When it becomes law, the Foreign Investment Law could be the most significant milestone in China's transition from a planned to a market economy. And it could also be another strait-jacket on foreign investment.
"The Foreign Investment Law represents a major step in merging the legal and regulatory systems for the foreign and Chinese-owned economies and unifying their status" but "buried in the fine print are some provisions that should be of great concern to those who expect the new law to open up key sectors of China's economy to foreign investment."
This essay will examine the history behind the drafting of the Foreign Investment Law and why it may be of marginal benefit in further opening China's market to foreign investment.
When China opened its doors to foreign investment 35 years ago, it was faced with the task of rapidly building a legal system that could overlay private capital on a planned economy managed by diktat not laws. Such was the extent of compromise between reformers and those who opposed their capitalist road; China built two parallel legal systems to accommodate them both.
Laws and regulations governing foreign investment were initially far more sophisticated and comprehensive than those governing the planned economy. Later, parallel laws and regulations were also enacted for the domestic economy, but as time passed they reflected the gradual decline of the planned economy and its merger with the private economy, including foreign investment.
For those of us old enough to remember, there used to be one contract law for "foreign related" contracts and another for "economic" (read, planned) contracts. Contract disputes were handled by parallel arbitration commissions for either foreign or Chinese-only disputes. Foreign related contracts and investment were always denominated in U.S. dollars and there was a special currency for foreigners. For 30 years, foreign invested companies in China have been subject to special laws on wholly foreign-owned and joint venture companies and every foreign investment still requires government approval (with the recent exception of the experimental Free Trade Zones). For many years foreign and Chinese businesses were regulated by parallel ministries and departments. This is still true for the state-owned sector.
By the late 1990s, the stage was set for the two systems to merge, but we have been waiting for this to happen ever since. That it has still not yet happened is a salutary reminder of the ideological conundrum faced by successive Chinese leaders wanting to be recognized as a market economy whilst remaining a people's democratic dictatorship led by the Chinese Communist Party.
"For many years foreign and Chinese businesses were regulated by parallel ministries and departments. This is still true for the state-owned sector."
The Foreign Investment Law represents a major step in merging the legal and regulatory systems for the foreign and Chinese-owned economies and unifying their status. A market economy should make no such distinction. On its face, this is exactly what it does.
One of the major changes in the Foreign Investment Law will be the transition from the long-standing government approval system to a report-based system. The new foreign investment control regime will work together with a "negative list" approach, which is being pioneered in China's pilot Free Trade Zone in Shanghai. The Chinese State Council will publish a "negative list" that sets out sectors in which foreign investors are restricted or prohibited, as well as investment thresholds. Under this regime, only when a foreign investor intends to operate in the restricted or prohibited sectors, or its investment amount exceeds the thresholds will the foreign investor have to apply for market entry approval with MOFCOM. However, to make up for the reduced oversight by the government over market entry, all foreign investment has to be reported to MOFCOM either before, during or after the investment is made, depending on the nature and phase of the investment.
Another change will be to erase the line between Chinese-owned and foreign-invested business organizations. When enacted, the Foreign Investment Law will replace the current laws governing special foreign investment entities, such as the WFOE, EJV, and CJV. Therefore, the corporate structure to be used by foreign investors will be unified with Chinese-owned business entities and will all be governed by the same laws for all business organizations, such as the Company Law, the Partnership Law, and the Securities Law.
These important steps have attracted much attention, but buried in the fine print are some provisions that should be of great concern to those who expect the new law to open up key sectors of China's economy to foreign investment (or at least not to tighten control over them even further).
"Instead of regulating foreign investment on the basis of its source of investment, the Foreign Investment Law will focus on nationality and control. The distinction between Chinese and foreign investors will no longer be about the place of incorporation of the holding company, but about the nationality of the ultimate beneficial owners."
Instead of regulating foreign investment on the basis of its source of investment, the Foreign Investment Law will focus on nationality and control. The distinction between Chinese and foreign investors will no longer be about the place of incorporation of the holding company, but about the nationality of the ultimate beneficial owners. The Foreign Investment Law has introduced the concept of de facto control to identify foreign investors. The definition of control in the Foreign Investment Law is so broad that many popular methods to circumvent foreign investment control will have to be reevaluated and restructured in order to comply with the Foreign Investment Law.
