China: TMT Liberalized In The Shanghai FTZ: Part 1

Last Updated: 18 November 2014
Article by Karen Ip and Huang Yilin

The China (Shanghai) Foreign Trade Zone (Shanghai FTZ) has new opportunities for foreign investors wishing to invest in or expand value-added telecommunication services (VATS) operations in China. Foreign investors are now allowed to invest in the Shanghai FTZ to engage in VATS operations that, outside the Shanghai FTZ, are either not open to foreign investment or are subject to greater restrictions on foreign ownership.

The Shanghai FTZ, formally launched in September 2013, is a pilot ground for China's economic, financial and industrial reform and innovation. Various rules have relaxed foreign investment restrictions in certain business sectors, including VATS, in the Shanghai FTZ.

Foreign Investment in VATS before the Shanghai FTZ

Telecommunication services in China are divided into basic telecommunication services and VATS. The Administrative Regulations on the Foreign-invested Telecommunication Enterprise, effective in 1 January 2002 and amended in 10 September 2008, (National Rules) allow foreign investment in both basic telecommunication services and VATS. However, publicly-available sources indicate that no foreign investor has been approved to invest in basic telecommunication services under the National Rules.1 As noted below, foreign investment is allowed in VATS.

Under China's telecommunication services catalogue, VATS includes: (1) online data processing and online transaction processing business; (2) domestic multi-party communication business; (3) domestic Internet virtual private network (VPN) business; (4) internet data centre business; (5) store and forwarding business; (6) call centre business; (7) internet access business; and (8) information service business.

When it joined the WTO in 2001, China committed to open up three of the eight VATS above to foreign investment.2 Specifically, China opened up item (1) online data processing and online transaction processing business, item (5) store and forwarding business, and item (7) information service business.

VATS is a highly-regulated sector for foreign investment. Under the National Rules, foreign investors are not allowed to set up a wholly foreign-owned enterprise (WFOE); rather, they must team up with a Chinese partner to set up a joint venture (JV). Foreign investment is capped at 50%.

To engage in VATS, a JV needs a VATS licence from the Ministry of Industry and Information Technology (MIIT), which is the authority in charge of VATS in China. The National Rules require, among other things, that to engage in VATS in China (i) a JV must have a total minimum capital contribution of no less than RMB 10 million (approximately US$ 1.6 million) for national or cross-provincial VATS business, or a total minimum capital contribution of no less than RMB 1 million for VATS business within a particular province (approximately US$ 0.16 million), and (ii) foreign investors must demonstrate to the MIIT their experience in telecommunication industries overseas.

The National Rules allow foreign investors to set up JVs to engage in limited VATS in China; however, it remains difficult to obtain the required VATS licence. Based on the publicly-available statistics, no more than 30 JVs have been granted a VATS licence to date. China's reluctance to grant VATS licences to foreign-invested entities may be a result of heightened internet security concerns in the recent years.

New VATS opportunities in the Shanghai FTZ

On 6 January 2014, the Shanghai Municipal Government and the MIIT issued the Opinions on Further Opening up Value-added Telecommunication Business to Foreign Investments in the China (Shanghai) Pilot Free Trade Zone (the "Opinions"). On 15 April 2014, the MIIT issued the Administrative Measures on Foreign Investment in Value-added Telecommunication Business in the China (Shanghai) Pilot Free Trade Zone (the "Administrative Rules").

Both the Opinions and the Administrative Rules apply only to entities that are established in the Shanghai FTZ to engage in VATS. The Opinions introduce a number of new initiatives that allow increased participation by foreign investors in VATS. The Administrative Rules provide guidance on the application procedure and documentation for VATS licences.

In Part 2 of our article we will outline some of the new opportunities arising under the Opinions and the Administrative Rules.

TMT liberalized in the Shanghai FTZ: Part 2

Part 1 examined the background of value-added telecommunication services (VATS) in China and noted that new VATS opportunities have opened in the Shanghai FTZ. These new opportunities have been introduced by the Opinions on Further Opening up Value-added Telecommunication Business to Foreign Investments in the China (Shanghai) Pilot Free Trade Zone (the "Opinions"), issued on 6 January 2014, and the Administrative Measures on Foreign Investment in Value-added Telecommunication Business in the China (Shanghai) Pilot Free Trade Zone (the "Administrative Rules"), issued on 15 April 2014.

