New Draft Foreign Investment Law Signals Major Overhaul in China

The Chinese Ministry of Commerce has released the draft of the proposed new Foreign Investment Law to solicit public opinions. The proposed law will significantly reduce barriers to foreign investment, while increasing scrutiny of foreigners trying to evade the regulations on investing in restricted industries.

The draft law proposes five major changes:

  • replace  foreign-invested company laws
  • broaden definition of foreign investment
  • replace pre-approval with annual reports
  • require pre-approval only for negative list
  • implement a national security review process

Repeal of three foreign-invested company laws

When the new Foreign Investment Law comes into effect, it will repeal the Sino-foreign Equity Joint Venture Law, the Wholly Foreign-owned Enterprise Law, and the Sino-foreign Contractual Joint Venture Law.

This means that foreign-invested companies will largely be subject to the same legal treatment of domestic companies. Wholly foreign-owned enterprises (WFOEs), foreign-invested equity joint ventures and contractual joint ventures will no longer have separate legal regimes.

Broader definition of foreign investment

Instead of regulating the different types of foreign-invested legal entities, the new Foreign Investment Law creates a new definition for the term ‘Foreign Investment.’ Foreign Investment is now defined as:

  1. Setting up a company in China
  2. Acquiring shares, equity, property shares or voting rights in a Chinese entity
  3. Providing financing for over one year to an entity mentioned under No. 2 above
  4. Acquiring and exercising the rights to exploiting natural resources or develop and exploit infrastructure
  5. Acquiring land use rights, house ownership or other rights to immovable property
  6. Acquiring rights to and control over a Chinese-owned entity through contracts, trusts or in any other manner

Additionally, when a transaction done outside of China results in a foreign investor acquiring control over a Chinese entity, this will be deemed foreign investment as well.

Annual report replaces pre-approval

Most foreign investment, including setting up a new company, will no longer need pre-approval from the State Council. The only exception is where a foreign party intends to invest in one of the restricted industries on the negative list – likely to be based on the Catalogue of Restricted and Prohibited Industries for Foreign Investment – or where the investment amount exceeds the level set by the State Council.

Instead, all foreign investors need to submit a report upon making an investment (this includes those setting up a company). After making the investment, the investor needs to submit an annual report to the local department tasked with handling foreign investment.

The initial investment report should provide basic details about the foreign investor (name, domicile, organization form, main business etc.) and the investment itself (amount, source, time, ratio to other investors etc.). For investment into a domestic entity, the report must also include basic information about the company, like name, location, registered capital, investment amount, equity structure etc.

A new report has to be issued every year. All reports must provide the information about the foreign investor and the investment. Apart from all the information in the initial report, investors of a domestic entity must also provide operational information about the entity.  This includes financials statements, tax paid, imports and exports, major legal cases and the domestic entity’s dealings with the foreign investor and its affiliates (among other things, to inform the government of transfer pricing practices).

Pre-approval only for negative list

The State Council will publish a negative list of industries in which foreign investment is restricted or prohibited. It will also set limits on the investment amount.

Investments exceeding the limit will need to be pre-approved by the State Council itself. This includes investments in several installments. Investments in the restricted industries need to be pre-approved on the provincial level or the State Council. The draft law also lists the factors considered in the approval, such as compliance with international treaties, foreign influence on production, impact on the environment, production safety, use of natural resources etc.

National security review

The National Development and Reform Commission will host the National Security Review for Foreign Investment, together with other ministries. This body will assess whether foreign investment poses or may pose a threat to national security.

A foreign investor can voluntarily request a review. The State Council may commence an investigation of its own as well. The law states a number of grounds for a review, such as telecom and internet security, influence on economic stability, control by a foreign government or access to technology crucial to national security. The list is open-ended, saying the State Council may investigate “other factors it deems necessary.”

Following a review, the State Council may decide to approve the investment, set conditions or prohibit the investment. Note that the national security review is not a requirement for setting up a company, and you can voluntarily apply for one. However, the government retains the flexibility of carrying out a review on its own accord. In case of doubt, applying for a review would give certainty to the investor.

The investor cannot appeal against the decision.

Some implications

Some foreign investors have succeeded in circumventing Chinese laws, including regulations restricting investment, through the use of a Variable Interest Entity or VIE. A VIE is a completely Chinese owned company, with all the capital provided by Chinese nationals, with all Chinese directors and so on. But the funds to set up the company are lent to these Chinese nationals by a WFOE (a wholly foreign-owned enterprise) set up by the foreign investors.

The Chinese nationals and the Chinese ‘domestic’ company then sign contracts granting all the rights related to the running the ‘domestic’ company to the WFOE, such as profit distribution, voting right etc. In this way, the VIE looks like a fully Chinese company on paper, but is controlled through these contracts by the foreign investors.

VIEs will now be covered by the proposed Foreign Investment Law. This will extend the restrictions on foreign investment to VIEs. That way, they will no longer be able to circumvent the restrictions imposed by Chinese law.

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