Treasury Department Finalizes Rule to Prohibit and Regulate U.S. Outbound Investments in China

On November 15, 2024, the U.S. Department of the Treasury published a Final Rule to implement the August 9, 2023 Executive Order addressing outbound investments in certain national security technologies and products in “countries of concern.” Effective January 2, 2025, the Final Rule prohibits and regulates certain investments by U.S. persons in the People’s Republic of China (PRC), Hong Kong, and Macao. The Final Rule differs in some key ways from the Proposed Rule issued by Treasury on June 21, 2024, updating the scope of covered technologies, adding some excepted transactions, clarifying the knowledge requirement, and enhancing specificity in other areas. The key elements of the Final Rule are (1) prohibitions on certain investments made by U.S. persons and their controlled foreign entities in the Chinese semiconductor, microelectronic, quantum information technology, and artificial intelligence (AI) sectors; and (2) requirements for U.S. persons to notify Treasury of certain other investments in these sectors. The Final Rule provides exceptions and the opportunity to seek exemptions from its prohibition and notification prongs, as discussed below.

What Transactions Are Prohibited or Require Notification?

The Final Rule focuses on (1) “covered transactions” involving investments in a (2) “covered foreign person” (CFP) in (3) one of the technology sectors noted above. Both “covered transactions” and “covered foreign persons” are multifaceted terms.

(1) Covered Transactions

Covered transactions include the direct or indirect:

1. Acquisition of equity interest or contingent equity interest
2. Conversion of an equity interest after January 2, 2025
3. Provision of certain kinds of debt financing
4. Greenfield or brownfield investment that engages with or results in the creation of a CFP
5. Entrance into a joint venture, wherever located, with a party the U.S. person knows is engaging or plans to engage in a covered activity (prohibited or notifiable transaction)
6. Acquisition of a limited partner interest in a non-U.S. person pooled investment fund that invests in a CFP

(2) Covered Foreign Persons

Covered foreign persons include the following:

1. A person of a “country of concern” that engages in a covered activity
2. A person with the power to direct the management or policies of any person described in (1) and which derives more than 50% of its revenue, net income, capital expenditure, or operating expenses from such person
3. A person of a country of concern involved in a joint venture with a U.S. person when that joint venture is engaged in a covered activity

Currently, Treasury has identified only three “countries of concern”: the PRC, Hong Kong, and Macao. However, Treasury has the discretion to add additional countries at any time. A “person of a country of concern” includes (non-U.S. citizen) Chinese citizens or permanent residents; entities headquartered or incorporated in the PRC, or otherwise organized under the laws of the PRC; any part of the Chinese government; any person directed by or acting for or on behalf of the Chinese government; and any entity owned 50% or more by someone previously described.

These definitions of a “covered foreign person” and “person of a country of concern” capture both (1) parent companies whose subsidiaries in the PRC are involved in activities related to a covered technology and (2) entities located outside the PRC that are majority Chinese-owned.

(3) Covered National Security Technologies

As noted, the Final Rule outright prohibits certain covered transactions while allowing other covered transactions to proceed, subject to a requirement that Treasury be notified. Transactions involving investments in technologies that may pose a threat to U.S. national security require such notification, which is designed to help the U.S. government identify sectoral trends and related capital flows to determine whether new regulatory action should be taken. Prohibited transactions concern investments in technologies that are deemed impermissibly threatening to U.S. national security. The table below details the types of technologies in which covered investments are either subject to notification (notifiable) or prohibited entirely.

Covered transactions involving third-party AI systems are neither prohibited nor subject to the notification requirement if the investment is to customize, configure, or fine-tune a system for one’s own internal, noncommercial use. The use may not be for government intelligence, mass surveillance, military end use, digital forensics tools, penetration testing tools, or the control of robotic systems.

The Knowledge Requirement

To be covered by the Final Rule, the U.S. person engaging in a covered transaction must have “knowledge” at the time of the transaction that it involves or would establish a CFP. “Knowledge” includes actual knowledge of a fact, awareness of a high probability of a fact, and reason to know of the fact’s existence. In addition, U.S. persons must stay diligent and notify Treasury if they acquire knowledge of a transaction’s covered nature after its completion.

When determining whether a U.S. person had the requisite level of knowledge, Treasury will consider both information the U.S. person actually had and information the person could have acquired through a “reasonable and diligent inquiry.” The Final Rule recommends some components of such an inquiry, including investigating the investment target or joint venture partner, obtaining contractual assurances about the transaction, considering any available nonpublic information, and recognizing warning signs such as evasive responses from investment targets. Adjudication will be based on the totality of the circumstances.

U.S. persons also may not “knowingly direct” a transaction by a non-U.S. person that would have been a prohibited transaction if it had been undertaken by a U.S. person.

Excepted Transactions and Exemption

The Final Rule lists several excepted transactions that are “less likely to raise national security concerns,” including the following:

1. An investment by a U.S. person in any publicly traded security
2. An investment by a U.S. person in a security issued by an investment company, such as an index fund, mutual fund, or exchange-traded fund
3. Certain investments made by a U.S. person limited partnership into a venture capital fund, private equity fund, fund of funds, or other pooled investment funds
4. Certain derivatives, as long as they do not confer the right to acquire equity or any rights associated with equity
5. A U.S. person’s full buyout of all interests of any person of a country of concern in an entity, such that the entity would not constitute a CFP following the transaction
6. An intracompany transaction between a U.S. person parent and its subsidiary to support ongoing operations (or other activities that are not covered activities)
7. Fulfillment of a binding capital commitment entered into prior to January 2, 2025
8. The acquisition of a voting interest in a CFP upon default or other condition involving a loan
9. The receipt of employment compensation by an individual in the form of an award of equity or the grant of an option to purchase equity in a CFP
10. Transactions occurring in certain partner and ally countries that commit to implementing similar outbound investment review measures

In addition, a U.S. person may seek an exemption from the prohibition or notification requirement on the ground that the transaction is in the national interest of the United States.

Conclusion

Companies and individuals that invest, or seek to invest, in sensitive technologies and products in any of the countries of concern should carefully review Treasury’s Final Rule and analyze its potential impact on their business. As of January 2, 2025, U.S. persons will be expected to conduct additional due diligence (“a reasonable and diligent inquiry”) to determine whether contemplated investments in the PRC, Hong Kong, and Macao would be notifiable or prohibited transactions. They will also need to remain vigilant about investment targets’ activities to avoid after-the-fact liability. If a U.S. person does violate the Final Rule, there are ways to mitigate liability, such as by initiating a voluntary self-disclosure with Treasury.

It will be prudent for interested parties to keep abreast of the technical specifications for covered technologies and the list of countries of concern (both of which may change over time), to establish or enhance due diligence protocols, and to consider consulting about the subtleties of the Final Rule before proceeding with potential covered transactions. Please contact any author of this Advisory or your Arnold & Porter relationship attorney if you have any questions or to seek further guidance or advice.

© Arnold & Porter Kaye Scholer LLP 2024 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.