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China seeks foreign investment but exercises tight control over investors

Foreign investment in China is highly regulated by the government and it is evaluated under two different parameters, one applicable to all foreign investment activities in the country and the other only to foreign investment that raises national security concerns. 


Not all foreign investment is permitted in China. There are four categories for investment: encouraged, permitted, restricted, and prohibited. 


A system of Negative Lists establishes the areas where foreign investment is prohibited, while foreign investment is permitted in restricted sectors, under specific conditions. Investment is fomented in certain sectors, through the Catalogue of Encouraged Industries for Foreign Investment.  



The Negative Lists and the Encouraged Industries Catalogue are updated every one to two years by the Ministry of Commerce (MOFCOM) and the National Development and Reform Commission (NDRC). Foreign investment in sectors that are not listed in the Negative Lists or the Encouraged Industries Catalogue is considered permitted. 


The MOFCOM, NDRC and the State Administration for Market Regulation (SAMR), which is China's corporate registry, are the main government agencies in charge of evaluating foreign investment in the country. 





Since 2020, when the Foreign Investment Law (FIL) came into effect, the information provided by foreign investors or foreign invested enterprises (FIEs) is reviewed by SAMR and its local branches, and no longer needs prior approval by MOFCOM. 


SAMR evaluates the foreign investment and decides if it is in compliance with the restrictions set out in the Negative Lists. In addition, foreign investment that involves fixed asset projects may require the approval of NDRC or its local branches in specific circumstances. 


If a foreign investment falls within certain categories, it may be necessary to undergo a national security review. This stipulation was introduced in 2011, whereby MOFCOM would take the lead with reviews in coordination with other government agencies.  


In 2015, the State Council issued the Circular on Issuing Provisional Measures for National Security Review of Foreign Investment in Pilot Free Trade Zones (the Free Trade Zone Circular), under which a slightly modified security review regime was created for foreign investment in the Shanghai, Guangdong, Tianjin, and Fujian pilot free trade zones (FTZs).  


In 2020, the Measures on National Security Review of Foreign Investment (NSR Measures) amended the 2011 Circular and the Free Trade Zone Circular and provide more detailed rules to implement the national security review regime.  


According to the NSR Measures, which took effect on January 18, 2021, national security reviews are conducted by a Working Mechanism led by NDRC and MOFCOM at an office located at the NDRC. In practice, the national security regime is vague in terms of timing, procedures and outcome. 


The most significant recent update was the 2022 version of the Encouraged Industries Catalogue, effective from January 1, 2023, which includes two sub-catalogues, one covering the entire country and the other covering the central, western and northeastern regions.  


Advanced manufacturing industries and modern service industries, in particular renewable energy technologies and products, medical consumables, recycling, and energy saving technologies and products, are areas where foreign investment is encouraged in the new 2020 version of the catalogue. 


To ensure a better regional distribution of foreign investment, the central, western, and northeastern regional sub-catalogue expands the scope of encouraged industries based on the advantages or unique local resources of each province.  


Benefits of investing include tariff exemptions on imported self-use equipment within the value of total investment amount, priority access to and preferential price for industrial land supply and, in some regions, a reduced corporate income tax rate. 


In recent years, the national security regime, under the supervision of NDCR, has called in several transactions for national security review, often triggered by third-party complaints, pushing some companies to abandon a transaction. This was rarely enforced before 2020. 


Foreign investment regime 

Since its adoption, the FIL has marked a significant improvement in liberalizing the Chinese market and facilitating access to foreign investors. Under this legislation, foreign investors are provided with greater protection for intellectual property rights and trade secrets, and a more simplified and transparent regulatory regime.  


At the same time, the Chinese government continues to evaluate the classification system of foreign investment to further open the domestic market. The latest Encouraged Industries Catalogue identifies more industries in which China welcomes foreign investment with preferential treatments, while the Negative Lists have gradually lifted access restrictions on foreign investment. 


On the contrary, the NSR Measures and security reviews seek to counterbalance the more liberal approach to investment provided by the FIL and offer an opportunity to the Chinese government to exercise control over foreign investment. 


Laws and regulations 

The FIL and its implementing regulations establish the principles that foreign investment in certain strategic or sensitive sectors is prohibited or restricted in accordance with the Negative Lists, but national treatment is granted to other foreign investment. 


There are additional sector specific regulations that need to be respected by foreign investors. For example, the regulations in relation to foreign investment in banking and the insurance sectors.  