Below are the salient points of the Opinions and the Administrative Rules:

  • Greater foreign ownership permitted

Foreign Investors may own:

  1. up to 100% in an entity engaging in an app store under information service business,3 or a data store and forwarding business; and
  2. up to 55% in an entity engaging in operational e-commerce under online data processing and online transactions processing business.4

Three types of VATS had already been opened up to foreign investment in China's WTO commitments; however, higher foreign investment percentages are now allowed.

  • New VATS business available to foreign investors

Foreign Investors may own,

  1. up to 100% in an entity operating a call centre business, or engaging in a domestic multi-party communication business, or an internet access business; and
  2. up to 50% in an entity engaging in a domestic VPN business.

Before the promulgation of the Opinions, these types of VATS businesses were generally reserved exclusively for Chinese domestic entities. Except those preferential treatments under CEPA as mentioned in footnote 2, these opportunities are yet to be opened up to foreign investors outside the Shanghai FTZ.

  • Expedited approval procedures on granting VATS licenses

An entity wishing to engage in VATS is required to receive a VATS licence from the MIIT. The timeline under the current National Rules is approximately five months from acceptance of the application.

For entities in the Shanghai FTZ, a VATS licence will be issued by the Shanghai Communication Administration (SCA), which is the local counterpart of the MIIT in Shanghai. Unlike under the current National Rules, the SCA is not required to forward applications to the MIIT in Beijing for approval. The SCA is required to issue the decisions on approving the VATS license or not within sixty (60) days after accepting the applications. Thus the Shanghai FTZ has significantly reduced the approval time line for VATS licences.

  • Relaxed approval requirements on granting VATS licences

The minimum registered capital has been reduced for a foreign-invested VATS entity set up in the Shanghai FTZ. Outside the Shanghai FTZ, a foreign-invested VATS must have a minimum registered capital of RMB 10 million (approximately USD 1.6 million) to carry out cross-province VATS business. For foreign-invested VATS entities set up in the Shanghai FTZ, a minimum registered capital of RMB1 million (approximately USD160,000) is required to apply for a VATS licence to carry out cross-province VATS business.

Moreover, based on our telephone consultations with the SCA, it is not necessary for foreign investors to provide operational records in a telecommunication industry overseas, which is required under the current national rules on the establishment of a foreign-invested VATS entity outside the Shanghai FTZ. Therefore, at least in theory, any foreign investor is allowed to set up an entity in the Shanghai FTZ to engage in VATS.

Under the Opinions, each of the above VATS businesses can be provided nation-wide by entities set up in the Shanghai FTZ, provided that all related infrastructure and servers are located in the Shanghai FTZ. The only exception is internet access services which can only be provided to customers that are also located in the Shanghai FTZ.

Implications for foreign-invested VATS business

  • VATS Licence

As noted above, it is difficult in practice for foreign-invested entities to obtain a VATS licence. This, however, may be changing for the Shanghai FTZ.

The Opinions expressly refer to VATS, and the subsequent Administrative Rules set out the required documents and steps for applying for a VATS licence. This indicates that the authorities may be more willing to actually grant VATS licences to foreign-invested entities in the Shanghai FTZ. The Chinese legal community also generally expects that it should be relatively easy in practice for an entity in the Shanghai FTZ to receive a VATS licence from the SCA.

In light of the above, foreign investors may wish to re-evaluate their existing business model, particularly if currently engaging in VATS in China through a contractual cooperation arrangement with Chinese partners (because of the difficulty in receiving a VATS licence). Foreign investors planning to enter China for the first time are also recommended to re-evaluate their plans for VATS in China. For example, setting up a WFOE or JV in the Shanghai FTZ to apply for the VATS licences and to engage in the VATS business could greatly expand the available business opportunities.

  • Increased ownership permitted

Foreign investors in the Shanghai FTZ can now set up WFOEs or majority-owned JVs to engage in certain VATS business, thus avoiding possible corporate governance and operational conflicts that can occur when teaming up with Chinese partners.

