In a landmark announcement earlier this month, the Chinese Ministry of Industry and Information Technology (MIIT) unveiled its latest efforts to open up China’s telecom market to international investors – a market that traditionally has carried strict barriers to overseas capital. 

MIIT’s new pilot program is designed to ease foreign ownership restrictions across a variety of crucial value-added telecom services within selected areas (Pilot Scheme), ultimately seeking to integrate China more closely with the rigorous economic and trade standards that govern global commerce. By enhancing the competitive edge and vitality of the Chinese market, authorities hope to establish a new phase of development that fosters better links between China’s digital economy and the rest of the world.

What services are covered?

Under the Pilot Scheme, foreign investors are permitted to set up wholly-owned entities within pilot areas to offer six value-added telecom services: (1) internet data centers (IDCs), (2) content delivery networks (CDNs), (3) internet service providers (ISPs), (4) online data processing and transaction processing, (5) information publishing platforms and information delivery services (except for services relating to internet news, online publishing, internet audio-visual services and internet cultural operations), and (6) information protection and processing services (each an In-scope Service). 

In contrast, under the prevailing national-level rules, foreign investors are generally prohibited from, or have restricted access to (by having a foreign ownership cap), investment into these In-scope Services, other than relaxations previously introduced where capital is routed through qualified Hong Kong or Macau entities under the Mainland and Hong Kong / Macau Closer Economic Partnership Arrangement (CEPA). 

The table below outlines the foreign ownership levels permitted under the different regimes for each In-scope Service: 

 Where the Pilot Scheme is available?

The following four regions are recognised by the MIIT as pivotal hubs for the Pilot Scheme:

• Beijing (in the Integrated Beijing Demonstration Zone for Opening up the Services Sector),
• Shanghai (in Lingang New Area of the Free Trade Zone and the Pioneer Area for Socialist Modernisation),
• Hainan (in the Hainan Free Trade Port), and
• Shenzhen (in the Pilot Demonstration Area of Socialism with Chinese Characteristics).

These areas have been selected based on their unique ability to formulate pioneering regulations that foster growth and innovation, their huge potential to advance the information communication sector, and their track record in attracting foreign investment, coupled with their capabilities for implementing robust security controls. 

To ensure the success of these designated pilot areas, the MIIT mandates that local governments develop detailed implementation plans that align with the ministry's vision for the Pilot Scheme. Plans must be approved by MIIT before being put into trial.  

Local government plans will be critical in determining the practical impact of the Pilot Scheme and how smoothly China's digital market can adapt to increased foreign participation. Should the Pilot Scheme prove successful, the MIIT may expand the pilot areas. 

Operational requirements

Foreign investors which seek to establish a wholly foreign owned enterprise (WFOE) under the Pilot Scheme must comply with certain requirements and restrictions, including:

• Locality: To streamline the oversight of the Pilot Scheme, the facilities of the WFOE (whether rented or purchased) must be located in the pilot area where the WFOE is registered. Furthermore, the WFOE cannot acquire or lease CDN or other facilities from outside of its designated pilot area to support its provision of acceleration services. This requirement mirrors existing regulations applicable within China’s free trade zones and will need to be factored into operational plans.
   
• Service scope: WFOEs may only offer ISP services within the boundaries of the pilot area where it is registered, and its internet access services must be provided to users through internet access equipment offered by basic telecom service providers. Other types of In-scope Services, however, can be offered on a nation-wide basis.

 IDC investment opportunities 

Notably, the relaxation in IDC investment under the Pilot Scheme has garnered significant market attention. 

Historically, foreign investors may only invest in Chinese IDCs by adopting either a CEPA structure or a variable interest entity (VIE) structure as a work-around. Specifically:

• CEPA structure: To the extent a Hong Kong or Macau entity within the foreign investor's global network can meet the threshold requirements for a qualified operator under CEPA, one option would be for the foreign investor to use this Hong Kong  / Macau entity to set up a joint venture in mainland China to apply for an IDC licence; or, alternatively, the foreign investor may consider acquiring or otherwise taking control of a qualified operator in Hong Kong or Macau SARs, which can then be used as a springboard to access the Chinese market through the CEPA channel. The diagram below briefly illustrates the CEPA structure:

• VIE structure: If the foreign investor does not have a qualified CEPA operator within its network (or has no intention of acquiring one), or is otherwise concerned by the disadvantages arising from the CEPA structure (e.g. operation and management of the IDC, as well as profit earned, will need to be shared with a Chinese partner), the foreign investor may consider using a VIE structure. This structure, which applies contractual control as opposed to equity control over the mainland Chinese operations, is commonly adopted by foreign investors to work around foreign investment restrictions in mainland China. 
  
  However, as an asset-heavy business and given the structural risks inherent in having only contractual control over a VIE, well-advised investors have sometimes looked to a double WFOE VIE structure (in place of the traditional one WFOE VIE structure with only one WFOE to control the VIE) to impose direct control over the heavy assets and light assets which do not require an operational licence. The diagram below illustrates how such double WFOE VIE structure works:

With the introduction of the Pilot Scheme, IDC investment can be made by foreign investors without these disadvantages and uncertainties associated with the alternative investment structures outlined above. 

That said, for foreign investors which have already opted for a CEPA or VIE structure for their IDCs investment in mainland China, the decision to switch to a WFOE structure under the Pilot Scheme should not be made immediately – the timing and financial implications of any transition will not be known until the implementation plan is rolled out for the investor’s preferred pilot area.

What’s next?

The Pilot Scheme represents an exciting opportunity for foreign investors to participate more fully in China's IDCs and other areas of its telecom market. Global telecom providers and digital infrastructure investors should monitor for details as the program becomes clearer upon issuance of implementation plans for each pilot area. 

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