On Jan 19, the draft of China's Foreign Investment Law was released for a public comment period that runs until Feb 17. An official explanation was also released that highlights the key points for interpretation.

One of the most significant changes in the draft legislation is the adoption of a de facto review of the variable interest entity, or VIE, structure of corporate ownership. This is a workaround structure that is used by foreign and Chinese investors in many industries where foreign direct investment is restricted or prohibited in China.

The current draft legislation states that domestic entities controlled by foreign investors must be engaged in non-prohibited industries. Previously, VIE structures were used to enable foreign investors to invest in almost any industry, even prohibited ones.

The VIE structure is also called the Sina Structure, because it became well-known after Sina Corp's 2000 listing. Under a VIE structure, a Chinese entity holding all the necessary licenses to operate a business in a restricted or prohibited industry is de facto controlled by a wholly foreign owned enterprise through contractual arrangements.

The profits of the domestic entity flow back to the controlling WFOE or joint venture. This arrangement enables foreign investors to engage in Chinese industries that they would otherwise be excluded from by law.

The VIE structure was never expressly prohibited or sanctioned under Chinese law. However, it has been widely used by foreign investors despite its ambiguous legal status. There has never been an express prohibition or any other legislation seeking to regulate the VIE structure until the draft Foreign Investment Law was released.

The draft law tries to address this legal ambiguity by requiring the identification of the de facto owner of the domestic entity engaging in the business operations for the VIE. Contractual or trust arrangements and other VIE structure arrangements are prohibited to circumvent relevant foreign investment restrictions.

Under Article 158 of the Draft Legislation and Section (iii) of Chapter 3 of the Draft Explanation, current VIE structure arrangements are subject to review by foreign investment authorities. The nature of control and who receives beneficial interests are factors in the final assessment of the identity of the de facto investor behind the VIE.

Different approaches are provided in different scenarios. For example, the VIE structure can be kept intact without interfering with its normal operation if the de facto investor is (or is determined to be) a domestic Chinese party.

If foreign investors are ultimately identified as de facto owner by the foreign investment authority, an application for a license for market access must be made, and such licenses will be granted or denied accordingly.

Both the draft legislation and the draft explanation are silent on whether such foreign investors are eligible for the relevant licenses at the current stage.

The current language only contemplates a case-by-case approach.

While the fate of VIEs with foreign investors is uncertain, these new procedures are good news for entities with domestic investors. The inherent defects and potential legal and regulatory risks endemic to the previous VIE model will vanish, to the extent that the de facto investors are domestic, since they will be considered identical to domestic investors.

No foreign investment restriction/prohibition will apply.

They would no longer be in a gray zone and the domestic de facto investors will no longer need to worry about not having the support of authorities.

One intent of the draft legislation may be to shut down the VIE structure by identifying the nationality of the de facto investor. Under the draft legislation, foreign enterprises will be given pre-establishment national treatment and foreign investment will be evaluated with a negative list approach as opposed to the current "positive" list approach.

Foreign investment will be welcome in more industries. We believe this approach would be very helpful to revitalize the economy. However, industries on the negative list will not be open to foreign investment.

This line of thinking is consistent with that behind the national security review. Therefore, the VIE structure might be less popular in the future as it will be less feasible for foreign investors to bypass government review and regulation and invest in such prohibited industries.

We believe that the draft legislation and the draft explanation are milestones for China and its further expansion into the world economy.