New Foreign Direct Investment Rules in China
Starting January 1st of 2020, Foreign Direct Investment (FDI) in China will be under a new regulation system. These new regulations largely simplify the process for foreign companies to invest in the Chinese market. Since China’s opening-up in 1979, the regulations governing the process for foreign companies to do business in the mainland have been constantly evolving. These new rules come during ongoing trade disputes with the United States and are encouraging more investment in China by making the rules fairer. It is valuable to understand how new foreign investment laws impact your company.
How to Adapt to the New Regulations
The new regulations will take the place of the FDI laws passed in 2015. Under the new draft, there are 42 articles, instead of the previous version’s 170. With the new draft containing less information, many of the details continue to be handled by existing laws or are still pending regulation decisions. Essentially, the new draft replaces three prior ones:
- The Law of the People’s Republic of China (PRC) on Sino-Foreign Equity Joint Ventures
- The Law of the PRC on Wholly Foreign-owned Enterprises (WFOEs)
- The Law of the PRC on Sino-Foreign Cooperative Joint Ventures
For those companies which have been incorporated under those previous rules, they will have five years from the enactment of the new regulations on January 1st, 2020 to continue operating with their original structure. After that, they will be expected to adapt to the new rules.
Following is an explanation of the key points in China’s new FDI laws.
Intellectual Property (IP) Rights
For many foreign firms, concerns about IP rights are some of their main worries regarding entering China. Even if an item is only partially manufactured in China, it has historically been at risk of being copied. Now, the Central Government is promising to protect the rights of foreign investors with sincerity. Also, local authorities shall be held legally responsible for protecting the IP rights of foreign companies. There is still some ambiguity surrounding this, but in the future companies will be more and more able to leverage laws in their favor if copyright is infringed upon. For example, in the past, many companies have accused local officials who had special rights that came with their position to inspect factories of stealing secrets and giving them to China-based companies. With the new laws, the government is showing its strong desire to protect foreign companies.
Rights to Industry Standard Formulation
Standards are important to many industries in China, from telecommunications to manufacturing. Foreign companies have often felt left out of the decision-making process, believing that the government and local firms were behaving unfairly. With the new regulations, the Central Government has guaranteed that going forwards, firms in an industry will have equal right to set new standards and that those standards will apply equally to foreign and domestic companies.
Equal Domestic and International Company Treatment Pre-establishment
Before a company has even been set up, there are many legal requirements that must be overcome. However, starting in January 2020, the setup process for foreign and domestic companies will be more similar. One major change is that the additional step of pre-approval for foreign companies before setup will no longer be required. This does not mean that the setup process is now extremely simple. Most foreign companies choose to use an in-country service provider like FDI China to make sure all the steps of the company set up are accomplished. Partnering with a local provider can ensure that the company structure is compliant and safely established within the company’s future scope of activity. Learn more about how you can utilize our services!
Expropriation (Government Taking Over Company Assets)
Several parts of these new regulations further clarify legal content found elsewhere in the People’s Republic of China’s laws. Expropriation is one such case, also implied in the Constitution. Now, in Article 20 of the new regulations, a further explanation is made. “The State is not to expropriate any investment made by foreign investors.” Foreign companies can rest increasingly assured. However, as stated in the Constitution, out of the interests of the public, expropriation is still possible. It must go throw standard statutory procedures, and fair compensation from the government must be made to the company.
Lack of Variable Interest Entity (VIE) Restriction
In the Chinese market, there are several industries that foreign companies are banned from participating directly. However, foreign companies often still invest in those interests, in what is known as VIE. They provide funding to domestic companies in return for control and profits. In the previous evolution of regulations passed in 2015, the government cracked down on this loophole, classifying foreign investment to include those domestic companies that are controlled by a foreign entity.
Interestingly, in March of 2019, the government seemed to open this loophole again, removing that additional classification for what is considered a foreign investment. It seems that the VIE structure will continue to be workable, at least in the near future. In some industries, VIE is not considered a grey area, with detailed rules being in place. This is an example of the complexity of the Chinese environment. Foreign companies should still proceed cautiously with VIE, as new regulations may be passed in the next few years.
Foreign Exchange Assurance
International companies must frequently move money across borders. For foreign companies in China, this is an understandable concern. According to the Foreign Investment Law, foreign investors’ profits, capital contributions, capital gains, asset disposal proceeds, liquidation proceeds, technology transfer royalties, and legal compensation in China can be freely moved outward or inward, if the appropriate legal procedures of the PRC.
Reducing Industries on the Negative List
Like other countries, China has certain economic areas that it considers sensitive and feels should be closed to foreign firms. Unlike other countries, the industries on the negative list are quite extensive. With the revised regulations, the PRC promises for one, to make the negative list officially announced, and for two, to reduce the industries on it.
