Foreign Direct Investment: Changes in China

This article was written by He Wei.

Have there been any recent changes to the Foreign Investment rules in China?

The most important recent change was the introduction of the Foreign Investment Law (FIL) which was enacted on March 15, 2019 and took effect on January 1, 2020, replacing the Sino-foreign Equity Joint Venture Law, the Sino-foreign Cooperative Joint Venture Law and the Wholly Foreign Owned Enterprise Law (collectively the Previous FIE Laws) which were first passed in the 1980s and amended thereafter from time to time. On the same day the FIL took effect, a number of related regulations and notices (including the Implementing Regulations of the Foreign Investment Law) issued at the end of 2019 also came into force. The new FIL and related regulations mark the beginning of a new era for foreign investment in China, underscore the commitment to continue to open up industry sectors to FDI, level the playing field for foreign businesses and protect the IP of Chinese and international companies alike.

Further, the introduction of the latest version of the negative list for foreign investment (the Negative List), which was issued on June 23, 2020, sees a relaxation of restrictions on foreign investment in various sectors. The PRC National Development and Reform Commission (NDRC) have indicated that all restrictions on foreign investors beyond the Negative List will be cancelled.

If yes, please provide a brief summary of the changes

The previous case-by-case approval/filing system that existed for decades has been replaced by a much simplified regime. National treatment is one of the key words for the FIL and related regulations. Key aspects of the new regime are set out below:

• National Treatment Plus Negative List - The Negative List reflects China's approach to continue to liberalize foreign investment. For investments falling within the category of the restricted sector, the competent authorities will review the transaction to determine if the restrictions are complied with; for investments falling outside the Negative List, domestic and foreign enterprises will be treated the same, and no additional approval or license for foreign investments is required. The latest version of the Negative List was also significantly shorter than the first one issued in 2013. In the latest Negative List, foreign shareholding restrictions on financial companies such as securities companies and life insurance companies are lifted, one year earlier than expected and as a result, there is no foreign investment restriction in the financial sector. Further streamlining is expected. Examples of restricted areas being opened up include the lifting in 2022 of restrictions on the foreign shareholding in a passenger vehicle joint venture and number of such joint ventures.
• Information Reporting – Ministry of Commerce (MOFCOM) – the long-time watchdog for foreign investment – now takes a back seat in monitoring foreign investment through its information reporting system. This means no approval or record filing will be required from MOFCOM for incorporation of or any change related to a foreign-invested enterprise (FIE). FIEs will be required to submit information such as the initial report, change report, dissolution report and annual report through the information reporting system but are explicitly exempted from separate submission of information which can be obtained via information sharing between different governmental bodies, such as information regarding deregistration and domestic investment (including multi-layer investment).
• Unification of corporate governance rules - Prior to the FIL, China adopted a dual-track corporate administration regime where the FIEs were mainly subject to the Previous FIE Laws and the domestic enterprises were subject to the PRC Company Law (or the PRC Partnership Law, as applicable), which stipulated different rules on corporate governance, voting, share transfers, profit sharing and so on. Further, the Previous FIE Laws stipulated different rules for various types of FIEs. The new FIL provides that the organizational structures and activities of all FIEs shall be governed by the PRC Company Law and the PRC Partnership Law, thus unifying the fragmented corporate administration regime. The FIL also introduces a transition period of five years for the existing FIEs to adjust their organizational forms and corporate structure in accordance with the FIL.
• National Security Review - The FIL stipulates that the State is responsible for establishing a security review system, where foreign investments that affect or may affect national security will be subject to national security r The national security review was first mentioned under the Notice on Establishing the Security Review System for the Mergers and Acquisitions of Domestic Enterprises by Foreign Investors issued by the State Council in 2011 and the implementing rules issued by MOFCOM in the same year. The FIL establishes the national security review system for foreign investment for the first time in the context of a national law, and expands the scope of national security review from M&A transactions to all types of foreign investments. It is anticipated that Chinese authorities will pass separate implementing regulations to provide for details for national security review (such as review authority and process).

What was the rationale for the changes?

It has been forty years since China enacted the Previous FIE Laws. Despite their tremendous contribution at the early stages of China's reform and opening-up to the international community, the Previous FIE Laws required updating to modernise and simplify China's FDI regime. For example, the inconsistencies between the Previous FIE Laws and the PRC Company Law often caused  confusion with respect to how the rules should operate in practice, and the governmental approval or filing requirements applicable to the FIEs' entire life cycle imposed additional burdens for foreign investment.

