The Foreign Investment Law: open questions in a new era for businesses in China - Part 2
The new Foreign Investment Law (FIL), which took effect on
January 1, 2020, can be considered the most important piece of
legislation implemented in China since the 1990s and a new era for
foreign investment in the country. However, the new FIL raises more
questions than it provides answers.
The FIL comes at a time when China’s economic growth has been weaker, the COVID-19 health crisis deeply impacted businesses and the effects of a trade war with the United States have become more tangible.
Encouraging Foreign Direct Investments (FDIs) seems to be China’s latest strategy to create jobs and improve the current economic situation.
The FIL lays down the basic principles for foreign investment. It is too general in nature and leaves many details to be addressed in other regulations. As the BBC has reported, the FIL is seen “as a kind of sweeping set of intentions rather than a specific, enforceable set of rules.”
The FIL Implementing Regulation’s most imminent mission is to provide guidance for the FIL and facilitate transition into the new foreign investment regime. Given the complexity of the existing foreign investment regime and rules created in the past 40 years, the transition is not going to be easy. Questions which are left unanswered by the FIL Implementing Regulation need to be further clarified and addressed step by step.
The new law and its implementing regulation still lack details on how to protect the legitimate rights and interests of foreign investors. For example, China’s negative list indicates in which industries certain investments are restricted for foreigners. The FIL will regulate “indirect foreign investment,” in part to prevent foreign investment from circumventing negative list management through indirect investment.
However, the law does not specify what constitutes “indirect.” To make things more complicated, the FIL will apparently not apply to Hong Kong, Macau, and Taiwanese investments, as these will be considered special “domestic” investments. It’s not yet clear how the law would be applied in the case of a more complex and multilayered holding structure.
In addition, the FIL will regulate four categories of foreign investment activities: the establishment of FIEs, M&A, new project investment, and investment in other forms. But it does not define “investment in a new project” and leaves this to the reader’s interpretation.
It does not specify if the definition includes any investment projects in which a foreign investor does not set up or acquire an enterprise in China, but only relies on contractual relationships (such as natural resource exploration and development concession agreements, infrastructure construction and operation concession agreements). It does not clarify either how to apply the foreign investment management system (such as information reporting system, security review system, etc.) for such new investment projects.
Another challenge might be represented by the grace period of five years after the FIL comes into effect. The FIL allows the original organizational form of the established enterprise to be retained for five years. Does this mean that the current contracts and the article of associations of existing FIEs will continue to be effective and be implemented during the transition period, even if the three foreign-funded laws have been abolished? How would disputes over the five-year transition period be interpreted?
Moreover, Variable Investment Entities (VIEs) have been widely used in the past to overcome restrictions in certain sectors. How would these investments be considered going forward? All these questions remain unanswered and will need to be tested in practice. More amendments may come through in the future months once the government has observed from a practical level the necessity for a recalibration.
On another instance, the FIL forbids forced technology transfer by “administrative means,” but does not define what “administrative means” are. In practice, the government may apply non-administrative measures to acquire technology from foreign invested enterprises (FIEs).
In addition to concerns over the FIL’s vague wording, some observers believe that new provisions may in fact empower the government to intervene in investments in the event of a dispute with a foreign country.
According to the FIL, foreign investments could be expropriated under “special circumstances” and “for the public interest” and are subject to broad national security reviews. This may give the government a statutory basis to retaliate against a foreign company in the event of an international dispute.
Other aspects of the new legislation have business professionals concerned about how the FIL will be interpreted and implemented in practice. Although China promised measures will be implemented based on the central government’s interpretation, investors worry that they will remain subject to inconsistent implementation by local governments, which has been common in China over the past several decades.
The new FIL will lead to the change of company structures, especially for joint ventures (JVs). Investors should proactively assess the FIL’s impact as it develops further, keeping a close eye on the supporting legislation, regulations, local administrative approvals, and even “window guidance” of relevant bureaus in charge.
JVs will also be able to retain some flexibility after the 5-year period. For example, after a JV reorganizes, any agreement regarding ownership or its transfer, allocation and distribution of profit and losses, and distribution of assets after liquidation may remain effective.
In addition, investors should pay attention to missing details that may affect the foreign investment in a more general way, such as the definition of “foreign investors”, the specifics and procedures of “national security review”, as well as the attitudes towards variable interest entity (VIE).
In addition to the VIE structure and transitional period, there are a number of issues that need to be resolved, such as reinvestments by FIEs, the governing law for joint venture contracts and shareholders agreements, and the national security review, among others.
With the devastating effects of the coronavirus pandemic on the world economies taking center stage, it may be months before some of the FIL related questions can be answered. Still, existing FIEs and foreign entities planning new investments in China should at least understand and prepare accordingly to adapt to the new rules.
Over the years, numerous Chinese government entities (usually local municipalities) have promised foreign investors preferential treatment, only to renege or renegotiate after a leadership change or government reorganization. The FIL explicitly requires local governments and government agencies to honor all contracts legally entered into with foreign investors and FIEs, and provides that if changes in circumstances cause the local government to breach a contract, the government shall compensate foreign investors and FIEs their damages.
According to the FIL, a court should not nullify a contract regarding a sector not on the negative list because of lack of approval or registration but should nullify a contract regarding a sector on the negative list. That said, investment contracts regarding sectors on the negative list can still become effective if the parties take necessary corrective measures (i.e., revising so that the contract no longer relates to a sector on the negative list) before courts adjudicate the case. Finally, if a contract concerned a sector on the negative list, such contract can still be effective if such restriction is removed before a court issues a decision.
Putting the concept of “national treatment” front and center in the FIL is a positive sign. Yet Non-Chinese companies investing in China face far more restrictions than do Chinese companies investing in countries outside China. The list of industries on the negative list still contains a number of attractive, popular sectors. And the FIL doesn’t address the issue of foreign ownership of Chinese companies.
Despite concerns over the vague wording and the potential selective implementations, the new FIL is in many ways a step in the right direction and a unified measure to address long-existing issues in foreign investment. From that standpoint, the FIL is a welcome and long-overdue piece of legislation. Though it is early to tell if it will provide meaningful changes, having a cautiously optimistic perspective is a good start.
Should you have questions about the Foreign Investment Law, complete the below inquiry form with your questions and comments.
DISCLAIMER: All information in this ebook is verified to the best of our ability and is assumed to be correct at time of release; however, Woodburn Accountants & Advisors does not accept responsibility for any losses arising from reliance on the information provided within. The information provided is for general guidance and does not replace specialized advice.