China published a draft Foreign Investment Law in December 2018 – it is not the first draft, but if this version becomes law, it will encourage foreign investment and remove some uncertainty related to the use of ‘captive company’ structures.
From an investor’s point of view, it will make things simpler, because it will replace the various obsolete joint venture laws and wholly foreign-owned enterprise (WFOE) law that constitute the basis of current China Foreign Investment Laws.
What changes are proposed and how will they affect UK and US investors?
The China Foreign Investment Law tries to encourage foreign investment in China and bring the two tracks of investment, which distinguish foreign investment from Chinese investment, a little closer.
- If a foreign investment enterprise (FIE) needs to obtain certain operating permits, it will be treated with the same criteria and procedures as a domestic company in China when applying for such permits.
- The ability of third parties (especially government entities) to break contractual arrangements between Chinese and foreign partners will be restricted. In particular, there should be no mandatory technology transfers by governmental officials.
- Foreign intellectual property rights are to be protected. It is unclear why this needs to be stated again as China has plenty of applicable law that protects such rights. The important thing is to enforce them.
- FIEs will be allowed to bid for government procurement projects. Whether they win or lose, however, is a different matter, so it is possible this won’t change much at first.
- FIEs may list on a Chinese stock exchange and may issue corporate bonds.
Foreign investors are entitled to be treated the same as Chinese investors (national treatment), as long as they abide by the Negative List for Foreign Investment issued in June 2018. This list sets out industry sectors that need approval or are prohibited for foreign investment.
Impact on captive company structure
In 2013 and 2015, the Ministry of Commerce issued an earlier draft of the China Foreign Investment Law which appeared to prevent the commonly used ‘captive company’ structure (also called the variable interest entity or VIE structure) which is used in restricted industry sectors such as media. A Chinese company would be held by nominee shareholders who are employed by a foreign company, and the revenue of that Chinese company would then be siphoned out by contract to the foreign company, with various rights for that foreign company to effectively control the Chinese company, despite having no direct shareholding.
The 2018 China Foreign Investment Law removes the broad definition of control, suggesting that the captive company structure is going to be tolerated for the time being. This tolerance is not unequivocal, however. ‘Foreign investment’ is defined in the China Foreign Investment Law as including “investment by a foreign investor through other means provided by law”. So one interpretation of this vague definition would cover captive company structures.
Will this version ease restrictions?
The redraft is less precise in its drafting than its previous incarnations. It appears that the intention behind it is to reassure foreigners that China is open for business, after a period of negative sentiment. However, there is enough discretion to provide a legal basis for implementing regulations that are either restrictive or more relaxed. Our hunch is that the general direction of travel for the investment regime is towards the latter.