The FIL will come into effect on 01 January 2020, alongside the abolition of the three laws currently governing foreign investment in China, namely, the Law on Sino-Foreign Equity Joint Ventures, the Law on Wholly Foreign-Owned Enterprises and the Law on Sino-Foreign Co-operative Joint Ventures (together, the Three Foreign Investment Laws).
This article will summarise the key changes brought by the FIL to the existing foreign investment regulatory regime, analyse the legality of a variable interest entity (VIE) structure under the FIL and highlight the practical implications of the FIL to foreign investors.
Key changes brought by the FIL
1. Embodying Equal Treatment between Foreign Investors and Domestic Investors
The FIL emphasizes equal treatment between foreign investors and domestic investors, which can be reflected in the provisions on pre-establishment national treatment and adoption of the negative list (the Negative List). The Negative List which is being updated would set out prohibited industry sectors which do not allow foreign investors’ participation and restricted industry sectors which allow foreign investments upon fulfilment of certain conditions. Under the FIL, a foreign investor will be treated no less favourably than a domestic investor, unless his/her investment falls within the Negative List. It is worth noting that such national treatment to foreign investors will apply not only in the stage of market entry but also in the later stage of business operations.
The Negative List is not a new concept to foreign investors. Before the passing of the FIL, the system of Negative List has been tested in the free trade zones and implemented nationwide through the amendments to the Three Foreign Investment Laws and the introduction of the Special Administrative Measures for the Access of Foreign Investment. By incorporating the Negative List into the FIL, the Chinese government formally recognizes, at the level of law, a more open and relaxed regulatory regime under which foreign investors will not need to go through extra hurdles for making an investment that is outside the scope of the Negative List.
This idea of equal treatment is further reinforced by other provisions in the FIL. For instance, it is expressly stated in the FIL that the government cannot expropriate investment of foreign investors, other than in exceptional circumstances for the need of public interest, in which case the affected foreign investor must receive fair and reasonable compensation in a timely manner. Moreover, some provisions in the FIL specifically impose obligations on local governments and their relevant departments to protect the legitimate rights and interests of foreign investors. They are not allowed to impose any additional obligations or market access and exit conditions, or to intervene the normal production and operation activities of the foreign-invested enterprises (the FIEs).
2. Enhancing Protection to Foreign Investors
The FIL specifically addresses foreign investors’ concerns over the protection of intellectual property rights in China. In particular, the FIL stipulates that the intellectual property of the foreign investors and FIEs will be protected. Any infringement of intellectual property rights will be subject to legal liabilities. It is also stated that any technological cooperation will be carried out on a voluntary basis and no administrative body may compel any technological transfer by administrative means. The FIL also requires administrative bodies to keep confidential the trade secrets of any FIEs acquired by them in the performance of their duties.
3. Unifying the Three Foreign Investment Laws
Upon the promulgation FIL, all FIEs will either be governed by the Company Law of the PRC (the Company Law) and the Partnership Enterprise Law of the PRC in terms of organization form, corporate structure and operating rules. This aligns the legal requirements applicable to a FIE with those applicable to a domestic enterprise. The FIL provides for a five-year transitional period from the effective date of the FIL to any FIEs established pursuant to any of the Three Foreign Investment Laws. During the transitional period, such entities may continue to operate in their original organizational forms.
We will discuss the issues surrounding to the transitional arrangement later.
Implications and Challenges
1. Legality of the VIE structure
Many foreign investors have been adopting the VIE structure to gain control over a domestic entity through contractual arrangements, with a view to investing in prohibited and restricted industry sectors. The legality of the VIE structure under the FIL has been one of the major concerns of foreign investors.
As background information, when the draft FIL was first published by the Ministry of Commerce in 2015 for public consultation, a lot of controversies arose regarding the introduction of the concept of “effective control” to the definitions of “foreign investor” and “foreign investment”, which aimed to include an entity effectively controlled by foreign investors through VIE structure as a foreign invested entity. Such drafting was widely seen as a ban on the use of VIE structures to get around the foreign investment regulations in China. However, this concept was taken away from the subsequent drafts and is not reinstated in the current version of the FIL. While this may be interpreted as an acquiescence for the operation of the VIE structure in the grey area, one should note that the term “foreign investment” is defined in the FIL to include “any other form of investments stipulated under laws, administrative regulations or provisions of the State Council”. This catch-all provision leaves room for the Chinese government to enact new laws or regulations in the future negating the use of the VIE structure. The development in this area is yet to be observed.
2. Potential Changes to Corporate Governance Structure of FIEs
The current Three Foreign Investment Laws contain requirements different from the those stipulated in the Company Law on matters such as decision-making mechanism, capital contribution, profit distribution and transfer of equity interest. For example, the highest authority of an equity joint venture is the board of directors, while the highest authority under the Company Law is the board of shareholders. Such differences suggest that the constitutive documents of a FIE, such as its articles of association and joint venture contract, may need to be substantially revised for compliance with the new requirements under the FIL, especially for Sino-foreign joint venture companies. It goes without saying that, where Chinese investors are involved in the structure, heavy negotiation will be required to ascertain the new structure of corporate governance.
3. More implementing rules expected
While the FIL has been very encouraging in affording foreign investors national treatment and protection, it mainly sets out general governing principles with limited guidance on the implementation aspect (the official version has been significantly streamlined from the draft version). Before the relevant implementing rules are in place, we expect the foreign investors may momentarily face uncertainties and inconsistencies in practice in terms of how the provisions of the FIL will reconcile with the remaining rules of the foreign investment regime and to which extent the relevant authorities are enforcing certain provisions of the FIL. We anticipate further implementing rules and regulations to be rolled out in the coming future, for example, reconciliation of the existing Three Foreign Investment Laws and the FIL, for the implementation of the Negative List mechanism, the information reporting system and the security review system.
This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document. Please contact our business development executive Elva Jia if you no longer wish to receive regulatory updates from Simmons & Simmons: email@example.com.