The New Foreign Investment Guidelines and Market Reform in China

The 1995 Provisions have been accompanied by more detailed lists of industries in various catalogues. The first Foreign Investment Industrial Guidance Catalogue (外商投资产业指导目录) was issued in 1995, revised on December 31 1997, and then revised again recently. The State Economic and Trade Commission, the State Development Planning Commission and the Ministry of Foreign Trade and Economic Cooperation revised the Catalogue on March 11 2002 (see page 37). As part of efforts to develop the interior, the State Council approved the Guiding Foreign Investment in the Dominant Industries of the Central and Western Regions Catalogue, which was issued on June 16 2000. In addition, PRC foreign investment laws, including the Sino-foreign Equity Joint Venture Law (中外合资经营企业法) (EJV Law), Sino-foreign Cooperative Joint Venture Law (中外合作经营企业法) (CJV Law) and especially the Wholly Foreign-owned Enterprise Law (外资企业法) (WFOE Law) imposed a number of further restrictions, as did other national and local regulations. The three major investment laws and their implementing rules have all been amended to remove any provisions regarding industrial guidance. Instead, the amended laws and rules simply refer investors to the Provisions and the catalogues, which are to be updated from time to time. Other national and local regulations, however, continue to impose restrictions.

The Provisions were revised to bring China's industrial guidelines into line with WTO rules. However, anyone expecting major changes will be disappointed. The 2002 Provisions contain surprisingly few express changes. The basic structure remains the same, with projects divided into encouraged, permitted, restricted and prohibited. Only the restricted category contains any changes, and even there the changes are modest. Nevertheless, over time investors may find more openings and opportunities in practice than suggested by the minimal changes of the Provisions themselves. The revised Catalogue contains many more changes that reflect detailed, industry-specific WTO market access agreements. More generally, the overall trend of the last twenty-plus years towards market and legal reforms will continue to contribute to a more favourable foreign investment environment.

Encouraged Projects

The 2002 Provisions include the same list of encouraged projects, slightly reorganized, as the 1995 Provisions:

• agricultural projects using new technology or integrated development agricultural projects and energy industry projects, transport industry projects and major raw material industry projects;
• high-tech projects or advanced-application technology projects that can improve product performance, improve the technological and economic results of enterprises or produce new equipment and new materials for which domestic production capability is inadequate;
• projects that meet market demand and that can improve product grades, open new markets or improve the international competitiveness of products;
• projects using new technology or new equipment that can conserve energy, that involve raw materials, integrated utilization of resources or recycling of resources, or that can prevent and treat environmental pollution;
• projects that can make use of the special manpower and resource advantages of the central and western regions and that comply with state industrial policies; and
• other kinds of projects stipulated by laws and administrative regulations.

Prohibited Projects

Similarly, the list of prohibited projects remains the same for all intents and purposes:

• projects that jeopardize national security or harm the public interest;
• projects that cause pollution, damage the environment, destroy natural resources or that are harmful to health;
• projects that occupy large amounts of cultivated land and that are detrimental to the protection and development of land resources;
• projects that jeopardize the security and effective use of military installations;
• projects that use special China processes or technology to produce products; and
• other kinds of projects stipulated as prohibited by laws and administrative regulations.

Restricted Projects

The 1995 Provisions restricted the following projects:

• those which have already been developed in China or for which technology has already been imported into China, and of which the productivity has already met domestic market demand;
• those which involve industries in which the state attracts foreign investment on a trial basis or exercises a monopoly;
• those which involve exploration or exploitation of rare or precious mineral resources;
• those which involve industries that are under the state's central planning; and
• other projects which are restricted under laws or administrative regulations of the state.

In contrast, the 2002 Provisions restrict the following:

• projects where the level of technology is outdated;
• projects that are detrimental to energy conservation and environmental improvement;
• projects for the exploration and mining of specially designated minerals for which protective mining is required by the state;
• projects in industries to be liberalized gradually by the state; and
• other kinds of projects stipulated as restricted by laws and administrative regulations.

The change from the first clause of the 1995 Provisions appears to reflect China's commitment in its Protocol of Accession not to condition foreign investment approval on the existence of domestic suppliers of the products. Also, the mining clause was revised to reflect greater liberalization in recent years in this area.

Perhaps more important than any substantive changes, however, is the difference in tone. In keeping with trends toward market reforms and enhanced competition, and consistent with China's WTO commitments to expand market access over time in certain key industries, the 2002 Provisions emphasize gradual liberalization rather than the continuation of state monopolies and limited trial experiments.

