It has been just over a month since the launch of the Shanghai Pilot Free Trade Zone (FTZ) on 29 September 2013. The importance of the FTZ lies not only in the investment opportunities that have been opened, but because China has expressly indicated that reforms successful in the FTZ will be rolled out to other parts of China. The initial pilot period of the Shanghai FTZ is three years.

Few regulations governing the FTZ had been issued prior to the launch, though Chinese media had been publicizing various concessions for companies established within the FTZ. While the basic regulatory framework has now emerged, comprehensive implementing rules (of the kind that is common for Chinese legal developments) have yet to be issued.

We survey below various highlights of the policies and regulations issued so far.

Highlights of the FTZ:

·         Negative list

The FTZ now has a “negative list”, which lists the areas in which foreign investment is not permitted. Foreign investment is allowed, on the other hand, in any area that is not specified on the negative list. Moreover, foreign investment not on the negative list will generally be subject only to a filing procedure and will not be subject to approval requirements.

The negative list represents a potentially significant change of approach. Rather than setting out sectors and activities that are encouraged, restricted or prohibited to foreign investment, the negative list simply lists sectors and activities that are prohibited. Everything else is permitted. But while the concept has changed, the practical details remain similar.

Pending further guidance or a shortening of the “negative list”, many of the restrictions are effectively the same as under the current foreign investment industrial guidance catalogue. It is hoped that the next version of the “negative list” will provide for more openings for foreign investment.

·         Simplified approval process

With the removal of approval requirements for foreign investment not on the negative list, it may only take days to establish a foreign investment enterprise (FIE) in the FTZ. In other parts of China, where both approval and registration is required, the establishment of an FIE can take months.

Outbound investment by enterprises incorporated in the FTZ may also be exempt from approval, being subject only to filing requirements.

·         Fewer foreign investment restrictions promised

The general plan of the FTZ, issued by the State Council, promises liberalization in the FTZ for financial services, shipping services, commerce and trade services, professional services, cultural services and social services. The stated goal is to ensure equal entry for both domestic and foreign investors. This may also involve the elimination of business scope restrictions for most FIEs.

Pending detailed implementing rules, however, the promise of fewer foreign investment restrictions remains just promise for various of these sectors. Foreign investment in financial services has been somewhat liberalized, though as noted below restrictions remain.

·         Financial innovations

One aim of the FTZ is to reform the existing financial system. Some of the important policies include:

o    Private Chinese capital is allowed to establish Sino-foreign joint venture banks with foreign financial institutions.

o    Restricted licence banks may be established in the FTZ. It is expected that restricted licence banks will be similar to those permitted in the UK and Hong Kong. However, as yet, there are no rules or policies regarding restricted licence banks in the FTZ.

o    Interest rates may be set by the market and RMB capital amounts may be freely converted in the FTZ, but only on the condition that “relevant risks” remain controllable.

The establishment of foreign-invested banks will generally remain subject to approval.

·         More service industries opened

Foreign investment is allowed in the FTZ in some areas which are restricted or prohibited by the existing foreign investment industrial guidance catalogue. For some investments, foreign investors are allowed a higher percentage of equity ownership.

Examples include:

o    Shareholding restriction for foreign investment in international shipping enterprises is relaxed. More than 49% foreign shareholding (in contrast with up to 49% elsewhere) is allowed in foreign-invested international shipping enterprises in the form of equity joint venture or cooperative joint venture.

o    Wholly foreign-owned international shipping management enterprises are permitted in the FTZ. In other parts of China, foreign-invested enterprises engaging in international shipping management can only be incorporated in the form of equity joint venture or cooperative joint venture.

o    Up to 70% foreign investment (up from 49% elsewhere) is allowed in joint ventures providing human resource services, and the minimum registered capital is USD125,000 (down from USD300,000 elsewhere). (Human resource companies established under the Closer Economic Partnership Arrangement between China and Hong Kong (and also Macau) are already permitted to be 100% foreign owned, with a registered capital of USD125,000.)

o    Foreign investment in credit investigation companies is permitted. Outside the FTZ, credit investigation companies are restricted for foreign investment.

o    Performance brokerages in the FTZ may be wholly foreign-owned. Outside the FTZ, foreign investment is restricted and a Chinese investor must have a controlling interest.

 

·         Customs and tax

Customs procedures have been further simplified, with a view to facilitating the import and export of goods and to promote trading in the FTZ. In addition, preferential import duties and better income tax treatment has been adopted. More tax concessions have also been promised.

·         Operating outside the FTZ

The general plan of the FTZ, issued by the State Council, provides that enterprises established in the FTZ may, in principle, conduct business and reinvest outside the FTZ. However, the general plan also provides that FTZ enterprises intending to operate outside the FTZ will need to comply with special provisions. The special provisions have not yet been issued.

The Chinese government is taking a cautious and gradual approach towards reform, with the actual benefits to foreign investors being somewhat less than the media fanfare might have suggested. Some foreign investors will no doubt benefit, but for many the current restrictions have been essentially untouched.

The FTZ may also prove a challenge to the existing administrative system. With removal of many establishment approvals in favour of simpler filings, the government authorities in the FTZ will need adopt different rules and systems to be compatible with the new approach. To this extent, the FTZ represents a possible transformation of the role of government in China.

The good news is that the FTZ represents a small step toward making foreign investment in China easier. If the FTZ experiments are successful over the coming three years, then we may well see a country-wide removal of approvals for most foreign investment, and the lowering of investor criteria. Such a reform would represent perhaps the most significant overhaul of China‘s foreign investment regime since China opened its doors, and Shanghai would be proud that the reform started in the Shanghai FTZ.

* Karen Ip, a partner of Herbert Smith Freehills, is principally involved in private equity investment projects, merger and acquisition transactions and greenfield investments in the manufacturing, infrastructure and financial institution sectors. She also advises on regulatory issues in China.