New Foreign Investment Law of China Enters into Effect
China's new Foreign Investment Law (FIL) enters into effect from January 1, 2020. As we reported in our earlier alert, the passage of the FIL opened the door to a new era of foreign investment in China by overhauling the foreign investment regime that had been in place for almost 40 years. Now with the FIL taking into effectiveness from January 1, the new era has just started. For implementing this milestone law from January 1, many new regulations and rules were rushed out literally in the last couple days of 2019, including the Implementing Regulations of Foreign Investment Law (Implementing Regulations) by the State Council, a judicial interpretation by the Supreme Court, and several ministerial rules by the Ministry of Commerce (MOFCOM) and the State Administration of Market Regulation (SAMR, formerly known as the State Administration for Industry and Commerce or SAIC). Plus, certain rules issued under the prior laws have been repealed or amended, and more will be rolled out in the coming days. There are quite a number of provisions in the FIL and the Implementing Regulations concerning the promotion and protection of foreign investment, which we would address them in other context. In this article we intend to focus on certain key aspects of the newly issued regulations and rules concerning the earnest issue on making foreign direct investment in China, i.e., incorporating a foreign invested enterprise (FIE) in China.
- Elimination of the Front Office Role of MOFCOM
The most significant, visible change introduced by FIL to the traditional regime of FIE incorporation is about removing the front office role of MOFCOM. In the past, foreign investors would have to first deal with MOFCOM (or its predecessors) by obtaining MOFCOM's approval (or a less strict form, recordal) before an FIE can be set up by registering with SAMR (or SAIC in the past) and obtaining a business license. In the context of a joint venture, this means the relevant joint venture contract (which must adopt the PRC law as the governing law) must be approved by MOFCOM. Essentially, MOFCOM had the authority to review and judge whether a particular foreign investment project complied with the state's foreign investment policy and therefore held a gatekeeper role in approving the establishment of an FIE.
The new FIL is centered on the concept of negative list, which has expressly listed what businesses are prohibited or restricted for foreign investment. No foreign investment is allowed in prohibited businesses, yet investment into restricted businesses would require certain approval to be rendered by applicable industrial ministries. For all other investment in businesses outside the negative list, there is no whatever approval at all. This has made the gatekeeper role of MOFCOM redundant.
Per the Implementing Regulations as well as the Measures on Foreign Investment Information Reporting (Information Reporting Measures) jointly issued by MOFCOM and SAMR, foreign investors no longer need to obtain approval or recordal of MOFCOM for setting up an FIE, and, subject to any approval from a competent industrial ministry, the registration with SAMR alone would be sufficient to set up the FIE. Even if certain foreign investment information shall be still reported to MOFCOM as discussed below, removing the visible role of MOFCOM will significantly simplify the FIE incorporation process.
- Foreign Investment Information Reporting to MOFCOM
Per the Information Reporting Measures, the foreign investors or FIE are still required to report certain foreign investment information to MOFCOM, mainly consisting of the following four types:
- Initial report, which covers the basic information about an FIE, each investor and its actual controller and investment transaction, to be submitted when an FIE is initially set up or when a PRC domestic company is acquired and converted into an FIE;
- Report on change, which covers any change of information reported in the initial report;
- Deregistration report, which covers the information about deregistration of an FIE or conversion of an FIE into domestic enterprise;
- Annual report, which covers the basic information about an FIE, each investor and its actual controller, and operational information, assets and liabilities, etc.
All the information to be reported to MOFCOM by the foreign investors or FIEs will be handled via certain online systems administered by SAMR including the enterprise registration system (for the first three types of reporting) and the enterprise credit information publicity system (for the annual report). SAMR is required to timely share and push the submitted information to MOFCOM pursuant to the Information Reporting Measures. However, in case of a change of the relevant information that does not trigger any amendment of registration with SAMR, for example, a change of the information concerning an FIE's actual controller, the foreign investor or the FIE is still obligated to timely report such change of information to MOFCOM.
- Transition of Existing FIEs
First, FIL provides that the existing FIEs that were set up before January 1, 2020 ("Existing FIEs") can enjoy a 5 year transition period from January 1, 2020, in which period they can still maintain their original organization form and corporate governance structure despite any difference from the current company law (or partnership enterprise law as applicable). The Implementing Regulations clarify that the Existing FIEs may either keep or change their organization form and governance structure for compliance with the company law during such transition period. However, if their organization form or governance structure still has not been updated after the transition period, which would be viewed a non-compliance to the law, SAMR will not entertain their application for any business registration and will publicize such non-compliance after January 1, 2025.
Second, the Implementing Regulations provide that after the organization form and governance structure of the Existing FIEs have been updated to comply with the company law, the various contractual provisions in the original joint venture contracts concerning the transfer of equity interest, distribution of profits and distribution of remaining assets after liquidation may continue to be binding as originally agreed.
The above transition arrangement can bring up some practical concerns in particular for the existing joint ventures. For example, whether the joint venture partners are willing to cooperate and agree to timely adjust the organization form and corporate governance structure; whether this would open the floor for a joint venture partner to request for revisiting and amending any other provisions in the joint venture contract.
