By Xu Ping, Yao Lijuan and Gao Wei    King & Wood Mallesons’ M&A Group

On November 4, 2014, the National Development and Reform Commission (“NDRC”) released the latest draft updating the current 2011 “Foreign Direct Investment Industries Guidance Catalogue (“2014 Draft”),” and called for public opinions on the draft until December 3, 2014.

The Foreign Direct Investment Industries Guidance Catalogue (“Catalogue”) is the central policy of the Chinese government that regulates the inflow of foreign investment in various Chinese industries. The Catalogue classifies foreign direct investments in the industrial sectors as “encouraged,” “restricted,” “permitted,” or “prohibited” and imposed restrictions on foreign investment forms and shareholdings on certain key industrial sectors. Since its inception in 1995, the Catalogue has been revised once every few years. The 2014 Draft, once takes into effect, will become the sixth revision and replaces the current 2011 Catalogue.

Since the resumed discussion between US and China on the Sino-US Bilateral Investment Treaty in July 2013, the topics of further liberation on Chinese industrial sectors and simplifying the government administrative approval procedures to foreign investments have attracted much attention. Under such pretext, in Sept. 2013, Shanghai Free Trade Zone (“FTZ”) initiative was launched and it bypassed the Catalogue by adopting the “negative list” approach which specified the industries in which foreign investment is either restricted or prohibited. When the 2013 Negative List was first introduced, it included virtually all of the restrictions and prohibitions on foreign investment set out in 2011 Catalogue thus disappointed many foreign investors. In response, 2014 Negative List, which introduced in June 2014, reduced the number of industries and activities that are restricted from 190 to 139. However, as many viewed 2014 Negative List, which is only applicable to FTZ, as a limited improvement over 2011 Catalogue, the public has been expecting greater degree of reform to be carried out by the Chinese government.

Then comes 2014 Draft, which promises to offer the most considerable changes to date. 2014 Draft proposes to reduce the number of “restricted” industrial sectors to foreign investors by more than halved, from 79 to 35, significantly cut the number of industrial sectors that currently limited to joint ventures and partnerships from 43 to 11 and decrease the numbers of industrial sectors that require a Chinese majority shareholder from 44 to 22.

The key changes in different major industrial sectors can be summarized as follows:

1. Manufacturing

Under 2014 Draft, the restrictions on manufacturing industry has been greatly lifted. The beverage manufacturing, chemical raw material and products manufacturing, chemical fiber production, general machine building, special equipment manufacturing (excluding arms and ammunition, which still fall under the “prohibited” category), transportation equipment, communication equipment, computers and other electronic equipment manufacturing are removed from the “restricted” category. It implies that the aforementioned activities will be considered as “permitted” where foreign investment can be carried out without restrictions on shareholding or investment forms.

2. Pharmaceutical and Medical

We also see a considerable change in the health care industry under 2014 Draft. 2014 Draft categorizes certain pharmaceutical products plagued with overcapacity to the “restricted” category (such as multivitamins and calcium) and categorizes narcotics and “A” class psychoactive drugs as “permitted”, which allows market screening instead of pure administrative regulation in the manufacture of these types of drugs .

On the other hand, under 2014 Draft, we notice the government imposes tighter control over the establishment of foreign invested medical institutions. Medical institution was once categorized as “restricted” industry under 2007 Catalogue, which only allowed foreign investment in the form of joint ventures. Then under the current 2011 Catalogue, medical institution was removed from the catalogue completely suggesting that foreign investors should be “permitted” to invest in medical institutions without restrictions. However, in practice, the establishment of wholly foreign-owned medical institutions remains difficult in China, and, only recently, FTZ begins to allow wholly foreign-owned medical institutions to be established. Since 2014 Draft moves medical institution back to the “restricted” category, it suggests that foreign investment in medical institution will remain restricted in the near foreseeable future.

3. Auto Industry

Under the current 2011 Catalogue, a number of activities under the automobile electronic device manufacturing and R&D sector are in the “encouraged” category, but foreign investors are required to work with Chinese partners in the form of joint ventures in certain areas, such as manufacturing of automobile electronic bus network technology, electronic controller for electric power steering system and embedded electronic integrated system. 2014 Draft has abolished such restriction, hence once it takes into effect, foreign investors are permitted to establish WFOEs in the aforesaid sectors.

