The status quo of foreign investment in China
Xu Tian, Felix Engelhardt
Despite global trade tensions, controversial national security legislation or widely deplored insufficient protection of intellectual property rights (IPR), the People’s Republic of China (PRC) still plays a central role for hundreds of thousands of foreign companies in their international production and marketing strategy.
Expanding and keeping their business in the mainland has always been a decision which required careful planning and analysis of the existing legal landscape in the Middle Kingdom. Since 1 January 2020, this analysis has to be conducted against the background of a further liberalised system of foreign investment that finds its legal basis in the Foreign Investment Law (FIL) of the PRC, which is considered a major development in the regulatory environment, redefining general standards. This article provides an outline of the most important changes initiated by the FIL, its implementation procedures, and points out some practical implications which have been observed since it came into force.
The situation before the FIL
Before the FIL came into effect, access to the Chinese market was considerably more difficult for foreign individuals and companies than for their domestic competitors. Different and, in most cases, more strict legal requirements and administrative procedures, preferential treatment for domestic companies in areas such as public procurement and lacking protection of IPR have for many years caused an openly discriminative environment for non-Chinese persons who wanted to invest and operate in China.
Unlike companies owned entirely by Chinese nationals which are subject mainly to the PRC Company Law or the PRC Partnership Law, foreign invested companies were required to be set up and managed according to three completely different sets of rules, namely: Wholly Foreign-Owned Enterprise Law; the Sino-Foreign Equity Joint Venture Enterprise Law; and the Sino-Foreign Cooperative Joint Venture Enterprise Law, and their respective implementation regulations. The gap between these different legal frameworks with regards to, among other areas, investment restriction, incorporation procedure, internal organisation, minimum capital contribution, equity caps or distribution of profits was often large. For example, decisions regarding important matters such as capital increase had to be approved unanimously by the board of directors of the Sino-foreign equity joint venture (EJV), as opposed to a majority of shareholders representing two-thirds of all voting rights according to the Company Law.
Another significant difference in regulating foreign investment and market access in China has been the use of special lists (Special Management Measure for the Market Entry of Foreign Investment, Special Management Measures for the Market Entry of Foreign Investment in Pilot Free Trade Zones and Market Access Negative List) ('Negative Lists') which encouraged, restricted or prohibited investment activities depending on the corresponding industry sector. Furthermore, all foreign investment was subject to a record-filing with China’s Ministry of Commerce (MOFCOM), an obligation that was not required for domestic investors. Generally speaking, foreign investors saw themselves confronted by a highly uneven playing field.
What has changed on paper since 1 January 2020
The FIL is the result of a five years drafting process and can be seen as a reaction to the longstanding critique over the disparities described above. With the goal of ‘[...] further opening up to the outside world, actively promoting foreign investment, protecting the legitimate rights and interests of foreign investment [and] standardizing foreign investment management [...]’, the FIL is supposed to be a crucial step in creating a fairer business environment for foreign companies doing business in China. The main changes proposed by the law are:
• National treatment for foreign investors, except for those falling into the above-mentioned Negative Lists.
• Comprehensive definition of foreign investment [ie, setup of foreign-invested enterprises in China]; acquisition of shares, equities, property shares or other similar rights and interests of Chinese domestic enterprises; investment in new projects in China; other forms of investment according to other laws and regulations.
• Market access system based on Negative Lists upheld, but number of items on the lists gradually reduced.
• Promotion of foreign investment (eg, equal participation in commenting on foreign investment related legislation, standard setting and government procurement).
• Protection of foreign investment, especially trade secrets and other IP rights.
• Diversification of company funding methods.
• Establishment of a foreign investment reporting system to replace the previous recordal system (see below).
• Establishment of a foreign investment security review system.
• The repeal of old laws relating to foreign investment, with a five-year transition period for companies to adapt to the new legal framework.
Since the wording of the FIL is extremely vague, general and creates a lot of uncertainty when applied in practice, China’s legislature adopted Implementation Regulations of the Foreign Investment Law which also came into force on 1 January 2020. These regulations follow the structure of the FIL: Investment Promotion – Investment Protection – Investment Management – Legal Liabilities – Supplementary Provisions. They also provide some clarity by laying out in more detail the rights of investors and relevant government authorities’ obligations and liabilities when handling foreign investment matters.
Also in force from 1 January 2020 are Interpretations of the Supreme People's Court [SPC] on Several Issues concerning the Application of the Foreign Investment Law of the People's Republic of China, which deal with questions regarding validity of investment agreements, in particular where the subject matter of the contract is investment in an industry banned or restricted by the Negative Lists.
Finally, MOFCOM and the State Administration for Market Regulation (SAMR) released Foreign Investment Information Reporting Measures and a Notice Regarding Matters on Reporting of Foreign Investment Information on 30 December 2019 and 31 December 2019 respectively which came into force on 1 January 2020 too. They replace the foreign investment recordal with MOFCOM by an integrated reporting system managed by SAMR, provided the investment project does not fall within the scope of the Negative Lists. Consequently, regulations, notices and circulars relating to the old recordal system have been repealed.
