China’s FIE Registration and the New Actual Controlling Person Requirement

April 11, 2017 Posted by China Briefing Reading Time: 6 minutes

By Dezan Shira & Associates
Editor: Weining Hu

The Standing Committee of the National People’s Congress has recently made changes to the laws and regulations governing foreign-invested enterprises (FIEs) in China. Key changes include that MOFCOM requires both consolidated and future market entrants to disclose extensive and sensitive information concerning their corporate structure. Specifically, the new FIE online filing registration form (“new form”) requires FIEs to explicitly report the actual controlling person of their enterprise – a requirement that has little precedent internationally.

Determining the actual controlling person

In the new form, FIEs are required to register basic information of the enterprise’s actual controlling person(s). First, FIEs are required to select the nature of the actual controlling person(s), which applicants must select from the following seven options: foreign listed company, foreign natural person, foreign government agency (including funds controlled by government), international organization, domestic listed company, domestic natural person, and state-owned enterprise (SOE) or collective enterprise. It is noteworthy that the private entity, the most common corporate type, is not listed by MOFCOM as an option. This means that if the investor is not a listed company or public institution, a natural person would need to be selected, such as a CEO, or group of individuals, such as a board, who can be identified as in control of the private entity.

To register the nature of the actual controlling person(s), FIEs are required to explain how “control” operates under the registered actual controllers by choosing one of the following three options: equity ownership; contractual control over the foreign entity’s decision-making body; or rights over the enterprise’s operation and management, personal nomination, financial conditions, technology, or other aspects.

Challenges for complex corporate structures

These three options seem to present the basic elements of “control,” but in practice, many FIEs will find it difficult to decide which option to select when more than one kind of “control” conflict. For example, the new FIE laws do not determine which party possesses actual control for a Sino-foreign joint venture where the Chinese investors hold the majority equity ownership and the foreign investors have decisive influence on technology.

When considering the variety of corporate structures, the features of “control” summarized in the checkboxes are simply unable to represent all types of corporate structures. In some cases, decision-makers intentionally structure their business to ensure no single individual or group has actual control. In other cases, the ownership structure is so complex that the subject enterprise does not even know who their ultimate beneficiary shareholders are, such as private equity, venture capital funds, angel funds, family trusts, and limited partnerships. Under such circumstances, the new rules undoubtedly make the FIE online filing registration an extremely cumbersome process for companies that have complex corporate structures. It is therefore recommended that companies with complex controlling structures consult professional legal agencies.

VIE investors in restricted industries

The actual controlling person standards also affect another group of investors: variable interest entity (VIE) structure investors in restricted and prohibited industries. Prior to the new FIE laws, many foreign investors adopted the VIE structure to access Chinese industries that were restricted on the Negative List. They did so by setting up an onshore company in China, and hiding the actual ownership by signing a series of contractual agreements. These agreements allowed Chinese executives to operate the company, but directed the profits of such onshore company back to the actual controlling entity. The VIE structure was not explicitly denied by the Chinese authorities until the formation of the actual controlling person standards. Since the new filing process requires the disclosure of actual controlling person(s), VIE structure adopters can no longer hide the identities of the actual controlling persons.

In order to stay in the restricted industries, both existing and new VIEs shall adopt one of the following three approaches to register its business status with MOFCOM. Existing VIEs have a three-year grace period starting from October 2016 to update their business information with MOFCOM.

Auto-filing Option: a VIE may file the new form online with MOFCOM, declaring the entity’s actual controlling person is a Chinese investor. In this option, the VIE automatically obtains approval upon filing if accepted.
Recognition Option: a VIE may apply to MOFCOM for a separate recognition of its actual controlling person’s status as a Chinese investor before filing the new form. Industry specialists indicated that applications where the company’s actual controller has already been recognized as a Chinese investor are unlikely to be rejected.
Market Access Approval Option: if the subject entity could not settle in an agreement that has the Chinese investor as its actual controlling persons, such VIE needs to start from scratch by applying to MOFCOM for a new market access license. The MOFCOM would make its decision on a case-by-case basis by weighing various factors, including the actual controller of the subject entity.

The first two options create a system that concentrates controlling power in the hands of Chinese executives, while the third one is a time-consuming process and is associated with risks for businesses embedded in restricted industries. None of the solutions is an easy choice for foreign investors: all three solutions show how market entry for restricted industries has become more difficult than before.

As the finalized Negative List is yet to be released by MOFCOM, it is uncertain which industries will be impacted by the new form. Concerns over the Negative List will likely increase uncertainty for VIEs over the long-term: the PRC State Council can reduce or expand the Negative List by amending market access restrictions for foreign investment at any time.

Takeaways

The actual controlling person standard will significantly alter the shape of foreign investment in China. On the positive side, it greatly cuts red tape for foreign investors, and facilitates a clearer framework for governing FIEs that were previously in a grey area of law. On the negative side, it over-simplifies modern corporate structures, and increases documentation efforts for sophisticated corporate structure entities and investors in restricted industries. Generally speaking, a majority of new market entrants will benefit from the reform, while foreign investors who would like to invest in restricted industries will need to operate in a more transparent way.

This article is an excerpt from the February issue of China Briefing Magazine, titled “New Considerations when Establishing a China WFOE in 2017” In this edition of China Briefing, we guide readers through a range of topics, from the reasons behind foreign investors’ preference for the WFOE as an investment model, to managing China’s new regulations.