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Voluntary Arrangement among Beneficiaries on the Distribution of Estate might lead to Stamp duty implication according to a recent District Court decision of Wong Suet Foon Shirly v Collector of Stamp Revenue [2019] HKDC 268

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It is common ground that inheritance tax or estate duty has long been abolished in Hong Kong. The recent case of Wong Suet Foon Shirly v Collector of Stamp Revenue [2019] HKDC 268, however, sheds light on possible stamp duty liabilities under section 27(1) of the Stamp Duty Ordinance (Cap. 117) arising from the assignment of property from the deceased’s estate by way of an Assent to the children of the deceased.

Background

The Appellant in this case is one of the five surviving children of the deceased who died intestate in 20 February 2012. The five children are beneficiaries having equal shares in the deceased’s estate comprising a property under the Tenants Purchase Scheme (租者置其屋計劃) of the Hong Kong Housing Authority (“HKHA”), which restricts alienation. Having received erroneous advice from the HKHA that only two children can become the succeeding owners of the property, the surviving children mutually agreed that 3 of them would renounce their rights in connection with the property, leaving the Appellant and another sibling as the joint tenants of the property. This agreement was effected by a Deed of Family Arrangement dated 3 May 2014. Subject to this Deed, the Appellant, being also the administrator of the estate, executed an Assent on 16 October 2014, thereby vesting the property onto the Appellant herself and the sibling beneficiary.

The Deed was presented to the Inland Revenue Department (“IRD”) for adjudication of any stamp duty payable. An amount of HKD16,650 was assessed and paid. As for the Assent, IRD initially adjudicated that it was not chargeable with any duty. However, the appellant was later informed by a letter of IRD that both the Deed and the Assent were chargeable with stamp duty as conveyances on sale within the ambit of section 27(1) of the Stamp Duty Ordinance, as they “operate as voluntary disposition(s) inter vivos” to the extent that “the transfer(s) of the Property is in excess of the transferee’s entitlement in the estate in accordance with Intestates’ Estate Ordinance”. Consequently, IRD opined that stamp duty at Scale 1 rates (the higher rates) were payable unless the property concerned was a residential property and that the transferor and the transferee were closely related, in which case the lower rates of Scale 2 rates would apply.

The Appellant’s contentions

Dissatisfied with the assessment, the appellant appealed and contended that:- (1) the erroneous advice by HKHA caused the assignment of the property; (2) the transfer was between two close relatives and thereby Scale 2 rates should apply; (3) the transfer of the property under intestacy should be exempted from any stamp duty; and (4) it would be inappropriate to levy the Scale 1 rates stamp duty for the transfer of a property to the beneficiaries succeeding.

Issues before the court

Noting that after the appeal had commenced, IRD changed its stance by written submission that stamp duty would only be payable on the Assent but not the Deed. The issues before the court were:- whether the disclaiming of the 60% interest or entitlement to the property was a conveyance operating as a voluntary disposition attracting stamp duty; and second, if it was, whether Scale 1 or Scale 2 rates should be chargeable.

Decision of the Judge

The two issues were ruled in IRD’s favour. The judge ruled that the Assent constituted a conveyance operating as a voluntary disposition inter vivos within the meaning of s27(1) of the Stamp Duty Ordinance. First, the wording in clause 1 of the Assent clearly stated that it was to be used as an assignment. Secondly, a conveyance operates to assign all rights and interests including beneficial interests and the Assent gave effect to that in the present case, resulting in the Appellant and the sibling beneficiary acquiring the legal and beneficial interest in the property. Thirdly, the Assent must be a conveyance as it conveyed a substantial benefit on the Appellant and the sibling beneficiary in excess of their entitlement. As to the contention point of the erroneous advice of HKHA, the judge found that it had no bearing on the two issues for the fact that HKHA never restricted the number of assignees for properties under the Tenants Purchase Scheme. In light of the above, the judge came to the conclusion that the Assent was chargeable, and chargeable with the amount of HKD16,650.

Conclusion

Whether the appellant will appeal the Judge’s decision remains to be seen and as such, the court’s decision on the two issues is yet to be definitive. Nevertheless, this case serves as a cautionary tale for the possibility of tax liabilities in probate scenarios. Being mindful of that in estate planning avoids unwanted and unnecessary costs incurred from the transfer of estate properties to your loved ones.