Among others, please note that there is a key difference between the company law and the repealed joint venture laws in term of corporate government structure and the protection on minority shareholder. The joint venture law provided that the board of directors shall be the highest authority of the joint venture, in which each director has one vote. The implementing regulations of the joint venture law provided more protection to minority shareholder since certain key issues concerning the joint venture would require unanimous approval of the board of director, such as amendment to articles of association, merger or division, termination or dismissal of the joint venture, and change of registered capital. In comparison, the company law provides that the shareholders' meeting is the highest authority of the company, where the shareholders will vote based on their respective shareholding, and the various key issues concerning the company could be determined with the vote by the shareholders representing more than 2/3 of voting rights. This means, unless the company's articles of association would have higher threshold than the statutory requirement, the shareholder holding 2/3 of shares of a company would have the absolute control over the company and hence there may not be sufficient protection for minority shareholder. Because of such different voting structure under the company law, it is particularly important for the minority shareholders in a joint venture to consider and re-negotiate how to better protect its interest under the company law after the expiration of the transition period. While 5 years sound long, time can pass by quickly, and it is better to prepare for the transition as early as possible.
- Investment Involving Chinese Individual Investors
Under the past practice before 2020, a Chinese individual investor cannot directly act as a joint venture partner to set up a joint venture with foreign investors in a greenfield project (unless the Chinese individuals had been shareholders for more than a year in an existing PRC domestic company, which can be converted into a joint venture upon acquisition by a foreign investor). This has forced Chinese individual investors to adopt an indirect investment structure by using their controlled China companies to partner with foreign investors for setting up a joint venture, which may not be tax efficient because of the extra layer of taxation at the controlled China company level.
vWhile FIL is silent, the Implementing Regulations provides that foreign investors may set up FIEs or invest in new projects jointly with Chinese individual investors. This is a significant breakthrough for Chinese individual investors since they can now directly become joint venture partners and enjoy the tax efficiency. This is also good news for foreign investors since they can have more choices when selecting potential business partners for setting up FIEs. Indeed, the very first joint venture with a Chinese individual investor has been reported to be registered in Shanghai on January 1, 2020.
However, the Implementing Regulations still have not clarified how to deal with the situation, that is, whether a Chinese company, which was established by certain Chinese individual investors but one of the Chinese investors later immigrated and changed his or her nationality to become a foreign passport holder, can then be treated as an FIE. We are expecting this issue to be further clarified.
- Reinvestment by FIEs
The Implementing Regulations clarify that the reinvestment made by FIEs in China is also subject to the FIL. This has followed the current practice in penetrating foreign investment. Therefore, regardless of how many layers such reinvestment would involve, reinvestment by FIEs will still be regulated as foreign investment. Because FIL has relaxed regulations on foreign investment overall, this also means that reinvestment by FIEs will be relaxed, for example, no more approval or recordal with MOFCOM is required. In connection with foreign investment information reporting, since all information would have been provided to SAMR, the Information Reporting Measures provide that SAMR shall share and push the information on reinvestment by FIEs to MOFCOM, and the company is not required to submit reports to MOFCOM.
- Investment by Hong Kong, Macau and Taiwan Investors and Overseas Chinese
The Implementing Regulations reinforce the current practice of regulating the investment made by Hong Kong, Macau and Taiwan investors and Chinese citizens residing outside China by reference to laws and regulations governing foreign investment. This means that investors from those special regions or overseas Chinese will also benefit from a simplified incorporation process under the umbrella of a negative list regime.
- Dealing with Potential Legal Conflicts
The Implementing Regulations provide that if any provisions in relation to foreign investment promulgated before January 1, 2020 are inconsistent with the FIL and the Implementing Regulations, the FIL and the Implementing Regulations shall prevail.
We note that MOFCOM has taken actions in cleaning up its rules issued in the past. Just by its Announcement on Abolishment of Some Normative Documents and Decision on Abolishment of Certain Ministerial Rules, more than 60 pieces of regulatory documents have been repealed by the end of 2019.
However, certain important ministerial rules issued under the past regime seem to have not yet been repealed or amended, for example, the Provisions on Merger and Acquisition of Domestic Enterprises by Foreign Investors, which among others are crucial in governing related party acquisition of PRC companies by Chinese investors, and Administrative Measure on Strategic Investment by Foreign Investors in Listed Companies. This means a lot of uncertainty in these sub-categories of foreign investment will exist for some time until those rules are changed.
- Unanswered Issues
Even if the Implementing Regulations have answered some of the issues that were not clear under the FIL, there are still many important issues on foreign investment that have not been otherwise clarified by the Implementing Regulation. For example, how to deal with the round-trip investment into China (China inbound investment made by Chinese controlled foreign company); how to deal with the VIE structure; what is the definition and scope of new projects for foreign investment purposes, etc. We expect that those issues will be ultimately clarified over the time. We will continue monitoring the development and share update with you from time to time.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.