US Treasury Department Issues Proposed Rules Restricting US Outbound Investment in Advanced Technologies Involving China

On June 21, 2024, the US Treasury Department (“Treasury“) issued a much-awaited Notice of Proposed Rulemaking (“NPRM“)—pursuant to Executive Order (“EO“) 14105 of August 9, 2023, “Addressing United States Investments in Certain National Security Technologies and Products in Countries of Concern”—regarding the upcoming outbound investment review regime, which prohibits or, alternatively, requires notification of certain investments into entities linked to China and engaged in subsets of three specified technologies (semiconductors and microelectronics, quantum information technologies, and artificial intelligence). The proposed rules show that Treasury’s outbound investment review regime will impact US persons’ ability to invest (or at least to do so without notifying Treasury) in China and China-connected entities in third countries with exposure to emerging technologies in the aforementioned fields.

The NPRM does not implement EO 14105 but rather unveils, for the first time, the draft text of the proposed rules reflecting Treasury’s consideration of public comments on the Advanced Notice of Proposed Rulemaking (“ANPRM“) that was published last year simultaneously with EO 14105. The NPRM solicits further comments from the general public which may be submitted by August 4, 2024. We expect final rules to be issued in Q4 2024 or early 2025.

Treasury’s press release and factsheet on the NPRM are respectively provided here and here, and the NPRM is provided here. We previously discussed the August 9, 2023 EO 14105 and the ANPRM here.

Outbound Investment Regime at a Glance

EO 14105 and the related rulemaking aim at addressing US national security threats by restricting certain US investments into China-related entities involving advanced technologies that can enhance China’s military, intelligence, surveillance, and cyber-enabled capabilities. These actions add to the US national security measures that focus on China’s advanced technology development efforts, including the expanded US export controls targeting China’s advance computing and semiconductor sectors and the Committee on Foreign Investment in the United States (“CFIUS”) inbound investment review process, as well as legislative efforts to enact a China-focused outbound investment regime.

The rules as envisioned by the NPRM center around the following key principles:

• US Person-Based Compliance Regime. The proposed rules would impose compliance obligations on US Persons in the form of either the prohibition on engaging in certain specific categories of transactions or a post-closing notification requirement with respect to certain other categories of transactions. Consistent with the ANPRM, no US government transaction-specific review akin to the CFIUS process is contemplated. Violations of these compliance obligations would be subject to civil and criminal penalties, including a divestment of a prohibited transaction, authorized under the International Economic Emergency Powers Act (“IEEPA“). A number of proposed rules set forth in the NPRM, often quite nuanced, should factor into a compliance risk management strategy, including in particular with respect to appropriate transaction due diligence to be performed and/or related contractual assurances to be sought by US Persons.
• Broad, Extraterritorial Reach. The proposed rules would apply to targeted US Person transactions involving a “Person of a Country of Concern,” as defined in the proposed regulations to include, inter alia, entities headquartered or organized under a Country of Concern and their subsidiaries—where Country of Concern means the People’s Republic of China, Hong Kong, and Macau (collectively, “China”). As was the case under the ANPRM, that would include an individual who is a citizen or permanent resident of China; the government of China; an entity headquartered or with a principal place of business in, or organized under the laws of, China; or an entity that is directly or indirectly majority-owned by any of the foregoing. The NPRM would also capture transactions involving a third-country entity that has a “specified interest” (such as a voting interest, board seat, equity interest, or even certain contractual rights) in a “Covered Foreign Person” (defined to include, inter alia, a Person of a Country of Concern that engages in activity related to the technologies specified as notifiable or prohibited in the proposed regulations) where more than 50 percent of one of several financial metrics of that entity can be attributed to a Covered Foreign Person.
• Targeted Technologies. The proposed rules would capture US Person transactions related to subsets of the following technologies (collectively “Covered Technologies,” referred to as “National Security Technologies and Products” in the regulations):
  • Semiconductors and microelectronics;
  • Quantum information technologies; and
  • Artificial intelligence systems.

Key elements of the outbound investment review regime—scope, definitions, exceptions, etc.—are largely unchanged from the ANPRM and certain core elements (e.g., categories of technologies eligible for prohibition or notification) are mandated by EO 14105. The NPRM does, however, elaborate and refine some ambiguities with respect to a number of areas, such as the proposed regulations:

• Scope of technologies that are notifiable and prohibited;
• Level of knowledge (or intent in certain cases) required by a US person in violating the proposed regulations;
• Harmonization of the definition of AI to match the subsequent EO 14110;
• Applicability in the context of specific transactions (e.g., the substitution of intent for knowledge in assessing US person violations for joint venture transactions, elaboration of limited partner (“LP“) transactions);
• Administration (e.g., adding a double-notification requirement for notifiable convertible debt and contingent equity transactions); and
• Ultimately enforcement thereof (e.g., Treasury’s commentary regarding the nature of LP investment violations).

