China: Proposed Foreign Investment Law Would Bring Profound Changes To Foreign Investment Regime In China

Last Updated: 12 February 2015
Article by Niping Wu

On January 19, 2015, China's Ministry of Commerce ("MOFCOM") released a draft Foreign Investment Law (the "Draft Foreign Investment Law") for public comments, together with MOFCOM's explanatory notes (the "Explanatory Notes"). If promulgated, the Draft Foreign Investment Law would supersede three important and long-existing PRC laws on foreign investment, namely the Sino-foreign Equity Joint Venture Law, the Wholly Foreign-owned Enterprises Law and the Sino-foreign Cooperative Joint Venture Law. In its current form, the Draft Foreign Investment Law would bring revolutionary changes to the legal and regulatory regime for foreign investment in China, as it would reduce government control over foreign investment admission, focus on substance rather than form of investment, clarify the legal status of VIE structures, and provide greater commercial flexibility for foreign investment transactions.

Relaxing Foreign Investment Control

The Draft Foreign Investment Law would eliminate the requirement of MOFCOM prior approval for foreign investments in a vast majority of Chinese businesses. The Chinese government has adopted a Foreign Investment Industrial Guidance Catalogue (the "Catalogue") which classifies foreign investments in particular industries as "encouraged", "permitted", "restricted" or "prohibited". Currently, prior approval from MOFCOM (or its local counterparts) is required for any foreign direct investment in China, regardless of under which category it falls. According to the Draft Foreign Investment Law, the State Council is expected to issue a "restricted catalogue" and a "prohibited catalogue". MOFCOM approval would only be required for foreign investments in the industries listed on the "restricted catalogue", and the industries listed on the "prohibited catalogue" will remain closed to foreign investment. Foreign investments in any other industry or sector will no longer be subject to MOFCOM approval.1

While the Draft Foreign Investment Law lifts the MOFCOM approval requirement for foreign investments in non-restricted businesses, it expands MOFCOM's approval authority to reach certain offshore transactions – that is, any transaction outside of China that results in the de facto control of a Chinese entity being passed to a foreign investor is deemed as a foreign investment in China, so if the business of such Chinese entity falls within the "restricted catalogue", the transaction will require foreign investment approval.2 This is a significant change from the current position where only onshore foreign investments are subject to MOFCOM approval. The rationale behind the change seems quite clear and fair – if foreign investment in a particular sector is restricted, it does not matter whether it is a direct onshore investment or an indirect offshore transaction, especially if de facto control is passed to foreign investors.

Focusing on "de facto Control"

Under the Draft Foreign Investment Law, who has "control" is the key to determine whether an investor or an investment is Chinese or foreign. In the event of a proposed investment by an offshore investor in a "restricted" business, if the offshore investor can provide satisfactory evidence to MOFCOM showing that it is ultimately controlled by Chinese investors, MOFCOM will treat such investment as domestic. On the contrary, a Chinese entity controlled by foreign investors will be deemed as a foreign investor, and the definition of "foreign investment" will expressly include foreign control of a Chinese business by means other than equity ownership, such as through contract or trust arrangements. In essence, MOFCOM will look at the investor with ultimate control rather than the type of entity used for the investment in determining whether an investment is foreign or domestic.

The Draft Foreign Investment Law defines "control" in respect of a company as (a) directly or indirectly holding 50% or more of the stock, equity, property interests, voting rights or other similar rights or interests in the company; (b) possessing the right or ability to (i) directly or indirectly appoint 50% or more of board members, (ii) ensure that its nominees will obtain 50% or more of board seats, or (iii) exert significant influence over decisions of the board or shareholders meeting; or (c) being able to exert decisive influence over operational, financial, human resources or technical matters of the company through contract, trust or other means.

However, the above definition raises some questions and calls for further clarifications. For example, what if Chinese and foreign investors both satisfy one or more prongs of the "control" definition? Would the single largest shareholder of a public company (e.g., the Chinese founders of some foreign-listed Chinese companies) satisfy the "control" definition?