OLN provides a full range of probate and trust and tax advisory services. If you have any questions regarding the above or on any tax issues, please contact one of the members of the tax advisory team.

Employee’s termination package: is it chargeable to salaries tax?

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Quite recently in Poon Cho-Ming, John vs Commissioner of Inland Revenue [2018] HKCA 297, the Court of Appeal held that Mr. Poon’s (“the Taxpayer”) entitlement to the termination package was not “from his office or employment” and thus was not taxable. Previously, in Fuchs v CIR (2011) 14 HKCFAR 74 and Mrs. Murad and Others v CIR HCIA 1/2009, the courts held that the relevant taxpayers’ entitlements to the termination payments were “from [their] office or employment” and were consequently chargeable to salaries tax.

Despite of the differences in findings and outcomes, the courts when assessing the taxability of the termination payments had consistently adopted a “substance over form” approach in which they looked at the purpose and nature of the termination payments notwithstanding the labels of such payments.

A. The facts in the Poon Cho-Ming case

The Taxpayer served, among other important roles, as the Group CFO and executive director of a company (“the Employer”). On 18 July 2008, the chairman of the board informed the Taxpayer of his immediate termination of employment and wished both parties could come to terms to avoid adverse publicity. The chairman also mentioned that the Taxpayer would be given payment in lieu of notice and for accrued and unused annual leave upon his termination. As to the unvested share options held by the Taxpayer, the chairman might consider them but there was no mention of the discretionary bonus.

The Taxpayer was aggrieved by the Employer’s decision and, after seeking legal advice, informed the chairman that he would either take this matter to the hands of the shareholders to create negative shareholder reaction or file a claim to the court to attract unwarranted media’s attention (“the Two Actions”). The Taxpayer, however, at that time failed to consider that he was obliged under his service agreement to resign at the request of the Employer upon his termination of employment. Nonetheless, the Taxpayer’s intention to challenge the Employer in respect of his directorship with his Two Actions was not disputed.

Finally, on 20 July 2008, the Taxpayer and the Employer signed a separation agreement and the Taxpayer’s employment was terminated on the same date (“the Separation Agreement”). The Separation Agreement contained the following material provisions:

  1. The Taxpayer would receive severance payment which included the payment in lieu of discretionary bonus (“Discretionary Severance Payment”);
  2. The Taxpayer would be entitled to exercise the share options held by him, tranche A to C within three months from 20 July 2008 which was accelerated from the original vesting dates (“Share Option Gain”); and
  3. The Discretionary Severance Payment and Share Option Gain were part of the considerations paid in full and final settlement of all claims and rights of action taken by the Taxpayer against the Employer.

Various sums under the Separation Agreement were later chargeable to salaries tax which prompted the Taxpayer to challenge their taxability in the Inland Revenue Board of Review (“BOR”). By the time the case reached the Court of Appeal, only the taxability of the Discretionary Severance Payment and Share Option Gain remained to be an issue.  

B. The relevant law and test for determining the taxability of termination payments

Section 8(1) of the Inland Revenue Ordinance (Cap. 112) provides that “income from office or employment” is chargeable to salaries tax and such income is defined in the following section 9 to include any salary, leave pay, bonus, gratuity and gain realized by the exercise of share options obtained by the taxpayer as an employee etc. Sections 8(1) and 9 apply to all payments including payments given on termination of employment. 

Even though section 9 defines the types of payments that would fall under the meaning of “income from office or employment”, labelling the payments otherwise than types specified under section 9 would not render such payments non-taxable. The test as set out in Fuchs v CIR (2011) 14 HKCFAR 74 stipulated that the court should look at the substance of the bargain for the payments, inter alia, the nature and purpose of the payments before deciding on whether the payments were “income from office or employment”.  

The Fuchs case further provided that (1) payments specified under the contract of employment and (2) payments in return of the person acting as or being an employee, or as a reward for his services past, present or future were both classified as “income from office or employment”.