For those seeking further detail, below we highlight some of the more nuanced rules comprising the NPRM, which we hope would be helpful to companies assessing the possible impact of specific provisions on their future transactions and those considering submitting comments on the NPRM.

NPRM Takeaways

The NPRM provides a full text of the proposed regulations (to be located at 31 C.F.R. Part 850) and discusses Treasury’s considerations of the approximately 60 public comments received in response to the August 2023 ANPRM. We summarize some of the key takeaways of the NPRM below.

• Categories of Covered Transactions and excepted transactions. The general, high-level categories of Covered Transactions remain largely the same as contemplated under the ANPRM—e.g., acquisition of equity interests (M&A, private equity, and venture capital) and contingent equity interests, greenfield investments, joint ventures (“JVs”), equity-convertible debt financing). The NPRM has, however modified and elaborated further on certain elements discussed below:
  • Brownfield investments: The NPRM has introduced the notion of brownfield investments (i.e., investments in existing facilities to launch new operations in a foreign country), which largely operates alongside greenfield investments and JVs in the context of the proposed regulations.
  • Indirect Covered Transactions: Treasury aims to address a potential loophole by extending the scope of Covered Transaction to instances in which a US person indirectly invests in any number of intermediary entities as long as the US person possessed knowledge that there would be an ultimate indirect investment in a Covered Foreign Person.
  • “Debt with special rights”: Treasury had contemplated the inclusion of equity-convertible debt into the scope of Covered Transaction in the ANPRM. However, the NPRM has expanded the scope of Covered Transaction into an additional category, “debt with special rights”—i.e., the provision of debt financing that affords or will afford the US person the right to make management decisions on behalf of a Covered Foreign Person or to appoint members of the board of a Covered Foreign Person.
  • Investments made by US person LPs in pooled funds: While the ANPRM contemplated the inclusion of certain LP investments into pooled funds, the NPRM has elaborated further on how such investments would constitute Covered Transactions: (i) the rule only applies to funds managed by non-US persons (as US person-managed funds would already be covered by the main prongs of Covered Transaction); (ii) LP investments would only be covered if the US person knows at the time of the investment that the pooled fund likely will invest in a Covered Foreign Person (accounting for the reality that pooled funds may not know the specific future investments at the time of fund solicitation); (iii) restrictions relating to LP investments would only apply when the pooled fund undertakes an investment that would otherwise be a Covered Transaction if made by a US person directly; and (iv) a prohibited or notifiable Covered Transaction by the LP would only occur if the pooled investment actually invests in a Covered Foreign Person.
  • Excepted transactions:
    • Like the ANPRM, Treasury clarifies in the NPRM that certain categories of transactions do not fall within the definition Covered Transaction in the first place (e.g., university-to-university research collaborations; contractual arrangements or the procurement of material inputs for any Covered Technology (such as raw materials); intellectual property licensing arrangements; bank lending; processing, clearing, or sending of payments by a bank; underwriting services; debt rating services; prime brokerage; global custody; equity research of analysis; or other services secondary to a transaction).
    • Further, the NPRM specifies transactions that are excepted from the definition of Covered Transaction, which include but are not limited to:
      • (i) An investment by a US person in a publicly traded security;
      • (ii) An investment by a US person in a security issued by an investment company, such as an index fund, mutual fund, or exchange traded fund;
      • (iii) An investment of a “certain size” (undefined) by a US person LP in a pooled investment fund; and
      • (iv) An intracompany transaction between a US person parent and its subsidiary to support ongoing operations.
    • US person LP investment exception—two alternatives: Treasury is contemplating two alternative approaches for defining a threshold beneath which a US person’s LP investment into a pooled fund that subsequently invests in a Covered Foreign Person would constitute an excepted transaction:
      • LP exception, alternative 1: A US person LP’s investment would be an excepted transaction if (1) the LP’s rights are consistent with a passive investment and (2) the LP’s committed capital is not more than 50 percent of the total assets under management of the pooled fund (or the US person LP secured a binding agreement that the pooled fund would not use its capital for a prohibited transaction).
      • LP exception, alternative 2: A US person LP investment in a pooled fund would be an excepted transaction if the LP’s investment is not more than $1 million.
    • Partner country exception—”piggybacking” plurilateral controls: In light of emerging plurilateral interest in outbound investment controls targeting China (particularly from EU member states) and pre-existing outbound investment controls from other US-allied countries (e.g., Taiwan), the NPRM introduces the potential exception in instances where a transaction involves a non-US person from a country or territory to-be-designated by Treasury (i.e., as implementing an outbound investment review regime harmonized to that of the United States’) and the transaction is somehow (to-be-clarified) approved or in compliance with that partner country’s outbound investment review regime. This would be in line with the approach the US government has recently taken in the context of other regulatory regimes implicating US national security interests, particularly US export/reexport controls applicable to Russia and the CFIUS inbound investment regime.