Depending on transaction structure and other factors, foreign investments must comply with additional rules and regulations. For example, if the target company is listed on a Chinese stock exchange, the Chinese securities law and relevant stock exchange rules shall apply. If the target company is a state-owned company, regulations that govern the acquisition of state-owned assets will come into play. 


Under the FIL, foreign investment includes any direct or indirect investment activity conducted by foreign investors (including foreign individuals, enterprises, or other organizations) within China, including but not limited to incorporation of FIEs, acquisition of equity interests or assets in Chinese companies and investment in greenfield construction projects. 


Chinese laws and regulations apply to all foreign investors and FIEs that carry out investment activities within China.  




Offshore merger and acquisition (M&A) transactions that take place outside China are not subject to the Chinese foreign investment review regime; however, if an offshore transaction results in changes to the information in the reports submitted to MOFCOM or its local branches (e.g., a change of the actual controller of the foreign investor), these changes should be reported to MOFCOM. 


Foreign investment that involves fixed asset construction (including modification and expansion) may also require NDRC's approval or filing procedure. 




A national security review will be triggered in the following situations: 


  • investments in military or military-related industries or investments located near military facilities; or  

  • acquisition of control over a Chinese target active in critical agriculture, critical energy and resources, significant equipment manufacturing, critical infrastructure, critical transportation services, critical cultural products and services, critical products and services relating to information technology or the internet, critical financial services, key technologies, and other critical sectors.  


This 'control' refers to when a foreign investor: 

  • holds 50% or more of the target's shares post-transaction; 

  • holds fewer than 50% of the target's shares but has sufficient voting rights to materially influence resolutions at meetings of shareholders or the board of directors; or 

  • can exercise material influence over key matters such as business decisions, personnel, finances, and technology through other means. 

 

The regulations do not specify the meaning of critical, leaving this to the discretion of the Chinese authorities. NSR Measures include a catch-all clause, which allows the authority to further expand the scope of transactions subject to the national security regime.  


The national security regime covers both direct and indirect investments in the form of M&A, greenfield investments (both wholly owned projects and joint ventures) and investments through other means (variable interest entity -VIE- arrangement).  


Under the NSR Measures, an indirect acquisition of a domestic enterprise already owned by foreign investors (e.g., as a result of a pure offshore transaction) can also be subject to the national security review regime. 


An investor is deemed a foreign investor if the person is not Chinese or is not incorporated in China. For the purposes of the foreign investment review and national security review regimes, Hong Kong, Macau, and Taiwan investors are considered foreign investors. 


Reporting of foreign investment information to MOFCOM is mandatory. With respect to restricted investments, only those that have passed the review of SAMR or its local branches will be allowed. If a foreign investor invests in a prohibited sector or does not comply with relevant restrictions, the investor may be ordered to discontinue the transaction. 


Security Review 

The national security review consists of three phases: 

  1. a preliminary review to determine whether a foreign investment falls under the national security review regime must be completed within 15 business days; 

  2. a general review must be completed within 30 business days if a foreign investment is subject to the national security review regime and raises no issues; and 

  3. a special review must be completed within 60 business days but can be extended in special circumstances if a foreign investment affects or may affect national security. These 'special circumstances' are not defined and there are no statutory time limits for extending the review period. 


The NSR Measures introduced a 'stop-the-clock' mechanism. This enables the authority to pause the review period while it awaits a foreign investor's responses to information requests. Foreign investors will need to address the authority's requests promptly to advance the review process. 


The decision by the Working Mechanism is final and cannot be appealed. The national security review regime does not publish information about the number of transactions that have been reviewed, prohibited or subject to mitigation. 


Prohibited sectors 

Under the 2021 National Negative List, foreign investors are prohibited from investing in 21 industries within 10 areas, ranging from agriculture to information technology and scientific research. Some prohibited industries include: 


  • internet news information services, internet publishing services, and internet video and audio program services; 

  • development and application of diagnosis and treatment technologies relating to human stem cells and genes; 

  • domestic express mail services; 

  • editing, publishing and production of books, newspapers, periodicals, audiovisual recordings and electronic publications; 

  • compulsory education; 

  • social survey service; and 

  • artistic performance groups. 


The FTZ and the Hainan Negative Lists have fewer prohibited areas. For example, foreign investors can make investments in artistic performance groups in FTZs or the Hainan FTP. 


Restricted sectors 

There are 10 restricted industries under the 2021 National Negative List. When making investment in a restricted sector, foreign investors should usually team up with Chinese partners and follow certain requirements imposed by the Negative Lists (such as requirements on shareholding percentage and nationality of legal representative). 

