Copyright Euromoney Institutional Investor PLC Dec 2007/Jan 2008

 

With the issuance of a new guidance catalogue, China has re-defined the industries into those that are encouraged, restricted, or prohibited for foreign investment. At the same time, FIE tax preferences and approval procedures are being more closely aligned with the PRC government's evolving national economic development policy. Foreign investors in the PRC must now adapt to some transitional uncertainty and prepare for a somewhat different investment environment.

By Thomas Y. Man, Yan Zeng & Jing (Jean) Sun of Orrick, Herrington & Sutcliffe LLP

A policy realignment of sorts took effect on December 1 2007, under the newly revised version of the Foreign Investment Industrial Guidance Catalogue (Amended 2007), which was jointly issued on October 31 2007 by the National Development and Reform Commission (NDRC) and the Ministry of Commerce (MOFCOM). This marks the fourth revision to the Foreign Investment Industrial Guidance Catalogue since its first promulgation in 1995 (the previous revisions occurred in 1997, 2002, and 2004 respectively).

POLICY OBJECTIVES

An official NDRC news release 1 has summarized the policy objectives of the 2007 Catalogue as follows:

1) To upgrade China's industrial structure by encouraging investment projects that use new and high technologies and new materials, and by reducing support for investment in the manufacturing sector using traditional technologies;

2) To enhance resource conservation and environmental protection by encouraging investment in environmentally friendly and resource-saving technologies, and by restricting or prohibiting foreign investment in projects that cause high pollution and consume high amounts of energy and resources;

3) To address China's trade surplus and rapid increase of foreign exchange reserve by eliminating the encouragement policy for investment projects that export 100% of their products;

4) To improve balanced regional development by revising the policy that provides favorable treatment for investment projects in the Central and Western Regions; and

5) To protect national economic security by applying "cautiously open" (meaning more restrictive) policy to foreign investments in the sectors that are deemed by the government to be "sensitive" or have strategic importance.

To a very large extent, the 2007 Catalogue faithfully reflects these policy articulations.

CONTINUITY & CHANGE

The three basic categories: "encouraged", "restricted", and "prohibited" have been carried over to the 2007 Catalogue. Like those in the 2004 Catalogue, industries not listed are considered to be in a default category normally referred to as "permitted", and are open to foreign investment unless otherwise specified in other PRC regulations.

The 2007 Catalogue has substantially increased the number of listed industries:

the "encouraged" category contains 351 industrial areas (an increase of 94 from the 2004 Catalogue);

the "restricted" category contains 87 industrial areas (an increase of 9); and

the "prohibited" category contains 40 industrial areas (an increase of 5).

Omitted from the 2007 Catalogue are two notes contained at the end of the 2004 Catalogue, which are now understood to be unnecessary as they are reflected in the catalogue listings or in related administrative regulations and implementing rules:

Note 1, which provides that the provisions of the Closer Economic Partnership Agreements (CEPA) between Mainland China and Hong Kong and Macau, respectively, prevail over the provisions of the catalogue;

Note 2, which appends an Annex listing China's commitments in the Protocol on China's November 2001 accession to the World Trade Organization (WTO), relating to specific industrial areas and subject to time schedules ranging from one to five years from the date of the Protocol.

CATALOGue CONSEQUENCES

Tax incentives and approval requirements can each be affected by whichever industry category is deemed to apply to a particular foreign-invested enterprise (FIE).

Under the current PRC regulatory regime, foreign investment projects that fall within the "encouraged" category may enjoy certain tax incentives and be subject to less onerous approval requirements. Tax incentives that are applicable to an "encouraged" foreign investment project mainly include: (a) equipment imported for own use within the total investment amount of the project will be exempt from tariffs and import-stage value-added tax, 2 and (b) foreign investors may claim a refund of value-added tax for purchasing domestically-made equipment within the total investment. 3

There are two types of basic approval requirements for a foreign investment project: (a) the project approval by NDRC or its local counterparts and (b) the foreign investment approval by MOFCOM or its local counterparts. For foreign investment in the "encouraged" or "permitted" industries, if the total investment amount is US$100 million or more, the project must obtain approval from the central NDRC and MOFCOM with the attendant requirement that any project of US$500 million or more shall be submitted to the State Council for verification. For any project with a total investment of less than US$100 million, approval by the NDRC and MOFCOM counterparts at the provincial level or below will be sufficient. By contrast, for foreign investment projects in the "restricted" category, no approvals may be obtained below the provincial level, the threshold for national approval is lowered to US$50 million in total investment, and the threshold for verification by the State Council is lowered to US$100 million. 4 Approval at a lower government level is generally preferred, because it usually entails simplified procedures (thus less time-consuming and costly), which are also more flexible, with easier access to approving officials than would be the case in a national approval process.

