Series
Blogs
Final US Regulations on Outbound Foreign Investment: Key Changes and Their Implications
Final US Regulations on Outbound Foreign Investment: Key Changes and Their Implications
4 November 2024
Series
Blogs
4 November 2024
On October 28, 2024, the US Department of the Treasury (Treasury) published final regulations implementing the US outbound foreign investment program (Program) initiated in August 2023 by Executive Order 14105. The Program targets US-led investments directly or indirectly supporting certain activities by entities in or controlled from China that relate to semiconductors and microelectronics, quantum computing, and artificial intelligence. Depending on the specific technology and its nexus to US national security, a transaction may require notification to Treasury or may be prohibited outright.
The Outbound Investment Security Program, as the Program is formally called, is nominally focused on US investments in Chinese entities, but the scope of the regulations is much broader, and can include transactions in which neither party is from the United States or China.
Draft regulations for the Program were published four months earlier in a Notice of Proposed Rulemaking (NPRM). Most of the draft regulations in the NPRM remain unchanged, and we refer readers to our June 2024 blog post for an overview of key provisions of the regime. In this post, we highlight some of the changes in the final regulations and their implications for certain types of investors and investment targets.
The NPRM distinguished generally between AI technologies developed exclusively for military end-uses (for which investments would be prohibited), dual-use technologies with various security-related applications (for which investments would be notifiable), and purely civilian technologies (which would be outside the Program’s scope). The NPRM also asked for guidance as to the number of computational operations used to train an AI system that should factor into whether the AI system would trigger a prohibited or notifiable transaction.
To address indirect investments in Chinese entities engaged in activities relating to the covered technologies, the NPRM introduced the “50% rule,” which extends the Program to any investments in any target entity (including target entities outside China) that directly or indirectly holds a voting interest, board seat, equity interest, or contractual governance rights with respect to one or more entities engaged in covered activities if the target:
(i) Derives at least 50% of its revenue or net income from one or more of the covered entities;
(ii) Makes 50% or more of its capital expenditures through one or more of the covered entities; or,
(iii) Incurs 50% or more of its operating expenses from one or more of the covered entities.
In each case, the NPRM requires the figures to be determined from the investor’s most recent annual financial statement.
The 50% rule may bring a significant number of businesses outside China into scope; for instance, a US investment in a US company designing high-end semiconductors could be in scope if the US business has a capital-intensive joint venture in China through which the semiconductors are fabricated.
The Program’s scope includes investments in relevant entities made by US persons and by non-US entities if “knowingly directed” (as discussed below) by a US person. The definition of “US person” in the final regulation has not changed since the NPRM; in both cases, the definition (US citizens and permanent residents, as well as US-domiciled entities and their non-US branches, and “any person in the United States”) is drawn directly from Executive Order 14105.
US persons are prohibited from “knowingly directing” a transaction by a non-US person that would be a prohibited transaction if undertaken by a US person, and are required to submit a notification for any notifiable transaction knowingly directed by the US person. The definition of “knowingly directing” is critical for both US investors and US persons who work with non-US investors.
US persons, even if authorized as described above, will not be deemed to have directed an investment decision if they recuse themselves from each of the following:
(i) participating in approval and decision-making processes, including making a recommendation for the investment;
(ii) reviewing, editing, commenting on, approving, and signing transaction documents; and,
(iii) engaging in negotiations with the investment target or other counterparty.
Note that US persons are not required to recuse themselves from post-transaction activities relating to the investment.
The NPRM originally considered two options for exempting limited partnership (LP) investments from the scope of the Program: (i) passive LP investments representing less than 50% of a fund’s assets under management, or (ii) LP investments of US$1 million or less.
In response to comments that the first option would create uncertainties and add diligence issues while the second option was too low a threshold to be practical, the final regulations went a different direction, excepting either (i) LP investments (aggregated over multiple funds and co-investment vehicles, if applicable) of US$2 million or less or (ii) LP investments in which the fund gives a binding assurance that the capital will not be used in covered transactions.
The NPRM excepted investments pursuant to uncalled capital commitments made before August 9, 2023, when Executive Order 14105 took effect. Given the fairness issues arising from applying the Program to transactions entered into before the final scope of the Program was established, the final regulations now exclude transactions arising from uncalled capital commitments entered into before the Program takes effect on January 2, 2025.
Issuance of derivatives in “covered foreign persons” (which includes entities meeting the “50% rule” discussed above) is now excluded from the scope of the Program, so long as (i) the derivative does not give the holder the right to acquire equity, rights associated with equity, or other assets of the entity; and (ii) the holder will not have any rights with respect to the entity beyond the minority investor protections discussed above.
Issuance of equity, options, or similar compensation to employees of “covered foreign persons” is now excluded from the scope of the Program. This exception should be of particular value to employees of non-Chinese companies that meet the “50% rule” discussed above.
Treasury plans to provide illustrative examples and other guidance on the final regulations via the Program’s website. With less than two months remaining before the Program takes effect, we hope and expect initial guidance to be posted soon, but also expect the guidance to change over time to address issues identified through practical experience.
Parties required to submit notifications or who wish to submit applications for national interest exemptions will be required to do so via the Program’s online portal. A link to the portal and instructions for its use are also expected to be posted soon to the Program website.