For a company to set up a WFOE, its industry must not be on the negative list. However, even after a WFOE is set up, an additional license may be needed to fully operate, depending on the intended activity, whether it be importing/exporting or manufacturing. For example, being in the travel agency business is not restricted in China. However, there is an additional permit required to transport Chinese citizens overseas that only domestic companies can acquire. Even if their industry is not on the negative list, foreign companies must understand the relevant permits that they need to operate.
Wider access to Government Procurement
A large source of income for many companies is government procurement, meaning government agencies purchasing a firm’s goods or services for use. Up until the new regulations, foreign companies were not treated equally in this area. Now, the government is required to consider both domestic and foreign companies on a level playing field.
Local Government Commitment
China, being a vast country home to so many people on the planet, has an extensive government structure, consisting of local, intermediate, and national level officials. The Chinese system also has been known to have different rules at different levels, providing room for corruption. This is a factor that is discouraging to foreign investment. Under the new rules, it is clearly stipulated that unless under special conditions approved by the central government, local governments may not infringe on rights, impose additional requirements, set market entry or exit conditions, or interfere foreign companies’ operations.
If, because of special circumstances caused by public or national interest, local governments must deal with foreign companies in a special way, those companies are entitled to compensation for their loss or damage suffered. This is welcome news for foreign-owned companies and provides a level of clarity and trust not had before.
Generic National Security Review
In 2015, the FDI laws draft had a whole chapter devoted to the procedures and requirements for a national security review of foreign companies’ operations. Those provisions seemed to be designed after the United States’ Committee on Foreign Investment in the United States (CFIUS) structure. Unusual to the overall bearing of the 2019 Foreign Investment Law update, that chapter was removed, keeping only a generic clause that China’s national security department will review foreign investments which may influence China’s national security and that decisions made by the review will be final. Many observers anticipate that the Chinese authorities are in the process of revising the regulations for the national security review and that there will be separate regulations passed soon.
New Reciprocity Rule
With the new regulations, there has been a rule passed that states if a country adopts any negative measures against Chinese investments in their country, China has the right to take corresponding, appropriate measures against that country by targeting its companies doing business in China. This is the first time that this kind of reciprocity language has been seen in China’s foreign investment regime. Considering the ongoing trade war, it will be interesting to observe how this law will be used by the Chinese government.
Corporate Governance and Decision-Making Flexibility
In the past, the corporate governance and decision making of foreign companies, including profit dispensation, has been tightly regulated. Going forward, the restrictions have been greatly eased, essentially to the level of Chinese-based companies. Out of all the changes the new laws make, this newfound freedom may be the greatest change for foreign companies. Here are several facets of the new law.
Shareholders Highest Authority
In the past, foreign companies were required to be closely controlled by a board of directors. Now, the shareholders shall have the highest authority, in the same way as most modern companies, including their domestic Chinese counterparts. The board of directors shall be established based on the Articles of Association, giving shareholders more voting power.
Leadership Appointment Flexibility
After the Foreign Investment Law comes into practice, leadership and legal positions can be freely appointed by the invested parties, again following the Articles of Association. Gone are the mandatory requirements for foreign companies to be regulated tightly in this area prior to the law passing.
Increasing Flexibility of Decision Making
Before, every major decision of foreign-owned companies was required to be unanimously decided on. That meant that even a minority shareholder could block a decision. Such important decisions include an increase or reduction of registered capital, an amendment to the shareholders’ agreement and Articles of Association, termination or liquidation, and merger and division. From a commercial, practical perspective, having decisions blocked by minority shareholders means that the decision-making process is slow, and the company does worse from a commercial standpoint. Now, changes can be made according to respective bargaining power.
Profits/Liquidation Proceeds can be Distributed as Seen Fit
Prior to the new regulations, liquidation proceeds and profits must be distributed proportionally to the equity of each shareholder. There was only one permissible exception, which was that a foreign investor can recover its capital early by receiving a larger chunk of the profit if special conditions were satisfied. However, this was a complex process and often met with resistance from local authorities. Now, as long as the distribution plan has been unanimously agreed upon by all shareholders, money can be distributed unevenly as is seen fit.
The 2019 announcement of the changes to the Foreign Investment Law, passed on March 15th, is mostly welcome news to foreign investment companies. They not only provide greater clarity but also bring the treatment of foreign and domestic companies to similar levels. In the context of the trade disputes China has with the United States, it will be interesting to consider how effective these measures are at promoting foreign investment in China. Contact us today to understand how your company can effectively navigate the changing Chinese landscape.