 C. Applying the Fuchs test to the Discretionary Severance Payment and Share Option Gain

The Court of Appeal held that both the Discretionary Severance Payment and Share Option Gain were not payments “from the employment”. It is because the Taxpayer was not entitled to such sum under his service agreement and the purpose of such payments was for the Taxpayer to agree to give up on taking the Two Actions and to resign from his office peacefully. 

In relation to the Discretionary Severance Payment, the Taxpayer‘s right to discretionary bonus stemmed from his service agreement, however, the decision-making procedure which was required for the board to make decisions as to the bonus had not even commenced yet. As such, the Discretionary Severance Payment was an “entirely arbitrary amount”. The COA also considered that attention should be placed to the actual facts surrounding the Discretionary Severance Payment at that relevant time and it was irrelevant that the Taxpayer would have had to pay tax if he had received the discretionary bonus.

Separately, even though the board had a discretion under the Grant Letters of the share options to the Taxpayer to accelerate the vesting dates of share options that fell within the notice period, the vesting date of tranche C of the share option did not fall within the notice period at that time. The number of share options with accelerated vesting was therefore decided “arbitrarily”.

D. The main takeaway

Not until the judgement is overturned by the Court of Final Appeal (which in our view is quite unlikely), the following remarks still hold: 

  1. Payments that were made in consideration of the employee agreeing to surrender his pre-existing rights under his employment contract and payments that were made as compensation for the loss of employment, given that none of them was made pursuant to any entitlement under the employment contract, were unlikely to be considered as “income from office or employment’ and thus were not taxable.
  1. A detailed analysis of the facts and evidence surrounding the termination payments would be made by the court and the BOR. As such, the employer and the taxpayer should be cautious at all stages starting from the drafting the employment contract to the drafting of the termination agreement, especially when answering any requisitions raised by the Inland Revenue Department (“IRD”).

Issues relating to the taxability of the termination payments are technical and merely relying on the labels of the termination payments is not going to achieve the intended purpose. OLN offers a range of related services to assist our clients, including drafting of the employment contract and the termination agreement, advising on the negotiation of the termination payments and handling any requisitions raised by the IRD. If you are interested in our services or have any issues regarding the above, please contact any member of our employment law and tax advisory team.

Forget the label, what is the true effect of your trust deeds?

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It is common for settlors to try retaining a degree of control over their settled assets.  After all, it is only human nature wanting to keep an eye on your wealth.

However, in order to enjoy the benefits of a trust, the trust needs to withhold scrutiny. In this article, we shall look at the recent landmark case of Mr. Pugachev to understand more of the Court’s considerations. 

Prior to Mr. Pugachev’s case, in Clayton v Clayton [2016], the New Zealand Supreme Court asserted that a finding of the trust as a sham or to be illusory would both invalidate a trust. Following that, the English High Court in JSC Mezhdunarodniy Promyshlenniy Bank v Pugachev [2017] held that an analysis of the true effect of the trust deeds is needed in order to determine whether the trust is illusory or, in more general terms, succeeds in divesting the beneficial ownership of the assets from the settlor.

Background of the Pugachev case

The case centers on Mr. Sergei Pugachev, a Russian entrepreneur and the founder of MezhProm Bank (the “Bank”) which was once a leading private bank in Russia but collapsed following the financial crisis and finally declared bankrupt in 2010.

From 2011-2013, Mr. Pugachev set up five discretionary New Zealand trusts (the “Trusts”). Although the Trusts were not identical, they shared the features below:

  • Settlor: Mr. Pugachev
  • Trustee: New Zealand private trust company of which Mr. Patterson and his wife were directors
  • Protector: Mr. Pugachev
  • Beneficiaries: Mr. Pugachev, his wife and their children
  • All trust deeds were drafted by Mr. Patterson and the Trusts were governed by New Zealand law

In 2014, proceedings were brought against Mr. Pugachev in London to enforce the judgement given in Moscow where Mr. Pugachev allegedly embezzled the Bank leading to its downfall. The English Court has since issued numerous orders and in this latest judgment, the claimants alleged that Mr. Pugachev has retained beneficial ownership of the assets in the Trusts and sought orders requiring the assets be vested in them or the Court appointed receiver.