 

For instance, in a Chinese public air transportation company, no single foreign investor is allowed to hold more than 25% equity interest, the company must be controlled by a Chinese shareholder and the legal representative must be a Chinese national. 


Transactional structures 

There are two principal channels for foreign investors to enter the Chinese market: establishing new FIEs or investing in existing domestic companies via M&A transactions. 


There are generally four types of legal entities available for foreign investment: 


  1. a representative office, which is an agency office of a foreign investor in China for liaison and communication purposes. A representative office is not allowed to conduct business in China and therefore does not serve the business purposes of foreign investors in many cases; 

  2. a wholly foreign-owned enterprise (WFOE), which is a 100 per cent owned subsidiary of a foreign investor; 

  3. a joint venture with a Chinese partner, which is normally used when there is a good commercial reason or where foreign investment restrictions impose a local ownership requirement; and 

  4. a foreign invested joint-stock company, which is adopted where there are numerous shareholders, an initial public offering is contemplated, or the company is already publicly listed. 


Investment in private Chinese companies 


An M&A transaction by a foreign investor can be structured as a share deal or an asset deal. Under Chinese law, a share deal may be structured either onshore or offshore; however, for an asset deal, the deal would have to be structured onshore because, in most cases, the law requires that an onshore FIE shall be set up to host the assets acquired. 

 

Investment in listed companies  


Foreign investment in companies listed on Chinese stock exchanges (A-share listed companies) is subject to additional requirements under the Chinese securities law and the rules of the relevant stock exchange. 


Foreign investors need to satisfy certain qualification requirements (such as the minimum value of assets owned or managed by the foreign investor) before they can invest in A-share listed companies.  


Under current regulations, there are three main transaction structures through which a qualified foreign investor can invest in an A-share listed company: 


  • private placement, which usually involves a listed company issuing new shares to a small group of selected investors, allowing the issuing company to negotiate deals directly with the selected investors and set a share price that is often below market price; 

  • share transfer by agreement, which involves an acquisition of shares from existing shareholders of the listed company by way of a private share transfer agreement; and 

  • tender offer, which refers to the investor making an offer to acquire all (a general offer) or some (a partial offer) of the shares held by the other shareholders of a listed company – usually when the investor intends to acquire control. 


Foreign exchange 


The inflow of investment funds, the repatriation of dividends and the outflow of proceeds from divestment by foreign investors are subject to various foreign exchange control requirements and must follow prescribed procedures. 


VIE structure 


A VIE structure allows a foreign investor to invest in restricted sectors through contractual arrangements – the foreign investor controls Chinese domestic operating companies holding the required licenses through a set of legal agreements rather than through share ownership.  




It is widely used in the technology, education and healthcare sectors where foreign investments are prohibited or restricted. There are concerns about the enforceability and legitimacy of the VIE structure, as foreign investors effectively circumvent foreign investment restrictions with such a structure.  


However, the current legal regime remains silent on the legitimacy of the VIE structure, and the Chinese government seems to allow its existence in practice. 






Structure of the investment vehicle 


Foreign investors can use offshore entities or FIEs to make investments in China. Alternatively, foreign investors may consider using an innovative fund structure – a qualified foreign limited partnership (QFLP) – as a special purpose vehicle to make investments in China.  


The QFLP allows foreign funds to partner with domestic investors to form a yuan fund within China in the form of a limited partnership, which enjoys more flexibility in foreign exchange settlement and preferential tax treatments. Currently, QFLPs can be formed only in provinces or cities where local QFLP regulations have been promulgated. 


Conclusion  


China’s policy on foreign investment seems to have a contradictory nature: while opening up and facilitating access to foreign investors, it wants to exercise a strict control over investment based on national security reasons.

  

Last year, the government expanded the Encouraged Industries Catalogue and reduced the prohibitions and restrictions set out in the Negative Lists in late 2021. Pilot programs to promote foreign investment were announced to demonstrate China's firm standing on economic opening and welcoming of foreign investors.  


Analysts believe that the Chinese government will continue its opening-up policy. However, it is expected that national security reviews will be a more prominent part of China's foreign investment regulatory framework, given the removal of the pre-vetting procedure for investments in most sectors under the Negative Lists and the shift of the Chinese merger control regime towards focusing on genuine competition issues when reviewing transactions rather than on national security or industrial policy concerns. 


 

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