• US person obligations regarding certain non-US person transactions: The proposed regulations place obligations on US persons in certain instances of investments by related non-US persons.
  • US obligations regarding US person-Controlled Foreign Entities: US persons controlling a non-US entity (“Controlled Foreign Entity“) would be required (i) to take “all reasonable steps” to prohibit and prevent its Controlled Foreign Entity from undertaking a transaction that would be a prohibited transaction if undertaken by a US person, and (ii) to notify Treasury if the Controlled Foreign Person undertakes a transaction that would be a notifiable transaction if undertaken by a US person.
    • In assessing whether the US person parent of a Controlled Foreign Entity has taken all reasonable steps, Treasury would consider certain factors regarding the US person and its Controlled Foreign Entity, including the existence and implementation of periodic training and reporting requirements with respect to compliance with the proposed regulations and the implementation of internal controls. Treasury would assess compliance based on the totality of the facts, including consideration of the size and sophistication of the US person parent.
  • US person “knowingly directing” a transaction by a non-US person: Commentors to the ANPRM sought clarity on the specific actions by a US person that could constitute “knowingly directing” a transaction by a non-US person. Treasury has responded by largely retaining the ANPRM’s definition of “knowingly directing” to include a transaction when a US person has authority to make or substantially participate in decisions on behalf of a non-US person entity and exercises the authority to direct, order decide upon, or approve a transaction that would be a prohibited a transaction. A US person would have such authority if the US person is an officer, director, or senior advisor, or otherwise possesses senior-level authority. Treasury has indicated, as in the ANPRM, that it intends to exclude third-party services such as banking services from the scope of “knowingly directing.”

• Definition of Controlled Foreign Entity: Treasury has stated in the NPRM that it favors a bright-line definition of Controlled Foreign Entity. The proposed regulations contemplate two separate avenues by which an entity would become a Controlled Foreign Entity: via a US person’s (i) voting interest or (ii) voting power of the board of the potentially Controlled Foreign Entity.
  • Controlled Foreign Entity by US person voting interest or voting power: In determining whether a US person indirectly holds voting interest or voting power of the board via a tiered ownership structure, where the relationship between an entity and another entity is that of a parent and subsidiary, the voting interest or voting power of the board of a subsidiary would be fully attributed to the parent. By contrast, if an entity holds 50 percent or less of another entity’s voting interest or voting power of the board—that is, if the relationship is not a parent-subsidiary relationship—then the indirect downstream holdings of voting interest or voting power of the board, as applicable, attributed to the first entity would be determined proportionately. If a US person holds both direct and indirect holdings in the same entity, the direct and indirect holdings of the US persons’ voting interest or voting power of the board would be aggregated. Voting interest and voting power would be evaluated independently from the other.
    • Example, as provided by the NPRM: A US person holds a 25 percent voting interest of the non-US person Company C, and Company C holds 60 percent of the voting interest of the non-US person Company D. The US person indirectly holds 15 percent of the voting interest of Company D. Company D would not be a Controlled Foreign Entity of the US person because the US person only indirectly holds 15 percent of the voting interest of Company D.
• Pre-transaction knowledge standard for US persons: Because a US person must determine whether a transaction is prohibited, notifiable, or not covered by the regulations, Treasury received numerous comments regarding the knowledge standard. Treasury has determined that specific provisions, such as the definition of the Covered Transaction, would only apply if a US person has knowledge (or intent in some circumstances) of the relevant facts or circumstances at the time of the relevant transaction.
  • Definition: Treasury has defined knowledge to include any of the following based on publicly available information or through information available through reasonable and appropriate diligence: actual knowledge that a fact or circumstance exists or is substantially certain to occur; an awareness of a high probability of a fact or circumstance’s existence or future occurrence; or reason to know of a fact or circumstance’s existence.
  • Application: Consequently, the proposed definition of Covered Transaction would generally require the US person know at the time of a transaction that the transaction involves a (i) a Covered Foreign Person or (ii) will result in a Person of a Country of Concern’s (i.e., China) engagement in a new Covered Activity (in the case of a business pivot).
  • Modification for JVs and greenfield/brownfield investments: The NPRM introduces a modification for the knowledge standard for US persons in the case of investments in JVs or greenfield/brownfield investments where the US person intends (at the time of the investment) to either (i) establish a Covered Foreign Person or (ii) pivot an existing Person of a Country of Concern’s (i.e., Chinese entity’s) operations into a new Covered Activity. The proposed regulations apply on the basis of US person knowledge or intent in the case of JV investments, and only apply on the basis of US person intent in the case of greenfield/brownfield investments.
  • Modification for US person LPs investing in pooled funds: In assessing whether a US person LP knew or had reason to know that a pooled fund was likely to invest in Covered Foreign Person at the time of LP solicitation, Treasury expects LPs to consider the intended geographic and sectoral focus of the pooled fund in assessing the likelihood that the pooled fund would later invest in a Covered Foreign Person.
  • Harmonization with the US Export Administration Regulations (“EAR”): The NPRM confirms that the definition of “knowledge” in the proposed regulations would be harmonized to the definition under the EAR.

