The Foreign Investment Regulation Review: China
There are two separate regimes regulating foreign investment in China: the foreign investment regime and the national security review regime. The former regime is applicable to all foreign investment activities carried out directly or indirectly by foreign investors in China, while the latter regime only applies to foreign investment that raises national security concerns.
All foreign investment in China is classified into four categories: encouraged, permitted, restricted and prohibited. The Chinese government uses a system of Negative Lists (as defined below) to control foreign investment in 'prohibited' sectors, which is not allowed, while foreign investment in 'restricted' sectors is permitted, subject to certain restrictions (such as foreign ownership limits). Foreign investors are incentivised to make investments in the 'encouraged' sectors listed in the Catalogue of Encouraged Industries for Foreign Investment (the Encouraged Industries Catalogue). The Negative Lists and Encouraged Industries Catalogue are usually updated by the People's Republic of China (PRC) Ministry of Commerce (MOFCOM) and the PRC National Development and Reform Commission (NDRC) on an annual basis. Foreign investments in the sectors that are not listed in the Negative Lists or the Encouraged Industries Catalogue are deemed 'permitted'.
The main governmental authorities for foreign investment review include MOFCOM, NDRC and the State Administration for Market Regulation (SAMR). Previously, any foreign investment that fell within the restricted sector category needed to be approved by MOFCOM before registration with SAMR or its local branches, which is China's corporate registry. Since the PRC Foreign Investment Law (the FIL) came into effect on 1 January 2020, the prior approval of MOFCOM is no longer required in any case. Instead, SAMR or its local branches will, as part of the corporate registration process, review the information provided by foreign investors or foreign invested enterprises (the FIE), or both, to verify whether the underlying foreign investment is in compliance with the restrictions set out in the Negative Lists. In addition, foreign investments that involve fixed-asset projects may require the approval of NDRC or its local branches in certain circumstances.
A national security review may also be required if a foreign investment falls within certain categories (see Section III.iii below). China's national security review regime was first introduced in 2011 by the Circular of the General Office of State Council on the Establishment of Security Review for the Merger and Acquisition of Domestic Enterprises by Foreign Investors (the 2011 Circular). The 2011 Circular set forth a national security review regime where MOFCOM would take the lead with reviews in coordination with other government agencies. In 2015, the State Council issued the Circular on Issuing the 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. In practice, since 2011, only a few transactions have been reviewed under the 2011 Circular and the Free Trade Zone Circular.
On 19 December 2020, the Measures on National Security Review of Foreign Investment (the NSR Measures) were jointly issued by NDRC and MOFCOM. The NSR Measures amend 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 18 January 2021, national security reviews are conducted by a working mechanism (the Working Mechanism) led by NDRC and MOFCOM with its office located at NDRC. In practice, the national security regime is opaque in terms of timing, procedures and outcome.
The foreign investment and national security regimes are stand-alone regimes and not part of the merger control regime.
Year in review
The most notable development for the foreign investment regime over the past year is that the FIL and its implementing regulations came into effect on 1 January 2020, which further streamlined the foreign investment procedures in China and enshrined the principle of equal treatment for FIEs and other domestic companies. The old record-filing regime that required the filing of foreign investment with (in the case of permitted and encouraged investment) or seeking approval of foreign investment from (in the case of restricted investment) MOFCOM or its local branches has been replaced by the new reporting regime. Under the reporting regime, foreign investors or FIEs only need to submit a report to MOFCOM or its local branches through online systems.
As China continues to shorten its Negative Lists and open its domestic market to foreign investment, the national security regime has begun to play a more prominent role. China established its national security regime in 2011 but rarely enforced it until 2020, when NDRC replaced MOFCOM as lead coordinator for national security reviews. Since then, NDRC has called in a number of transactions for national security review over the past year, often triggered by third party complaints and these reviews have sometimes led to companies abandoning a transaction.
Foreign investment regime
The FIL contains a number of market-liberalising principles (e.g., national treatment of foreign investments) that reflect the Chinese government's desire to facilitate further market access and create a level playing field for foreign investors. Under the FIL, foreign investments are provided with greater protection, such as enhanced protection for a foreign investor's intellectual property rights and trade secrets, and a more simplified and transparent regulatory regime. The latest Negative Lists have further lifted access restrictions and the latest Encouraged Industries Catalogue identifies more industries where China welcomes foreign investments with preferential treatments (such as tariff exemption for imports of self-use equipment).
