China Proposes Draft New Foreign Investment Law

The Chinese Ministry of Commerce ("MOFCOM") released the draft of its proposed new foreign investment law (the "Draft Law") for public consultation on 19 January 2015. If adopted, the Draft Law will have a pronounced impact on the regime for foreign investment in China, but in many ways can be seen as a double-edged sword. It marks a significant move by MOFCOM to reduce barriers to foreign investment and to streamline the current fragmented regulatory framework, where market entry is often determined on a case-by-case basis. Yet at the same time, MOFCOM intends to increase scrutiny on foreign investment in "restricted" sectors and re-emphasise its role as the gate keeper on foreign investment related issues. For any Northern Irish company wishing to do business in China, it is worth bearing the below factors in mind.

An overview of the principal changes proposed is set out below.

  1. Repeal of existing foreign-investment company laws
    The Draft Law will replace the three existing foreign investment laws in China: the Sino-Foreign Equity Joint Venture Law, Sino-Foreign Cooperative Joint Venture Law and Wholly Foreign-Owned Enterprises Law (together the "FIE Laws"). The existing FIE Laws conflict with other sets of laws and are deemed inadaptable because of the case-by-case approval system. Going forward, the Draft Law will abolish the specific organisational requirements applying to foreign invested enterprises ("FIEs"), as it clearly mandates all FIEs to conform their respective governance structure in accordance with that under Chinese company law.

    This uniform application of relevant laws and regulations should considerably simplify the governance of FIEs. For example, under the current FIE Laws, certain matters must be approved unanimously by all the directors of a joint venture. However, under Chinese company law, such matters only require the approval of 2/3 of the shareholders.
  2. Enlarged scope of "foreign investment" and "foreign investors"
    A broad scope of foreign investment activities are now subject to the regulation of the Draft Law. Foreign investment now not only includes (i) green-field investment and (ii) merger and acquisition, but also (iii) provision of long-term financing (with a term of more than one year) by a foreign investor to its subsidiaries in China, (iv) obtaining a licence to explore natural resources or operate/construct infrastructure project; (v) acquisition of real property; (vi) controlling, or holding interest of, a domestic entity, by way of contractual or trust arrangements; and (vii) offshore transaction which results in actual control of a domestic company being transferred to a foreign investor.

    Foreign investors are defined under the existing FIE Laws to be those incorporated outside China irrespective of their source of capital or who their ultimate controller is. The Draft Law, for the first time, takes a substance over form approach and therefore, Chinese subsidiaries "controlled" by a foreign investor will also be deemed to be an FIE and will be regulated as a foreign investment activity.
  3. Pre-approval for negative list only
    Existing regulations require all foreign investors who intend to set up or acquire a company in China to first obtain approval from MOFCOM or its local branch before business registration can be made with the relevant Administration of Industry and Commerce (“AIC”). The Draft Law fundamentally changes this requirement by limiting foreign investment approval to only those investments listed on a negative list (the “Negative List”), which will set out industry sectors in which foreign investment is restricted, as well as investment thresholds for foreign investment. Foreign investment outside the Negative List will be offered national treatment and may register with AIC directly.

    While the Negative List remains to be published, it is generally expected that most foreign investment projects will no longer require pre-approval by MOFCOM when the Draft Law comes into place.
  4. New information reporting scheme
    Although the Draft Law relaxes the pre-approval procedures and requirements for establishing a foreign investment project, it strengthens the regulation of the project after the investment is made. Specifically, if any changes are made to the project, the foreign investor or the FIE must file such changes on a timely basis. FIEs are also required to submit annual reports, providing information about the foreign investor and the investment. For larger FIEs with total assets, sales revenue or operational income exceeding RMB 10 billion or having more than 10 subsidiaries, quarterly reports are to be submitted within 30 days from the quarter end.

    In addition, the Draft Law proposes the establishment of a publicly accessible database that provides information on the creditworthiness of foreign investors.
  5. National Security Review
    The Draft Law proposes to expand the review for national security concerns. Until now, this kind of review was limited for foreign acquisitions in specific industries. Under the Draft Law, any foreign investment in any industry might be subject to a national security review. Foreigners will be able to voluntarily request a security review, as well as any interested party. After the review, the State Council will have the power to approve, limit or prohibit the investment.
  6. Impact on VIE structures
    Currently, many foreign investors have succeeded in investing in restricted industries by circumventing Chinese regulations and restrictions by using a variable interest entity structure ("VIE structure"). A VIE structure enables foreign investors or Chinese shareholders investing through offshore entities to have effective control over a domestic company through a series of complex contractual arrangements. The VIE structure has been merely tolerated by the Chinese government since its emergence in the early 2000s and Chinese Internet companies such as Alibaba Group Holding, Baidu Inc and are listed in this way.

    Specifically, the Draft Law provides that a domestic enterprise established in China that is "controlled" by a foreign investor will be deemed to be an FIE, even if the domestic enterprise is directly owned by Chinese shareholders (see section 2 above). However, the Draft Law remains silent on the treatment of existing VIE structures and an explanatory note to the Draft Law contemplates three possible approaches with respect to domestic companies under existing VIE structures which are in the restricted or prohibited sectors:
    • reporting - a company under a VIE structure may report to MOFCOM that it is controlled by Chinese investors, with the result that the VIE structure can remain in place;
    • verification - a company under a VIE structure may apply to MOFCOM for certification that the company is controlled by Chinese investors, and upon such verification, the VIE structure can remain in place, or
    • approval - a company under a VIE structure may apply to MOFCOM for foreign investment approval, and MOFCOM would assess the situation (taking into account the actual controlling parties) together with other relevant regulators and make a decision.

Whether any grace period will apply, within which existing VIE structures must comply with foreign investment restrictions remains to be seen. However, the explanatory note to the Draft Law suggests that MOFCOM will not unnecessarily shut down VIE structures that are not immediately compliant. Much will also depend on what sectors will be covered by the "negative list", which is yet to be published.

The Draft Law reflects China's desire to create a unified foreign investment regime that further opens China to and advances foreign investment, and improves the regulation of foreign investment management, all of which are to be welcomed. Nevertheless, it raises new issues for investors in China and it is apparent that the government intends to increase its control and scrutiny over more sensitive industries.

As part of the Chinese legislative process, the Draft Law is expected to undergo further revisions. How much of it is preserved or changed before its final reading before the National People's Congress, remains to be seen.

For more information please contact Peter Stafford, Chairman and corporate partner, A&L Goodbody (NI).

Date published: 23 February 2015