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HOME > Publications > Professional Articles > FIVE TAKE-AWAYS FOR FOREIGN INVESTORS ABOUT FIL IMPLEMENTATION

FIVE TAKE-AWAYS FOR FOREIGN INVESTORS ABOUT FIL IMPLEMENTATION

Author: Carl Li Carl Li 2019-11-16629

Introduction


On November 1, 2019, the Ministry of Justice published Implementing Regulation for the Foreign Investment Law of the People’s Republic of China (Draft for Comment) (“Draft for Comment”), which it jointly drafted with the Ministry of Commerce and the Development and Reform Commission. Draft for Commentclarifies and refines the provisions in Foreign Investment Law, published in March earlier this year and to be implemented on January 1, 2020.


Some of the questions left open in Foreign Investment Law are answered to varying degrees in Draft for Comment. However, like Foreign Investment LawDraft for Comment is also short and concise. It contains 45 provisions only, leaving many other issues unresolved. This article aims to analyze some of the provisions in Draft for Comment that most affect foreign-invested enterprises (FIEs) in China, explaining their specific meanings and their impact on FIEs. We also raise questions that are left open in Draft for Comment.


I. Protective and Promotive Measures for Foreign Investors Emphasized and Further Refined


Some good news for foreign investors is that the measures listed in Foreign Investment Law about the protection and promotion of foreign investors’ interests in China, some of which long-term concerns by foreign investors, are emphasized and substantiated with more details in Draft for Comment. Most of them are principled statements though, leaving the enforcement details to be further addressed by respective competent authorities:


♦ Allowing free access of FIEs to government procurement markets in their respective regions or industries (Article 17);


♦ Allowing capital gains, royalties, and IP license fees gained by foreign investors and foreign employees to be freely remitted in RMB or foreign exchange in accordance with the law and after paying tax (Article 23);


♦ Establishing punitive damages systems for the infringement of IP rights (Article 24);


♦ Limiting the extent, scope, and exposure of material concerning a foreign investor’s trade secrets that will be required to be handed over to administrative bodies, and protecting the internal management system to protect this information (Article 26); and


♦ Government officials cannot force or induce foreign investors to transfer technology either directly or using indirect methods (Article 25).


II. Chinese Natural Persons can be Shareholders in a Sino-Foreign JV


According to Article 3 of Draft for Comment, “foreign investors may invest in China on their own or jointly with other investors including Chinese natural persons pursuant to the law.” In the traditional foreign investment legal framework, a Chinese natural person can not set up joint ventures or cooperative enterprises with foreign investors (except in certain pilot jurisdictions such as the Pudong New District in Shanghai). As a result, Chinese natural persons, in practice, need to set up Special Purpose Vehicle (SPV) companies to serve as the shareholders of the Sino-foreign joint ventures they want to invest in. Draft for Comment clarifies that Chinese natural persons can directly invest in Sino-foreign JVs without first setting up SPVs, therefore clearing the obstacles for Chinese natural persons and foreign investors to establish Sino-foreign JVs in China.


III. Retainable Arrangements during the Transition Period


Draft for Comment adds a 6-month grace period to the 5-year transition period under Foreign Investment Law, giving existing FIEs a total 5 years plus 6 months to adapt their organization form, organization structure, etc. to be consistent with Company Law of the People’s Republic of China (“Company Law”) and Law of the People’s Republic of China on Partnership Enterprise (“Partnership Enterprise Law”).


Because wholly foreign-owned enterprises (WFOEs) are already established according to the relevant provisions of Company Law or Partnership Enterprise Law, there is no need to adjust the organization form or organization structures.


Sino-foreign JVs and Sino-foreign cooperative enterprises in the form of companies need to adjust their organization forms and organization structures, however, because they are established according to separate laws under the original foreign investment legal framework. Necessary changes include but are not limited to the abolition of joint venture contracts or cooperative venture contracts, adjustment of the highest authorities, changes of rules of deliberation and voting procedures, the addition of supervisors or board of supervisors, etc.


Among the things that existing FIEs can retain during the transition period, other than the abovementioned organization form and organization structure, Article 43 of Draft for Comment also explicitly enumerates two other items that can be retained, that is, income distribution methods and distribution methods for the remaining assets. The “etc.” at the end of the article leaves open the question of what other arrangements can be retained. For example, it is unclear whether the loss-sharing clause, the composition of the liquidation committee clause, or the liquidation procedure clause are among the retainable matters.


Note that although Company Law and JV Law impose different provisions on income distribution, because the provision under JV Law (income must be distributed according to the shareholders’ capital contribution ratio) is stricter than that under Company Law (income distribution can be agreed among the shareholders), Sino-foreign JVs shall automatically satisfy the requirement of Company Law without the need for any adjustment if they retain their arrangements in the joint venture contracts (JVCs). But since it is a usual practice that Sino-foreign JVs have more complicated arrangements regarding income distribution, which are often reflected in other transaction documents than the JVCs (in Shareholders’ Agreements, for example) for the very purpose of evading the restrictive requirement in JV Law, the transition to Company Law, in fact, provides investors of Sino-foreign JVs the opportunity to decide income distribution among themselves freely without having to make separate, supplementary arrangements on the side. 