• Extension of Covered Foreign Person to non-Chinese parents of Covered Foreign Persons: The NPRM has retained a notable extraterritorial (i.e. outside of China) extension to the definition of Covered Foreign Person, to include non-Chinese parents located in third countries (including the United States) that:
  • (i) Hold a “specified interest” (e.g., voting interest, board seat) in a Person of a Country of Concern (i.e., China) engaged in a Covered Activity (e.g., development of electronic design automation software for the design of integrated circuits, in the case of a prohibited transaction); and
  • (ii) Draw more than 50 percent of the parent’s revenue, net income, capital expenditure, or operating expenses attributable to the Person of a Country of Concern engaged in a Covered Activity. (Treasury intends the threshold analysis of any of the aforementioned financial metrics to be evaluated independently rather than in combination.)
  • This rule also applies in the aggregate for parents holding “specified interests” in more than one Person of a Country of Concern engaged in a Covered Activity.

• Notifiable and Prohibited Covered Technologies:
  • Standardized definition of AI: Subsequent to EO 14105, the US President issued EO 14110, “Safe, Secure, and Trustworthy Development and Use of Artificial Intelligence.” The NPRM incorporates EO 14110’s definitions of AI and AI system into the proposed regulation’s definition of “AI system” which is:
    • (a) A machine-based system that can, for a given set of human-defined objectives, make predictions, recommendations, or decisions influencing real or virtual environments—i.e., a system that uses data inputs to:
      • Perceive real and virtual environments;
      • Abstract such perceptions into models through automated or algorithmic statistical analysis; and
      • Use model inference to make a classification, prediction, recommendation, or decision.
    • (b) Any data system, software, hardware, application, tool, or utility that operates in whole or in part using a system described in (a).
  • Prohibited Covered Technologies: The proposed regulations anticipate the below technologies to be within the scope of Covered Technologies that would trigger a prohibited transaction:
    • Advanced integrated circuit design and equipment:
      • Developing or producing any electronic design automation software for the design of integrated circuits or advanced packaging would trigger a prohibited transaction, where “advanced packaging,” “develop,” and “produce,” are further defined the proposed regulations.
      • Developing or producing (i) certain front-end semiconductor fabrication equipment designed for performing the volume fabrication of integrated circuits, (ii) equipment for performing volume advanced packaging, or (iii) other items designed exclusively for use in or with extreme ultraviolet lithography equipment.
    • Advanced integrated circuit design and production: Prohibited Covered Technologies include designing any integrated circuit that meets or exceeds certain advanced technical thresholds identified by the Commerce Department’s Bureau of Industry and Security, or integrated circuits designed for operation at or below 4.5 Kelvin. The term would also include (i) the fabrication of advanced integrated circuits that meet the technical criteria specified in the proposed regulations and (ii) the packaging of any integrated circuit using “advanced packaging” techniques.
    • Supercomputers: Developing, installing, selling, or producing any supercomputer enabled by advanced integrated circuits that can provide a theoretical compute capacity of 100 or more double-precision (64-bit) petaflops, or 200 or more single-precision (32-bit) petaflops of processing power within a 41,600 cubic foot or smaller envelope.
    • Quantum computers and components: Developing a quantum computer (as defined in the proposed regulations) or producing any of the critical components required to produce a quantum computer such as a dilution refrigerator or two-stage pulse tube cryocooler.
    • Quantum sensors: Developing or producing any quantum sensing platform designed for—or which the relevant Covered Foreign Person intends to be used for—military, government, intelligence, or mass-surveillance end uses.
    • Quantum networking and quantum communications systems: Developing or producing any quantum network or quantum communication system designed for—or which the relevant Covered Foreign Person intends to be used for: (1) networking to scale up the capabilities of quantum computers; (2) secure communications, such as quantum key distribution; or (3) any other application that has military, government intelligence, or mass-surveillance end use.
    • AI systems:
      • AI systems designed to be exclusively used for—or which the relevant Covered Foreign Person intends to be used for—any military end use or government intelligence or mass surveillance end use.
