Final US Regulations on Outbound Foreign Investment: Key Changes and Their Implications

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.

It’s not just about the United States and China

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.

Covered business activities – artificial intelligence

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.

• For prohibited transactions, where exclusive military uses were formally listed in the draft rule, those uses are now identified as mere examples of relevant applications. Alternatively, prohibited transactions can involve AI systems trained using either 10^25 computational operations generally or 10^24 computational operations using primarily biological sequence data. 
• Notifiable transactions now involve AI systems designed (though not exclusively) for various military end-uses or intended for other dual-use applications, or that are trained using at least 10^23 computational operations. The final rules also add an exception from notification requirements for entities that just customize or configure a third-party AI system for internal use, so long as that internal use does not involve certain prohibited applications.

Covered investment targets – the “50% rule”

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 final regulations reduce the scope of the 50% rule by requiring the person making the 50% calculations to aggregate the revenues, net income, capital expenditures, and operating expenses associated with a covered entity only if they are at least US$50,000.
• In addition, the final regulations state that in the absence of an annual financial statement, the 50% thresholds should be calculated on the basis of an independent appraisal, or if an appraisal is not available, on the basis of a good-faith estimate. This new provision may help early-stage companies lacking prior year financial statements.

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.

Covered investors

US persons

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.

• However, in response to public comment requesting guidance on how “any person in the United States” would apply to unincorporated branches of non-US entities, Treasury notes — in the explanatory language, but not the regulations themselves — that the non-US entity will not be deemed a US person solely by virtue of its employee in the United States. This begs the question as to other circumstances that, in combination with the US-based employee, would lead to a non-US entity being considered a US person, but at the very least, it is advisable for non-US entities to ensure that US-based employees of unincorporated US branch offices avoid “knowingly directing” investments within the scope of the Program, since those employee’s activities would be in scope. Treasury plans to provide illustrative examples on this topic via the Program’s website (see below).

Knowledge standard

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.

• “Knowledge” is defined as actual knowledge of a fact or circumstance, awareness of a high probability that a fact or circumstance exists or will occur, or reason to know of a fact or circumstance’s existence. Part of the analysis of whether a party has knowledge is whether relevant information can be learned through “reasonable and diligence inquiry.” Among the concerns of commenters on the NPRM was the fact that Chinese entities may be prohibited from providing information about their activities that would allow investors to complete a diligent inquiry. While the final regulations do not offer a “safe harbor” for investors faced with this hurdle, they now allow Treasury to consider “the totality of relevant facts and circumstances” in assessing whether a party conducted an adequate inquiry.
• “Directing” a transaction, as clarified under the final regulations, requires the US person to both (i) have actual authority, whether individually or as part of a group, to make or substantially participate in decisions on behalf of a non-US person; and (ii) actually exercise that authority.
  • The final rules indicate that to have the requisite authority, the US person must be an officer or director or have other executive responsibilities with respect to the non-US investor; the NPRM also included “senior advisor” to the non-US person, but this language was dropped from the final regulations.

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.

Excepted transactions

Limited partners

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 latter exemption may be attractive to LPs making sizable investments, but may be less attractive to financial sponsors who would have to provide the assurances and perform the necessary diligence on prospective portfolio companies.
• Notably, this exception is not available to LPs (or to investors benefitting from some of the other Program exceptions such as investments in listed securities or registered investment funds) if the investment would afford the investor any rights beyond the narrow list of minority investor protections listed in the regulations. LPs may therefore have to relinquish “extra” rights typically sought in limited partnership and side letter agreements.

Uncalled capital commitments

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.

Derivatives

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.

Employee compensation

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.

Program website

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.