China published draft regulations for the implementation of the Foreign Investment Law for public consultation

On November 1, 2019, the Ministry of Justice of the People's Republic of China (PRC) released the draft Regulations on the Implementation of the Foreign Investment Law (Draft Implementation Regulations) for public consultation. This is a long-awaited step following promulgation of the Foreign Investment Law (FIL) on March 15, 2019. The formal version of the implementation regulations is intended to take effect, together with the FIL, on January 1, 2020. For further information on the FIL, please refer to our recent publication.

The key aims of the FIL are to:

• reduce entry barriers for foreign investors in China
  
  
• enhance the protection of foreign-invested enterprises
  
  
• address concerns of foreign investors in respect of, inter alia, intellectual property protection and national treatment.

The promulgation of the FIL has demonstrated the Chinese Government’s firm and continuous commitment to open up its market to foreign investment. However, the FIL is rather generic and high level in terms of its provisions. The Draft Implementation Regulations also lack the level of details as expected by the market but have clarified a few ambiguous points arising from the FIL.

We set out below the key highlights under the Draft Implementation Regulations:

Foreign-invested enterprise (FIEs) in China

• The FIL permits foreign investors (whether independently or jointly with other investors) to set up FIEs in China and the Draft Implementation Regulations clarify that “other investors” may include Chinese natural persons. This is a significant development as currently, a Chinese natural person may only become a shareholder of an FIE if this is as a result of the acquisition of a domestic company (where the Chinese natural person is an existing shareholder) by a foreign investor(s).
  
  
• A particularly notable provision of the Draft Implementation Regulations is Article 35 which provides that when a foreign investor is wholly-owned by a Chinese natural person or legal entity (excluding FIEs), investments made by such foreign investor in China will not be subject to the restrictive measures in the Negative List provided that the approval of the State Council is obtained for such investment. This key change indicates the legislative intention of looking at the ultimate ownership of foreign investors and signals the relaxation of restrictions on “round-tripping” investments²  back to China. However, the thresholds are rather high to meet as (i) the State Council approval is required, and (ii) the foreign investor needs to be wholly China-owned (i.e. wholly owned by a Chinese natural person or legal entity).
  
  
• The Draft Implementation Regulations introduce a new requirement on foreign investors investing, by way of a partnership, in an industry that is subject to shareholding restrictions under the Negative List. In respect of such foreign investors, the ratio of that investors’ voting rights in the partnership agreement shall comply with the foreign shareholding restrictions in the Negative List.

Foreign investment services system

The FIL states that China will establish a foreign investment services system to provide services to FIEs with regard to laws, regulation, policies and potential investment projects. The Draft Implementation Regulations clarify that the National Integrated Online Government Service Platform (the Platform) will be used to provide such services³. The infrastructure of the Platform (http://gjzwfw.www.gov.cn/) was completed at the end of 2018 and a trial website was launched in September 2019. The Platform now incorporates over 1000 service items offered by 44 government agencies at the central level and over 3 million service items provided by 32 provincial governments, available to not only legal entities operating in the China market but also individuals.

Intellectual Property rights

The FIL provides that China will protect the intellectual property rights of foreign investors and FIEs and “strictly hold the infringers legally liable according to the law”. The Draft Implementation Regulations further provide, although still rather briefly, that China will establish a punitive damages system against intellectual property infringements in order to strengthen intellectual property protection.

Policy commitments made by local governments

• The FIL provides that local governments shall perform their policy commitments legally made to, or contracts entered into with, foreign investors and FIEs. If a policy commitment or contractual provision is required to be changed in the national or public interest, such change shall be made in accordance with the local government’s statutory powers and procedures. In addition, foreign investors and FIEs shall be compensated for their losses so incurred.
  
  
• The Draft Implementation Regulations re-emphasise that:
• local governments must not make any policy commitment outside of their statutory powers
• if a policy commitment is made, it shall be in writing and strictly comply with laws, regulations and state policies
• local governments may only change such policy commitments or contractual provisions for reasons of national or public interest, but not for any other reason.

However, the Draft Implementation Regulations stay silent on the legal consequences if the local governments fail to comply with these requirements.

Transition period

The FIL implements a five-year transition period (starting from January, 1 2020) for existing FIEs to convert their corporate governance structure/arrangements to be in line with the PRC Company Law. Upon the FIL taking effect on January 1, 2020, the current laws and regulations specially applicable to Sino-foreign joint ventures and wholly foreign-owned enterprises will cease to be effective, and accordingly the PRC Company Law will apply to the corporate governance structure/arrangements of FIEs. The Draft Implementation Regulations further require existing FIEs to complete the conversion within six months following January 1, 2025, otherwise the local authorities will not process applications made by FIEs for any other company registration matters (e.g. change of board directors).

Variable Interest Entity (VIE)

• The legality of VIE structure has been a hot topic concerning foreign investment in China since the circulation of the first draft of the Foreign Investment Law for public consultation (外国投资法（征求意见稿)) by the Ministry of Commerce in 2015. The essence of a VIE structure is that by virtue of various contractual arrangements, foreign investors gain de facto control over, and quasi ownership in, domestically-owned business operators holding critical licenses (which would otherwise not be available if the domestic business operators are directly foreign-owned). The VIE structure has been used in regulated sectors such as telecom services and education.
  
  
• The VIE structure has generally been tolerated by Chinese regulators. However, in recent years, this structure has started to receive more scrutiny. The 2015 version of the draft Foreign Investment Law indicated the regulator’s intention to tackle this issue explicitly but the relevant provision was dropped from the 2018 version of the draft FIL as well as the final version of the FIL. The Draft Implementation Regulations remains silent on this point as well.
  
  
• As noted above, the Draft Implementation Regulations indicate the legislative intention of looking at the ultimate ownership of foreign investors. However, it remains unclear whether or not the VIE structure falls within the regulatory ambit of the FIL at all⁴ and the Draft Implementation Regulations do not provide any clarity on this point either. The uncertainty surrounding the VIE structure suggests that the regulators’ interpretation could go either way. In other words, there is a risk that the VIE structure may be interpreted by Chinese regulators of certain sensitive industries as falling within the scope of FIL and will therefore be scrutinised based on the ultimate ownership behind this structure. The “catch-all” provision in Article 2 (which deals with the application ambit of the FIL) of the FIL that “investment in any other manner as specified by law, administrative regulation or the State Council” also leaves room for future legislation to tackle VIE structure explicitly, if considered necessary. In light of this, foreign investors should continue to act with caution before embarking on a VIE structure involving any industry falling within the Negative List.

Foreign investment in China- the road ahead

These recent legislative developments signal the Chinese Government’s continuous commitment to enhancing the legal framework for foreign investment in China. While the road ahead for foreign investors looking to invest in China is exciting, to what extent the high-level principles set out in the FIL will be implemented depends on the final shape of the Draft Implementation Regulations and related legislative and enforcement practices.

We are closely monitoring the changes to China’s foreign investment laws and will continue to provide further updates.