Providing Greater Commercial Flexibility

Under the current system, MOFCOM (or its local counterparts) reviews, as part of the application package for foreign investment approval, the main transaction documents for a proposed investment, including the equity/asset purchase agreements, the joint venture contracts and the articles of association. It is not uncommon for an approval authority to challenge some of the contractual provisions that have been negotiated and agreed-upon between the parties to a transaction. This limits the parties' freedom and ability to include deal-specific terms in the main transaction documents, such as closing conditions, price adjustments, etc.3 Such practice will be changed per the Draft Foreign Investment Law, which does not include transaction documents in the list of application information and materials required to be submitted to the approval authority. Further, MOFCOM has made it clear in the Explanatory Notes that it will focus its review on the nature of the investor and the investment, but that it will not scrutinize the underlying agreements. This will give foreign investors greater flexibility to negotiate the terms of their investments and include such terms in the main transaction documents.

Regulation of VIE Structures

VIE (variable interest entity) is a term used by the U.S. Financial Accounting Standards Board to refer to an entity (the VIE) that is required to be consolidated by another entity (the primary beneficiary) which possesses a controlling financial interest in the VIE, although the primary beneficiary does not have a majority or even any of the equity interest in the VIE. In the Chinese context, the VIE structure can be used to enable an offshore entity that, due to foreign ownership restrictions, does not own a majority stake in a Chinese entity, to nonetheless consolidate such Chinese entity. In a typical Chinese structure, the VIE is owned by Chinese founders and holds the necessary licenses/permits to operate the business that is subject to foreign ownership restrictions. The Chinese founders invest along with foreign investors in an offshore holdco, which separately establishes a wholly-owned subsidiary in China to enter into captive contractual arrangements with the VIE which provide such wholly-owned subsidiary, and indirectly the offshore holdco, with economic benefits of and control over the VIE that replicate the economic benefits and control of direct ownership.

The VIE structure was initially introduced in China by Internet companies in the early 2000s. Since then, nearly all overseas-listed Chinese Internet and technology companies have operated under this structure. Despite the prevalent use of the structure, and except for the issuance of certain ad hoc ministerial rules that aimed to regulate the use of the structure in specific industries, PRC law is unclear about the legality of the VIE structure. Such regulatory uncertainty is often a cause for concern among foreign investors.

The Draft Foreign Investment Law represents a major step towards the formal regulation of VIE structures. "Contractual control", which has become a synonym for the VIE structure, is expressly listed as one form of foreign investment. MOFCOM will treat an investment through the VIE structure as a foreign investment, if the VIE, although 100% Chinese-owned, is ultimately controlled by foreign investors.

It leaves a placeholder on how pre-existing VIE structures in restricted or prohibited industries should be handled. MOFCOM discusses three possible approaches in the Explanatory Notes:

  1. Reporting. A pre-existing VIE can continue to operate its business under the same structure if it notifies MOFCOM that it is controlled by Chinese investors.
  2. Reporting and Verification. A pre-existing VIE can continue to operate its business under the same structure if it requests MOFCOM to verify its Chinese-controlled status and MOFCOM so verifies.
  3. Approval. A pre-existing VIE should apply to MOFCOM for foreign investment approval, and MOFCOM would decide whether to grant such approval based on various factors including the identity of the VIE's de facto controller.

The above approaches suggest that after the Draft Foreign Investment Law is adopted, MOFCOM will likely permit a VIE structure to continue to operate, even in a restricted or prohibited industry, if the VIE is ultimately controlled by Chinese investors. However, if a pre-existing VIE structure engaged in "restricted" or "prohibited" business is not controlled by Chinese investors4, the potential impact of the Draft Foreign Investment Law may be severe and also hard to predict. Grandfathering all of them may sound too good to be true, whereas forcing all such VIEs to be unwound seems too harsh and draconian. MOFCOM indicates in the Explanatory Notes that it is keen to seek public opinions on the treatment of pre-existing VIEs.

