How to Read China’s New Foreign Investment Law

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Despite the general nature and the vague wording of the new Foreign Investment Law (FIL), foreign investors with operations in China or planning to enter the Chinese market should review the legislation carefully.

By understanding what the FIL says and does not say, businesspeople will be better prepared to make plans and adapt their business to effectively comply with the new law’s provisions as it comes into effect on January 1, 2020.

Here we break down the key clauses in China’s new law on foreign investment.

Definition of Foreign Investment

In Article 2 of the new FIL, foreign investment is defined as “investment activity directly or indirectly carried out by foreign natural persons, enterprises or other organizations”. To better illustrate, Article 2 further defines four circumstances that are regarded as foreign investment:

  • A foreign investor establishes a foreign-invested enterprise within the territory of China, either alone or together with any other investor;
  • A foreign investor acquires shares, equities, property shares or any other similar rights and interests of an enterprise within the territory of China;
  • A foreign investor invests in any new project within the territory of China, either alone or together with any other investor; and
  • A foreign investor invests in any other way stipulated under laws, administrative regulations or provisions of the State Council.

A “foreign-invested enterprise” (or FIE) refers to an enterprise incorporated under Chinese laws within the territory of China, and with all or part of its investment from a foreign investor.

What does it mean?

This article redefines the terms ‘foreign investment’, ‘foreign investors’, as well as ‘foreign-invested enterprises’.

It distinguishes ‘foreign investment’ into ‘direct investment’ and ‘indirect investment’, both of which will be subject to the adjustment of the new FIL and the forthcoming supporting laws.  Currently, only foreign direct investments (FDI) are regulated by the three laws on wholly foreign owned enterprises (WFOEs), Sino-foreign contractual joint ventures (CJVs) and Sino-foreign equity joint ventures (EJVs).

Further, this article adds ‘merger and acquisition’ (M&A) into the scope of foreign investment. Currently, foreign investment only includes setting up FIEs and investing in projects.

Moreover, the article abolishes the distinction between WFOE, EJV, and CJV – which has been used for decades – and refers the enterprises of foreign investment uniformly as ‘foreign-invested enterprise’.

In other words, the current WFOE, EJV, and CJV structures will no longer exist after the new FIL comes into force.

What is missing?

Despite the important innovations in this article, many questions remain unsolved. This creates uncertainty as whether an enterprise will be subject to adjustments in the new FIL and other complementary laws.

First, it doesn’t specify what constitutes an ‘indirect investment’. From Article 2, there is no clarity on whether FIE’s reinvestment in China will be regarded as indirect investment – this determines whether the reinvestment of the FIE will be subject to the adjustment of the Negative List.

There is also no clarity on whether the ‘actual controller’ of the indirect investment should be considered – this is relevant to the future management of some special business forms, such as the variable interest entities (VIE) structures and the special purpose vehicle (SPV).

VIEs are usually used by foreign investors to access the restricted areas under the Negative List, while SPVs are usually used by domestic investors to raise funding overseas and round-trip an investment back to China to take advantage of tax breaks and other benefits awarded to foreign investments.

Second, Article 2 doesn’t specify the exact scope of ‘foreign natural person, enterprises or other organizations’. Will Chinese natural persons who acquire foreign citizenship be regarded as ‘foreign natural person’? How about foreigners who acquire Chinese permanent residence? For ‘foreign enterprises’, will it be decided by the enterprise’s registered address, or the actual controller’s citizenship or registered address? Does ‘other foreign organizations’ include foreign governments and international organizations?

Third, Article 2 doesn’t specify the scope of ‘other investor’ mentioned in the listed four circumstances. Critically, it doesn’t mention if Chinese individuals – who are traditionally excluded from foreign investment under the three laws on WFOE, CJV and EJV – qualify as an ‘other investor’.

In addition, it doesn’t clarify whether ‘investment from Hong Kong, Macau, and Taiwan’ will still be treated as foreign investment, despite the statement given by Premier Li Keqiang in the conference held on March 15 suggesting that they will be treated as foreign investment.

Moreover, in the definition of ‘foreign-invested enterprise’, it doesn’t mention the ratio requirements of foreign investment for an enterprise to be qualified as foreign-invested.

All these questions are expected to be addressed or clarified in the future legislation of the supporting laws.

 

Pre-investment National Treatment and the Negative List

Article 4 and Article 28 of the new FIL clarify that China will adopt the management system of pre-establishment national treatment and Negative List for foreign investment.

The pre-establishment national treatment refers to the principle that will grant foreign investors and their investments market access with no less favorable conditions than what is granted to domestic investors and their investments.

The Negative List refers to special administrative measures for foreign investment market access to specific fields. The government will give national treatment to foreign investments outside the Negative List.

