China’s Foreign Investment Law
The Foreign Investment law (FIL) of the People’s Republic of China (PRC) will become effective on January 1, 2020, ushering in a new era of foreign investment legislation in China.The FIL will become the basic law for the foreign investment legal framework, establishing core principles for the promotion, protection and market access of foreign investment. Many aspects of the law are not new but if the law and its principles are fully implemented, the FIL will mark a fundamental turning point in PRC foreign investment law.
The law will have significant implications for foreign invested enterprises (FIEs) in China.
National Treatment & Negative List
The FIL will fully implement the system of pre-establishment national treatment plus the ‘negative list’ for foreign investment.
If an activity is not included on the negative list then foreign investment will be permitted to the same extent as domestic investment.
The negative list approach is not new, having been introduced first in China’s free trade zones then applied nationally over the past few years. But the FIL has enshrined the mechanism in law and has reinforced it by coupling it with the principle of national treatment.
The negative list itself is a document called ‘Special Administrative Measures for Foreign Investment Access’ that is jointly issued by the National Development and Reform Commission (NDRC) and the Ministry of Commerce (MOFCOM).
It is updated periodically and has been steadily shrinking over the years. Activities on the list may be either prohibited outright to foreign investment, such as TV and film production, prohibited subject to China’s WTO commitments, such as internet and telecom services, or may be restricted, such as automotive manufacturing. Where an activity is restricted, approval is expressly at the discretion of the authorities, and a joint venture (JV) with a Chinese party will be required, often with a Chinese controlling interest.
Nevertheless, in the past even an activity not on the negative list, and therefore ostensibly ‘permitted’, was subject to the approval of the authorities. Approval for such ‘permitted’ activities was often withheld. Indeed, it was almost universally denied in some sensitive sectors supposed to be open under China’s WTO commitments, such as value added telecoms. Hopefully, with the FIL’s express commitment to national treatment, such arbitrary limits on access will soon become a thing of the past.
It is also worth noting that, under the FIL, the principle of national treatment extends beyond market access. It also extends to operations. Previous laws called for the protection of foreign investors’ operating interests, and so does the new law. But the new law goes beyond previous legislation to state unequivocally, in the strongest terms yet, that foreign-invested enterprises should equally enjoy, in accordance with law, the various state policies supporting the development of enterprises.
Although the elements of the FIL’s system of national treatment plus a negative list are familiar, their combination in this way, and their enshrinement in national law, reflects a deeper commitment to equal treatment of foreign investors. This promises to result in more fair, transparent and predictable regulation of foreign investment over time.
But the realisation of this promise will depend on implementation. And even with thoroughgoing implementation, important limits will remain.
Continuing limits on access
The advent of the FIL regime does not mean that foreign entities can undertake, by right, any activity that is not on the negative list. It only means that they can do so to the same extent permitted to domestic Chinese investors. But the Chinese government continues to exercise various controls over investments by domestic entities. And particular requirements, like the security review, will continue to apply to foreign investments alone.
General limits on business scope
One key limitation on domestic companies is the company registration authorities’ practice of approving businesses to conduct only specifically enumerated activities. This is the so-called ‘business scope’, contained in company business licenses. Chinese companies simply are not licensed, as in other jurisdictions, to undertake “any lawful business”, except in a few limited categories including banking and insurance. In practice they are generally only approved to undertake a quite limited number of closely related activities.
Under the FIL such limits on business scope could continue to hamper the flexibility of both domestic and foreign businesses to adapt to changing business needs.
In some cities the local authorities have started to allow domestic Chinese companies to apply for a business scope of “any business except those subject to a license or permit according to the law”. But it remains to be seen whether this practice will continue under the FIL. Of course in accordance with the principle of national treatment, if and where it does continue, the practice should also be extended to FIEs, which seems unlikely.
China has long had in place a system of pre-approval licensing requirements for domestic investment in various activities, mirroring to a limited extent the approval requirements for foreign invested enterprises. Over time the government has replaced pre-establishment with post-establishment licensing, and the list of pre-approval items has shrunk. Nevertheless the current list of pre-approval items, maintained by the company registration authorities in the State Administration for Market Regulation, is around 30 items long.
