18 January, 2013

This article will take a look at some of the key legal and regulatory issues entities face when negotiating arrangements with strategic partners in China, whether in the form of a simple standalone technology license, or as part of a more complex joint venture relationship, with particular regard to technology import rules, restrictions on foreign investments, intellectual property protection, and tax implications.

Many of the commercial issues that arise when negotiating strategic partnership arrangements in China are similar to those faced when contracting with strategic partners in other jurisdictions. However, 
China’s extensive and multi-layered regulatory regime can place significant fetters upon the structures and commercial accommodations that are commonly used to address those issues in other jurisdictions, and must be taken into account when contemplating any strategic partnership there.

Technology Licenses

Technology licenses, whether for patented active compounds, medical 
databases, or manufacturing knowhow, can be found at the heart of most cross-border strategic partnerships in the China life sciences sector. In some cases, the license is essentially the entire relationship; standalone commercial licenses under which the technology owner may earn royalties without the burden of establishing its own onshore business are commonplace. In other cases, the technology license forms just one aspect of a more complex relationship—for example, a joint venture in which the offshore technology owner takes an equity interest.

Restrictions on Technology Imports

As we noted in the last issue, one attractive and relatively unusual aspect of the Chinese market is the opportunity to marry Western products and technologies with Chinese partners and financial investment. Typically strategic partnerships in China will entail the import of existing core technology by the offshore partner, whether by way of license or assignment. While the import and distribution of APIs and finished products are typically tightly regulated in most countries, Western companies are often surprised by the extent to which the provision of underlying patents and know-how to China is also regulated. The import of technology into the PRC is primarily governed by the Regulations on Administration of Technology Imports and Exports, which came into effect on January 1, 2002 (the “TIE Regulations”). Technology imports are defined very widely and include, in addition to patent assignments and licenses, mere transfers of technical know-how and the provision of technical services. As such, the TIE Regulations will affect the vast majority of strategic partnerships for R&D in China.

The TIE Regulations divide technology imports into the categories of ‘prohibited’, ‘restricted’, and ‘permitted’. The first two categories are defined by reference to a catalogue later amended and maintained by the PRC Ministry of Commerce (“MOFCOM”). (The catalogue was initially published by the PRC Ministry of Foreign Trade and Economic Cooperation (“MOFTEC”) and the State Economic and Trade Commission in 2001.) Government approvals are required for the import of ‘restricted’ technologies, while, as the name suggests, ‘prohibited’ technologies cannot be imported into China. Any technology that is not included in either the ‘prohibited’ or the ‘restricted’ category is considered ‘permitted’. ‘Permitted’ technologies may be imported only by registering the import contracts.The TIE Regulations, together with the Administrative Measures for the Registration of Technology Import and Export Contracts (the “Administrative Measures”), impose several equirements upon the import of permitted technologies; these requirements can be particularly onerous on the offshore party:

• The import agreement must be registered with MOFCOM within 60 days of execution. Documents filed must be translated into Chinese if they were executed in English;
• The import agreement must include a warranty of IP non-infringement from the offshore party;
• The import agreement must include a warranty from the offshore party that the technology is ‘complete, correct, effective, and capable of accomplishing the agreed technical targets’; and
• The license agreement must not restrict the Chinese party from making improvements to the technology. The IP in any improvements the Chinese party does make will vest in the Chinese party by operation of law. 

Non-compliance with the TIE Regulations is fairly common, though typically this arises from ignorance of the existence of the TIE Regulations rather than from any party’s intention.

Although the TIE Regulations do not expressly set out any penalties (monetary or otherwise) that would apply to the licensor or licensee of ‘permitted’ technologies (with the exception of fraud), non-compliance may give rise to several adverse consequences:

• Difficulty Paying Fees. The Chinese party may not be able to remit license or service fees or other forms of revenue share to the offshore party, because to do so lawfully, the Chinese party must present its bank with a MOFCOM registration certificate for the import agreement.
• Possible Loss of IP Protection. The import of any technology under arrangements that are not in compliance with the TIE Regulations is unlawful. As such, if the PRC courts consider a technology owner to have been a willing participant in a violation of the TIE Regulations, they may decline to grant discretionary remedies such as injunctive relief against both the Chinese party and infringing third parties in China. Furthermore, the PRC authorities are likely to decline to take administrative action to protect unlawfully imported IP.
• Possible Loss of Contract Enforcement. It is unclear whether a contract that violates the TIE Regulations would be enforceable by the PRC courts. Certainly any non-compliant provisions regarding improvements would be void. Moreover, injunctive relief to restrain any ongoing breach would likely be unavailable (see above).
• Damaged Reputation with the PRC Government. A foreign company that is found to have violated the TIE Regulations is likely to face increased difficulty when applying for future permits and approvals from the Chinese government.