What does it mean?

The Negative List system has been piloted in the Shanghai Free Trade Zone since 2013 and was expanded countrywide in 2018.

However, the FIL marks the first time that the Negative List system was anchored in the form of law.

Most significantly, Article 4 and Article 28 clarify that the Negative List will be released by or upon approval by the State Council. That is to say, neither ministries nor local governments can set restrictions to foreign investment based on their discretion.

The articles maintain that foreign investors shall not invest in any field prohibited for foreign investment by the Negative List.

For any field restricted by the Negative List, foreign investors shall meet the conditions stipulated under the Negative list. And for the fields not included in the Negative List, foreign investment shall be treated in consistency with domestic investment.

What is missing?

Currently, if foreign investors want to access to the restricted sectors under the Negative List, they need to get relevant approvals from Ministry of Commerce (MOFCOM) or their local branches under the three laws on WFOEs, CJVs, and EJVs.

With the new FIL coming into force, the legal basis for this approval will no longer exist, but approval is still listed as one of the conditions for foreign investors to get access to the restricted area.

Investors therefore need to pay close attention to how the approval process will be changed under the new management system.

However, foreign investors should pay close attention to the Negative List anyway because it is frequently updated.

 

Foreign Investment Information Reporting System

Article 34 and Article 37 of the new FIL establish a foreign investment information reporting system in China for the management the foreign investment.

According to Article 34, foreign investors and FIEs are required to submit relevant information to the commerce department in charge through the Enterprise Registration System or the Enterprise Credit Information Publicity System.

The content and scope of foreign investment information report shall be determined based on necessity.

Authorities will not be allowed to request any investment information that can be obtained by interdepartmental information sharing.

Article 37 stipulated the penalties of noncompliance. The commerce department in charge shall order the foreign investors or the FIEs to make corrections within a time limit if they fail to report the investment information as required. If they fail to do so within the prescribed time limit, a fine between RMB 100,000 (US$14,542) and RMB 500,000 (US$72,711) shall be imposed.

What does it mean?

The new FIL defines the bureau in charge of the foreign investment information reporting system and the reporting path, as well as the penalties of non-compliance.

What is missing?

It doesn’t specify the timing for the reporting, the categories of the report, or other reporting details, such as the scope of the information that needs to be reported.

Although the articles emphasized that reporting shall be based on necessity, and no repetitive information shall be required, it is hard to tell from the new FIL how will the two principles will be implemented in practice.

 

National Security Review

Article 35 of the new FIL established the national security review system for foreign investment. Under this article, the security review shall be conducted for foreign investment that affects or will likely affect the national security of China.

What does it mean?

Article 35 anchors the national security review system for foreign investment in the law for the first time.

It answers long-held questions on the current measures on national security review, defined in the Notice of on Establishment of Security Review System Pertaining to Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (Guo Ban Fa [2011] No.6, Circular 6). Circular 6 has been criticized as too low level in the legal hierarchy, meaning that it can be overridden easily by higher level legal documents.

Compared to Circular 6, the national security review mentioned in the new FIL is not limited to mergers and acquisitions made by foreign investment. Rather, we believe it will apply to all foreign investments defined by Article 2 of the new FIL.

In addition, Article 35 explicitly stated that any decision that follows a security review will be final. That is to say, once a decision has been made, the decision cannot be appealed or be reviewed again.

What is missing?

The new FIL lays the basis for the national security review for foreign investments, but details such as the scope of the national security review, the bureau in charge, and the review process are still absent.

In a notice released in late April, the National Development and Reform Commission (NDRC) will take over the responsibility of national security review of foreign investments starting from April 30, 2019.

Nevertheless, we still expect the bureau in charge and other details regarding national security review of foreign investments would be announced in the forthcoming matching laws.

 

Pro-investment Policies

Chapter 2 of the FIL establishes several pro-investment policies for foreign investors.

Among others:

  • Article 9 states that pro-business policies for domestic enterprises shall apply equally to FIEs;
  • Article 10 stipulates that opinions and suggestions of FIEs shall be solicited by appropriate means in the enacting of laws, regulations and rules relating to foreign investment;
  • Article 14 mentions that foreign investors and FIEs may enjoy preferential treatments according to laws, administrative regulations, or provisions of the State Council;
  • Article 15 says FIEs can participate equally with domestic enterprises in the setting of standards;
  • Article 16 suggests FIEs could participate in government procurement activities through fair competition, and that products produced, and services provided within the territory of China by FIEs shall be equally treated in government procurement; and
  • Article 18 states that a local government at or above the county level could develop foreign investment promotion and facilitation policies, as well as measures, within its statutory authority and according to laws, administration regulations, and local regulations.

