China’s Foreign Investment Law (FIL) implemented major reforms from 1 January 2020 affecting all aspects of foreign investment in China. The FIL greatly simplifies the legislative environment with only 42 articles over six chapters -albeit the FIL is accompanied by (draft) Implementing Regulations (IR) which contain another 45 articles.
Below are the most notable features of the (draft) Implementing Regulations.
A Transition Period for Existing Foreign Invested Enterprises (FIEs)
As the FIL will require the corporate governance structure of existing FIEs to be amended to fulfil the requirements under PRC Company Law rather than Three Laws on Foreign Investment, Article 42 of the Implementing Regulations provides as follows:
- A five-year transition period (01/01/20 – 31/12/24). In this transition period existing FIEs should undertake their corporate restructuring process and registration with the relevant authorities
- A six-month grace period (01/01/25 – 30/06/25). FIEs which have not yet modified their corporate governance will be obliged to do so by the end of this period; and
- Rejection of registration (01/07/25). If a FIE’s corporate governance structure does not satisfy the requirements as established in PRC Company Law, the FIE will be deregistered.
It is important for FIEs to modify their corporate governance in a timely manner as scheduled, as there will be significant changes to the corporate structure of Sino-foreign joint ventures which will likely include negotiations between all joint venture partners.
FIEs may now have Individual Chinese Investors
The FIL permits foreign investors to establish FIEs in China and the Implementing Regulations clarify that Chinese persons may also invest in such FIEs.
This is a significant development as currently; a Chinese individual may only become a shareholder of an FIE if that results from the acquisition of a domestic company in which the Chinese individual is an existing shareholder) by a foreign investor.
Foreign-Invested Enterprises and Round-Trip Investing
Article 35 of the IR provides that if a foreign investor is wholly owned by a Chinese person or legal entity (excluding FIEs), investments made by the foreign investor in China will not be subject to Negative List controls if approval of the State Council is obtained (See below for an explanation of the Negative List).
This potential exemption from the Negative List indicates a potential relaxation of restrictions on round trip investments back to China (See below for the meaning of “round trip investment”) . However, the threshold is quite high as:
- the State Council approval is required, and
- the foreign investor needs to be wholly Chinese owned in any event.
The Negative List
The “Negative List” is a published list of prohibited or restricted industries for foreign investment in China.
“Prohibited” industries are those in which foreign investors are not allowed to participate whether through direct investment, partnerships or acquisitions. “Restricted” industries are those in which foreign investors must meet specific conditions, such as shareholding limits, stipulated by the Negative List. For industries not on the Negative List, foreign investors are in the same manner as their domestic counterparts.
There are two negative lists, a National Negative List and a Free Trade Zone (FTZ) Negative List. The FTZ Negative List applies to FIEs located in the China’s pilot free trade zones and is less restrictive than the National Negative List, which applies elsewhere throughout China.
Round Trip Investing is defined in China as the direct investment activities conducted by Chinese residents through Special Purpose Vehicles. This direct investment includes establishing new FIEs or the merger with, or acquisition of, pre-existing entities. This may be done for a variety of reasons. For example, either the repatriating of foreign-earned money back to China; or done as a means of availing of benefits which are solely available to foreign direct investment.
Uncertainty Regarding Variable Interest Entities (VIE)
It is unclear under the FIL whether variable interest entities ("VIE") will be subject to FIL regulations. VIEs are structures which, by virtue of various contractual arrangements, allow foreign investors to gain de facto control over domestically owned business operators holding licenses on the Negative List.
However, the draft Implementing Regulations indicate a possible legislative intention to look at the ultimate ownership of foreign investors with regards to Round Trip Investing. Therefore, examination of the ultimate ownership structure may occur with VIE structures.
It is uncertain whether VIEs actually fall under the FI. The Implementing Regulations do not provide any clarity on this point. The uncertainty may allow the regulatory bodies to interpret the regulations on a case by case basis, perhaps applying the FIL regime for certain sensitive industries whereby ultimate ownership of the VIE will be considered.
With this in mind, foreign investors should continue to be cautious when considering a VIE structure with any company whose industry is on the Negative List.