The Court granted the said orders by reason of the following:

  1. Mr. Pugachev has retained the beneficial ownership of the assets as it is the “True Effect of the Trust”; and
  2. Even if it is not the “True Effect of the Trust” and hence Mr. Pugachev did not retain the beneficial ownership of the asset, the trust is a sham and is equally invalid.

The True Effect of the Trust

The Court held that when analyzing the True Effect of the Trust, it is entitled to construe the trust instruments as a whole and involves considerations such as who exercises the power and to whom the benefit of the power is given to and whether the individual is taking up several roles within the Trust. The relevant analysis is explained in detail below.

When answering the question of whether Mr. Pugachev has retained beneficial ownership of the Trust, the Court needs to make a finding whether Mr. Pugachev’s extensive power given to him as the protector of the Trust is “fiduciary” or “personal” in nature. The power is “fiduciary” if the power must be exercised in the interest of the beneficiaries as a whole and “personal” if he can exercise the power for his own selfish interest. Mr. Pugachev might be regarded to have divested himself successfully of the beneficial ownership of the trust assets if the power is found to be “fiduciary”.

Mr. Pugachev’s wide-ranging power which includes vetoing any distribution made by the trustee to the beneficiaries and removing the trustees as he wishes can be “fiduciary” if Mr. Pugachev is not one of the class of discretionary beneficiaries and he is only performing a “watchdog” role. However, that is not the case and Mr. Pugachev can theoretically use this power to force the trustee to make distribution for his sole benefit as a beneficiary and remove the trustees that did not follow his instructions. Thus, the power attached to Mr. Pugachev’s role as the protector is not “fiduciary” and the True Effect of the Trust is for Mr. Pugachev to retain beneficial ownership of the assets.

The Trust is a sham

As mentioned above, even if that is not the True Effect of the Trust, the Court is prepared to declare the trust as a sham and will make the orders regardless.

A trust might be declared as a sham if the parties to the trust deeds have a common intention of creating a false impression of the rights and obligations as appeared in the trust documents. In this case, based on the extensive power given to Mr. Pugachev as a protector, the Court held that Mr. Pugachev’s intention of the Trusts “was not to cede control of his assets to someone else” and this intention is shared with all other individuals within the Trusts, especially the trustees who took instructions from Mr. Pugachev from time to time.

Notes to take when setting up a trust

Bearing in mind that a trust is only valid and can withstand attack from creditors only if, when viewed objectively, the trust constituted a true divestiture of the assets, it is still possible and common to devise mechanism to retain certain control over the assets. However, after taking the lesson from Mr. Pugachev, the following should be kept in mind when doing so: – 

  1. All the power, oversight and control given to any individual within the trust must be viewed individually and collectively within the trust;
  2. No excessive control over the trust should be reserved to the settlor or granted to the protector;
  3. Transfer assets to offshore location which is different from the settlor’s place of residence and its place of business;
  4. The protector should ideally not be a beneficiary of the trust;
  5. The trustees have to be truly independent; and
  6. All individuals should carry out the terms as stated in the trust deeds.

OLN provides a full range of probate-and-estate-planning-related services. If you have any questions regarding the above or any other private asset management issues, please contact one of the members of our Probate and Estate Planning team.  

Disclaimer: This article is for reference only. Nothing herein shall be construed as Hong Kong legal advice or any legal advice for that matter to any person. Oldham, Li & Nie shall not be held liable for any loss and/or damage incurred by any person acting as a result of the materials contained in this article.

Renewed Suitability Requirements for the Distribution of Investment Products in Hong Kong

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After rounds of consultation, the Securities and Futures Commission’s (the “SFC”) Guidelines on Online Distribution and Advisory Platforms (the “Guidelines”) and the related revisions to the Code of Conduct for Persons Licensed by or Registered with the SFC (the “Code of Conduct”) will soon come into effect. The effective date was initially set to be on 6 April 2019 but the SFC has declared a 3-month extension to 6 July 2019 (the “Effective Date”). While the Guidelines is a response to the growing number of online advisory and distribution platforms for investment products operated by licensed or registered persons/corporations (“Online Platforms”) targeting individual customers, the revised Code of Conduct will have a wider effect in that it will cover both online and offline activities.

