Treasury Issues Final Regulations Prohibiting Certain US Investment in Chinese Technology Companies

Key Points

• Treasury has issued a Final Rule to implement President Biden’s 2023 EO targeting U.S. investments in Chinese companies engaged in certain activities related to semiconductors, quantum computing or AI.
• Once the Final Rule becomes effective on January 2, 2025, U.S. persons will be prohibited from engaging in certain transactions in these sectors involving China or Chinese persons, while others will require a notification to the U.S. government. The focus is on equity investments, though some debt financing as well as greenfield, brownfield and joint venture-related investments will be covered.
• The rules squarely apply to private equity and venture capital funds with a U.S. general partner. In addition, some U.S. limited partner investments in funds with non-U.S. general partners will also be captured, effectively shifting some of the compliance burden to foreign general partners that take U.S. investment.
• Certain majority-owned Chinese companies and parents of Chinese companies in third countries will be covered, which will necessitate greater due diligence than if the focus were solely investment directly into China. In addition, U.S. persons will need to take steps to ensure compliance by their subsidiaries in third countries, including preventing them from making investments that they themselves would not be permitted to make. Although the set of prohibited transactions is relatively narrow, the notification obligation will apply to a broad set of transactions and require a significant amount of information to be notified to Treasury.
• We recommend that U.S. persons conduct diligence on prospective investments to identify entities and activities that may trigger these prohibitions and notification requirements and implement any necessary compliance procedures to avoid violations.

Background

On November 15, 2024, the U.S. Department of the Treasury published the final rule implementing President Biden’s August 9, 2023 Executive Order on outbound investment, which addresses concerns related to China’s advancement in sensitive technologies critical for military, intelligence, surveillance or cyber-enabled capabilities (Final Rule and EO, respectively).

The U.S. government believes that U.S. investments are “often more valuable than capital alone” due to the potential transfer of intangible benefits such as enhanced standing and prominence, managerial assistance, access to investment and talent networks, market access and enhanced access to additional financing. The EO designated China, including Hong Kong and Macau, as the sole country of concern and semiconductors and microelectronics, quantum technologies and artificial intelligence (AI) as “covered national security technologies and products.”

The Final Rule targets the sensitive technology sectors that are consistent with the “force multiplier” technologies that National Security Advisor Jake Sullivan referenced in his September 2022 remarks at the Special Competitive Studies Project Global Emerging Technologies Summit, where he noted that “microelectronics, quantum information systems, and artificial intelligence” are included in the “select few technologies [that] are set to play an outsized importance over the coming decade” and that, “[g]iven the foundational nature of certain technologies, such as advanced logic and memory chips, we must maintain as large of a lead as possible.”

As directed by the EO, the Final Rule prohibits or requires notification regarding certain types of outbound investments by U.S. persons into certain entities that are (1) connected to a country of concern and (2) engaged in activities involving “covered national security technologies and products,” i.e., semiconductors and microelectronics, quantum technologies and AI.

Key Changes from the NPRM

The Final Rule follows two rounds of public comments, first on the August 2023 Advance Notice of Proposed Rulemaking (ANPRM) and second on the July 2024 Notice of Proposed Rulemaking (NPRM). While the Final Rule clarifies certain provisions and makes some changes on the margins, it does not significantly change the overall scope of the program set forth in the NPRM.

The key changes from the NPRM include further defining the scope of coverage over AI; clarifying the exceptions for certain limited partner (LP) investments and intracompany transactions; adding an exception for equity-based compensation, e.g., stock options for employees; and clarifying the recusal policy for U.S. persons who are senior managers at non-U.S. person companies.

Treasury specifically declined to narrow the scope of coverage over AI systems, noting that the requirements may implicate consumer or civilian applications.

Implications

U.S. investors, investment funds and companies, Chinese investment funds and Chinese target companies, and other non-U.S. funds and companies with U.S.-person officers or directors must begin preparing for the outbound investment program. For example, to the extent they have operations or are making investments in these sectors in China:

• U.S. companies, such as those in the semiconductor sector, should assess the implications on their operations in China.
• U.S. fund managers and investors should prepare diligence procedures, excusal policies, side letters, covenants, and representations and warranties in order to ensure compliance.
• Non-U.S. entities with U.S. officers or directors should establish recusal policies to avoid violations of these rules.