In the meantime, the introduction of the NSR Measures indicates China's willingness to use its power to review and control foreign investment under the national security review regime to balance the FIL's more liberalised approach to foreign investment.
The NSR Measures are silent on the applicable standard of review, but the 2011 Circular (which has not yet been repealed) provides a review standard at a high level. This includes, for example, whether the underlying transaction will impact national defence and security, the national economy, social order or R&D capabilities for core technologies relevant to national security. It is anticipated that the NSR Measures may apply similar standards.
ii Laws and regulations
The FIL and its implementing regulations are the fundamental laws and regulations of the foreign investment regime. They establish the following foreign investment review principles: foreign investment in certain strategic or sensitive sectors are prohibited or restricted in accordance with the Negative Lists, but national treatment is granted to other foreign investments.
In addition, foreign investment may also need to comply with the applicable sector-specific regulations issued by the sector regulators. For example, the China Banking and Insurance Regulatory Commission – the primary regulator for the Chinese banking and insurance sector – have issued regulations in relation to foreign investments in the banking and insurance sector.
Depending on transaction structure and other factors, there are additional regulations and rules with which the foreign investment may need to comply. For example, if the target company is listed on a PRC stock exchange, the relevant PRC securities law and stock exchange rules shall apply. If the target company is a state-owned company, the regulations that govern the acquisition of state-owned assets will come into play.
The main regulation that governs the national security review is the NSR Measures, which generally combines the features of the previous regulations (the 2011 Circular and the Free Trade Zone Circular) and provides further detailed rules on how the national security framework will be operated. However, the 2011 Circular and the Free Trade Zone Circular have not yet been repealed and remain technically effective.
Under the FIL, foreign investment means any direct or indirect investment activity conducted by foreign investors (including foreign individuals, enterprises, or other organisations) 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.
Foreign investors and FIEs that carry out investment activities within China shall observe Chinese laws and regulations. In practice, foreign investments falling within the Negative Lists will be reviewed by SAMR or its local branches in the corporate registration process or relevant sector regulators, or both, in the operating licence approval process. Offshore M&A transactions that take place outside China (e.g., offshore acquisition of an FIE's foreign shareholder) are not subject to the PRC foreign investment review regime; however, where an offshore transaction results in changes to the information in the reports submitted to MOFCOM or its local branches (e.g., change of the actual controller of the foreign investor), these changes should be reported to MOFCOM or its local branches.
Foreign investments that involve fixed-asset construction (including modification and expansion) may also require NDRC's approval or filing procedure.
For national security reviews, a filing obligation will be triggered in either of the following scenarios:
- 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 IT-related or internet products and services, critical financial services, key technologies, and other critical sectors. Such 'control' covers scenarios where a foreign investor:
- holds 50 per cent or more of target's shares post-transaction;
- holds less than 50 per cent of target's shares but has sufficient voting rights to materially influence resolutions of shareholders' meetings and of the board of directors; or
- can exercise material influence over key matters such as business decisions, personnel, finances and technology through other means.
What is considered as 'critical' is not set out in any regulation, leaving the Working Mechanism with discretion to make determinations that shift from time to time with changes in policies or national security outlook. Furthermore, the NSR Measures include a catch-all clause, which allows the authority to further expand the scope of transactions subject to the national security regime. Owing to the absence of detailed rules and insufficient precedents, a case-by-case analysis is required to determine if a transaction triggers filing obligations.
In terms of the covered transaction types, 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 (potentially capturing an acquisition through contractual means, such as a variable interest entity arrangement). Under the NSR Measures, an indirect acquisition of a domestic enterprise already owned by foreign investors (for example, 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 investor is not Chinese or is not incorporated in China. For the purposes of the foreign investment review and national security review regimes, Hong Kong, Macao and Taiwan investors are considered foreign investors.
iv Voluntary screening
Both the foreign investment review and national security review regimes are mandatory.
As mentioned above, 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 if a restricted foreign investment does not comply with relevant restrictions, depending on the status of the investment transaction, the foreign investor may be ordered by the authorities to discontinue the transaction, dispose of the shares or assets, or both, acquired, or unwind the transaction.
