Making provisions

In a significant development for foreign investors, the Ministry of Foreign Trade and Economic Cooperation (Moftec; and the State Administration of Industry and Commerce (SAIC) jointly promulgates the Investment Within China by Foreign Investment Enterprises Tentative Provisions on July 25, 2000.

Effective from September 1, 2000, these FIE investment regulations provide clear rules governing investment in China by foreign-invested enterprises (FIEs) and resolve jurisdictional friction that had existed since 1995 when the SAIC issues similar regulations without Moftec's involvement. These are the first Moftec issued regulations expressly sanctioning domestic China investment by FIEs.

Unprecedented appeal process
As well as improving the regulatory environment for FIE investment, these regulations set out an unusual and probably unprecedented appeal process for certain approval rejections. They also appear to hold out special incentives for investment by FIEs in central and western regions.

The regulations define domestic investment by FIEs as investment in or establishment of an enterprise within China by limited liability Sino-foreign equity join venture, cooperative joint venture or wholly foreign-owned enterprise, or Sino-foreign joint stock company, including the purchasing of the equity of an investor in another enterprise inside China.

This definition excludes investment made by FIE holding companies, which are governed by the separate provisions. The definition also excludes investment made jointly with a foreign investor, which instead is governed by general foreign investment laws. However, the FIE investment regulations stipulate that if such investment is made jointly with a foreign investor the capital contribution of the foreign investor `generally' should not be less than 25 percent of the registered capital of the target company.

Historically, the legality of investment by FIEs has been uncertain. In 1995, the SAIC issued provisions that set out rules according to which the SAIC would register FIEs as shareholders in or as sponsors of domestic Chinese companies. Moftec, however, never signed off on these regulations and provided mixed signals regarding their validity. Nevertheless, FIE investment at the local level with the approval of the local investment authorities has been relatively common.

In other words, reflecting a pattern seen frequently in the development of Chinese law, regulation has lagged behind practice. The FIE investment regulations have now closed this gap.

The FIE investment regulations set out relatively straightforward preconditions for investment by FIEs in China. The target company must be a limited liability or joint stock company. In compliance with China's Company Law, the regulations restrict the aggregate amount of investment by the investing HE to no more than 50 percent of its net asset value.

In addition, the amount of the increase in capital resulting from the conversion into capital of profit received from an invested company shall not be included. In other words, capitalised dividends are not counted in the amount invested. This is apparently meant to encourage, or at least not discourage, the reinvestment of distributable profits by the parent FIE in the subsidiary company.

Eligibility for investment
To be eligible to invest in another company an FIE's registered capital must be fully paid in, it must have begun making profits and it must have no record of operating in violation of the law. In this respect, the FIE investment regulations represent an improvement over the 1995 SAIC provisions which, instead of requiring that an FIE shall have begun making profits, required only that it shall have begun paying taxes. Given that most FIEs enjoy a two-year exemption (from the first profit-making year) on corporate income tax, the implication was that no FIE investment was possible until this tax holiday had expired. The FIE investment regulations eliminate this confusion; however, evidence of the relevant tax holiday must be submitted to the relevant registration authority as part of the application.

Like the SAIC provisions, the FIE investment regulations are applied primarily according to industry category and location, rather than on the basis of investment amounts. When an FIE invests in and establishes a new company in an industry sector that is `encouraged' or `permitted' under the Foreign Investment Industrial Catalogue, the FIE need only submit an application to the relevant branch of the SAIC where the new company will be established. No approval from Moftec or its local branches is required. In this respect, the FIE investment regulations represent a streamlining of the SAIC provisions, which required an FIE first to obtain approval of its original registration authority before applying to invest elsewhere.

Change in approval procedures
If the FIE invests in and establishes a new company in a `restricted' sector, it must seek approval from the relevant provincial-level authority. This authority will then solicit the opinions of the provincial or state-level industrial administrative department, apparently regardless of the percentage of registered capital the FIE plans to hold in the target company. This reflects a change in approval procedures, in that the provincial-level approval authority is authorised to approve, subject to certain specific restrictions noted below, investment by an FIE without any reference to the amount of investment involved. The same approval requirement is imposed where an FIE obtains equity via a transfer from a third party in an existing target company in the `restricted' sector.

Also omitted is the SAIC provisions' previous maximum limit of 25 percent for FIE investment in `restricted' industry enterprises.

However, if the original FIE plans to use its fixed assets to make the investment and changes its original business scope in the process, the approval of the FIE's original approval authority is required. This is meant, in part, to encourage the investment of retained earnings and to prevent investors from gutting already-approved projects for the sake of investing in more favourable projects elsewhere. Similarly, FIEs are prevented from investing in a `permitted' or `encouraged' sector and subsequently changing the scope of business to include a `restricted' category, without the approval of the original approval authority.

The FIE investment regulations also expressly state that FIEs may not invest in `prohibited' sectors, thus closing off a loop-hole whereby foreign investors have established FIEs (technically domestic entities) and have then used these FIEs to invest in industries off-limits to direct foreign investment.

There are two sets of circumstances in which Moftec approval is required:

-if the target company is located in the central or western regions and if the total investment of the target company exceeds the provincial-level approval limit, or
-if other laws or regulations provide that it is required due to the nature of the industry.

In an extremely unusual and, perhaps, unprecedented move, the FIE investment regulations now allow investors the opportunity to appeal to Moftec if approval is refused at lower levels. Previously, the relevant approval authority has discretion to accept or reject applications to establish FIEs, and there was no legal basis for appealing a decision to a higher level. It is interesting to consider whether this innovation reflects an attempt to appear more WTO-friendly, or whether it simply indicates the desire of the Chinese government to reinvigorate the foreign investment environment. It will also be interesting to note whether this type of appeals process is expanded to cover other areas of foreign investment as foreign investment laws are revised to comply with WTO requirements.

FIE status for new companies
If an FIE invests in central or western China and the proportion of foreign investment in the registered capital of the target company is not less than 25 percent, the target company shall benefit from FIE status and treatment. The implication is that FIE investment in other regions and FIE investment in the central and western regions involving less than 25 percent foreign investment do not qualify for FIE status and. treatment. This is a significant change from previous practice, and Moftec officials have confirmed that it was intended as such. However, FIE status is not automatic even for those eligible. Provincial-level approval is still required, apparently reflecting an attempt to rein-in overly generous local approval authorities.

Given that many investors do not meet the high-threshold requirements of establishing a holding company, the FIE investment regulations are a welcome and positive development in China investment law. Investment by existing FIEs provides an attractive option for developing operations within China. Moreover, the simpler approval process provides both time and cost advantages over direct foreign investment, and Moftec's involvement in drafting these regulations has removed the major legal uncertainty in FIE investment under the SAIC provisions.

This article was written by Douglas C. Markel and Tarrant M. Mahony of Fresh-fields Bruckhous Deringer. For further details, contact Lucille Barale in Hong Kong (tel: +852 2846 3400) or by e-mail (lucille.barale@freshfields.com) or Matthew Cosans in London (tel: +44 207 936 4000) or by e-mail (matthewcosans@freshfields.com)