However, 2014 Draft moves the manufacturing of complete auto vehicles, special purpose vehicles and motorcycles to the “restricted” category. It also mandates that Chinese ownership cannot be less than 50% and the same foreign investor is not permitted to invest in more than two joint ventures which manufacture the same category of auto vehicles (i.e. passenger cars, commercial cars and motorcycles) in China. Notwithstanding, such restriction will not apply if the foreign investor acquires or merges other automobile manufacturers in China together with a Chinese joint venture partner. The above restriction is consistent with the Automobile Industry Development Policy issued in 2004, except that the manufacturing of agricultural vehicles is not covered in the “restricted” category under 2014 Draft.

The manufacture of auto vehicles was once categorized as “encouraged” under the 2007 Catalogue, but later was categorized as “permitted” under the 2011 Catalogue subject to regulation by the Automobile Industry Development Policy. 2014 Draft for the first time explicitly categorizes auto manufacturing as “restricted” industry. This signifies the policy trend and the attitudes of regulatory authorities on gradual tightening of foreign investment in the auto manufacture industry and their on-going support for the development of domestic auto brands. On the other hand, it is envisaged from this draft that further relaxation of foreign equity ratio in auto manufacturing joint venture, which has drawn significant attention recently, may be temporarily halted.

4. Telecommunication and Internet

The Chinese governments are generally in support of the development of emerging technology sectors such as telecommunication and internet. Under “restricted” category of 2014 Draft, foreign investment in “e-commerce” now can exceed 50%. Currently, in FTZ, foreign investment in e-commerce business can be made up to 55%. As such, it would be interesting to see whether the FTZ will further lift the restriction on foreign investment in e-commerce business (i.e. from 55% to above) or area outside of FTZ will follow the 55% threshold set by the FTZ.

In addition, the development and application of technologies related to Internet of Things is added to the “encouraged” category for the first time. We understand that this new addition is in line with the Chinese government’s continuing efforts in obtaining leading advantage in technologies related to Internet of Things in era of mobile internet. For certain technologies in the telecom industry that may potentially fall into the “technologies related to Internet of Things” (the definition is subject to the authorities’ further interpretations), such as Internet of vehicle technology, smart grid technology and mobile wearable devices technology, the foreign companies investing in the development and application of such technologies may enjoy some preferential policies including tax.

On the other hand, internet publishing related services are “prohibited activities” which is not surprising as it is consistent with the views of the Ministry of Culture and Press and Publication Administration where they explicitly prohibit foreign investment in internet publication in their jointly issued “Opinions on Foreign Investment in the Cultural Sectors” in 2005.

5. Infrastructure and Real Property

Compared with the current 2011 Catalogue, 2014 Draft lifts the restriction on foreign investment in metro and real property projects. Specifically, the construction and operation of rail transit such as city metro and light rail under the “encouraged” category no longer have the Chinese majority shareholding requirement. Hence, once 2014 Draft takes into effect, foreign investors are permitted to establish WFOEs to operate and construct the aforesaid projects.

In addition, real property projects are now falling under “permitted” category under 2014 Draft, which means that there are no more restrictions on foreign investment in land development and the construction and operation of luxury hotels, office buildings and international convention centers.

6. Education

Contrary to the liberalization trends enjoyed by other industrial sectors, generally 2014 Draft imposes more stringent restrictions on foreign investment in educational sector. Higher education and day-care are added to the “restricted” category and are limited to cooperative joint ventures led by the Chinese party. High school education remains “restricted” which also must be led by the Chinese party. Compulsory education is categorized as “prohibited,” which means compulsory education remains off-limit to foreign investors.

7. Service Sector

For accounting and auditing services which fall under the “encouraged” sector, 2014 Draft removes the “the form of cooperative joint ventures and/or partnership” requirement. This signifies that foreign investors are permitted to establish WFOEs to run accounting firms for provision of accounting and auditing related services in China.

Restrictions on entertainment industry are also liberalized. Under 2014 Draft, the operation of performance venues under the “encouraged” category no longer require Chinese majority shareholdings, while the construction and operation of large-scale theme parks and entertainment venues are now categorized as “permitted” activities.

However, services such as legal advice and auction of Chinese cultural relics are under tighter control. Under the current 2011 Catalogue, providing legal advice is categorized as “restricted”. In 2014 Draft, however, providing Chinese law related consulting services is explicitly listed as “prohibited”. In addition, operating auction houses selling Chinese cultural relics and antique stores is also explicitly listed as “prohibited” under 2014 Draft.

In general, 2014 Draft is further relaxed by lifting restrictions on foreign investments across a wide array of industries and business activities. At the same time it also indicates that we can expect to see a series of major reforms to the foreign investment regulatory regime in the foreseeable future.