Nov. 2015

The Ministry of Commerce released the PRC Foreign Investment Law (Draft for Comments) (“Draft Law”) in early 2015 for public comment. Although some provisions may change in the final version, which is still under revision and expect to be promulgated is late 2016 or 2017, the Draft Law represents a paradigm shift for foreign investment. It includes both good and bad news for U.S. investors in China.

On the positive side, the Draft Law 1) replaces the encouraged, restricted and prohibited industry lists with a single “negative list” of industries restricted or prohibited to foreign investment, 2) replaces the foreign investment approval system and its time-consuming procedures with a simpler reporting system for non-restricted industries, and 3) repeals the current three foreign-invested enterprise laws, reverting to the PRC Company Law as the uniform basis for corporate structure and governance.

Less helpfully, the Draft Law also 1) requires disclosure of detailed information about each foreign investment and the ultimate party controlling the investor; 2) includes civil and criminal penalties for filing false information, 3) implements an “effective control” test that prevents use of variable interest entities (VIEs) to invest in restricted or prohibited industries, 4) includes civil and criminal penalties for investing in such industries through VIEs or other indirect means, and 5) raises the level of the foreign investment security review from a departmental regulation to national law, broadening its scope and prohibiting any appeal from a negative determination.

By way of background, all investments in a company in China under the current foreign investment regime must be approved by the relevant foreign investment authority, either the Ministry of Commerce at the national level or a commerce commission at the local level. The foreign investment authority conducts a substantive review of the formation documents for a new company or the purchase contract and formation document amendments for an acquisition, and may require revisions. The documents and underlying the transaction are not effective until the authority accepts them and issues an approval letter. Subsequent capital increases, share sales and structural changes are not effective until approved.

Foreign investments in China are restricted by industry. The PRC National Development and Reform Commission and Ministry of Commerce publish catalogs guiding foreign investment. The catalogs list industries that are encouraged, restricted or prohibited to investment, and impose conditions on investment in restricted industries, e.g., limiting foreign investors to holding no more than a minority interest. Under the current regime, the nationality of the company making the investment determines whether it is “foreign”. As a result, a non-Chinese company owned wholly by Chinese nationals may be treated as a foreign investor.

The current regime includes three laws and related implementing regulations governing wholly-owned subsidiaries and equity and contractual joint venture investments by foreigners in China. The three laws prevail if they conflict with provisions of the PRC Company Law, but the many laws governing foreign-invested companies in China sometimes lead to confusion. If adopted, the Draft Law will do away with many inconsistencies and redundancies, and simplify investment.

It will replace the foreign investment catalogs with a “negative list”, similar to the one implemented in the Shanghai Free Trade Zone. The negative list includes certain industries and investments exceeding certain financial thresholds. Only foreign investments in industries on the negative list will require approval from the relevant foreign investment authority. For an industry not on the negative list, the investors will simply file a report with the foreign investment authority – the report can be submitted as late as 30 days after completing the investment.

U.S. investors familiar with the approval process in China will be relieved not to be required to go through it. Eliminating approval will level the playing field, because local investors are not subject to such approval. It will also bring China into line with practices in major economies such as the United States. Also, the approval authority will no longer review the formation documents, and investors should be able to draft more flexible shareholder contracts and articles of association to support fund raising and common control structures, provided they comply with the PRC Company Law.

However, the reporting requirements that replace approval will still present some challenges. Article 32 of the Draft Law includes criteria to consider in the implementation stage report, such as impact on national security, energy resources, technical innovation, environmental protection, employment and other matters that could affect national security. Foreign investors are required to report the amount of their investment, the invested industry and method of investment, location of the project, shareholding percentages and governance structure. They are also required to disclose their identity and the identity of any party that in fact controls them.

Both the foreign investors and the invested company in China must continue to file annual reports, or quarterly reports for larger projects. They must include financial statements for the invested company, and disclose taxes paid, imports and exports, lawsuits, and dealings between the invested company, its foreign investors and their affiliates. The reporting requirements in the Draft Law are more detailed and more comprehensive than disclosure requirements for non-listed companies in most developed economies.

The Draft Law, when finalized and promulgated, will represent a major step forward in facilitating the process of establishing a subsidiary or investing in an existing company in China. While the detailed disclosure requirements and control “look through” provisions should not be overlooked, the changes to the Law will bring China more into line with international practice in developed economies and should substantially reduce registration headaches for foreign investors for projects that are not on the negative list.

If you have questions or would like assistance complying with new regulations in China, please contact Allan Marson at allan@marsonlaw.com or +1 650-387-7038 for a complimentary consultation.