How a New Law in Mainland China Will Impact Foreign Investment

Parker Poe Adams & Bernstein LLP
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Parker Poe Adams & Bernstein LLP[co-author: Jingqiao Tian]

In less than six months, a new law will take effect in China that will have a major impact on foreign investment. The National Congress of the People’s Republic of China passed the Foreign Investment Law in March, three years after the draft version was circulated for public comment.

This law will govern foreign investments in China, so any foreign investors who have or will invest in China should understand it, including manufacturers. In this article, we will explain the law and its influence on Chinese foreign investments.

The Definition of Foreign Investment and Two Versions of the Negative List

According to Article 2 of the Foreign Investment Law, “foreign investment” means investment activities within China directly or indirectly conducted by one or more natural persons, business entities, or other organizations domiciled in a foreign country. This generally includes establishing an enterprise within China with foreign capital or acquiring equity or similar rights and interests in a Chinese enterprise. “Foreign-invested enterprise” in the law refers to an enterprise all or part of whose capital derives from a foreign investor. The State Council of China will amend and publish from time to time the Special Administrative Measures for Foreign Investment Access, commonly called the Negative List because of the foreign investment restrictions it contains.

There are two versions of the Negative List. One is applicable in the whole country except for pilot free trade zones, while the other is only applicable in the pilot free trade zones (FTZs). The Negative List applicable in FTZs has fewer restrictions for foreign investment, making FTZs more attractive to foreign investors. Currently, there are 12 FTZs located in: Shanghai Municipal City, Guangdong Province, Zhejiang Province, Tianjin Municipal City, Fujian Province, Henan Province, Hubei Province, Chongqing Municipal City, Sichuan Province, Shanxi Province, Liaoning Province and Hainan Province. Shanghai, as the hottest foreign investment destination, established the first FTZ. And now there is widely-spread news that Hei Long Jiang Province will become the 13th pilot free trade zone, and Hei Long Jiang Province is bordered with Russia.

Compared to the whole-country Negative List, the Negative List for the FTZs deletes foreign investment restrictions on a number of business activities. However, even in an FTZ, news publishing, broadcasting, production and management of radio and television programs, internet news information services, online publishing services, and a number of other business activities remain completely forbidden to foreign investors. In addition, the representative offices of foreign law firms in any part of China can only provide legal services relating to foreign laws, not Chinese laws. There are details relating to numerous industries in the Negative List, so it is important to consult a lawyer to check the restrictions on investment before moving forward with an investment decision.

Use of Variable Interest Entity to Avoid the Negative List

Variable interest entities (VIEs) are commonly used structures for Chinese companies to get listed in overseas stock exchange markets. The founders usually set up an offshore company that will get listed in overseas stock markets. In order to overcome foreign investment restrictions, this offshore company may establish a Hong Kong company that can set up a Chinese company as a wholly foreign-owned enterprise (WFOE). Under most circumstances, the founders of companies structured as VIEs are Chinese citizens who will set up another Chinese company, and this Chinese company is often treated as a domestic company. The domestic Chinese company would not have the business restrictions of a foreign-owned company. Then the WFOE can sign various agreements with this domestic Chinese company, like a lending agreement, voting agreement, management agreement, IP license agreement, and so on. When a lending agreement is signed and the WFOE lends money to a domestic Chinese company, the shares of the domestic Chinese company can be pledged to the WFOE so it can have some degree of control with respect to the domestic Chinese company.

Until the Foreign Investment Law is effective, the pledge of a domestic Chinese company’s stock to a foreign entity may result in the domestic Chinese company being treated as a foreign entity. But in order to support the development of high-tech companies, stimulate the domestic economy, and provide more job opportunities, the new Foreign Investment Law deleted provisions from the draft version treating domestic Chinese companies in the VIE structure as foreign-invested companies.

The corresponding effect is that the VIE structure may become a suitable method for foreign investors to overcome the business obstacles established by the Negative List. At this point, however, there is no case law showing how Chinese courts would approach these issues since the Foreign Investment Law will not take effect until January 1, 2020.

Methods to Invest in Mainland China

Before establishing a Chinese company in mainland China, many foreign investors set up a Hong Kong company as the sole shareholder of the Chinese company. Under the Arrangement Between the Mainland of China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, the withholding tax rate on profit distribution from a Chinese company to a Hong Kong parent company is 10 percent. If the Hong Kong parent company can obtain a Certificate of Resident Status from the Hong Kong Inland Revenue Department, the withholding tax rate can be reduced to 5 percent provided the Hong Kong company owns at least 25 percent of the Chinese company and other administrative requirements are met. In order to obtain such a Certificate of Resident Status, the Hong Kong company needs to have a presence in Hong Kong, such as operating a business office and generally employing at least one employee in Hong Kong. These requirements, however, may be subject to change.

Many foreign investors adopt a WFOE structure, which makes a foreign legal entity the sole shareholder of the domestic Chinese company. However, pursuant to Article 63 of the Company Law, the shareholder of a sole-shareholder company who is unable to prove that the company's assets are independent of the shareholder's personal assets shall bear joint liability for the company's debt. Thus, it is better that a domestic Chinese company has at least two shareholders. An option is to give a foreign employee a small ratio of shares in the Chinese domestic company. This arrangement will prevent sole shareholder liability and may provide the foreign employee an option for certain personal tax advantages. There may be other options for avoiding personal liability in a WFOE structure, and such options can be considered in consultation with a Chinese lawyer.

The Three Laws Relating to Foreign Investment That Are Repealed by the Foreign Investment Law

When the new Foreign Investment Law goes into effect next year, the Law of the People’s Republic of China on China-Foreign Equity Joint Ventures, the Law of the People’s Republic of China on Wholly Foreign-Owned Enterprises, and the Law of the People’s Republic of China on China-Foreign Contractual Joint Ventures will be repealed. This is good news for some China-foreign equity joint ventures (foreign JVs), especially for those foreign JVs in which the foreign investors and Chinese investors separately hold 50 percent of the shares. Pursuant to Article 32 of the Regulations for the Implementation of the Law of the People's Republic of China on China-Foreign Equity Joint Ventures, a board meeting requires a quorum of more than two-thirds of the directors.

This is a mandatory requirement for foreign JVs and can easily cause a deadlock, especially in some industries in which the foreign investors can only hold a maximum 50 percent of shares, like in the automotive industry. Once the Foreign Investment Law takes effect, such quorum requirements for foreign JVs will be repealed, and the corresponding articles of Company Law of the People’s Republic of China will apply. Pursuant to Article 48 of the Company Law, the rules of procedure and voting procedures of the board of directors shall be stipulated by the articles of association of the company, so foreign JVs will be able to freely choose the best procedures of their boards of directors. Current foreign JVs, therefore, should consider revising their governing documents accordingly.

Intellectual Property Protections

Article 22 of the Foreign Investment Law provides for protection of the intellectual property rights of foreign investors and foreign-invested enterprises, protects the lawful rights and interests of intellectual property right holders, and holds those who infringe upon other’s intellectual property rights legally accountable. In addition, on March 2, 2019, China amended the Regulations on the Administration of Import and Export of Technology by deleting Article 27. This article previously provided that during the period of validity of a technology import contract, the results of any improvements in the technology would belong to the party that makes the improvements. This article was favorable to the technology importer, normally a Chinese legal entity or individual, and now its deletion allows foreign companies greater flexibility in protecting and developing their intellectual property.

Conclusion

The new Foreign Investment Law in China is meant to encourage foreign investment. Those companies with operations in China and those contemplating such operations should review this law with counsel to determine how to optimize the legal structure of their operations once the law comes into effect.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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