PROHIBITED CATEGORY

The changes in the "prohibited" category have highlighted two overriding policy objectives of the Chinese government: (a) control and elimination of investment in environmental unfriendly industries; and (b) prohibition of foreign participation in industries that are deemed to be politically "sensitive."

In the manufacturing sector, manufactures of open orifice-type (direct efflux of acid mist) lead-acid batteries, mercury silver oxide button batteries, paste-type zinc-manganese batteries, and Ni-Cd batteries have been added to the "prohibited" category due to their adverse impact on the environment.

"Scientific research, technical services and geological exploration industry" are important additions to the "prohibited" category. This phrase is not clearly defined but is likely to cover a variety of activities ranging from development and application of human stem cells, gene diagnosis and treatment technology to geographic surveys, marine mapping, aerial survey mapping photography, administrative boundary mapping, relief map compilation, and electronic navigation map compilation.

In the culture, sports and entertainment sector, radio and television program production and operation companies as well as film production companies have been downgraded to the "prohibited" category from the "restricted" category (where a Chinese party must hold a controlling stake), as have the construction and operation of golf courses. Foreign investment in news websites, Internet-based video and audio program services, business premises for Internet access services, and Internet cultural operations have also been added to the "prohibited" category, underscoring the heightened control over foreign participation in Internet-based news and cultural services. But it is questionable whether this prohibition is WTO-compliant, because China's WTO commitments do not specifically mention Internet-based services, which are widely considered to be a telecom service that belongs to the "restricted" category.

RESTRICTED CATEGORY

The 2004 Catalogue's Annex listed China's commitments and deadlines to open or conditionally open selected industries to foreign investment. Those industries have now mainly been incorporated into the "restricted" category or have become "permitted.". The only notable exception is the domestic and international operations of the basic telecommunications business, in which the foreign equity ratio limit of 35% will be raised to 49% "by" (presumably on) December 11 2007. This approaching deadline has been referenced in the main text of the 2007 Catalogue.

Since December 11 2006, China has opened domestic wholesaling of certain products (vegetable oils, autos, and chemical fertilizers, and similar products) to foreign investors without equity participation restrictions. But the 2007 Catalogue, in a rare instance of potential non-compliance with China's WTO commitments, seems to have reiterated the previous restriction, limiting wholesaling of these products to majority Chinese-controlled joint ventures.

With great caution, China has gradually opened up its financial services sector to foreign investment since China's accession to the WTO. The 2007 Catalogue retains most of the conditions set out for the financial service sector in the 2004 Catalogue: insurance (foreign equity ratio in life insurance companies is limited to 50%); securities firms (foreign equity ratio is limited to 1/3); securities investment and fund management companies (foreign equity ratio is limited to 49%); and futures companies (where a Chinese party must hold a controlling stake). The 2007 Catalogue further provides that foreign-invested securities firms can engage in the underwriting of A-shares and both the underwriting and trading of B-shares, H-shares and government and corporate bonds.

One significant change in the financial services sector is that futures companies have been upgraded from the "prohibited" category to the "restricted" category, although the controlling stake should be held by a Chinese party. New additions to the "restricted" category also include, among others, some conventional industries downgraded from the "permitted" category (such as foreign investment in the real estate secondary market trading and real estate brokering or agency business, due diligence and credit rating services companies, performances brokerage agencies, entertainment venue operations, as well as the repairing, designing and manufacturing of common vessels).

In addition to being subject to more stringent government approval requirements than the investment projects in the "encouraged" and "permitted" categories, foreign investment in the "restricted" category may also be subject to further restrictions in terms of investment form (e.g., limited to Chinese-foreign equity or cooperative joint ventures) or equity ratio. Moreover, the 2007 Catalogue should not be regarded as an exhaustive list of all the restrictive conditions for investment projects in the "restricted" category, as local governments and administrative agencies in different industries may impose additional requirements, sometimes without justifiable legal basis. Foreign investors should refer to these industry-specific and location-specific regulations when determining the applicable requirements for a specific investment project.

ENCOURAGED CATEGORY

The service sector has been opened wider to foreign investors in line with China's WTO commitments with some new areas, notably "modern logistics" (not yet defined) and "outsourcing services," added to the "encouraged" category.

Longstanding export preferences have been substantially cut back, as the 2007 Catalogue omits the 2004 Catalogue provision. The provision specified that any "permitted" foreign investment project exporting 100% of its products would automatically qualify as an "encouraged" project. This signifies the ending of a policy dating back to China's initial opening up to the world in the late 1970s.

Consistent with the Chinese government's efforts to cool down the real estate market by preventing hot foreign money from swarming into China, the 2007 Catalogue stripped the "encouraged" status from the category of development and construction of "common residences."