It is important to note that the TIE Regulations are mandatory and will apply regardless of the choice of governing law in the import agreement. However, strategies do exist for avoiding or mitigating the adverse impact of the TIE Regulations while avoiding the consequences of non-compliance. For example, it may be possible to structure the arrangements so that the technology is provided to an offshore joint venture or affiliate of the Chinese party, which then imports the technology intra-group, or to provide the technology via an onshore affiliate of the offshore party (so that the technology import stage is wholly within the offshore party’s group). We will explore these more complex structures in greater detail in our next issue.

Restrictions on Technology Exports

The TIE Regulations also regulate the export of technology from China and will apply to any assignment or license of patents and/or disclosure of know-how from the Chinese party (or onshore joint venture) to the offshore party. Accordingly, there is a catalogue specifying technologies that are prohibited or restricted for export, maintained by MOFCOM and the PRC Ministry of Science and Technology. Assuming that the exported technology does not fall within the catalogue, the Administrative Measures merely require that the export agreement (together with a Chinese translation) be registered with MOFCOM within 60 days of execution. The other requirements noted above with regard to import agreements do not apply to exports of technology.

Tax Implications

Under the PRC Enterprise Income Tax Law (“EIT Law”), license fees or other consideration payable by a Chinese licensee to a foreign licensor under a cross-border technology license is subject to Enterprise Income Tax levied on a withholding basis. The current tax rate applicable to technology licenses is 10% of the gross fees. Generally speaking, such license fees are also subject to a 5% PRC Business Tax, although certain types of technology transfer are eligible for an exemption from Business Tax. In some pilot locations, such as Shanghai and Beijing, Business Tax has recently been phased out and the scope of valueadded tax (“VAT”) expanded to include supplies previously covered by Business Tax. In Shanghai, for example, technology transfer services are part of the VAT pilot and subject to VAT instead of Business Tax. Depending on the annual turnover, a VAT taxpayer providing technology transfer services is subject to a VAT rate of 3% or 6%. (A VAT ‘general taxpayer’ has an annual turnover of more than RMB 5 million and is subject to a VAT rate of 6% in the technology transfer services. A VAT ‘small-scale taxpayer’ has an annual turnover of RMB 5 million or less and is subject to a VAT rate of 3% in all the pilot services.)  In addition, under the PRC Provisional Rules on Stamp Duty, technology transfer contracts are subject to PRC stamp duty, payable by each party to the contract at a rate of 0.03% or 0.05%, depending on the type of contract. (Under a notice on the imposition of stamp duty on technology transfer contracts issued by the PRC State Administration of Taxation in 1989, contracts for transfer of patent application or non-patented technology are subject to a stamp duty rate of 0.03%, and contracts for transfer of patent right or patent licensing are subject to a stamp duty rate of 0.05%.)

Technology transfer as a way of capital contribution to a Chinese company is not subject to PRC Business Tax. Technology licensing between two associated enterprises is often subject to close scrutiny by the Chinese tax authorities, however. Under the EIT Law, if a technology licensing transaction between an enterprise and its associated party does not comply with the arm’s-length principle and results in a reduction in the taxable income or revenue of either party, the tax authorities may make adjustments under China’s transfer pricing rules. Foreign companies are well-advised to retain adequate documentation justifying any transfer pricing if their royalty rates are set so high as to reduce the profits of their Chinese affiliates to a level unacceptably low to the Chinese tax authorities.More Complex Partnering StructuresRecent years have seen many offshore technology owners seeking more active participation in their Chinese partnering arrangements than can be achieved under standalone technology license arrangements. Such participation will often involve the establishment of a joint venture vehicle in which the offshore party can acquire an equity interest. This vehicle may be an onshore Sino-foreign Equity Joint Venture (“EJV”), or an offshore joint venture company that owns an onshore operating entity in China. Such arrangements give rise to several additional regulatory concerns on top of those applying to simpler license structures. 

