The lure of China's vast market and inexpensive labor is proving irresistible to foreign companies, despite continued regulatory uncertainty and bureaucratic red tape. China now sees approximately 200 cross-border M&A deals a year, a number that is expected to rise as foreign companies angle for a share of China's 1.3 billion consumers. But the complexity of China's regulatory environment continues to challenge dealmakers, and the speed of regulatory change can surprise even seasoned players.

The rules that may cause the most headaches are those adopted by the State Development and Reform Commission, or SDRC, and the State Administration for Foreign Exchange, or SAFE. Consider this hypothetical deal structure, typical of many transactions involving Chinese companies: A U.S.-based consumer products company acquires an interest in a Chinese consumer products company owned and operated by a Chinese resident. The business owner's remaining interest is transferred to an offshore company jointly owned by the acquirer, taking advantage of the flexible corporate law and tax advantages offered by the offshore jurisdiction.

Up until late last year, this structure could be accomplished without much uncertainty. New SDRC rules have changed that and, in the process, ignited a turf war between SDRC and the Ministry of Commerce, or MOFCOM, the sole authority with which foreign companies would interface prior to the new SDRC rules. The rules require that foreign investments involving "fixed assets" require "verification" from SDRC or its local counterpart. This is in addition to the existing approval needed from MOFCOM or its local counterpart. While the two authorities wrestle over their relative turfs, local interpretation and implementation of the SDRC rules vary from one province to another. Some local officials have ignored the rules altogether.

Compliance is further compounded by the ambiguity of certain provisions and the potentially unpredictable "verification" process. There's no shared definition of what should be considered "fixed assets," and it's not clear whether the term "verification" is different in substance from an actual approval. Finally, SDRC and its local counterparts are given discretion regarding subjective "verification" standards that, among other things, require projects to conform to the public interest and meet national economic and social development requirements.

Nonetheless, the consequences of noncompliance could be grave. The SDRC rules direct that agencies overseeing areas such as commerce, tax and foreign exchange withhold relevant certificates, licenses and registrations necessary for business operation. For foreign M&A players, it pays to pursue compliance even if local authorities may tell you to ignore the rules from Beijing. And within the legal framework, it's best to attain SDRC verification and MOFCOM approval at the local level. While the red tape is still thick, it's usually more efficient and predictable to deal with local authorities.

While the SDRC rules have changed the regulatory landscape, rules issued and revised by SAFE in the past 12 months could force the U.S. acquirer and Chinese partner in our example to abandon key aspects of the desired structure. The latest version of the SAFE rules require that a Chinese "domestic resident" involved in a cross-border M&A transaction register with a local bureau of SAFE. That's actually an improvement over SAFE rules adopted in early 2005, which required a Chinese resident to obtain approval from SAFE in Beijing. The bad news is that the latest version requires extensive disclosure of sensitive business information such as the shareholding structure, valuation and pricing, material corporate change, etc. It also requires a "Chinese resident" to bring back any foreign currency income from dividend distribution and capital appreciation to China within six months of receipt.

It's unlikely the rules from SAFE and SDRC will keep foreign investors away from China in large numbers. But savvy investors should know going in that complexity and a fast-changing regulatory environment await them at nearly every turn. - Yingxi Fu-Tomlinson

Yingxi Fu-Tomlinson is a partner in the Shanghai office of Kaye Scholer LLP, practicing primarily in the areas of mergers and acquisitions, joint ventures and private equity investment.

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