Under the existing procedures, licensed or registered persons/corporations did not have to decide whether an investment product is suitable for a client in the case of an “execution-only” order, a term to denote that the order is made out of the request by the client not resulting from any solicitation or recommendation of a licensed or registered person/corporation. Since it was assumed that a client is aware of the risks involved or is willing to take on the risks anyway before proceeding with an execution-only order, it was thought that such orders required less protection comparing with solicited orders. However, in view of the increasing trend of consumers transacting a wide range of high-risk investment products on Online Platforms without involving any human element on the sale side, SFC has given up this long-held laxer approach towards execution-only orders.

To tackle the problem, the SFC has coined a term called “complex product” which essentially covers all non-plain vanilla investment products, whether exchange-traded or not. From the Effective Date, even for execution-only orders, Online Platforms will have to decide whether an investment product is a complex product, and if yes whether that product is suitable for a particular customer. If an Online Platform finds that a complex product is not suitable for a particular client, it will have to cease proceeding that order. The only exception seems to be that Online Platforms will not need to ensure complex products which are also derivative products traded on an exchange in Hong Kong or in a specified jurisdiction are suitable for a client where there has been no solicitation or recommendation. However, Online Platforms will still need to assess a client’s knowledge of derivatives and understand his net worth under these circumstances according to the old rules.

Furthermore, to enable clients to make an informed decision before buying a complex product, Online Platforms will have to provide the minimum prescribed information on the key nature, features and risks of such products. Online Platforms will also need to ensure that there are prominent and clear warning statements to clients with regard to such products.

The above requirements will apply to individual professional and retail investors.

For Online Platforms which provide execution-only services and continue to sell complex products, the regulatory changes mean that they will need to adjust their suitability framework. Firstly, Online Platforms will need to conduct extensive product due diligence on all products (especially overseas ETFs) that can be sold via their platforms to decide whether they are complex products and understand their features and risks. Secondly, Online Platforms will need to decide whether the product ordered is nevertheless a qualified exchange-traded derivative product so that they are exempted from the suitability obligation. When receiving an order for a complex product that is not a qualified exchange-traded derivative product, Online Platforms will then need to ensure that the product ordered matches the client’s risk profile and other specific circumstances by assessing whether there is any risk mis-match, tenor mis-match, concentration risk, etc., before execution.

In conclusion, licensed or registered persons/corporations may need to rethink their relevant policies and procedures for suitability framework to take into account the latest requirements, which will also apply to offline selling activities from the Effective Date.

Funding Declined! – Raafat Imam v Life (China) Co Ltd

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The age-old common law doctrines of maintenance and champerty prohibit third parties from funding an unconnected party’s litigation. Whilst some other common law jurisdictions, such as Australia and Singapore, have abolished the torts and crimes of maintenance and champerty, developments in this area of law have been slow in Hong Kong.

In Unruh v Seeberger [2007] 2 HKC 609, the Court of Final Appeal developed exceptions to the common law doctrines, allowing third party funding in litigation in three narrow areas.  In the more recent case of Raafat Imam v Life (China) Co Ltd [2018] HKCFI 1852, the Court affirmed the narrow exceptions but refused to approve a proposed commercial litigation funding agreement.

Background

The Plaintiff brought an action against the Defendants for breach of a consultancy agreement. The Plaintiff claimed that he did not have the financial means to pursue the action himself without the support of a third party litigation funder. He then applied to the Court for a declaration that a proposed commercial litigation funding agreement to be entered into between the Plaintiff and a commercial third-party funder (the “Funding Agreement”) did not offend the law prohibiting maintenance and champerty and that the Funding Agreement be approved by the Court.

The issues before the Court were:

  1. Whether the Court should exercise its discretion to grant the declaration sought?
  2. Whether the Funding Agreement per se fell foul of the common law prohibitions of maintenance and champerty?
  3. Whether the Funding Agreement fell within the access to justice exception?

Decision

The Court found that the declaration sought by the Plaintiff was essentially a declaration of non-criminality and recognised that a civil court would be slow to grant a declaration relating to the criminal consequences of conduct. The fact that there was no criminal prosecution against the Plaintiff or the funders at the time of the application was of no significance. As long as there was a possibility of prosecution, a civil court should not grant a declaration of innocence with respect to the subject matter of the potential criminal proceedings unless there are exceptional circumstances. The two established exceptions are where the integrity of the relevant criminal proceedings is questionable and where human life is at stake. The Court went on to find that the Plaintiff’s case did not fall under either of the exceptions.