What does it mean?

Chapter 2 emphasizes China’s determination to attract foreign investment. It specifically seeks to address the principle of equal treatment for foreign and domestic investment, which is echoed among the articles of the FIL.

At the same time, it is also emphasized that foreign investors and FIEs should enjoy the pro-business policies ‘according to laws’.

This wording suggests China expects FIEs to operate within the boundary of the current law, rather than get exceptional privileges beyond the law.

What is missing?

Article 16 ensures FIEs equal participation of government procurement, which is regarded as a big improvement by relevant observers. However, the article doesn’t define what will constitute ‘products produced or service provided within the territory of China’.

In future legislation, investors that would like to participate in government-led projects should pay close attention to any ratio requirements for local composition in the matching laws for government procurement.

 

Enhanced Intellectual Property Protection

Article 22, Article 23 and Article 39 of the new FIL focus on the intellectual property protection issues that concern foreign investors and their investments.

What does it mean?

Article 22 stipulates that any infringement upon intellectual property shall be investigated for legal liability according to law.

It also clarifies that technical cooperation shall be based on free will and business rules in the process of foreign investment, and that technical cooperation conditions shall be determined by the principle of fairness upon equal negotiation.

Article 23 provides that government departments and personnel are not allowed to divulge or illegally provide the trade secrets learned in the course of performing duties to any other third party. In case of non-compliance, Article 39 provides the legal penalties imposed on government personnel, which could trigger criminal liability if a crime is constituted.

These two articles establish general intellectual property protection rules and confidentiality obligations for government departments. Going forward, we can expect the accelerated amendments to relevant laws regarding intellectual property protection, such as the Patent Law. We can also expect that forced technology transfer in JVs shall be reduced.

What is missing?

Article 22 states that government departments and personnel are forbidden to force the transfer of any technology by administrative means. But some analysts believe non-administrative measures might also be used to coerce foreign investors transfer relevant technologies to Chinese parties. We expect this issue could be further clarified in the later implementation process.

 

Compliant Mechanism

Article 26 of the new FIL establishes a compliant mechanism for FIEs to manage problems encountered during the investment process in a timely way.

What does it mean?

According to Article 26, if a foreign investor or FIE deems that the administrative practice of a government department or its personnel infringes upon its legitimate rights and interests, the foreign investor or FIE can apply for coordination and resolution through the complaint mechanism.

Beyond that, the foreign investor or FIE may also apply for administrative reconsideration or institute an administrative lawsuit to protect its legitimate rights and interests.

What is missing?

This article doesn’t provide further details for the complaint mechanism, such as the bureau in charge, the specific procedures, as well as the compliant management principles. We expect these will be specified in the matching laws.

 

Organization Form and Governing Structure

Article 31 stipulates that the organization form, governing structure, and operating rules of FIEs will be subject to the provisions of the Company Law, the Partnership Enterprise Law, and other applicable laws.

Article 42 provides that the new FIL shall come into force as of January 1, 2020, repealing simultaneously the three laws on WFOEs, CJVs, and EJVs. Further, Article 42 stipulates that FIEs established in accordance with the three laws on WFOEs, CJVs, and EJVs before the effective date of the new FIL may keep their original organization forms for five years after the FIL takes effect.

What does it mean?

Article 31 and Article 42 clarifies applicable law for foreign investment, which will significantly reduce confusion about the co-existence of the general law and special law, as well as the transition from the old law to the FIL.

Article 42 provides a five-year transitional period for existing FIEs. This five-year transitional period gives foreign investors more time to arrange relevant transitions to become compliant with the new requirements. But at the same time, it also sets a deadline for FIEs to make timely changes to the current organization forms, governing structure, as well as other operating rules.

What is missing?

Despite the five-year transitional period, it’s not clear whether FIEs need to get a new approval, go through supplementary record-filing, or make relevant changes to its business registrations within the five-year period.

Further, some of the changes implied by the new FIL may result in modifications to FIEs investment contract and articles of association, especially for CJVs and EJVs. There is a possibility that foreign and domestic investors cannot reach consensus on certain clauses within the time limit, such as the ownership of the JVs’ property.

In this case, the consequence for not making the required changes is not yet clear.

In addition, according to EJV law, certain industries – such as service industries – are required to have a term of cooperation.

With the three laws on WFOE, CJV and EJV being abolished soon, it’s not yet clear how such term of cooperation will be dealt with.

 


(This article is part two of a three-part series on China’s new foreign investment law. It was originally published in the magazine, The New Foreign Investment Law in China, produced by Asia Briefing.)

This article was first published by China Briefing, which is produced by Dezan Shira & Associates.