In addition, against the background of US-China trade negotiations, the FIL also addresses some of the key concerns from the US, such as national treatment of foreign investment subject to the Negative List, protection of foreign IP rights and trade secrets, and equal treatment of domestic and foreign companies in government approval procedures. The changes indicate that China is committed to further opening up its market to FDI and welcoming inbound foreign investment. 

Are these changes temporary and if yes, when are they likely to be reviewed again? If not, are they part of a bigger reform (ie have there been any other recent developments, and are you expecting any further changes)?

The FIL are permanent and mark the most important milestone of China's recent reform of its foreign investment regime. Since the issuance of the FIL, a number of existing rules and regulations have been amended or abolished to align them with the FIL. We expect that more existing regulations will be amended and new regulations will be issued to implement the FIL.

Are there any particular sectors that are affected the most?

Healthcare industry

Under the current Negative List, FDI in the healthcare sector can only be made through joint ventures.

However, there are other positive changes as well. The State Council issued a guiding opinion in 2019 to encourage private investment in the healthcare sector generally, according to which the quantity and scale of public hospitals will be controlled to leave room for private investment in funding medical institutions, and public medical institutions will be encouraged to cooperate with privately owned medical institutions. Given the promotion of privately owned medical institutions by the government, it is expected that joint venture, M&A and other forms of investment activity in medical institutions will increase in the coming years.

Auto industry

China's auto market has suffered almost two years of sharply declining sales and the COVID-19 pandemic has caused the sector to suffer further. The latest version of the Negative List has lifted the restrictions on the share ratio of foreign investment in commercial vehicle manufacturing and all of the restrictions on the auto industry will be removed by 2022.

In addition, China signalled its intention to play a central role in the future of auto manufacturing when 11 central level Chinese governmental departments jointly issued the Strategy for Innovation and Development of Intelligent Vehicles (the Strategy) on 24 February 2020. The Strategy sets out a comprehensive and detailed plan for the development of autonomous vehicles in China. China recognizes the advantages it has in data, market, technology innovation and environment to build an autonomous car manufacturing titan. The Strategy also recognizes and seeks to address some of China's disadvantages such as its restrictions on mapping and some relevant laws that require updating

Financial market

Under the current Negative List, all the restrictions on foreign investment in the financial sector have been lifted in 2020, one year earlier than expected by the market. In addition, recent years also saw encouraging reforms in capital markets  such as the launch of the registration system under the amended Securities Law.

In addition, foreign shareholding in a securities company, a securities fund management company, a futures company or a life insurance company was previously capped at 51% before the latest Negative List was issued on 23 June 2020. The long-awaited removal of such restrictions means there will be no foreign shareholding restriction in any sector within the financial services (i.e. foreign investors will now be able to  establish their wholly owned subsidiaries in these sectors). In keeping with the easing of restrictions under FIL, there has also been a general trend toward lifting foreign shareholding restrictions for companies in the financial sector, unifying the market entrance requirements and allowing FDI into a broader range of businesses operating in the financial market.

What is the outlook for foreign investment in China?

In 2019, the total inflow of FDI to China was $140 billion USD. This meant that China ranked as the world's second largest FDI recipient after the United States. Despite ongoing trade tensions, China has remained an attractive market for foreign investors as domestic economic growth continues to lead to  rising disposable incomes amongst upper and middle-class consumers.

The FIL and the latest version of the Negative List  have relaxed restrictions on foreign investment in various sectors. The NDRC have indicated that all restrictions on foreign investors beyond the Negative List will be cancelled. Domestically, China has continued to grow its web of Free Trade Pilot Zones, particularly in central and western regions. These inland investment hubs will allow foreign investors to capitalize on the rapid growth of China's lesser-developed areas as the costs of doing business rise in Tier One and Two cities.

What is your advice to foreign investors in China?

Foreign investors should actively explore investment opportunities in China. Through the FIL, the Chinese government has sent a positive signal to the outside world that it is keen to open the Chinese economy  and promote foreign investment. Moreover, China's strong economic recovery and response to COVID-19 should make it an attractive market for FDI.

At the same time, China has successively issued a series of policies and measures in finance, taxation, insurance, and social security, and actively promoted more foreign-funded enterprises to resume work in an orderly manner. This has played an important role in stabilizing the economy and encouraging foreign investment.