The Court also found that the Plaintiff had failed to join a proper contradictor in the proceeding, i.e. a party who has an interest in opposing the declaration sought by the Plaintiff. The real dispute in the Plaintiff’s application was therefore not between the Plaintiff and the Defendants but between the Plaintiff and the Director of Public Prosecutions or the Secretary for Justice.

Further, though the Plaintiff attempted to support their case by referring the Court to third party funding cases in insolvency contexts, the Court found that such cases did not assist the Plaintiff’s application. In fact, the Court of Final Appeal in Unruh expressly treated insolvency proceedings as a special category which was excluded from the ambit of the prohibition against maintenance and champerty.

In light of the above, the Court refused to grant the declaration sought or to approve the Funding Agreement and considered it unnecessary to rule on issues 2 and 3. Nevertheless, the Court made the following useful observations:

  1. Having considered the terms of the Funding Agreement, the Court expressed its concerns that there was a real risk that the Plaintiff may easily become a figurehead in the conduct of the litigation and that the litigation may be controlled by some unknown third party.
  2. The Court recognised that the purpose of the access to justice exception is to ensure that a litigant can gain access to justice, not to facilitate access to his ideal legal representation and in any event, the Plaintiff’s alleged impecuniosity appeared artificial.

Conclusion

Though Raafat confirms that Hong Kong courts adopt a cautious approach in permitting third party funding in litigation cases, the Court accepted that the totality of facts must be considered when assessing whether a litigation funding agreement poses as a genuine risk to the integrity of the Court’s processes and that countervailing public policies must be taken into account.

Whether the Plaintiff may succeed on appeal (if any) remains to be seen but a successful appeal would open up the possibility for wider litigation funding in Hong Kong.

China’s Legislature Enacts Its New Foreign Investment Law

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After a month-long consultation period, China’s National People’s Congress today passed the country’s new Foreign Investment Law (the “FIL”). The FIL, which comes into effect on January 1, 2020, will abrogate substantial parts of the legal framework that has governed foreign investment in China for the past 40 years.

First introduced as a draft in 2015, the FIL became bogged down but late last year, an amended version was re-released and then fast-tracked for consultation, in an effort to placate concerns in the EU and the United States about unfair trade practices. In particular, China is accused of limiting market access, forcing technology transfer to Chinese partners and doing little to curb theft of intellectual property, all in violation of its WTO commitments.

The FIL clearly aims to address those concerns but it goes further, overhauling a divided system that regulates inbound investment separately from domestic businesses and which imposes significant restrictions on foreign-invested projects. That system will be unified and standardized.

We have summarised below the major details of the draft law for your reference.

Streamlining of Market Entry Procedures & National Treatment

China has been shifting away from an approval-based system to a reporting-based business supervision system since 2015. Foreign investors merely file information with a regulator when they incorporate and thereafter on a periodic basis. The FIL takes this a step further by invoking consistency between filing requirements of foreign-invested enterprises (“FIEs”) versus Chinese-invested businesses.

In late 2018, China’s National Development and Reform Commission implemented a “Negative List” approach like the one used in the Shanghai Pilot Free Trade Zone, permitting foreign investors to invest in any sector that does not appear on the negative list. This has been co-opted by the FIL.

The negative list prohibits foreign investment in some sectors, for national security reasons, while merely imposing restrictions on others. Non-Chinese investors seeking to invest in sectors categorized in the negative list as restricted must first apply to the Ministry of Commerce (“MOC”) for approval and may be subject to other restrictions as well, such as having to partner with a Chinese investor. However, once established, FIEs are meant to be free of arbitrary restrictions or conditions imposed by PRC government agencies (Article 24).  

The key take-away is that foreign investors in sectors that are not on the negative list will be free of all foreign investment restrictions and entitled to ‘national treatment’ in terms of how they are regulated which is no less favourable than what Chinese investors enjoy (Article 4).  In principle, this should level the playing field for both FIEs and domestic businesses in China in all respects including bidding for government procurement projects (Article 16) and obtaining equity or debt financing (Article 17). Article 8 is a grim reminder that a level playing field also means compliance with unwelcome laws and policies.