  • Abandoning the VIE structure

The requirements under the national rules, together with the practical difficulty of obtaining VATS licences from the MIIT, have deterred foreign investment in VATS. As an alternative, the so-called Variable Interests Entities (VIE) structure5 has been extensively used by many foreign investors, and Chinese internet entrepreneurs wishing to invest from overseas, to engage in VATS in China.

Because of inherent regulatory and structural risks,6 VIE structures seeking overseas finance in the capital markets have recently received increasing attention from foreign regulatory authorities (especially in the US). The legality of the structure has also been heatedly debated and challenged in the business and legal communities. Foreign and Chinese investors looking for an alternative to the VIE structure to engage in the VATS business in China now have an alternative. Overseas capital markets and regulatory authorities are also likely to welcome the abandoning of the VIE structures.

Looking forward

The Shanghai FTZ provides foreign investors opportunities to participate in and benefit from China's growing VATS opportunities. The Opinions and the Administrative Measures also signal a degree of VATS liberalisation and represent an important development in Chinese telecommunication regulation. However, we consider that China's telecommunication sector will continue to be highly regulated, and will not be fully opened up to foreign investments.7 Given the recent campaign by the Chinese authorities to enforce internet security, any further opening of VATS for foreign investment should not be expected soon.

Even though the SCA has started to accept applications for, and issue VATS licences, it remains to be seen how the Opinions and Administrative Measures will be implemented in practice. Specialist advance legal advice remains necessary for investors exploring VATS opportunities in China.

Footnotes

1 China Mobile, China Unicom and China Telecom, the three biggest telecommunication operators in China, have their shares listed in overseas stock exchanges; therefore, foreign investors may invest in and own shares in these three Chinese basic telecommunication service operators. However, the listings of these three companies were specially approved by the Chinese government and foreign ownership in them does not assist other foreign investors who are interested in carrying out basic telecommunication services in China.

2 Investors from Hong Kong and Macau are foreign investors. However, certified services providers from Hong Kong or Macau are treated separately under the Closer Economic Partnership Arrangement and its subsequent amendments ("CEPA") between Hong Kong and Mainland China, and between Macau and Mainland China. Certified Hong Kong or Macau service providers are allowed to engage in seven of the eight types of VATS (with the exception being domestic multi-party communication services) in China in the form of a JV. As a matter of practice, however, relatively a few certified Hong Kong or Macau service providers have ever received the VATS licences.

3 The operation of an app store is one of the many services under information service business. The Opinions do not permit higher foreign investment ownership in entities engaged in other business (such as online data search or online visual or audio service) that also come within the information service business category; such foreign investments are still capped at 50%.

4 "Operational e-commerce"is one of the many services under online data processing and online transactions processing business. The Opinions do not permit higher foreign investment ownership in entities engaged in other business (such as online stock trading or electronic data interchange under online data processing and online transactions processing business category); such foreign investments are still capped at 50%.

5 In a typical VIE structure, a Chinese domestic operating company holds a valid VATS licence in China, whereas a WFOE set up by foreign investors (including Chinese entrepreneurs investing through overseas entities) will enter into series of contracts and documents with that Chinese domestic operating company or its shareholders to control the corporate governance and operations of, and to receive a majority of operations revenues from, the Chinese domestic operating company.

6 The regulatory risk is that the activities of foreign investors using a VIE structure to engage in the VATS business in China may be considered as circumventing Chinese law with respect to the restrictions on foreign investment in VATS business in China. If it is considered as circumventing Chinese law, then the VIE structure will be considered invalid in China. So far, this risk of this happening is still heatedly debated in the legal community, and markets have not reached a consensus. A structural risk is that control by investors through series of contractual obligations on a Chinese domestic operating company and its shareholders is not as secure as control by investors directly owning equity interest in the Chinese domestic operating company. It is possible and, it has also occurred, that those contracts under a VIE structure might be breached by the Chinese domestic operating company or its shareholders. If breach takes place, then investors (acting through WFOEs) could lose control of the domestic operating company.

7 For example, one of eight types of VATS business, also an important and inevitable business for cloud computing technology, internet data centre business is still not available for foreign investment, except it is available under CEPA as mentioned in footnote 2.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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