Restrictions on Foreign Ownership

The ability of foreign-invested entities (“FIEs”—a term including both EJVs and wholly owned subsidiaries of offshore companies) to participate in Chinese industries is governed by the Industrial Catalogue Guiding Foreign Investments, now in its sixth edition, issued by the National Development and Reform Commission and MOFCOM in 2011 (the “Foreign Investment Catalogue”). The Foreign Investment Catalogue sets forth certain activities in which FIE participation is encouraged, restricted, or prohibited. Any activity that falls outside these three categories is generally considered to be permitted. There is no general prohibition on FIEs participating 
in the development, manufacturing, and distribution of pharmaceuticals or medical devices in China and indeed the manufacture of certain strategically important pharmaceuticals falls within the encouraged category of the Foreign Investment Catalogue. We highlight below the listings of some of the industries relevant to forming R&D strategic partnerships in the areas of pharmaceuticals and medical devices.

Restrictions on the Use of IP Assets as Capital Contributions

Capital funding rules in China are relatively inflexible. In order to acquire an equity interest in an EJV, the offshore party will need to contribute towards the 

registered capital of the EJV in proportion to its ownership interest. Many offshore technology owners wish to make their capital contributions in the form of technology and IP. While this is generally permitted, Chinese law and practice impose several key restrictions upon such contributions:

• First, the relevant regulations impose certain restrictions on the maximum proportion of registered capital which can be contributed in the form of noncash assets such as IP.
• Second, while registered IP such as patents and trademarks may be contributed with relative ease, the PRC authorities will not typically acknowledge contributions in the form of unregistered IP (such as copyright or know-how). This can be problematic for partnerships in areas such as manufacturing, in which much of the IP is in unregistered form. 
• Third, the PRC authorities will generally require that the IP be assigned to the EJV if the IP is to qualify as a capital contribution. A mere license will generally not suffice. While only the PRC rights need to be assigned, many offshore technology owners are uncomfortable with the inevitable consequential loss of control over the China IP.

For these reasons, offshore technology owners wishing to contribute technology in return for equity typically prefer to establish an offshore joint venture company that owns an onshore operating entity in China.

Regulatory Approvals and Licenses

In addition to any categorical restrictions imposed by the Foreign Investment Catalogue, the manufacturing and sales of pharmaceuticals and medical devices are subject to a variety of licenses and approvals in China, required at various stages of a product life cycle, including product registration, manufacturing, and distribution. We discussed some of these requirements in our inaugural issue of the China Life Sciences Newsletter in 2011, and briefly review them below. Note that these licenses and approvals are required regardless of whether the FIE activity falls within the encouraged or restricted categories. Therefore, those contemplating strategic partnerships in the fields of pharmaceuticals and medical devices at the product level are well-advised to be cognizant of these licenses and approvals.

In addition to the industry-specific advertising approvals listed above, the online trading of both pharmaceuticals and medical devices will generally require an Internet Pharmaceuticals Trade Certificate and a value-added telecoms license. Most FIES will not be eligible to apply for said license. Furthermore, in order to participate in the advertising of pharmaceuticals and medical devices, a company will need to possess a business license that includes advertising business in its scope. While relatively simple to obtain for purely domestic entities, FIEs must be able to demonstrate that their direct parent companies fulfill strict experience criteria in the advertising industry in order to be eligible to apply. 

Other Concerns

Technology Protection

In life science business transactions, IP is frequently the most important asset. For the IP to be valuable, it needs to adequately protect the technology and effectively exclude competitors from developing a similar technology or product. Full assessment of the value of IP requires not only a good understanding of IP law, but also deep scientific and industrial knowledge. In addition, considerations may differ significantly between China and other countries because the patentability standard is jurisdiction-dependent. For example, a patent claim directed to a medical procedure may be very strong in the U.S., yet may encounter significant patentable-subject-matter issues in China. On the other hand, a patent claim that may be deemed obvious in the U.S. may nevertheless be found sufficiently inventive in China. It is therefore important to involve IP attorneys knowledgeable about IP law both in China and offshore in the formation of any strategic partnership in China from a suitably early stage.

Dispute Resolution

It is common for IP licensors to insist that the license agreement be subject to the jurisdiction of the court of the licensor’s home territory. However, the PRC has entered into relatively few bilateral enforcement treaties with other jurisdictions, and consequentially offshore judgments are unlikely to be enforceable against Chinese parties in the PRC. Conversely, as China is a party to the New York Convention, overseas arbitral awards are generally enforceable in China. As a result, offshore licensors are well-advised to include clear arbitration provisions in their license agreements

 

For further information, please contact:

 

Thomas Chou, Partner, Morrison Foerster

[email protected]

 

Gordon Milner, Partner, Morrison Foerster

[email protected]

 

Can Cui, Morrison Foerster

[email protected]

 

Morrison Foerster TMT Practice Profile in China

 

Homegrown Telecommunications, Media & Technology Law Firms in China

 

International Telecommunications, Media & Technology Law Firms in China