Protection of Foreign Investment & Intellectual Property 

  • The FIL contains several provisions aimed at promoting foreign investment in China and protecting foreign interests in those investments, including those:
  • affording greater protection to commercial secrets and other intellectual property rights (“IPRs”) of foreign investors and FIEs that rely on those IPRs (Article 22)
  • respecting commercial agreements reached between foreign investors and Chinese partners (Article 22). All pre-existing laws and regulations placing limits on or requiring parties to restructure their commercial agreements are to be repealed (Article 24)
  • abolishing mandatory technology transfers by governmental officials and repeal of all pre-existing laws and regulations in China used to force such technology transfers (Article 22)

Variable Interest Entities (“VIEs”)

The FIL extends China’s existing foreign investment regime to include foreign-controlled entities, where “control” is broadly defined and includes contractual control (Article 2). This reverses the currently-ambiguous legal status of VIEs which Chinese regulators have tacitly permitted for many years.

Taking advantage of a legal loophole, foreign investors seeking access to restricted sectors have frequently used VIEs in the past, using contractual arrangements between their FIEs and Chinese companies, to facilitate foreign investment where investment would otherwise be prohibited or restricted.

The FIL closes the loophole by explicitly designating VIEs as FIEs, subjecting them to regulatory control which is likely to restrict formation of future VIE-type arrangements (Article 28) and may result in existing VIEs having to be unwound (Article 36).

National Security Review Process

Although the FIL only briefly touches on China’s Anti-Monopoly Law and national security review regime processes, the fact that these are mentioned at all implies that they may exert greater influence in regulating foreign investments in the future. The national security review regime, similar to CFIUS in the United States, currently applies to any foreign acquisition or merger deemed “sensitive”. Investors then decide whether or not to voluntarily seek a formal review or wait to respond to demands for one by regulators.

Article 35, when read together with Article 6 and Article 40, appears to widen this scope for national security reviews. Our assessment is as follows:

  • additional rules and structures will likely be added to the existing national security review criteria, through separate implementing legislation, to prohibit foreign investment in key businesses or sectors to avoid “harming the public interest” (Article 6)
  • among the factors considered in any national security review of any proposed foreign investment will be the anticipated economic impact on domestic PRC businesses
  • foreign investment deemed too sensitive will either not be approved or only approved subject to market entry restrictions
  • the FIL prohibits appeals from unfavorable national security review decisions (Article 35).

Criticisms

Although it is tempting to dismiss the FIL as mere window-dressing meant to appease trade officials in the United States and EU, its impact on foreign investors and FIEs over the medium and long-term is likely to be significant. Expect to see regulators redoubling efforts to crack down on theft of IPRs and a sudden influx of global market leaders, in sectors like financial services and civil aviation, as those gates are opened. The simplification of corporate governance requirements will likely

Nevertheless, it’s important to not lose sight of the FIL’s deep flaws; most its provisions are vaguely worded and despite the high-minded statements of principle concerning fair and equal treatment, discrimination against foreign investors and FIEs lies at the very heart of the FIL and China’s foreign investment legal framework as a whole. Most worrying are Articles 6 and 40 which hint at the politicization of China’s national security review regime and its use to keep foreign competition out of consecrated sectors. Hence, foreign investors should not be surprised if they still encounter barriers to entry, or if they remain subjected to unfair disadvantages when bidding for government contracts.

Whether or not the FIL noticeably improves conditions for foreign businesses depends almost entirely on how faithfully the FIL and its implementing regulations are enforced at the local level.

Final Comments

The FIL will not come into force until January 1, 2020. Until then, all inbound investments into China will continue to be governed by China’s current foreign investment regime which has already been slightly liberalised with the revised negative list already in effect. Investors planning to establish new businesses in China, particularly in sectors listed in the Negative List, would be better off waiting until after January 2020, when current market entry approvals and restrictions on corporate governance are lifted.

In the meantime, we will continue to closely monitor all new developments in relation to the FIL and issue updates on how foreign investors will be affected.