Understanding China’s Proposed Foreign Investment Law

How does China’s proposed Foreign Investment Law impact the country’s business landscape?

On 19th January 2015 China’s Ministry of Commerce (MOFCOM) published a draft Foreign Investment Law (FIL) which if successfully passed would overhaul China’s foreign investment rules and signify the biggest change in decades to the way foreign companies conduct business in China.

And the timing is most welcome. As it stands, China’s strict controls block foreigners from directly investing in Chinese companies. At the same time, the world’s second-largest economy is seeing growth at its slowest rate in twenty-four years. And this year, for the first time, the money flowing out of China is set to exceed the investment coming in.

The new law includes policies to promote foreign investment, loosen restrictions in non-sensitive sectors, unify regulations, and crucially, tackle the variable interest entities (VIE) structure that until now has been commonly used to circumvent foreign ownership limits in sensitive industries such as the Internet, telecommunications, and education.

Some of the highlights include:

A broader definition of foreign investment

The law would create a new and broader definition for the term foreign investment, bringing together all different types of foreign investment under one umbrella to be treated in the same way.

Foreign investment would thus include: setting up a company in China; acquiring shares, equity, or voting rights in a Chinese entity; providing financing for over one year to a Chinese entity; acquiring and exercising land use rights, home ownership, or the rights to natural resources and infrastructure; and acquiring rights to and control over a Chinese owned entity.

Additionally, when a transaction done outside of China results in a foreign investor acquiring control over a Chinese owned entity, it would be deemed foreign investment too. Indeed, under the draft FIL, the question of control would become central to foreign investment in China.

Existing foreign investment laws repealed

The Sino-foreign Equity Joint Venture Law, the Wholly Foreign-owned Enterprise Law (WFOE), and the Sino-foreign Contractual Joint Venture Law would all be repealed to bring foreign investment under one single body of law. Foreign-invested companies would become subject to the same legal treatment as domestic Chinese-owned companies (called national treatment), unifying domestic and foreign investment.

Exceptions to national treatment would be set out in a negative list.

Creating the negative list

The negative list – or Special Catalogue – would be published by China’s State Council detailing industries in which foreign investment is restricted or prohibited. Investments in the negative list industries would need to be pre-approved by the State Council. The negative list would also set limits on the investment amount, and any investments exceeding the limits set would also need pre-approval from the State Council. Foreign investment within the negative list would remain largely the same as the current process.

Annual report to replace pre-approval

Foreign investment in industries not listed in the negative list would no longer need pre-approval from the State Council and would no longer be required to apply for entry clearance. Instead, foreign investors would be required to submit a report upon making an investment or setting up a company, which the investor would then need to continue to submit on an annual basis.

Implications for variable interest entities (VIEs)

The other major aspect of the draft is its potential impact on the legal loophole of variable interest entities (VIEs).

A VIE is an international offshore holding company set up by a Chinese national or Chinese company in which foreign investors can then buy shares and in doing so, sidestep Chinese investment laws. VIEs look like fully Chinese-owned companies on paper, but are actually controlled by foreign investors. They are particularly used in sensitive industries, such as the internet, and are popular with, for example, Chinese Internet start-ups seeking US funding. The legality of these commonly used structures has always been a little unclear, but until now, the Chinese government has largely turned a blind eye and let the practice continue.

However, under the new draft law, the issue of control when determining whether a company falls under Chinese- or foreign-invested law, will affect VIEs. Foreign investment through the VIE structure would in theory be allowed, but only as long as it could be proved that it was the Chinese national or Chinese company that wields control. If the actual controller was found to be a foreign investor, then the domestic VIE company would be treated as a foreign-invested company, and this could render some current VIEs – particularly those in sensitive negative list industries – illegal. The big question is, how will Chinese officials define control?