Once the Draft Foreign Investment Law is adopted (assuming substantially in its current form), foreign investors will no longer be able to use the VIE structure to bypass foreign investment restrictions and to operate in prohibited (and certain restricted) industries via the structure. Therefore, we could expect significantly less use of VIE structures in this context. For future investments in "restricted" businesses involving VIEs that are ultimately controlled by Chinese investors,5 MOFCOM may treat such investments as domestic. However, the Draft Foreign Investment Law does not provide for such "domestic treatment" in respect of investments in "prohibited" businesses through VIEs and offshore entities controlled by Chinese investors. Apparently, the Chinese government will not allow Chinese investors to make "round-trip" investments in "prohibited" businesses, which seems to make sense because foreign investment in "prohibited" industries is supposed to be banned completely.

* * *

If adopted substantially in its current form, the Draft Foreign Investment Law will modernize the existing regime for foreign investment in China and have a profound impact on both existing investments and future transactions. In summary, foreign investors may no longer be able to use the VIE structure, which will be regulated under the new law as one form of foreign investment, to circumvent foreign investment restrictions. At the same time, foreign investments in a vast majority of businesses that are not on the "restricted" and "prohibited" catalogues will be facilitated by the new law, as approval from MOFCOM (or its local counterparts) will no longer be required.

There is no anticipated timetable with regard to the formal promulgation and effective date of the Draft Foreign Investment Law. As a procedural matter, the adoption of the Draft Foreign Investment Law would require the approval of the plenary session of the PRC National People's Congress. Given the priority of the Draft Foreign Investment Law in relation to the other pending legislations as well as the legislative process of the National People's Congress, it is unlikely that the Draft Foreign Investment Law will come into effect within one year. Moreover, several rounds of consultations among different ministries and interest groups are required before the new law can be finalized, and certain key accompanying legislation, such as the "restricted" and "prohibited" catalogues to be issued by the State Council, will need to be in place. We, as well as the legal and business market in China, will closely watch and follow the legislative process of this important law on foreign investment.

Footnotes

1 Although the Draft Foreign Investment Law does not make a reference to the Catalogue, it is probable that the new "restricted" and "prohibited" catalogues to be adopted by the State Council will replace the Catalogue. It remains to be seen to what extent the new catalogues will differ from the "restricted" and "prohibited" categories in the Catalogue.

2 Offshore structures involving Chinese businesses engaged in "prohibited" activities currently are only possible through the use of VIE structures, but such structures will be challenged and likely disallowed once the Draft Foreign Investment Law comes into effect (assuming substantially in its current form).

3 This has prompted the popular use of side agreements to document certain agreement between the parties that cannot be included in the documents required to be submitted to and reviewed by the approval authority. The PRC Supreme Court has upheld the validity of such side agreements, even if they have not been approved by the authority, so long as they do not contain any material changes to the documents that have been submitted to and approved by the authority (e.g., registered capital, business scope, term of operation and capital contributions).

4 Such VIE structure could have been controlled by foreign investors from the beginning or could have been formed initially by Chinese founders whose interests were subsequently diluted as a result of overseas capital raisings.

5 One may wonder why Chinese investors would want to use VIE structures after the adoption of the Draft Foreign Investment Law. VIE structures have also been used to address a different regulatory issue in China. Circular 10, which came into effect in September 2006, has made it nearly impossible in practice for Chinese founders to set up an offshore structure enabling overseas financings with the offshore holding companies owning the Chinese operating company. The VIE structure is one of the ways to overcome Circular 10 hurdles. If MOFCOM's practice under Circular 10 remains unchanged after the promulgation of the Draft Foreign Investment Law, Chinese founders may in some circumstances still use VIEs for purposes of dealing with the Circular 10 issue.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Events from this Firm
16 Oct 2018, Other, California, United States

This highly interactive colloquium will provide a deep understanding and practical advice regarding major e-discovery challenges facing organizations t​oday.

16 Oct 2018, Conference, California, United States

Women are a more powerful presence in business than ever, as entrepreneurs and corporate leaders.

22 Oct 2018, Other, San Francisco, United States

The event also features a panel of in-house IP counsel from prominent companies discuss best practices and strategies for confronting IP issues. Plenary sessions will address recent developments in privacy issues;

Similar Articles
Relevancy Powered by MondaqAI
Zhong Lun Law Firm
 
Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Zhong Lun Law Firm
Related Articles
 
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions