Status of the new Foreign Investment Law

In an attempt to attract more foreign investment at a time when economic growth has stalled to a quarter-century low, the Chinese Government has initiated reforms to the current laws governing foreign investment in order to introduce consistency and to eliminate uncertainties. The Ministry of Commerce of China (MOFCOM) took the lead to produce the first draft, and released the draft Foreign Investment Law (Draft FIL) on 19 January 2015 for public consultation. In particular, the Draft FIL seeks to create a stable, transparent and predictable legal environment for foreign investors through restructuring the approval, supervision and governance mechanisms. It also aims to reduce the administrative costs of investing in China.

One year on, observers both within and outside of China may be wondering what the status of the Draft FIL is. We have learnt from our sources within MOFCOM that the Draft FIL was submitted to the Legislative Affairs Office of the State Council (guo wu yuan fa zhi ban (国务院法制办)) at the end of 2015. This is a necessary step in the legislative process in China, after which the bill will be introduced to the National People’s Congress (quan guo ren min dai biao da hui (全国人民代表大会)).

Key changes to the current regime under the Draft FIL

As it stands, the Draft FIL proposed by MOFCOM will bring several changes to the current regime, including introducing the national treatment and negative list (with the main purpose being to establish a “limited approval and comprehensive report” system) as well as amending the scope of foreign investor and foreign investment. Under the new regime, foreign investment will no longer be subject to approval from MOFCOM unless it falls within the negative list.

The key changes include: 

Draft FIL to replace three existing laws

The Draft FIL will replace the three laws currently governing foreign investment in China: (i) Law of the PRC on Sino-foreign Equity Joint Ventures, (ii) Law of the PRC on Sino-foreign Co-operative Joint Ventures, and (iii) Law of the PRC on Wholly Foreign-owned Enterprises.

Essentially, this means that the regulation on foreign investment will cease to be dependent on the form of the investment (ie whether investments are made by way of wholly-foreign-owned entities, foreign invested equity joint ventures or contractual joint ventures). These forms of organisation will cease to exist and foreign invested entities will have to comply with the same requirements as Chinese entities. In particular, Foreign-Invested Enterprises (FIEs) will need to comply with the corporate governance requirements set out in the Company Law of the People’s Republic of China, the Partnership Law of the People’s Republic of China or the Law of the People’s Republic of China on Individual Proprietorship Enterprises 1999.

National treatment

Under the current regime, FIEs require governmental approval, whilst most of these approvals are not required for domestic enterprises. Further, FIEs are required to be incorporated under one of the three FIE laws (the Sino-Foreign Equity Joint Venture Law, the Sino-Foreign Contractual Joint Venture Law and the Wholly Foreign-Owned Enterprise Law), which includes a number of conflicting provisions with the PRC Company Law.

With the adoption of the Draft FIL, foreign investors will no longer be subject to a separate regulatory regime from Chinese investors, and will be treated in the same way as Chinese investors. In other words, the Draft FIL adopts the pre-establishment national treatment principle for foreign investment, so there is no longer a need for foreign investors to apply for approval from the Chinese government, unless the investment falls within the negative list.

Negative list

Foreign investment in China is currently subject to the Foreign Investment Guidance Catalogue (the Catalogue) which divides industrial sectors into three categories for the purposes of foreign investment: “encouraged”, “restricted” or “prohibited”. Under the Draft FIL, foreign investors will be subject to restrictions on foreign investment in “restricted” industries, and barred from investment in “prohibited” industries (the "encouraged” category will be removed). This means that foreign investment in industries not included in the negative list will not require approval and will be able to proceed directly to registration with the Administration of Industry and Commerce. However, the negative list that will apply under the Draft FIL has not been published yet and it is unclear how this will look compared to the existing Catalogue.

Chinese reporting obligations for foreign invested entities

The new regime will abandon the current case-by-case approval system and will instead impose extensive reporting obligations that are distinct from the approval process. Foreign investors and foreign invested entities will be required to submit reports of initial investment (ie 30 days after the date of the investment), reports of certain events (ie events that currently require MOFCOM approval such as share transfers and share pledge) as well as periodic reports (ie due by 30 April of following calendar year with information in relation to the investor, investment and entity’s operations).

Definition of foreign investor

The new definition of “foreign investor” introduces the concept of de facto control (or “effective control”) for the first time according to the “substance over form” principle. This means that a Chinese entity will be subject to the restrictions on foreign investment where foreign persons or entities control the composition of their board or exercise control under contractual arrangements. In particular, the Discussion Draft underlines the legal liabilities of foreign investors and foreign investment enterprises which attempt to get around the investment restrictions through entrusted holding, trust or contractual control relationships.