Under the FIL these pre-approval requirements will apply to FIEs even in otherwise ‘permitted’ sectors. Many if not all of the licensing regulations will need to be adapted to apply to FIEs. This may constitute a major challenge for the administrators, and if not done well will be a major source of frustration for foreign investors. Also, because the licensing authorities have significant discretion in evaluating applications and there are some other practical issues, there will be ample opportunity to impede foreign investment in these otherwise permitted sectors.
As most of these decisions will be made by local authorities, this will be a real test of China’s ability to ensure national treatment for foreign investment on a national scale.
Regulations require security review of foreign investments in sectors deemed sensitive to national security. As in other countries’ regimes, the scope of projects requiring review, the procedures, and the criteria for review are left somewhat vague. Under the FIL this will remain as another potential impediment to foreign investments which would otherwise be characterized as permitted.
Acquiring land use rights by manufacturing companies
Before the FIL if a foreign investor intended to set up a manufacturing company in China and acquire land use rights for such manufacturing entity it had to commit to the local government on the investment scale, tax contribution and revenue targets of the project. It remains to be seen whether local governments, in practice, will apply the same criteria to domestic Chinese companies and foreign-invested companies in these respects under the FIL.
Convergence of company law, and the need for new registration regimes
In the interest of national treatment the FIL does away with three long-standing basic laws on different types of FIEs: wholly foreign owned enterprises (WFOEs), Sino-foreign equity joint ventures (EJVs) and Sino-foreign cooperative joint ventures (CJVs). In the future all foreign invested enterprises will be governed by the same company law and partnership law that apply to domestic entities. However, the FIL provides for a five year transitional period after coming int oforce, during which such existing FIEs may continue in their present form.
This situation is likely to result in significant confusion for existing CJVs and EJVs in particular. This is because EJVs and CJVs differ in a number of ways from standard company law limited companies.
It remains to be seen whether, during the five year grace period after the FIL comes into force, existing JVs will need to choose between the new regime and old regime. If so what would it mean for them to elect to be governed by the old regime, which will no longer exist? Indeed, this will be an issue even if existing JVs do nothing, and simply fail to amend their articles of association and restructure during this period.
Presumably if a JV elects to be governed by the Company Law, it will be issued a new business licence indicating its new form, and permitted as a matter of course to amend its Articles of Association and governance to be consistent with the Company Law terms.
But these and other registration changes for existing FIEs (WFOEs and JVs alike) are currently governed by an administrative regime particular to FIEs. That regime will presumably need to be jettisoned, and FIEs incorporated into the existing registration regime for domestic companies.
We expect to see a number of new regulations and amendments to existing regulations issued prior to the effectiveness of the FIL, addressing such issues.
Meanwhile, subject to agreement among the parties, existing JVs may wish to consider amending their articles of association to be consistent with the Company Law provisions once the FIL becomes effective.
We also expect to see significant uncertainty and confusion for new FIEs, both before and after the effectiveness of the FIL.
Prior to the law’s effectiveness the existing approval and registration procedures will be clear enough, for both JVs and WFOEs. But during this period any parties considering a new JV will face all of the uncertainties highlighted above in contemplating the post-FIL regime. It may be difficult to manage and plan for that uncertainty, in advance.
After the law’s effectiveness, under the principle of national treatment, the current NDRC and MOFCOM filing or approval procedures, applicable only to FIEs, should be terminated. And, as discussed above, the currently separate company registration regime for new FIEs will need to be merged with that for domestic enterprises.
Therefore the regulators will need to cancel a number of rules, and put in place a completely new set of rules, or amendments to existing rules, to govern FIE establishment after the law comes into effect.
Hong Kong, Macao and Taiwan investments
The FIL does not mention Hong Kong, Macao and Taiwan enterprises. Such enterprises are generally treated as ‘foreign invested enterprises’ under the original FIE regime, although these home jurisdictions are considered to be Chinese territories.
On March 15 2019, the premier of the State Council, Li Keqiang, indicated that the regulation of Hong Kong, Macao and Taiwan investment would be carried out by reference to the FIL. In keeping with past practice, and consistent with the treatment of other foreign investments, we expect that such enterprises will also be accorded national treatment.