IV. VIE Still in the Gray Zone with One Exception


Article 35 of Draft for Comment says that upon examination by the relevant competent department of the State Council and approval by the State Council, any wholly-owned enterprise established outside China by a Chinese natural person, legal person or any other organization that invests in China (not including FIEs) may be exempted from the relevant restrictions in the negative list for foreign investment market access.


This provision carves out an exception to foreign investment market access, stipulating that fulfilling two conditions, “wholly-owned” and “State Council approval,” a Chinese natural person or entity who sets up enterprises overseas and make return investment may not have to be subject to the negative list. It provides an alternative to the VIE structure, which has long been used by foreign investors and Chinese companies in need of foreign capital to bypass restrictions on foreign investment market access. As to the VIE structure itself, it still remains in the gray zone of supervision, as neither Foreign Investment Law nor Draft for Commentmentions it.


However, the scope of the exception that Article 35 carves out is limited to foreign investors wholly controlled by Chinese investors, and it does not apply to enterprises that build the overseas structure and make the return investment for the purpose of obtaining overseas financing, which constitute the majority of Chinese investors abroad. In addition, Article 35 does not specify the conditions for approval for such exception, and the fact that the approval authority is concentrated in the State Council makes the exception hard to be implemented in practice.


V. Application of the Negative List to Sino-foreign Partnership Enterprises Further Refined


Foreign Investment Law does not clearly define how to determine the shareholding ratio of foreign investors in a partnership. Draft for Comment provides a groundbreaking basis for such determination. Article 34 stipulates that if a foreign investor invests, in the form of establishment of a partnership, in sectors for which the negative list imposes restrictive requirements, the “voting ratio” of foreign investors shall be used as the rule to determine if the partnership is complying with the requirements in the negative list.


In practice, however, it is difficult to apply the rule. Chinese and foreign partnerships often use the form of a limited partnership, which performs affairs by a general partner (GP). Article 68 of Partnership Law stipulates that a limited partner (LP) does not perform partnership affairs and may not represent a limited partnership. By convention, the general partner’s investment usually accounts for a relatively small proportion, while limited partners’ investment accounts for a relatively large proportion. Therefore, the investment amount ratio of a limited partnership does not necessarily reflect the actual controlling relationship in the partnership. The voting ratios on different matters in a limited partnership may also differ, with some requiring the unanimous vote of all limited partners, while others only requiring the consent of the general partners. All of the above leaves it difficult to determine the exact application of the “voting ratio” rule in practice.


Besides the restrictions on the shareholding ratio, the negative list imposes restrictive requirements for senior executives in some industries. For example, according to the negative list, “the public air transport company must be controlled by the Chinese investors, and the investment ratio of a foreign company and its affiliates must not exceed 25%. The legal representative shall be a Chinese citizen.” In a partnership, there is the concept of a managing partner only, but not the idea of a legal representative. This leaves the applicability of the restrictive requirements for senior executives to foreign-invested partnerships unclear.


Also, Article 34 only applies to the situation of newly established partnerships, without stipulating the situation where foreign investors purchase partnership shares through direct or indirect transfers. 


Conclusion


Draft for Comment provides details to some provisions in Foreign Investment Law, but also leaves many issues unanswered. The public has until December 1, 2019 to submit feedback and suggestions on Draft for Comment. We hope that the final Implementing Regulation for the Foreign Investment Law will have some of the unresolved matters answered.


Below are some other questions remaining to be answered about foreign investment, which may not all be resolved in Implementing Regulation for the Foreign Investment Law, but should still be addressed in other supporting regulations or administrative measures on foreign investment:


♦ Security Review System: Foreign Investment Law makes a principled provision for security review on foreign investment. Draft for Comment does not make any further explanations on this point. At present, provisions on security review in the field of foreign investment only cover foreign mergers and acquisitions. Therefore, a more comprehensive security review system has to be drawn up.


♦ Cleanup of current regulations and related policies on foreign investment: Foreign Investment Law abolishes the three laws on foreign investment and establishes a new foreign investment legal framework. The existing administrative regulations and departmental rules based on the old laws will inevitably be in conflict with the principles established in Foreign Investment Law. In order to adapt to the new framework, many regulations and policies concerning FIEs in the fields of business, development and reform, market supervision, foreign exchange, and taxation have to be cleaned up. Neither Foreign Investment Law nor Draft for Comment mentions any plan for such cleanup.


♦ The regulatory direction of FIE’s domestic reinvestment is unclear: In the current regulatory practice, it is not clear whether enterprises invested in by FIEs belong to FIEs or domestic enterprises. The issue only becomes more important as non-investment-oriented FIEs are now also allowed to make domestic equity investments using their capital (subject to the negative list) (in the past, only investment-oriented FIEs are allowed to reinvest) pursuant to Notice of the State Administration of Foreign Exchange on Further Promoting the Convenience of Cross-Border Trade and Investment published on October 23, 2019. It can be expected that more enterprises will soon be established or invested in through FIEs’ domestic reinvestment.


There are many other issues to be clarified and resolved about the new foreign investment legal framework in China. We will keep close track of the development of the Foreign Investment Law and its supporting regulations and policies and provide you with our latest analyses.