Light at the end of the tunnel? – the draft Foreign Investment Law

shutterstock_32740387 small sizeThe various laws and regulations pertaining to the incorporation of foreign-invested enterprises (FIEs) are soon to be consolidated.Theoretically this should ease the burden on FIEs, but is the light at the end of the tunnel actually a train coming the other way? Dr Michael Tan, Yang Cui and Lynn Zhao of Taylor Wessing dissect the draft Foreign Investment Law below and tell FIEs what they need to be aware of.

Despite China becoming the world’s top destination for capital inflow over the past 30 years its legal system is quite ‘messy’, particularly in the area of foreign direct investment (FDI). The simple establishment of a limited liability company may involve different FDI laws and regulations depending on its business scope and share structure. Most significantly, almost all investment requires governmental approval, which can sometimes develop into a time consuming, bureaucratic journey.

There appears to be a glimpse of light at the end of the tunnel, though. On 19th January, 2015, the Ministry of Commerce (MOFCOM) released the PRC Foreign Investment Law (Draft) to solicit public opinion. On the face of it this draft law seems quite refreshing as it introduces several new mechanisms which appear to overhaul the existing regime with respect to how the Chinese Government regulates FDI. However, despite a general trend of streamlining and increased transparency there are also signs of tightening of control, which foreign investors—both existing and potential—need to be aware of.

Laws to be consolidated

There are currently several laws and regulations pertaining to the incorporation of FIEs. The implementing rules of the most well-known—the PRC Sino-foreign Equity Joint Venture (EJV) Law, the PRC Sino-foreign Contractual Joint Venture (CJV) Law and the PRC Wholly Foreign-Owned Enterprise (WFOE) Law—were enacted way back in the 1980s. In addition to these are additional, special regulations applicable to the various different types of FIEs, such as holding companies or trading companies. They not only regulate investment access and incorporation procedures, but also cover many post-incorporation aspects such as corporate governance, contractual arrangements and operational issues. This situation is a result of Chinese regulators learning as they went along and from a purely legal perspective it is unsystematic and ‘messy’ – many laws and regulations conflict and discretionary interpretation by officials gives rise to bureaucracy and corruption.

The Draft now explicitly abolishes the EJV/CJV/WFOE laws by focusing on foreign investment access control. Corporate governance, contractual arrangements and operational issues, among others, aren’t covered by the Draft, and will be subject to other general laws (e.g. the PRC Company Law) instead. This should result in a transition to a more streamlined and structured regime but some legacy issues could be triggered. For example, the unanimous consent mechanism applicable to a signed equity joint venture (JV) deal might need to be re-opened for negotiation since the Draft will make such issues subject to the general Company Law, which only requires two-thirds majority vote by shareholders. Foreign shareholders of existing JVs will need to be prepared for another fight in this regard.

Broader coverage and control

Any of the activities listed below carried out by foreign investors in China—either directly or indirectly—will be subject to the Draft:

  1. Establishing an enterprise.
  2. Acquiring shares, equity, property shares, voting rights or other similar rights and interests of a domestic enterprise.
  3. Providing financing for one year or longer to a domestic enterprise in which it holds any of the above said rights or interests.
  4. Obtaining concession rights for natural resources or infrastructure.
  5. Acquiring real properties.
  6. Controlling a domestic enterprise or holding rights and interests in such an enterprise by means of contracts or trust.
  7. Changing of control in a domestic enterprise due to an off-shore transaction.

Compared with existing laws the reach of the Draft is quite extensive, covering almost all types of economic ‘foreign influence’ aside from pure investment activities. This is particularly apparent in its broad and flexible definition of the term ‘control’. The Draft appears to go beyond the topic of FDI to also cover indirect foreign investments (e.g. investments via capital markets) and some routine business activities (e.g. property acquisition and financing). Considering the various administrative mechanisms applicable to foreign investment activities, such as national security review and reporting obligations, it is hard to see how the Draft could be implemented in practice since it could potentially result in a substantial burden for foreign investors.

Streamlined market access

A significant breakthrough is that the approval requirement—presently a general requirement for all foreign investment projects—will be mostly abolished, although it will still apply in exceptional cases. Also notable is the introduction of the Catalogue of Special Administrative Measures—the so-called Negative List—which will be published and updated by the State Council. Provided the target business is not mentioned in the Negative List and no special industrial licence is required, the foreign investor will be free to invest and can simply file a new incorporation, or change of incorporation, with the company registration authorities.

Foreign investors will not be permitted to invest in areas that the Negative List classifies as ‘prohibited’, and for those that are ‘restricted’ they will require a prior-access permit (approval) granted by the MOFCOM. This requirement will also apply to investment projects that exceed the size threshold defined by the State Council. The Draft provides a flexible approach to the access permit – besides a simple ‘yes’ or ‘no’, there may also be approvals that come with preconditions such as an assets or business divestiture, limitation of the foreign stake and project term, geographical restrictions and local-hire requirements. It should also be noted that the Draft provides the MOFCOM the power to escalate the complexity of its approval process, for example by triggering a national security review and public hearing, which would potentially prolong the procedure.

Reporting, a new burden

The Draft stipulates that all foreign investors and FIEs will be subject to various reporting obligations. These include an entry report at the start of the investment and updated reports on any subsequent changes to the investment, both of which must be submitted within 30 days. The information required in these reports is substantial and includes certain things that are even not required under existing approval practices, such as the ultimate controller and the source of the investment. There is also a requirement for an annual—or in some cases quarterly—report. Heavy penalties will be imposed if these obligations are neglected – fines up to CNY 500,000 or five per cent of the investment and even a possibility of criminal liabilities in serious cases.

Taking into consideration the recent amendment to the Company Law, which requires all companies in China to submit an annual report to the company registration authorities, these additional requirements seem unnecessary and appear to discriminate against foreign companies. The requirement for detailed disclosure raises a further concern over potential loss of trade secrets, too.

A general overview

In many respects the Draft appears to make some effort to streamline existing FDI administration. It should not come as too much of a surprise to European investors that many of the new mechanisms to be introduced are closer to the business-friendly approach that they are accustomed to in Europe. Although the apparent tightening of controls has drawn criticism European companies shouldn’t be overly concerned – from a political perspective European investments will face less scrutiny than those from the US or Japan. Regarding the extremely controversial issue of the variable interest entity (VIE) structure, which has been widely adopted by Chinese technology companies to circumvent foreign investment restrictions in sensitive sectors, Europe appears to have less at stake – most foreign investment in these companies come from the US capital market.

Since the Draft was included in the five-year legislation plan of the present congress it is expected that it will be officially rolled out in the coming years, although there are still many legislative steps pending. European companies should prepare themselves for the foreseeable changes to come.

Taylor Wessing is a full service law firm with approximately 900 lawyers in Europe, the Middle East and Asia, with offices in Shanghai and Beijing. For more information please visit .