China: Merging Parallel Lines: China’s Draft Foreign Investment Law

Last Updated: 24 February 2015
Article by Edward J. Epstein

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.

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
Edward J. Epstein
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