Although some LP investments will be excepted from the new requirements, this exception only applies to transactions occurring after January 2, 2025, that are made pursuant to a “binding, uncalled capital contribution commitment entered into before January 2, 2025.” Otherwise, outbound transactions by or with a covered foreign person that close after January 2, 2025 will not be grandfathered, even if made pursuant to a signed/binding commitment before January 2, 2025.

Key Parameters in the Final Rule

The scope of coverage over U.S. persons and covered foreign persons, as well as the types of transactions that are covered and excepted, are consistent across the program. What determines whether a transaction is prohibited or notifiable is the type of activities the target undertakes with respect to covered national security technologies and products.

US Persons

To be covered by the Final Rule, a transaction must be by a U.S. person or an entity under the control of a U.S. person. It defines U.S. person to mean: (i) U.S. citizens and lawful permanent residents, (ii) entities organized under U.S. law or any jurisdiction of the United States (including branches) and (iii) any person in the United States. With respect to entities under the control of a U.S. person, the Final Rule requires U.S. persons to take “all reasonable steps” to prohibit and prevent its controlled entities from undertaking transactions that the U.S. person itself would be prohibited from taking and to comply with the notification requirements. Essentially, “controlled by” means that the U.S. person is a “parent” of such entity. Parent is defined as an entity that holds more than 50% of the voting interest or voting power of the board of the entity, the general partner of a fund or an investment adviser to a pooled investment fund.

Covered Foreign Persons

To be in scope, transactions must also be with “covered foreign persons,” which is scoped through a two-step definition. Essentially, a covered foreign person is a “person of a country of concern” that is engaged in a “covered activity.”

A covered foreign person includes:

(i)   Any person of a country of concern that engages in a covered activity.

(ii)  A person that either directly or indirectly holds any voting interest, board seat, or equity interest in or holds the power to direct policies (including variable interest entities) in one or more persons engaged in a covered activity (i.e., a person described in prong (i)), if persons covered by prong (i) individually or in the aggregate comprise more than 50% of its consolidated revenue, net income, capital expenditure or operating expense in the prior year (e.g., certain parent companies, including in the United States or third countries). Only persons accounting for at least $50,000 in an individual category will be considered in order to facilitate compliance.

(iii) The person of a country of concern that participates in a covered joint venture.

A person of a country of concern includes:

(i)   Any individual that is a citizen or permanent resident of China and is not a U.S. citizen or permanent resident.

(ii)  An entity with a principal place of business in, headquartered in, or incorporated in or otherwise organized under the laws of China.

(iii)  The Chinese government and persons controlled by or acting on behalf of the government (including the power to direct or cause the direction of the management or policies of an entity).

(iv)  Any entity in which one or more persons under (i) – (iii) hold at least 50% of the outstanding voting interest, voting power of the board or equity interest (not only subsidiaries but also companies where unrelated Chinese persons meet the 50% threshold).

(v)  Any entity in which one or more persons identified in (iv), individually or in the aggregate, directly or indirectly, holds at least 50% of the outstanding voting interest, voting power of the board or equity interest.

Covered Activities Involving National Security Technologies and Products

To be a covered foreign person, an entity must be engaged in “covered activities” involving certain technologies and/or products in the semiconductors and microelectronics, quantum information technologies or AI sectors. Depending on the activities, the transaction may be either prohibited or require notification. The Final Rule defines each of these categories in further detail. In summary:

• Semiconductors and microelectronics: The Final Rule generally targets advanced node integrated circuits and front-end semiconductor fabrication equipment that is currently controlled under U.S. export controls, but also targets all semiconductor electronic design automation (EDA) software and advanced packaging technology, some of which are currently not the subject of U.S. export controls.
  • Prohibited transactions: Covered transactions related to electronic design automation software; certain fabrication and advanced packaging tools; any items exclusively for use in or with extreme ultraviolet lithography (EUVs); the design of 3A090.a graphics processing units (GPUs) or integrated circuits (ICs) designed for operation at or below 4.5 Kelvin, fabrication of advanced nodes ICs or certain special ICs, or IC packaging using advanced packaging techniques; and certain supercomputers.
  • Notifiable transactions: Covered transactions related to the design, fabrication or packaging of ICs not otherwise covered by the prohibited transaction definition.
• Quantum information technologies: The Final Rule targets the development of quantum computers and the production of critical components of quantum computers, including some components that the Bureau of Industry and Security (BIS) recently added to the Commerce Control List. It also targets certain quantum sensing platforms and quantum networking and communication systems.
  • Prohibited transactions: Covered transactions related to the development of quantum computers and production of critical components; the development or production of certain quantum sensing platforms; and the development or production of quantum networking and quantum communication systems.
  • Notifiable transactions: None.
• Certain AI systems: The Final Rule targets AI systems that are used for certain military, government intelligence or government mass surveillance end uses, all of which are end uses that are consistent with current and past U.S. government interagency reviews in the U.S. export control context, while also targeting AI systems, regardless of end use, trained using certain specified computational power thresholds. The Final Rule draws some concepts from the October 30, 2023 “Executive Order on the Safe, Secure, and Trustworthy Development and Use of Artificial Intelligence.” The Final Rule also defines AI system very broadly, to include not only machine-based systems themselves, but also any data system, software, hardware, application, tool or utility that operates using a machine-based system.
  • Prohibited transactions: Covered transactions related to the development of any AI system designed to be exclusively used for, or intended to be used for, certain military, mass surveillance or government intelligence end uses. The Final Rule also prohibits transactions related to the development of any AI system, regardless of end use, that is trained using a quantity of computing power greater than 10^25 (and a threshold of greater than 10^24 computing power using primarily biological sequence data).
  • Notifiable transactions: Covered transactions related to the development of any AI system not otherwise covered by the prohibited transaction definition, where such AI system is designed or intended to be used for certain end uses (including control of robotics systems, which is potentially broad) or is trained using a computing power greater than 10^23.
  • The Final Rule also clarifies the scope of the rule as applied to developers of data systems, software, hardware, applications, tools, or utilities that operate in whole or in part using a third-party AI model or machine-based systems.  “Developing” such items would only fall within the scope of the rule where the developer is designing or making substantial modifications to the AI model or machine-based system, such as customizing, configuring, or fine-tuning the model. 
  • The Final Rule adds a note that a person customizing, configuring or fine-tuning a third-party AI model strictly for internal, non-commercial use would not be caught by the Rule’s prohibition requirement unless the internal, non-commercial use is for government intelligence, mass-surveillance or military end use, or for digital forensics tools, penetration testing tools, or the control of robotic systems.

Covered Transactions

The Final Rule only applies to certain types of transactions, referred to as “covered transactions,” defined to mean:

• Acquisition of an equity interest or contingent equity interest in a covered foreign person, as well as the conversion of contingent equity.
• Provision of debt financing to a covered foreign person where such debt financing is convertible to an equity interest, where the debt affords the lender the right to share in profits, appoint a board member, or certain other governance rights, or where foreclosure on collateral after default results or would result in the acquisition of equity.
• Acquisition, leasing or development of operations, land, property or other assets that the U.S. person knows at the time that the development will result in or plans to result in the establishment of a covered foreign person or the engagement of a person of a country of concern in covered activities (i.e., greenfield or brownfield investments). A transaction between a U.S. person and its controlled foreign entity that expands covered activities may be covered activities that will be covered by the program.
• Entering into a joint venture, wherever located, that is formed with a person of a country of concern and that the U.S. persons knows will engage in or the U.S. person plans to engage in a covered activity.
• Certain acquisitions of LP interests in a non-U.S. fund that is “likely” to invest in a person of concern in the covered sectors, based on reasonable due diligence.