Regarding the national security review regime, the NSR Measures make clear that the regime is mandatory and an investment caught by the regime must be filed for national security review. While there is no monetary penalty for failure to notify, the office of the Working Mechanism has the power to require the concerned parties to submit a filing.
We set out below the major steps of the review and reporting procedures in connection with foreign investments:
- foreign investment review procedures: China has implemented a 'national treatment plus negative list' approach for foreign investment in China. SAMR and its local branches will review the documents submitted by the foreign investors or the FIEs, or both, during the corporate registration process. If the foreign investment falls within the restricted sectors of the Negative Lists, the foreign investor will need to inform the authorities that applicable requirements under the Negative Lists have been complied with. After its review, the relevant authority will register permitted or encouraged investments as well as restricted investments that comply with the relevant restrictions and requirements, but will reject the registration of prohibited investments;
- foreign investment information reporting system: pursuant to the Measures for the Reporting of Foreign Investment Information (the Reporting Measures), where foreign investors carry out investment activities directly or indirectly within China, the foreign investors or the FIEs shall report investment information to MOFCOM or its local branches by submitting the required reports through the online enterprise registration system and the National Enterprise Credit Information Publicity System. Depending on the type of foreign investment, foreign investors or FIEs may need to submit the initial reports (when a foreign investor establishes an FIE through a greenfield investment or acquires a stake of a non-FIE company via an M&A transaction), change reports (when the information in the initial reports needs to be updated) and annual reports. Usually the initial reports and change reports should be filed simultaneously with the corporate registration procedure or, where the corporate registration procedure is not involved, within 20 days after the occurrence of the relevant changes. Although MOFCOM may update the form of the reports periodically, the required information usually includes corporate information of the invested enterprise, information related to the investors and their actual controllers, the invested enterprise's business operation and assets and liabilities information, and the industry licences and permits information if applicable; and
- project approval or record-filing by NDRC: depending on the sector and scale, foreign investments that involve fixed-asset projects may require the approval of, or filing with, NDRC or its local branches prior to the commencement of the investment project. If the approval process is triggered, the authority will have up to 30 business days to verify whether the underlying project is consistent with the foreign investment regulations, relevant industrial policies and public interests.
For national security reviews, the foreign investor is allowed to request a prior consultation from the office of the Working Mechanism before making a formal notification.
The national security review consists of three phases:
- preliminary review to determine whether a foreign investment falls under the national security review regime must be completed within 15 business days;
- 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
- special review must be completed within 60 business days but can be extended in special scenarios if a foreign investment impacts or may impact national security. A 'special scenario' is not defined and there are no statutory time limits for extending the review period.
In particular, the NSR Measures introduce a 'stop-the-clock' mechanism. This enables the authority to stop the clock because 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.
While the investment in question can be referred to the State Council for determination under the prior rules, such a referral no longer exists under the NSR Measures. This means the decision by the Working Mechanism is final and cannot be appealed.
vi Prohibition and mitigation
In terms of the national security review regime, the Working Mechanism may prohibit or impose remedies on a transaction. Although it remains unclear what types of remedy will be acceptable in a given case, both structural and behavioural conditions may be explored if a foreign investment in China attracts national security concerns. For example, NDRC reportedly called in Diodes Incorporated's acquisition of Lite-On Semiconductor for national security review. According to public sources, the Taiwan-based target eventually sold its controlling stake in a Chinese subsidiary before the parties received both merger control and national security review approval. It is unclear if the divesture was requested by the Chinese authorities or proposed by the parties proactively to facilitate the review process.
The national security review regime is opaque in terms of review and outcome. There is no publicly available information on the number of transactions that have been reviewed, prohibited or subject to mitigation.
There are currently three sets of the Negative Lists: the Special Administrative Measures (Negative List) for the Access of Foreign Investment (the National Negative List), Special Administrative Measures (Negative List) for the Access of Foreign Investment in Pilot Free Trade Zones (the FTZ Negative List) and Special Administrative Measures (Negative List) for Foreign Investment Access in Hainan Free Trade Port (the Hainan Negative List; together with the National Negative List and FTZ Negative List, the Negative Lists). The Negative Lists are primary sources prescribing prohibited and restricted sectors for foreign investment and the restrictions that apply nationwide, in all free trade zones (the FTZs), and in Hainan free trade port (the Hainan FTP), respectively.
