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What changes can be expected from the proposed new Foreign Investment Law

What is the proposed new draft Foreign Investment Law?

The new draft law is “Big.” The recently released document is only a draft, but it can tell us important things about where China is headed in terms of regulating Foreign Investment as it manages the planned transition away from a manufacturing and export driven economy toward a more domestic consumption driven economy. The newly proposed law is expected to replace the three existing laws now covering various types of foreign investments. The new unified Foreign Investment Law is intended to replace: the Law of the PRC on Chinese-Foreign Equity Joint Ventures, the Wholly Foreign-owned Enterprise Law and the Law of The People’s Republic of China on Sino-foreign Cooperative Enterprises.

The new law will look at “Actual Control.” What is “Actual Control”?

The introduction of the concept of “Actual Control” means that Chinese regulatory authorities will look to the actual beneficial owners and potentially those “calling the shots” of an entity in making the determination on whether it will be considered a “Foreign Investment” falling within the Foreign Investment Law or not. This is a departure from the current situation in which a WFOE fully owned and controlled by a foreign company, may itself establish an entity in China would then be considered a domestic company under Chinese law, and not a foreign invested entity.

What would happen if a Chinese individual or company, establishes a company outside the territory of China and then that foreign company establishes a new company in China?

In this situation, the law allows regulators to look to consider the fact that the controller and beneficial owner of the newly established China company is a Chinese national citizen or entity. The regulator will find that the new Chinese company shall not be regulated as Foreign Invested Enterprise, even though the immediate investor originates outside the territory of China.

So this means VIE’s are dead, right?

One of the factors likely behind the switch to the concept of “Actual Control” is the growing use of Variable Interest Entities (VIE) in China. VIEs are used by foreign companies to enable them to conduct business activities in industries which may be restricted or prohibited to foreign investment, VIE’s are also used by Chinese companies operating in such restricted and prohibited areas, to allow the Chinese company to seek foreign investment via listing on foreign stock exchanges.

The VIE entity is a specialized China company holding the licenses to carry out such restricted and prohibited activities. The VIE relationship is created through a series of contractual agreements between the VIE entity and the foreign entity granting the foreign entity control over the shares, management and operations of the VIE company, which is now technically a domestic Chinese company, but would be controlled by a foreign entity.

By looking to the “Actual Control” of the entity in making the determination on whether the company is a Foreign Invested Enterprise, the new FIE law would eliminate the efficacy and raison d'être of most VIE’s, particularly those established by foreign companies with the intent to operate in restricted and prohibited industries.

However, the law leaves the opportunity for Chinese companies operating via a VIE while soliciting foreign investments via international stock markets to apply for recognition and approval of their operation under the “Actual Control” of Chinese nationals.

And what’s the Negative List”?

The draft law proposes to simply Foreign Investment by freeing up investments in most industries and sectors. However, some areas will be placed on a “Native List” of Prohibitions and Restrictions on foreign investment. If that sounds familiar to you, its because China has already had a list of Prohibited, Restricted, and Encouraged sectors for foreign investment for several years. It remains to be seen how narrow or broad the new Negative List will be. At the worst, it is not expected to me more restrictive than the current classification system, but whether there will be a significant change toward more actual freedom for foreign investments is unclear.

What are the implications regarding the new National Security Review system?

Describes the establishment of a new united foreign investment national security review system which is intended to conduct national security examinations on any potential foreign investments which “may endanger the national security.” This appears to be a new development though it is unclear to what extent such reviews may or may not have taken place through the FIE approval process in the recent past. At the very least it is new that the law will make such reviews explcit and expected. It will also potentially give authorities more leeway in denying investments even where they may not fall within the “Negative List.”

Will reporting obligations of Foreign Enterprises change? What is the new Information Reporting System?

In addition to the usual reports on establishing the FIE and the expected Annual Report, the new FIE law will impose a requirement to file a report anytime a foreign investor purchases not less than 10% of the stock of a domestic entity, or less than 10% but the purchase results in a change of control of the domestic entity. These changes appear designed to assist authorities in enforcing “Actual Control” provisions as described above.

Complaint Coordination? Will the Chinese government listen to my company’s complaints?

Maybe. The draft Foreign Investment Law proposes the establishment of a Foreign Investment Complaint Coordination System. Such system is envision to handle the coordination and disposal of investment disputes between foreign investors, foreign invested companies and governmental departments. This may serve as a venue to Challenge a decision by authorities regarding whether or not to prohibit or restrict a proposed investment based on Actual Control, or National Security concerns.

So if we aren’t a fancy VIE, and our operation doesn’t pose a national security concern, its business as usual in China, right?

No.  The draft law proposes a new supervision and inspection system for Foreign Invested Enterprises. The inspection system will focus on compliance regarding industrial and commercial rules, taxation, foreign exchange laws, auditing and others. This along with the proposed simplification of the establishment process is an indication that Chinese authorities are focusing more on enforcing existing laws so as to promote compliance and “Rule by Law.” Much remains to be seen in the implementation of the final version of the new Foreign Investment Law, but foreign companies should not assume, “business as usual” will prevail in China. Now is the time for internal compliance reviews designed to catch legal problems with your China operation before the Chinese authorities do.

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