Other Restrictions

The 2002 Provisions note that the Catalogue may impose various restrictions on foreign investors, including limiting projects to "equity and cooperative joint ventures only", requiring that the "Chinese parties shall hold the controlling interest" or that "Chinese parties shall hold the relative controlling interest". These restrictions are similar to the three types of restrictions in the 1995 Regulations, though the terminology has been changed slightly to reflect the possibility of new forms of investment or simply for the sake of greater clarity. Moreover, in keeping with the general trend towards use of more specific language in drafting new legislation, the 2002 Provisions now include definitions of these terms. "Equity and cooperative joint ventures only" means that operation will be permitted only by Chinese-foreign equity joint ventures and Chinese-foreign cooperative joint ventures. "Chinese parties shall hold a controlling interest" means that the sum of the investment shares of Chinese investors in the foreign-invested project must be at least 51%. "Chinese parties shall hold a relative controlling interest" means the sum of the investment shares of Chinese investors in the foreign-invested project must be greater than the investment share of any single foreign investor.

Although these restrictions are usually imposed on projects in the restricted category, at times they also apply to encouraged projects, which seems counter-intuitive, especially when one recalls that permitted projects are not listed in the catalogues and thus not subject to restrictions unless there are specific laws and regulations passed to that effect. The 2002 Provisions do not include the 1995 Provisions' requirement that projects in the restricted category must have a definite term.

Other Incentives

The 2002 Provisions include various incentives for investors, most of them carried over from the 1995 Provisions or since incorporated in other regulations. The one new break is that permitted projects that export all of their products directly shall now be deemed encouraged projects.

As in the past, restricted projects that export at least 70% of their total sales shall be considered permitted projects upon approval by the competent department.

In addition to the preferential treatment stipulated by relevant laws and administrative regulations, encouraged foreign-invested projects for the building and operation of energy, transport and urban infrastructure involving large amounts of investment and long recovery periods may, upon approval, expand the relevant scope of business.

Permitted and restricted projects that head inland may also be able to take advantage of the preferential treatment afforded encouraged projects under the Guiding Foreign Investment in the Dominant Industries of the Central and Western Regions Catalogue. Such treatment includes a 15% income tax rate for three years after any other applicable tax holidays end¹ and exemption from duties and VAT on equipment imported by a qualifying FIE within its total
investment.² Certain permitted and encouraged projects also enjoy a somewhat simplified approval process where the project proposal and feasibility study may be submitted together and preliminary design and work commencement reports need not be submitted for approval.³

Previously, only qualifying encouraged and Restricted B projects were eligible for the exemption of duties and VAT on equipment imported within the FIE's total investment. Whether restricted projects that previously would have been classified as Restricted A that are not located in western and central regions will be entitled to the exemption is not clear.

Of course, FIEs regardless of category may also be entitled to various other advantages, including a host of tax exemptions and deductions that depend on the type of enterprise, the location, whether the enterprise is export-oriented or technologically advanced.

The Approval Process

In the past, Restricted A projects in effect required provincial-level approval of the project proposal, whereas Restricted B projects required central government approval even if the size of the project would normally have allowed for lower-level approval. The 2002 Regulations do away with the distinction between Restricted A and B projects. Now, restricted projects whose total amount of investment is below the threshold for central approval may be approved at the provincial level, with the project then filed for the record with the central authorities.

Conclusion: Foreign Investment Under WTO

Foreign investors who were hoping for a major relaxation in China's foreign investment rules now that China has joined the WTO might be surprised with the minimal changes in the Provisions as well as some of the seemingly onerous restrictions imposed in the revised Catalogue. Given all the hype surrounding China's entry into the WTO, investors may be excused for overestimating the immediate benefits they might enjoy from China's accession. However, the WTO agreement is primarily a free trade agreement, and does not require the complete dismantling of China's foreign investment regime or the elimination of industrial guidelines. That said, the Agreement on Trade-related Investment Measures (TRIMs) does address certain trade-related investment measures while the General Agreement on Trade in Services (GATs) addresses investment in the services sector. In addition, China has taken on specific market access and investment-related obligations as part of its accession to the WTO.

China, like all WTO member states, may prohibit or restrict certain types of investment. For example, all states may outlaw projects that jeopardize national security, harm the public interest or endanger public health or the environment. In setting out these kinds of broad standards for outlawed projects, the 2002 Regulations are consistent with WTO rules.