What has changed in practice
As the new regulatory framework has only been in place for about six months, its full effects will only be visible after some more time has elapsed and more data and experiences of the new system gathered. Nevertheless, some noticeable changes have already been identified when assisting clients in relevant matters.
One example is the shift from investment information recordal to an integrated online reporting system. Since 2016, establishment of and corporate changes to foreign-invested enterprises not falling under the Negative Lists no longer required case-by-case approval from MOFCOM, but were subject to a filing of those circumstances for recordal. After receiving the application files, MOFCOM reviewed them and issued a recordal notice if the documents submitted met the formal requirements. Now, foreign-invested companies can directly report relevant information to the competent administration for market regulation via two online platforms and MOFCOM now does not issue recordal notices. This is, in fact, no longer necessary for proving a correct incorporation as other government agencies have direct access to the data stored in the shared databases under the newly integrated system. This has the potential to streamline the foreign investment management process, helping companies save time and costs.
Another practical implication is the required adaptation to the new legal regime by bringing the corporate structure in line with the Company Law or the Partnership Law. This has to be accomplished by 31 December 2024 by going through the existing procedures for change of registration. If companies fail to complete the necessary changes within the five-year grace period, future applications for corporate changes shall not be processed by the competent authorities. In addition, such companies will be publicly labelled as being non-compliant with the requirements to adjust to the new law. Foreign-Chinese joint ventures will in particular, face considerable changes in their organisational structure. For example, in an EJV previously regulated by the Sino-foreign Equity Joint Venture Law, the highest authority used to be the board of directors that had to take decisions with at least two-thirds of all directors and could vote on significant matters (eg, change of registered capital, changes to articles of association, change of corporate form) only unanimously. In conjunction with the Company Law, under the FIL, the highest body in the company is the shareholders’ meeting which basically does not know any decision quorum and can vote on significant matters with shareholders holding at least two thirds of all voting rights. Another example would be the transfer of equity to a non-shareholder, which required consent of all shareholders under the Sino-foreign Equity Joint Venture Law whereas approval by more than half of the other shareholders is generally sufficient under the Company Law. And although there still seems to be enough time to amend a company’s articles of associations and restructure the internal organisation, we usually recommend commencing this as soon as possible not only to be compliant with the new law before the deadline expires, but also, in particular, to reserve enough time for inevitable negotiations with JV-partners and to get accustomed to the new situation.
We also see improvements with regards to the areas covered by the different Negative Lists which have been continuously amended and shortened since their introduction in 2016. The latest revision of the Special Management Measure for the Market Entry of Foreign Investment and the Special Management Measures for the Market Entry of Foreign Investment in Pilot Free Trade Zones, which came into effect on 23 July 2020, further reduces the number of prohibited sectors from 40 to 33 and from 37 to 30 respectively. In addition, a new mechanism has been introduced to give the State Council the ability to exempt specific investment projects from the restrictions set up by the Negative List upon application. How this tool will be used in practice and whether this will create more opportunities or uncertainty remains to be seen. In any case, the continuous dismantling of restrictive hurdles has opened up many areas to foreign investment that were previously reserved for domestic players.
What has yet to be done?
China has been showing its determination to make its economy more attractive to outside investors and offer them treatment equal to Chinese nationals. The adopted Implementation Regulations, judicial interpretation of the SPC and administrative measures certainly provide some more clarity with regards to the investment environment foreign investors can expect when setting foot on the Chinese mainland. However, the reform process is still far from concluded and some important areas require an overhaul. There are still some ambiguities in the newly-enacted implementing rules and it is hard to predict with certainty how the competent authorities will apply those rules in practice. Also, the mere existence of prohibitive or restrictive Negative Lists is diametrically opposed to the idea of a truly open market economy. Despite the successive removal of items belonging to industries that are of interest to European companies, such as the recent opening of the manufacturing of commercial vehicles, there are still considerable market entry barriers in other areas including telecoms, agriculture, entertainment, insurance and legal services. Furthermore, FIL and its Implementing Regulations do not address the important topic of the legality of variable interest entities (VIE), a very common investment vehicle used to attract funds from abroad through contractual agreements. Also, the question of how the national security review for foreign investment, which is only briefly mentioned in FIL and its Implementing Regulations, will be handled needs to be further specified.
Finally, the most essential part will be the actual practical enforcement of the new law along with a transparent and consistent transition from the old to the new system. We will closely monitor future implementation activities and take this into consideration when advising clients on their ongoing or future investment projects. What foreign investors can and should do now is to:
- get a solid understanding of the new legal framework;
- develop a ‘smart investment strategy’ tailored to their specific interests and needs;
- prepare and initiate necessary changes to existing operations in China; and
- keep a close eye on further developments, especially future administrative measures and judicial interpretations in the field.