Knowledge Standard

• Each of these types of transactions includes either a knowledge or intent requirement by the U.S. person. The Final Rule defines knowledge as actual knowledge that a fact or circumstance exists or is substantially certain to occur, awareness of a high probability of the existence or future occurrence of a fact or circumstance, or reason to know of a fact or circumstance’s existence. The Treasury will consider whether the U.S. person could have had knowledge of the relevant fact or circumstance through a reasonable and diligent inquiry.
• The Final Rule provides guidance on actions that the Treasury will consider in determining whether a U.S. person conducted a sufficiently diligent inquiry, including seeking representations and warranties, reviewing publicly available information, making efforts to obtain non-public information, utilizing commercial databases and following up on evasive responses. A U.S. person is responsible for knowledge that they had or could have had through a reasonable and diligent inquiry.

“Knowingly Directing”

• U.S. person officers, directors and other persons with executive responsibilities at non-U.S. companies will be prohibited from “knowingly directing” transactions by non-U.S. persons (i.e., their employer) that a U.S. person would be prohibited from undertaking.
• The Final Rule clarifies that such U.S. persons must recuse themselves from three activities: (1) participating in formal approval and decision-making processes related to the transaction, including making a recommendation; (2) reviewing, editing, commenting on, approving and signing relevant transaction documents; and (3) engaging in negotiations with the investment target.

Excepted Transactions

The Final Rule expressly carves out certain types of transactions from the definition of “covered transaction” – these types of transactions are referred to as “excepted transactions,” which include the following:

• Certain types of passive investments, such as investments in publicly traded securities or into an index fund, where the investor does not receive rights beyond certain minority protections.
• Certain U.S. LP investments where committed capital is not more than $2 million or where the LP has secured a binding contractual assurance that its capital in the fund will not be used in what would be a prohibited or notifiable transaction, and the investor does not receive rights beyond certain minority protections.
• Certain derivatives.
• Employee compensation in the form of equity, an option to purchase equity in a covered foreign person, or the exercise of such option.
• Full buyouts of all Chinese ownership in a company.
• Intracompany transactions between a U.S. person parent to maintain any covered activities its Chinese subsidiary has been engaging in prior to the Final Rule’s effective date on January 2, 2025, and any new non-covered activity.
• Certain pre-Final Rule binding commitments, meaning transactions made pursuant to a binding, uncalled capital commitment entered before the effective date of January 2, 2025. This exception covers LP investments in a fund, but it does not cover transactions with or involving a covered foreign person.
• Certain syndicated debt financing, where the U.S. person acquires a voting interest in a covered foreign person upon default as a member of a lending syndicate and cannot initiate an action vis-à-vis the debtor.

Additional Key Aspects of the Final Rule

• Otherwise notifiable investments will be prohibited if they involve Chinese persons on certain sanctions and export control lists maintained by the Departments of the Treasury, Commerce or State.
• Parties may apply for a national interest exemption that would permit a prohibited transaction to proceed. The Treasury will publish procedures for seeking such exemptions on its website. We anticipate that there will be a high bar for exemptions, and U.S. persons would need to demonstrate factors such as the transaction’s beneficial effect on matters such as: critical U.S. supply chain needs; domestic production needs in the United States for projected national defense requirements; United States’ technological leadership globally in areas affecting U.S. national security; or a negative impact on U.S. national security if the U.S. person is prohibited from undertaking the transaction.
• The Treasury is considering introducing a “white list” approach for covered transactions involving entities in third countries. This would except certain types of transactions (yet to be identified) with entities in countries that have been designated according to criteria that relate to actions by that country to address outbound investment risk. We anticipate that this will be a narrow exception.
• Violations could result in (i) civil penalties up to the maximum allowable under the International Emergency Economic Powers Act, which is currently $356,579 per violation, and (ii) criminal penalties up to $1 million or 20 years in prison for willful violations.
• The Final Rule includes confidentiality provisions to protect non-publicly available information submitted to the Treasury pursuant to the notification requirement.

What’s Next?

The new program will become effective on January 2, 2025. The Treasury has stated that it will continue to engage with stakeholders in this interim period and intends to issue guidance to address implementation and compliance questions that the Treasury believes requires clarification.