domestic companies that are controlled contractually through the so-called VIE structure, will be classified as a foreign investor and its investment will be subject to the foreign investment restrictions set out in the negative list. Control for these purposes can be exercised by:

Directly or indirectly holding more than 50% of the shares, voting rights or similar equity interests of another entity.
Directly or indirectly holding the power to appoint or nominate more than half of the members of the board of directors or other corporate governance body of another entity.
Directly or indirectly holding a voting right which can direct the decisions of the corporate governance body of another entity.
By way of contractual or trust arrangements (such as VIE arrangements, for example).

Chinese laws previously focused on formal equity ownership or board appointment rights to the exclusion of indirect control methods. This introduction of the concept of the de facto investor, widely recognised in other jurisdictions such as the United States and United Kingdom, has significant implications for foreign investment, in particular for the widely used VIE structure. The VIE structure, in which a foreign company obtains contractual control of a domestic Chinese entity through a series of contracts with the entity and its domestic Chinese shareholders, is commonly used by foreign investors to invest in industry areas which would otherwise be subject to restrictions on foreign investment. To take an example from the industry in which they are most common (technology and telecommunications), the foreign shareholding in a value-added telecommunication business such as an online service provider is generally capped at 50% (except for the pilot reform implemented in the Shanghai FTZ) and the remaining 50% must be held by a domestic Chinese entity. The legality of VIE arrangements under current Chinese law is a grey area although many businesses use them, including many of China's most prominent internet companies. The Draft Law makes clear, for the first time, the possible legal consequences of foreign investment into prohibited areas through VIE structure, including:

An order to cease business.
Mandatory disposal of shares or assets.
Confiscation of illegal gains.
A fine of up to RMB1 million or 10% of the investment amount.
A sentence of imprisonment for up to one year or criminal detention for the responsible management personnel.

De facto domestic investors

If a foreign investor is ultimately controlled by domestic Chinese investors (that is a Chinese citizen, a branch of the Chinese government or any domestic entity that is directly or indirectly controlled by either of those), it can apply to MOFCOM to be classified as a de facto domestic investor at the time it applies for an entry licence. Approval will not be routine and MOFCOM will scrutinise such applications. Although it is clear that de facto domestic investors will still need to apply for an entry licence to invest in areas which are listed as "restricted" (that is, open to foreign investment subject to certain conditions) on the negative list, it is not clear whether MOFCOM will treat de facto domestic investors as identical to true domestic investors in all respects (that is, with no restrictions or conditions) or will grant an entry licence subject to conditions for market access on a case-by-case basis. The Draft Law does not state expressly whether or not de facto domestic investors are permitted to invest in "prohibited" industrial sectors. However, since de facto domestic investors are still on their face foreign investors (despite being a sub-category of foreign investor to which less onerous rules apply than to true foreign investors), and therefore would not have the right to apply for an entry license in respect of such industries, it is unlikely that "prohibite"' industrial sectors will be made open to them in practice.

It is likely that the intention underlying this exception is to create a basis for the government to distinguish between VIEs used by foreign investors to circumvent restrictions on investment in China, and the high profile Chinese TMT (Technology, Media and Telecommunications) companies which have listed on capital markets outside China (for example, Alibaba, Tencent and Sina), as the effect of shutting down the VIE structure on these companies has in the past been advanced as a reason why the VIE structure would be difficult for the Chinese government to ban them outright.

Scope of "foreign investment"

The Draft Law defines foreign investment broadly, including:

Establishing a new onshore entity (that is, a greenfield investment).
Acquiring the shares or equity of an existing onshore entity.
Providing finance to an onshore entity with a term of more than one year.
Acquiring concessions to explore or develop natural resources or to construct or operate infrastructure.
Acquiring real estate located in China.
Controlling an onshore entity or holding the interest of an onshore entity by way of contractual or trust arrangements.

The scope of this definition of foreign investment is broad enough to cover most forms of investment activity, and the terminology and definitions of the Draft Law may also be used when the government replaces the current legal regime for managing inbound mergers and acquisitions.