Foreign investors are widely defined in the Draft FIL as: (i) individuals who are not Chinese citizens, (ii) enterprises incorporated under foreign laws, (iii) organs of foreign governments, (iii) international institutions, and (iv) domestic entities controlled by any of the above. Further, “control” for these purposes is defined as: (i) 50% equity ownership, (ii) the right or ability to nominate at least half of the directors, (iii) holding voting rights enabling the investor to exercise a major influence over shareholders’’ or directors’ decision, or (iv) the ability to have a decisive influence over an entity’s operations, finances, human resources or technology through contract, trust or other arrangements.

Definition of foreign investment

Under the current regime, the determination of foreign investment is based on the place of registration or nationality of the investor. With the adoption of the Draft FIL and the concept of “effective control”, it will be based on the nationality of its “effective controller”. Foreign investment activities are also widely defined in the Draft FIL. These include: (i) green-field investment, (ii) mergers and acquisitions, (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 projects, (v) acquisition of real property, (vi) controlling, or holding an interest in, a domestic entity, by way of contractual or trust arrangements (such as VIE), and (vii) offshore transactions which result in actual control of a domestic company being transferred to a Foreign Investor.

De facto Chinese investors

Where a foreign investor is ultimately controlled by a domestic investor, it will be able to apply to MOFCOM for treatment as a de facto Chinese investor when it applies for approval to invest in an industry categorised as “restricted” by the negative list. However, the Draft FIL does not specify whether de facto Chinese investors will be treated in exactly the same way as Chinese investors. Further, it is unclear as to whether a de facto Chinese investor would be allowed to invest in a “prohibited” industry under the negative list.

Implications for Variable Interest Entity (VIE) structures

Under the Draft FIL, the legality of VIE structures (where foreign investors gain control of domestic entities through contractual arrangements) will be recognised.

In publishing the Draft FIL, MOFCOM has made it clear that it is aware that VIE structures are used as a means to get around foreign investment regulations in China and that this will be expressly prohibited in the future. While the Draft FIL recognises the legal status of VIEs, VIEs controlled by a foreign investor will be regarded as a foreign investor and will be subject to the restrictions on foreign investment set out in the negative list.

China’s national security review

An enhanced national security review procedure is incorporated into the Draft FIL. It significantly extends the circumstances in which a national security review could be carried out, as the government would be able to conduct a national security review of any foreign investment which damages or may damage China’s national security.

Currently, a national security review is only conducted in respect of transactions resulting in foreign investors acquiring control over Chinese companies active in certain key industrial sectors (eg the military sector, infrastructure, agriculture, energy and transport).

What’s next?

Despite the progress the Chinese government is making to reform its existing foreign investment regulatory framework, a number of uncertainties remain. This includes the lack of clarity in how the Draft FIL will interact with other foreign investment regulations, such as (i) the Provisions on the Merger and Acquisition of Domestic Enterprises by Foreign investors, (ii) various regulations by the State Administration for Foreign Exchange, and (iii) the Catalogue, which has been jointly administered by MOFCOM and the National Development and Reform Commission (NDRC) (guo jia fa zhan he gai ge wei yuan hui (国家发展和改革委员会)) since 1995. The Catalogue is updated approximately every three years, with the latest version published in 2015, by both MOFCOM and the NDRC to reflect the government’s prevailing economic and political policies.

Furthermore, we have learnt from our sources within MOFCOM that the NDRC has been preparing its own draft law on foreign investment, which is currently going through consultations with various government authorities. The draft law that is being prepared by the NDRC is called wai shang tou zi fa (外商投资法) as opposed to wai guo tou zi fa (外国投资法), the Draft FIL proposed by MOFCOM.

Ultimately, there will only be one piece of legislation passed into law. The consequences of the current developments are two-fold:

• The process will be prolonged, as MOFCOM and the NDRC will have to work together to produce a consolidated draft before it is considered by the State Council. MOFCOM has already spent two years putting together the Draft FIL, including one year consulting with different government stakeholders such as various ministries and provincial governments.
• The Draft FIL published by MOFCOM in January 2015 will be modified more substantially than usual to accommodate NDRC’s views. However, at present the NDRC has not published its draft law to the public yet.

Given that there are currently two different drafts spearheaded by two powerful ministries, and the form or content of the draft law that is being prepared by the NDRC is still unclear, there is still a very long way to go before the enactment of the Draft FIL.