Overall, the number of prohibited or restricted sectors has been reduced and the restrictions have been relaxed over the years. In addition, the FTZ Negative List and Hainan Negative List, as local pilot measures, are less restrictive than the National Negative List, signalling China's intention of further reform in pilot free-trade zones and opening-up of its market.
i Prohibited sectors
Under the 2020 National Negative List (the latest version), foreign investors are prohibited from investing in 22 industries within 10 areas ranging from agriculture to information technology and scientific research. Some of the most widely discussed prohibited industries include:
- internet news information services, internet publishing services, internet video and audio programme services;
- development and application of diagnosis and treatment technologies related to human stem cells and genes;
- domestic express mail services;
- editing, publishing and production of books, newspapers, periodicals, audio-visual recordings and electronic publications;
- compulsory education;
- social survey service; and
- artistic performance groups.
The FTZ Negative List and Hainan Negative List have fewer prohibited areas. For example, foreign investors are not prohibited from making investments in artistic performance groups in FTZs and Hainan FTP.
ii Restricted sectors
There are currently 11 restricted industries under the 2020 National Negative List. When making investments in a restricted area, 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 representatives). For example, in a PRC public air transportation company, no single foreign investor is allowed to hold more than 25 per cent equity interest and the controlling shareholder and legal representative must be a Chinese person. Similar to prohibited sectors, the FTZ Negative List and Hainan Negative List have fewer restrictions on restricted sectors than the National Negative List.
As noted above, the national security regime is also a sector-specific regime (see Section III (iii) above). However, there is no publicly available exhaustive list for such sectors or key industries.
Typical transactional structures
Under the current PRC regulatory regime, there are two principal channels for foreign investors to enter the PRC market: (1) establishing new FIEs; or (2) making investments in existing domestic companies via M&A transactions.
i Establishment of new FIEs
There are generally four types of legal entities available for foreign investments:
- a representative office, which is an agency office of the foreign investor in China for liaison and communication purpose. A representative office is not allowed to conduct business in China and therefore does not serve the business purpose of the foreign investor in many cases;
- a wholly foreign owned enterprise (WFOE), which is a 100 per cent subsidiary of the foreign investor;
- 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
- a foreign invested joint stock company, which is normally adopted where there are numerous shareholders, an IPO is contemplated or the company is already publicly listed.
ii Investment in existing domestic companies
Investments in PRC private companies
The M&A transaction by foreign investors can be structured as a share deal or asset deal. Under the PRC 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 PRC law requires that an onshore FIE shall be set up to host the assets acquired.
Compared with the onshore structure, offshore acquisitions usually enjoy more flexibility because of the following reasons: (1) the laws of offshore jurisdictions such as the British Virgin Islands and Cayman law are often more flexible than PRC law; and (2) the PRC foreign exchange control regime does not apply to offshore transactions in general and thus there is less of a hurdle on deal structure. Nevertheless, foreign investors may still consider establishing an onshore WFOE (directly or through the special purpose vehicles) as its long-term investment vehicle in China.
Purchase price may be paid in cash or in kind (such as intellectual property rights). It is also possible for a foreign investor to use the equity interests of an offshore company to pay the purchase price by way of conducting a cross-border share swap deal. However, current PRC law severely restricts the permitted scope of cross-border share swaps, which makes implementation of this deal structure very difficult in practice.2
Investments in public companies
Foreign investment in companies listed on the PRC stock exchanges (the 'A-share listed companies') is subject to additional requirements under PRC securities law and the rules of the relevant stock exchange.
Foreign investors need to satisfy certain qualification requirements (such as the minimum amount of assets owned or managed by the investor) before they can invest in A-share listed companies. Under the current PRC regulatory regime, 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.
If a foreign investor holds less than 30 per cent of the shares in a listed company, and proposes to acquire shares that will result in the investor holding more than 30 per cent shares, unless an exemption is available or granted by the China Securities Regulatory Commission (CSRC), the investor must acquire such additional shares (in excess of the 30 per cent threshold) by making a tender offer. The confirmation of the relevant stock exchange on a formality review basis is required for a private share transfer by agreement, while the CSRC's approval is required for a private placement.