Over the years the variable interest entity (VIE) structure has commonly been used to circumvent China’s restrictions on foreign investment in certain sensitive sectors such as telecoms and education. The VIE is a structure using nominee and other arrangements to create a contractual functional equivalent to ownership, without taking direct legal ownership rights in equity or shares. This approach has also been widely adopted by numerous Chinese-controlled companies as a structure to facilitate listing on foreign stock exchanges.
In spite of their ubiquity, because their purpose and effect is to permit a kind of foreign investment in prohibited areas, VIE structures at best inhabit a grey area of the law. As a result, they carry a number of significant risks, including the risk of a wholesale government crackdown.
The advent of the FIL doesn’t seem to materially increase the risks around VIEs. The FIL does provide additional legal grounds for acting against VIEs, by providing a general definition of foreign investment that could include VIE contractual controls. But the law omits an important distinction, seen in earlier drafts, between ultimate foreign and Chinese control. That distinction would have allowed a selective crackdown on foreign-controlled VIEs, while sparing the many prominent publicly-listed VIEs under ultimate Chinese control – probably an important prerequisite for any crackdown.
So the FIL seems to reconfirm the government’s long-standing tacit tolerance of VIEs as a fact of life. However, the implementation rules of the FIL may further clarify under which circumstances a VIE structure could be considered illegal.
IP rights & forced technology transfers
In response to perennial complaints from foreign business and governments the new law expressly states two points concerning IP rights:
- administrative agencies shall not force technological transfer through administrative measures;
- the state protects the IP rights of foreign investors and foreign-invested enterprises, and strictly holds those who infringe on other’s IP rights legally accountable.
Of these, only the first is really new, directly addressing a key complaint of US president Donald Trump. The second simply reiterates what should anyway have always have been the case.
But foreign investors’ dissatisfaction with China’s IP protection regime is wide ranging, and runs deep. Even where the law is enforced as it should be, its protections and remedies are often seen as too little too late. It remains to be seen whether the law heralds a new commitment to more thoroughgoing change in the IP protection regime as a whole.
To address some long-standing complaints of foreign investors and further implement the policy of national treatment the FIL also adopts some further measures. Again, these are not all new, and will need to be effectively implemented in order to have any meaningful impact.
Foreign enterprises in China have long complained of being locked out of the Chinese government procurement process.
Previous government procurement law said that foreign supplies may be used only when comparable supplies are not available from domestic suppliers on reasonable commercial terms.
The FIL guarantees to foreign investment that they can participate in government procurement activities through fair competition. Changes to the procurement law itself, and in the protectionist attitudes of local government officials, will be required to give effect to this promise in practice.
Local government discretion
The FIL says that local governments and their relevant departments will formulate normative documents concerning foreign investment according to law, and shall not impair the legitimate rights and interests; impose any additional obligations; set any condition for market access and withdrawal, or intervene in any normal production and operation activity of foreign-invested companies without a legal basis.
This is welcomed. But, even without the FIL, government officials should anyway not have done such things in the past. And even where administrators do follow the law, foreign firms have long complained that the laws often appear to be enforced against them more aggressively than against their local competitors. This has been an important aspect of the perceived lack of fairness toward foreign investors.
Nevertheless, this statement in the FIL helps establish a clear standard of behaviour for local officials. Hopefully, this policy will be further developed, and local officials will gradually take the spirit of national treatment to heart. But this is not likely to happen overnight.
Enforceability of investment agreements with local authorities
The FIL says that local governments at all levels will strictly keep their policy commitments made to foreign investors and FIEs, and perform all contracts entered into in accordance with the law.
This, again, is a requirement for governments to do what they already should.
But the formalisation of this principle in national law is new, and will provide important high-level guidance to both local governments and the courts.
One truly innovative aspect of the FIL is its stipulation that a complaint mechanism be established to solve problems brought forward by FIEs and foreign investors.
It remains to be seen how this will be implemented in practice. What sorts of organs will be established, with what powers, resources and procedures? Surely there will be variation between areas? Perhaps this will be helpful in certain places, and cases. But insofar as the organ for handling complaints will itself be under the local government, the mechanism is not likely to be very helpful in many cases where FIE interests are adverse to those of either the local government itself or powerful local SOEs under its patronage.