FIEs in China should make use of the five-year transition period stipulated in the FIL to transition into the form of a limited liability company and update their constitutional documents in accordance with the provisions of the PRC Company Law or the PRC Partnership Law (or consider whether the relevant clauses can be renegotiated in accordance with the FIL).

FIEs and foreign investors targeting the Chinese market should pay close attention to the Negative List and the Catalogue of Encouraged Industries in order to select suitable industries and targets for investment in China. Negotiations should also be held with Chinese counterparts and local governments to maximize available preferential treatment.

What are the typical structures of foreign investment in China?

Foreign investment in China typically occurs by way of establishment of a wholly owned entity on a stand-alone basis, formation of a joint venture with a Chinese partner or by way of a merger or the acquisition of an existing Chinese owned business. In addition, a relatively recent development is for foreign investors confronted with restricted sectors to enter into contractual arrangements or hold restricted licenses in nominee company (this is known as a variable interest entity (VIE) structure).

JV or WFOE

In sensitive industries and markets, restrictions on foreign investment mean that investors are limited to joint venture structures (JV) with a Chinese partner. Many early JVs did not meet investor needs and were restructured – often due to insufficient due diligence, misaligned interests or management conflicts. Key reasons for selecting a JV structure are:

1. legal restrictions - i.e. required for certain restricted industries set out in the Negative List;
2. equity investment into an existing company with a shareholder that does not wish to exit;
3. reliance on a Chinese partner is deemed to be strategic or critical - JV contracts can contain a call option mechanism to transform the JV into a wholly foreign owned enterprise (WFOE) when conditions require; and
4. supportie structure for a private equity partner - private equity investors usually make minority equity investment and seek to exit the investments in the future for sizeable returns.

M&A transactions

M&A transactions have become an increasingly important route of investment in China by foreign investors. Typically, such transactions are made by way of acquisition of equity interests/shares in or assets of a private company or a public company. Overall, M&A transactions in China follow a similar pattern to other jurisdictions.  The acquisition of private companies is  relatively straightforward, whilst the acquisition of public companies is more complicated and subject to greater regulatory scrutiny and requirements.

In light of increased activity and enforcement  from Chinese regulators, international investors  should be aware of and take steps to manage compliance risks associated with unfair competition, bribery or corruption issues.

VIE structures

One type of contractual structure that has exploded in popularity and controversy, is the VIE structure. Where a proposed investment is subject to foreign investment restrictions (e.g. "value–added" internet services), parties commonly use a VIE to access the market. A VIE refers to a structure where a wholly or partially foreign owned entity enters into contracts with a Chinese operating company that has the approved business scope and holds the necessary licenses to operate in a foreign investment restricted or prohibited sector (Local License Company).

To obtain control over the operation and management of the Local License Company, various contractual arrangements are put in place between the WFOE, the Local License Company and its domestic shareholders. The controversy surrounding the VIE model stems from the legal uncertainty inherent in its structure. No Chinese regulatory body has officially approved a VIE structure and controls have tightened over VIE structured candidates that wish to list on the Hong Kong Stock Exchange.

FIL and the FIL Implementing Regulations do not clarify this issue. Considering the fact that large numbers of enterprises currently take advantage of the VIE structure, it comes as no surprise that the new foreign investment regime has allowed the status quo to continue.

Does China's FDI organisation coordinate with other government agencies, including the antitrust regulator?

China does not have a unified FDI organisation. A number of authorities interact with FIEs. The key government agencies include:

State Administration for Market Regulation (SAMR, also responsible for anti-trust fillings)

SAMR and its local counterparts are in charge of company registration and filing. The SAMR is one of China's super authorities which regulates broad areas of the economy including market competition, monopolies, intellectual property and drug safety. SAMR is typically the primary government agency that deals with foreign businesses and investors entering into China. Business sectors requiring special operational licenses or permits will also need to interact with the relevant authority in charge of the respective industry sector.

NDRC

NDRC retains its authority to approve/maintain filing records of foreign investment projects. Industry authorities have authority to issue industry specific licenses, for instance, ICP licenses in the telecommunications industry.

MOFCOM

MOFCOM has taken a back seat in monitoring FDI as the foreign investment process is more simplified and FIEs can now lodge their documents directly through MOFCOM's information reporting system.

State Administration of Foreign Exchange (SAFE)

SAFE is in charge of FIE's foreign exchange registration as well as the transfer of capital contributions, profits and other various incomes into or out of China.