Moreover, when deciding when certain foreign investment is subject to restricted or prohibited market entry, the concept of "cumulative investment amount" has been employed to prevent foreign investors from circumventing restrictions or prohibitions by breaking down their total investment into several installments of capital injection.
China's restrictions on foreign investment have given rise to structures to avoid foreign investment approval. In the late 1990s during China's telecom boom, these were known as "CCF" structures whereby, for example, a Sino-foreign joint venture would invest in a Chinese entity that would in turn hold another Chinese entity that procured a business license for telecoms business, which could not have been held by the joint venture or its immediate subsidiary. These three-tier structures were ultimately unraveled by China's telecoms regulators and, later during the dotcom boom, some value added telecoms business, still restricted or prohibited to foreign investment, became foreign controlled by employing a variable interest entity (VIE). Many of these, such a Sina.com and Alibaba.com, are now household names.
The VIE structure allows foreign investors to adopt various contractual arrangements between a foreign owned company and a wholly Chinese owned company, which holds the necessary licenses to operate restricted businesses. The various contractual arrangements give foreign investors control over the operation and management of the wholly Chinese owned company and consolidate revenues from its business operations. Therefore, through these contractual arrangements, the foreign investors are actually investing in China's restricted sectors such as the Internet, education and telecommunications.
This structure has worked because until now China has focused on equity ownership and distinguishes Chinese and foreign investors based on the place of incorporation. However, the Foreign Investment Law introduces the concept of de facto control by which a wholly Chinese-owned enterprise under the control of foreign investor as defined in Article 11 of the FIL will also be deemed as foreign-owned.
The FIL further defines control as control of shares, voting rights or other equity interests of a company, control of the decision-making bodies of the company, or possession of decisive power to influence the management, finance, personnel or technology of the company through contractual, trust or other arrangements (Article 18). Of course, this broad concept of control will cover the use of contractual arrangements as in VIE structures common today. According to this broad definition of control, the regulatory authority will consider a wholly Chinese owned company actually under foreign control as a foreign invested company. Such company is not allowed to invest in any sector on the "negative list" (Article 25) and heavy penalties are proposed for any contractual schemes that violate Chinese foreign investment restrictions (Article 149).
"The Foreign Investment Law introduces the concept of de facto control by which a wholly Chinese-owned enterprise under the control of foreign investor as defined in Article 11 of the FIL will also be deemed as foreign-owned."
For those existing companies with a VIE structure, a possible approach suggested in the Explanatory Note to the draft law is that where the business is controlled by foreign investors, a market entry approval by MOFCOM will be required and MOFCOM will assess the situation based on a multitude of factors. This risk will require a foreign investor to make a reassessment of the legal validity, and associated risks of the VIE structure shall be made. For VIE structures that remain under the control of Chinese nationals despite foreign investment and even foreign listings (such as Alibaba), the Explanatory Notes to the Foreign Investment Law suggest that such businesses can continue in their current form without further approvals.
While the Foreign Investment Law marks China's intention to constrain the use of VIE structure by foreign investors, the Chinese regulatory authorities are also opening up certain sensitive areas and expect future foreign investments in such areas by a simple WFOE structure. One recent example is that the China's Ministry of Industry and Information Technology (the "MIIT") has removed the restrictions on the foreign equity ratios in online data processing and transaction processing (operating e-commerce) business within China (Shanghai) Free Trade Zone, allowing up to 100% of foreign equity ratio.
According to the Classification Catalogue of Telecommunication Services, online data processing and transaction processing businesses are defined as services provided to users through data and transaction processing platforms which are connected with various kinds of communication networks (including the Internet). Such businesses include financial and securities trading and e-commerce related commodities and services transactions. In other words, foreign investors will be allowed to set up wholly-owned companies in the China (Shanghai) Free Trade Zone to engage in e-commerce businesses, such as establishing third party transaction platforms like JD.com and Tmall.com.
For the full text of the Foreign Investment Law (Draft for Comments), please click here.
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