Other strategic considerations
Apart from the above, it is advisable for foreign investors to consider the following issues when making an investment in China.
i Governing law
Theoretically, nothing under PRC law prohibits the parties from choosing the law of a non-PRC jurisdiction as the governing law of a cross-border transaction. In practice, however, PRC law is the governing law for most PRC onshore investment transactions. For PRC-related offshore investments, Hong Kong law is a more popular choice.
ii Foreign exchange
Despite the recent relaxation of the foreign exchange control regime, the inflow of investment funds, the repatriation of dividends and the outflow of proceeds from divestment by foreign investors are still subject to various foreign exchange control requirements and must follow prescribed procedures.
iii VIE structure
The variable interest entity (VIE) structure enables a foreign investor to invest in restricted sectors through contractual arrangements – the foreign investor controls Chinese domestic operating companies holding the required licences through a set of legal agreements rather than through share ownership. It is widely used in technology, education and healthcare sectors where foreign investments are prohibited or restricted. There are concerns around the enforceability and legitimacy of the VIE structure as foreign investors effectively circumvent foreign investment restrictions with such a structure. However, the current PRC legal regime remains silent on the legitimacy of the VIE structure and the Chinese government seems to allow its existence tacitly in practice.
iv 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 – 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 an RMB 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 only be formed in provinces or cities where local QFLP regulations have been promulgated.
v Data protection
The new PRC Data Security Law, which regulates a wide range of issues in relation to the collection, storage, processing, use and transfer of personal information and other data, came into force on 1 September 2021. The current data privacy legal regime does not prohibit data transfer across China's borders; however, the new Data Security Law will strengthen controls over outbound data transfer. This could have a significant impact on the daily business operation and data processing activities of FIEs and foreign investors.
vi National security review
The introduction of the NSR Measures indicates that any future foreign investments that may impact national security will be subject to greater scrutiny by the Chinese authorities. This echoes the global movement towards the adoption of more stringent national security review regimes. It remains to be seen whether the expanded national security review will prove as onerous as in other jurisdictions where national security rules have recently been introduced or tightened. For now, the impact of the expanded national security review regime is modest for the vast majority of the foreign investments in China.
For companies whose activities fall within covered sectors, national security review will no doubt add complexity to investments in China, potentially impacting deal timelines and conditions to be imposed, thereby giving rise to deal uncertainty. Sectors that have attracted investment recently such as technology, internet and financial services may be captured by the NSR Measures. Given the uncertainties that remain to be clarified under the national security review authority's wide discretion, investors are well advised to conduct a thorough national security assessment for transactions and ensure compliance with national security filing obligations.
China is pursuing two policies that appear contradictory: on the one hand, continuously opening up its domestic industries to overseas investors while, on the other hand, increasing its screening of foreign investment on national security grounds.
The FIL is a milestone and is designed to reshape China's foreign investment regime with a view towards deregulation. The restrictions and prohibitions set out in the Negative Lists have been reduced for the fourth consecutive year. There are also various local pilot programmes to promote foreign investment. Overall, we can expect that the Chinese government will continue its opening-up policy and optimise the foreign investment environment.
With respect to the national security regime, this has been in place for some time, but the government has only recently started to launch more investigations. However, for the time being, it is not expected to be enforced as actively as China's merger control rules. The year 2021 marks the first year of the implementation of the 14th Five-Year Plan (2021–2025), with the Chinese government pursuing 'high-quality' rather than 'high-speed' growth and 'high-end, intelligence and green production'. Foreign investments in these areas will continue to be welcomed and China's national security rules will more likely be applied as a 'defensive' measure instead of too intrusively to deter overseas capital.
That being said, the general expectation is that national security review will likely play a more prominent role in 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 issue when reviewing transactions, rather than national security or industrial policy concerns. Furthermore, the rising tide of regulatory scrutiny by Western governments of inbound investment (particularly those from China) will likely encourage the Chinese government to adopt a tit-for-tat approach in this respect.
1 Hazel Yin and Ninette Dodoo are partners and co-heads of the China antitrust, competition and trade practice of Freshfields Bruckhaus Deringer. Yuxin Shen is an M&A partner, and Wenting Ge and April Dong are associates at the Freshfields Bruckhaus Deringer's Beijing office.
2 Note: Pursuant to the PRC Provisions on the Merger and Acquisition of Domestic Enterprises by Foreign Investors, only (1) shares of an offshore listed company and (2) in rare cases, shares of an offshore special purpose vehicle established for the purpose of overseas listing of a Chinese 'red chip' company can be used as consideration for the acquisition of a Chinese domestic company.