      • In addition to the above end use-based control, Treasury is seeking comment on potentially (i) defining a set of technical parameters for controlling frontier AI models, (ii) controlling AI systems that are trained using a certain quantity of computing power, and (iii) any AI system that is trained using a certain quantity of computing power using biological sequence data.
    • Incorporation of US government restricted party lists and escalation to prohibited transaction: Any Covered Transaction (whether notifiable or prohibited) is rendered prohibited when it is with or involves a Covered Foreign Person listed on any one of several US government lists specified by the proposed regulations (e.g., the Entity List, the Specially Designated Nationals and Blocked Persons List).
  • Notifiable Covered Technologies: The proposed regulations anticipate the below technologies to be within the scope of Covered Technologies that would trigger a notifiable transaction:
    • Integrated circuit design and production: The proposed regulations include the design, fabrication, and packaging of any integrated circuit that is not covered by the definition of prohibited transaction, above. The proposed regulations separately define the terms “fabricate” and “package” for clarity.
    • AI systems: AI systems that trigger a notifiable transaction include the development of an AI system (i) not covered by the scope of a prohibited transaction and (ii) that is:
      • (1) Designed to be used for any government intelligence or mass-surveillance end use or military end use;
      • (2) Intended by the relevant Covered Foreign Person to be used for cybersecurity applications, digital forensics tools, penetration testing tools, or the control of robotics systems; or
      • (3) Trained using a quantity of computing power greater than a certain level of computational operations, the level of which is currently being assessed by Treasury between three alternatives identified in the proposed regulations.
      • Treasury has also stated that it is interested in considering further modifications (e.g., how to account for specialized AI models trained on high-quality data that could require a lower amount of computer power).
    • No quantum notifiable Covered Technologies: Although EO 14105 grants Treasury the authority to designate subsets of quantum information technologies that would trigger a notifiable transaction, the proposed regulations currently do not do so.
• Miscellaneous Features:
  • No de minimis transaction: In response to ANPRM comments, Treasury has considered a general de minimis threshold under which a transaction would not prohibited or notifiable under the proposed regulations, and rejected a possible de minimis provision.
  • No illustrative Covered Foreign Person list: Commentors to the ANPRM proposed that Treasury issue an illustrative list of Covered Foreign Persons, an idea which Treasury declined to adopt, noting that such a list be subject to frequent change and would be underinclusive. Note however, that any Covered Foreign Person incidentally listed in certain US government restricted party lists and involved in an otherwise notifiable Covered Transaction would render the transaction a prohibited transaction.
  • Non-US persons transiting through the United States: Despite comments seeking Treasury to exclude non-US persons transiting through the United States from the definition of US person, the proposed regulations currently include such persons when they take action that could constitute a Covered Transaction (e.g., signing investment paperwork while transiting through the United States). Treasury added that such an occurrence would not be frequent and could reasonably be mitigated with advance planning.
  • Double-notification of Contingent Equity and Convertible Debt: The NPRM introduces the possibility that Treasury notification would be required twice in instances of convertible debt or contingent equity interests; notification may be required (i) at the time of acquisition of the convertible or contingent interest and (ii) acquisition of the equity interest itself. Treasury justifies this double-notification for purposes of enhanced information gathering and monitoring of contingent equity and convertible debt transactions.
  • Violations: The proposed regulations provide for:
    • Penalties: A violation would be subject to civil and criminal penalties up to the maximum amount set forth under IEEPA.
    • Divestment: The proposed regulations confer, as granted under EO 14105, power to Treasury to compel nullification, voiding, or divestment of any prohibited transaction.
    • Voluntary Self-Disclosure (“VSD”): The proposed regulations also envision a process by which US persons may voluntarily disclose conduct that may have resulted in a violation of any provision of the proposed regulations.

The NPRM calls for comments by August 4, 2024 to the proposed regulations, and EO 14105 does not set a fixed deadline by which Treasury must issue binding rules (whether in interim or final form). Nevertheless, the proposed regulations may be expected to be issued in binding form as early as the fourth quarter of 2024 or early 2025.