Similarly, many of the restrictions contained in the 2002 Regulations as well as the more specific restrictions that are included in the revised Catalogue reflect the result of the hard-fought negotiations on market access that led up to China's entry to the WTO. They are therefore consistent with China's commitments under the Protocol of Accession and WTO market access schedules.

While easy to overstate, the direct impact of WTO in the investment area may still be felt in some ways. TRIMs prohibits trade-related investment measures that are inconsistent with the general principle of national treatment and provides for the general elimination of quantitative restrictions. Thus, local content requirements and trade or foreign exchange balancing measures that limit the amount of imports, or tie imports to the amount of exports, are prohibited. The various amendments to the EJV, CJV and WFOE laws reflect these TRIMs requirements.

In the past, restrictive policies were often contained in internal (neibu) regulations. Moreover, local governments have regularly passed regulations at odds with national laws and regulations, or have implemented national laws and regulations in inconsistent ways that are often at odds with their express purpose. Article 6 of TRIMs may help address these concerns in that it reiterates the general commitment to transparency set forth in Article X of GATT. Accordingly, China must notify member states of any trade-related investment measures, including those applied by local governments and authorities. More generally, China has agreed in its Protocol of Accession to establish a mechanism under which individuals and enterprises can bring to the attention of national authorities cases of non-uniform application of the trade regime.

More concretely, China did take on significant market access obligations in some industries, and these are reflected in the more detailed Catalogue. The amended Catalogue also breaks new ground and removes some restrictions even though such changes are not strictly required by WTO rules.

Indeed, perhaps more significant in the long run than the direct impact of the WTO is the indirect impact. There have been reports of China dragging its feet in bringing laws and practice into compliance with WTO requirements, particularly in the agricultural area, as well as charges that China has erected non-tariff barriers to protect certain key industries, most notably domestic banks. On the other hand, entry to the WTO appears to have strengthened the hand of legal reformers and encouraged a forward-looking reformist mentality that in some cases has led to changes not strictly required by WTO rules.⁴

To be sure, in many cases the changes reflect general trends toward market reforms and cannot be attributed to the WTO. For instance, the joint venture and WFOE laws have been amended to eliminate references to the "department in charge" not because WTO rules required it, but because requiring approval of key decisions by the department in charge is inconsistent with a market economy in which enterprises enjoy greater decision-making authority (not to mention the proliferation of private enterprises that have no department in charge in the traditional sense).

In other cases, however, the changes reflect both market changes and the spirit of WTO reform. For instance, the government has announced its intention to overhaul the approval process for foreign and domestic companies alike in an effort to enhance efficiency, and reduce corruption and red tape. The little discussed but potentially significant Opinion Regarding the Implementation of Reform of the Approval System, issued by the Bureau of Supervision, and approved by the State Council Office of Legal Affairs, State Council System Reform Office and the Central Party Editorial Office on October 9 2001, confirms a change in policy toward deregulation and greater reliance on market forces.

In sum, the WTO rules themselves may not compel the authorities to make fundamental changes to China's foreign investment regime. Nevertheless, the general trend toward market reforms and the momentum for reform resulting from China's entry into the WTO may lead to significant changes in the foreign investment regime and environment not captured by the modest changes to the Provisions. At the same time, foreign investors should expect some bumps in the road as threatened industries attempt to hold foreign investors at bay by pressuring national and local governments and government agencies to adopt protectionist measures. Membership in the WTO does not mean the end of trade protectionism. The recent US decision to limit imports of steel and China's threat to lodge a formal protest show that protectionism is not limited to China and that China sees WTO not simply as a source of obligations but also of rights. What we are likely to see is progress, sometimes unexpectedly, in some areas, and obstacles, perhaps even new obstacles, in other areas.

Endnotes

1 See the 1999 State Administration of Taxation, Implementation of a Preferential Three Year 15% Reduction in Enterprise Income Tax for Foreign Investment Enterprises Established in the Central and Western Regions Circular (国家税务总局关于实施对设在中西部地区的外商投资企业给予三年减按15%税率征收企业所得税的优惠的通知).

2 See the 1999 General Administration of Customs, Import Tax Policies Relevant to Further Encouraging Foreign Investment Circular (海关总署关于进一步鼓励外商投资有关进口税收政策的通知), and 1997's State Council, The Adjustment of Tax Policies on Imported Equipment Circular.

3 State Council, Several Policy Measures for Opening Up Western China Circular (国务院关于实施西部大开发若干政策措施的通知), issued October 26 2000.

4 In a move unrelated to foreign investment, for example, the government has now made it much easier for PRC citizens to obtain passports. Some officials explain the change as in keeping with the more open spirit of the WTO.