The 2007 Catalogue omits geographical preferences, but they will be detailed in a separate catalogue. All regional specific policies, applicable mainly to the "encouraged" industries for foreign investment in the less-developed Western, Central, and Northeastern regions, will be further specified in the Catalogue of Priority Industries for Foreign Investment in the Central and Western Regions. 5 Therefore, for an investment project located in the Central, Western or Northeastern regions, both the 2007 Catalogue and the Catalogue of Priority Industries for Foreign Investment in the Central and Western Regions should be consulted to ascertain the applicable investment policy. 6

Most of the increases in the "encouraged" category are in the broadly defined "manufacturing" sector. In particular, the two sections of "regular" and "special use" machinery manufacturing are significantly expanded. Most items in the Catalogue for Encouraging Foreign Investment in Products with High and New Technologies (2006) (?O,AOeth-not symbolonot symbol (2006)) have been added to the 2007 Catalogue. In general, the added items feature further division of existing areas into sub-areas, based on sophisticated technical criteria rather than a broadening of the overall scope of these industries. These changes reflect that the policy orientation is in favour of foreign investments in high and new technologies, equipment manufacturing, and new material industries. It also reflects the policy of environmental conservation and energy-saving, which have become conditions for investment projects to acquire the "encouraged" status (for example, the manufacture of agriculture equipment using fertilizer-saving, pesticide-saving and water-saving technology). At the same time, in conventional industries in which China has mastered advanced technologies and has competent production capacity, foreign investment is no longer encouraged, evidenced by the downgrading of several conventional industries from "encouraged" to "permitted", or even to the "restricted" category. 7

TIMING QUESTIONS

"Grandfathering" is likely to enable an existing FIE in a downgraded industry to continue to enjoy the more favorable treatment of the previous catalogue version, but its duration is not yet clear. It is also not yet clear whether an existing FIE in an upgraded industry would be able to enjoy more favorable treatment under the revised catalogue without obtaining approval for a capital increase. If past practices were followed, an existing FIE in an industry that has been downgraded from "encouraged" to "restricted" category would not be entitled to the tax incentives for its portion of new capital increase. These questions are expected to be clarified through additional administrative regulations, rules and, to a large extent, interpretations by the competent agencies in practice.

At the time of writing, no authoritative decision had been announced as to which stage of government approval would ensure that previously submitted foreign investment applications will be covered by the revised catalogue. If past practices are followed, then, regardless of whether a new FIE has completed its corporate registration with (and business license certificate issuance by) the local bureau of the State Administration for Industry and Commerce, the cut-off will be as follows:

A project approval issued before December 1 2007 by the NDRC or its local bureau is likely to ensure that an FIE's establishment or expansion is covered by the previous 2004 Catalogue.

For projects that do not require a project approval, a foreign investment approval issued by MOFCOM or its local department before that date is likely to have the same result.

Other applications that were pending on December 1 2007 will be subject to the 2007 Catalogue.

ACCELERATING CHANGE

Additional (and probably faster) changes in PRC policies can be expected in the future as the government responds to domestic and international policy challenges in a fast-changing environment, and as it monitors the effects of the catalogue on the PRC's attractiveness to foreign investors.

Endnotes

1 http://xwzx.ndrc.gov.cn/xwfb/t20071107_170997.htm.

2 See the Circular of the Customs General Administration on Import Taxation Policy for Further Encouraging Foreign Investment, promulgated on November 22 1999 and the Circular of the State Council on Adjustment of Imported Equipment Taxation Policies promulgated on December 29 1997.

3 See the Tentative Measures on Tax Refund Administration for the Purchase of Domestically Made Equipment for Foreign Investment Projects (O,AOethOoE +/- OAA?I'--I(R)), promulgated by the State Administration of Taxation and the National Development and Reform Commission on July 24 2006.

4 See Articles 3 and 4 of the Interim Measures for the Administration of Examination and Approval of Foreign Investment Projects (O,AOethOoA'--?II(R)), promulgated by the National Development and Reform Commission on October 9 2004.

5 The Catalogue of Priority Industries for Foreign Investment in the Central and Western Regions was promulgated in 2000 and was revised in 2004. Since September 25 2006, the Catalogue of Priority Industries for Foreign Investment in the Liaoning Province has been incorporated into this catalogue.

6 Article 3 of the Provisions on Guiding the Orientation of Foreign Investment (issued by the State Council, February 11 2002) provides that the Foreign Investment Industrial Guidance Catalogue and the Catalogue of Priority Industries for Foreign Investment in the Central and Western Regions shall be the basis for applicable policies in directing, examining and approving foreign investment projects.

7 For example, the smelting and pressing of ferrous metals (production of direct-reduction iron and melt-reduction iron), production of pitch used on major roads and production of assistant, grease, and dye-stuff for textile and chemical fiber drawn work and are downgraded from "encouraged" to "permitted". The manufacture of road-repairing mechanical milling equipment is downgraded from "encouraged" to "restricted".