National security review

The Draft Law consolidates and overhauls the current national security review regime through:

Expanding the scope of matters that are subject to national security review. The Draft Law permits the Chinese government to conduct a national security review of any foreign investment which damages or may damage the national security of China. Under the current regime, the national security review of foreign investment is limited to:
- foreign investors' mergers or acquisitions involving Chinese military industrial enterprises or related supporting enterprises, enterprises located near sensitive military facilities, or other entities relevant to national defence; or
- foreign investors' mergers or acquisitions of key domestic enterprises in areas such as agriculture, energy and resources, infrastructure, transport, technology, assembly manufacturing and others, where the foreign investors may obtain actual control.
  (Article 1(1), Notice of the General Office of the State Council on Launching the Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors 2011)
Establishing judicial immunity for national security review cases. The Draft Law provides that the government's actions relating to national security review cases (for example, the decision to conduct a national security review or the results of the process) will not be subject to challenge under any administrative review or administrative litigation.

Reporting obligations

The Draft Law imposes a comprehensive reporting obligation on foreign investors and FIEs as follows:

Initial reporting obligation. Foreign investors must submit an investment information report within 30 days after the implementation date for the investment (that is, the business registration date (where the foreign investment must be registered) or the completion date of the investment transaction (where no foreign investment registration is required)). If the industrial sector being invested in is not on the negative list, no MOFCOM approval or prior filing will be required.
Subsequent reporting obligations. Foreign investors must submit an updated investment information report within 30 days after the occurrence of any change to the matters reported in the initial investment information report. Most of the existing MOFCOM approval items (for example, share transfers or the pledge of the equity interest of an FIE) will be regulated through this reporting process, and will no longer require any government approval. However, if any of the changes would result in the investor having had to obtain a foreign investment entry licence if they had been the case at the time of the initial investment (for instance, if any capital increase would lead to the investment amount going above the approval threshold), the foreign investor would have to apply for an entry licence in accordance with the relevant restrictions in the negative list.
Periodic reporting obligations. Annual reporting requirements will apply to all FIEs and quarterly reporting requirements to any FIE which has total assets, sales income or revenues exceeding RMB10 billion per annum or which has more than ten subsidiaries. The annual report for a calendar year is due by April 30 of the next calendar year and the quarterly report is due within 30 days after the end of each quarter.

The scope of items that must be reported is very extensive and includes matters that are not currently subject to scrutiny under the existing legal regime (for example, the de facto controller of the investor and the source of capital of the investment). It is likely that these comprehensive reporting duties will impose a heavy corporate governance and compliance burden on foreign investors and FIEs, although this must be balanced against the convenience of dispensing with the burdensome requirement for prior approvals under the current regime.

Grandfathering protection

Any FIE in existence before the coming into force of the Draft Law will have grandfathering protection and can continue operations within its original scope of business and operation term. However, any such FIE will have to apply for an entry licence if it:

Amends its business scope to include items regulated under the negative list.
Increases its investment amount above the approval threshold set out in the negative list.

FIEs already in existence before the coming into force of the Draft Law will have three years to reform their corporate governance form to comply with the requirements of the Company Law, the Partnership Law and the Law on Individual Proprietorship Enterprises. For example, a WFOE must appoint a supervisor or a board of supervisors according to the Company Law if it has not done so already.

The FIE Laws will be repealed when the Draft Law comes into force.

How to comment on the draft

The international chambers of commerce generally collate responses from their members to significant legislative proposals such as the Draft Law. In addition, interested parties can comment on the Draft Law directly:

Through the designated MOFCOM website (http://tfs.mofcom.gov.cn).
By email to [email protected].
By fax to (0086) 010-65198905.
By post to Department of Law and Regulation of MOFCOM at No. 2, Dong Chang An Avenue, Beijing, 100731.

Parties submitting comments directly should mark "public comment solicitation for Law of Investment from Foreign Countries" on the subject line of their email, cover page of their fax or postal envelope.

Source

MOFCOM website.

Draft Foreign Investment Law open for comment until 17 February 2015 | Practical Law