Compliance review of FI contracts with governments

In its efforts to attract foreign investment, the government often undertakes to provide the investor with preferential tax, fiscal or land treatment in exchange for undertakings relating to place of incorporation, business scope, investment scale, tax amount, output, financial performance, etc. These undertakings are then reflected as rights and obligations in the foreign investment contract concluded between the government or its authorized agency as one party and the investor as the other. It is therefore important for the government to perform compliance review on foreign investment contracts to which it is a party. This article provides an overview of the areas on which the government should focus when reviewing such contracts.

The investor. The ultimate purpose of a campaign to attract foreign investment is to attract investors. To avoid signing deals with bogus companies or investors lacking the ability to perform contracts, the government should assess the investor’s eligibility and ability to fulfil the contract based on information available from sources that include the State Administration for Industry and Commerce, the National Enterprise Credit Information Publicity System, the China Judgments Online, the Enforcement Publicity Website, and the Credit Reference Centre of the People’s Bank of China before entering into a foreign investment contract.

Rights and obligations. In order to persuade the investor to sign the deal, the government often undertakes to provide the investor with preferential treatment relating to land, transitional premises, funding, talents and other aspects in the foreign investment contract. These undertakings will have to be fulfilled. As a precaution against disputes, properly defining rights and obligations of the government and the investor in the contract is important. The review on contractual provisions concerning rights and obligations should focus especially on the following issues:

(1) Legitimacy. Any preferential treatments provided by the government must be provided only to the extent permitted by law. For example, despite any preferential land treatment that may be granted to the investor, any parcel of land provided to the investor must be one intended for “industrial or commercial” purposes and transferred through the procedure of “bid invitation, auction or listing for sale” at a price not lower than the minimum land transfer price published by the Ministry of Land and Resources. Take fiscal subsidy as another example. No fiscal subsidy shall be granted to an investor unless the conditions prescribed under applicable laws and regulations are met. If any changes occur to these laws and regulations that results in a change to the investor’s entitlement to fiscal subsidy, it must be complied with accordingly.

(2) Reasonableness. To reflect reciprocity between rights and obligations, the foreign investment contract needs to specify that the government’s undertaking of providing preferential treatment will be fulfilled only if the investor meets agreed conditions relating to, including without limitation, place of incorporation, business scope as well as investment amount, scale and construction period of the project, and contribution of the commissioned project to local fiscal revenue and employment. For instance, to incentivize the investor to improve output on an ongoing basis, the mechanism of special funding support can be designed so that no support is provided unless the VAT and corporate income tax amounts (including total amount and the amount retained by the local taxation agency) paid by the investor meet prescribed thresholds.

(3) Realizability. The government should be confident at signing of the foreign investment contract that the undertakings it provides are realizable, because liability for breach will arise in the event of failure to fulfil them. For instance, an undertaking to arrange schooling for children is realizable only if it is related to compulsory education at local schools.

Well defined liability for breach. Most foreign investment contracts signed by the government include a general provision that requires a party whose breach of the contract causes any loss to the non-breaching party to indemnify and hold the non-breaching party harmless from and against loss. A simple provision like this is not conducive to protecting contractual rights and interests of the government because it does not relieve the government of the burden to prove loss in the event of breach by the investor.

Instead, we recommend sophisticated provisions that specify, in connection with each of the investor’s material obligations under the contract, event of default, liability for breach, and the method for computing losses or damages.

They work in two ways. On the one hand, the resulting rise in the cost of investment may become a driver for the investor to comply with the contract. On the other hand, they are conducive to safeguarding legitimate rights and interests of the government when a breach by the investor arises.

The provisions can be drafted in such a manner that: (1) an event of default occurs especially when the investor breaches its undertakings regarding place of incorporation, business scope, amount and schedule of capital contribution, investment intensity and scale, commissioning schedule, output and tax payment; and (2) once the investor commits a breach, the government shall be entitled to terminate the foreign investment contract unilaterally and request return and compensation of benefits received by the investor. If necessary, a provision on how to compute loss on occupation of fund can be added to the contract.

Dispute settlement. There have been arguments over whether disputes arising out of, or relating to, foreign investment contracts are of civil or administrative nature. In our opinion, they should be of civil nature, for four reasons. First, the subject matter of a foreign investment contract involves disposal of properties and interests governed by the civil code. Second, there is reciprocity between the government’s undertakings concerning tax, land, fiscal and other policies, and those of the investor regarding place of incorporation, business scope, investment, performance, output and so on. Third, the foreign investment contract is an outcome of mutual consultation. Finally, the investor is entitled to hold the government liable for breach if it fails to fulfil any undertakings provided in the contract.

There are therefore sufficient grounds to specify in the foreign investment contract that disputes will be referred to an arbitration institution or a court of competent jurisdiction. We recommend arbitration institutions given their timeliness and flexibility in dispute resolution.

Shen Rengang is a senior partner and Zhang Yanan is an associate at AllBright Law Offices