Tech Transfer Turning Point?

By Thomas T. Moga

Concerns about training foreign competitors and losing trade secrets have tempered the drive for foreign companies to send their most advanced technology to China, but much of this resistance has to do with the reward itself. After considering what is at stake, many foreign companies often decide that the cost is not worth the relatively low royalty rate being offered by the future Chinese partner. Past examples have shown that advanced technologies in many sectors would likely flow into China if royalty rates were competitive enough to justify the risks.

Licensing practices in China

Until the last 20 years or so, little licensing activity occurred in China. China lacked sufficient intellectual property (IP) rights rules and regulations, and enforcement of existing rules was poor, deterring foreign investors from transferring technology. Though China still has a long way to go in terms of developing IP law and practice, the country is rich in licensing activity, with growth in domestic research and development helping to fuel the drive for increased licensing. Traditional forms of IP—including patents, trademarks, and copyrights—are subject to licensing.

China’s royalty-rate regulation

The PRC regulations on technology import and export administration, which took effect in January 2002, serve as the primary guide for importing foreign technology. When a foreign entity enters into a technology licensing agreement with a Chinese entity, the license arrangement is characterized as a “technology import.”

Compared with previous regulations, the 2002 regulations minimize restrictions on the types of technologies that can be imported and exported—namely those types that apply to Articles 16 and 17 of the PRC Foreign Trade Law. These articles allow China to restrict imports and exports to protect national security, public interests, “public ethics,” public safety or health, the environment, fissile or fusion materials, or weapons. (With specific reference to importation, the PRC government publishes a catalogue of prohibited and restricted technologies.)

Technologies not restricted by the 2002 regulations are “freely importable,” meaning that these technologies are subject to China’s contract registration system. A contract for importing such technology must still be registered with the PRC Ministry of Commerce (MOFCOM), which then issues a certificate of registration that takes effect “from the time when the contract is established according to law.” To obtain a certificate, a company must include a copy of the technology import contract and a document that certifies the legal status of the two parties in the contract, along with the application. MOFCOM’s foreign trade department—or a local commerce branch, if the technology import does not require central-level approval—will issue the contract within three working days from the date of receipt. The exporter may need to produce the certificate during transactions that involve foreign exchange, banking, taxes, and customs.

Royalty rates and caps

China has no formal rules or regulations that regulate—or limit—royalty rates for technology transfer. Instead, royalty rates are determined by the parties themselves, based on

• The duration of the contract;
• Whether the agreement is exclusive or non-exclusive;
• The complexity of the technology and how difficult it would be for the Chinese party to develop the technology; and
• The Chinese party’s experience and knowledge in the technical area.

In general, licensing royalty rates in China range from 0.5 percent to 10 percent, with most falling around 2 percent to 6 percent. For example, oil industry sales royalty rates range between 0.5 percent and 2 percent, while rates in the mechanical equipment industry generally range between 2 percent and 3 percent. In the auto industry, which includes vehicles and parts, royalty rates typically reach 4.5 percent to 6 percent.

Though China does not formally cap royalty rates, regulatory practice may still result in restrictions on the rates that a foreign company can set. For example, royalty rates must conform to national standards and competitive practices before they are approved. At best, regulatory practices raise questions and uncertainty about how much freedom foreign companies have when negotiating rates; at worst, they discourage foreign companies from sharing advanced technologies with their Chinese counterparts.

At least three features of China’s royalties system appear to restrict royalty rates. First, China’s tax authorities may limit the rates. For example, authorities have in the past limited royalty rates to 5 percent of revenue, according to KPMG LLP. Though a formal rule no longer exists, agreements with rates that exceed 5 percent may have more difficulty registering with relevant government authorities and be challenged by tax authorities.

Second, late last year the standardization administration of China released draft Administrative Measures for the Formulation and Revision of National Standards Involving Patents, which may force foreign companies to accept royalty rates lower than their ordinary commercial worth. Specifically, Article 9 of the draft measures would require patent holders to license technology at a reasonable and nondiscriminatory rate that is “significantly lower than the normal licensing fee,” raising concerns that companies may be forced to license their technology at arbitrarily defined thresholds. Though these measures have not yet taken effect, the adoption of such language could significantly affect foreign companies’ willingness to introduce technology into China.

Third, in some cases, domestic companies may accept royalty arrangements only if the royalties are below standard market rates. This is driven, in part, by the belief among some Chinese companies that foreign industries are “extracting” huge, seemingly disproportionate profits by their royalty demands. For example, one Chinese-language auto industry newsletter noted, “It is obvious that foreign firms acquire high profits by means of technological advantages.” China’s indigenous innovation drive may also, in part, reflect such sentiment. (For more on China’s indigenous innovation policies, see Domestic Innovation and Procurement.)

Licensing tips

To license technology successfully in China, the foreign party must understand local preferences. In general, Chinese companies prefer to own a technology rather than license a technologically advanced device or method. On the other hand, foreign business partners, cautious of China’s history of weak IP rights enforcement, have sought to retain control of certain aspects of their technology, often preferring not to disclose or transfer key information that contributed to the development of a technology.

Successful licensing also depends on the foreign party developing a good understanding of its industry’s commercial environment in China. The foreign party must conduct thorough research to understand the competition and its products or services, and identify which companies in that industry are succeeding or failing, and why.

In addition, a company should consider several aspects of licensing technology in China:

• PRC government approval  As previously mentioned, the foreign licensor must receive MOFCOM approval that the contract conforms with China’s standards and competitive practices.
• Taxes on royalties  A tax of 10–20 percent, depending on the technology involved and the existing applicable bilateral tax treaty, is withheld on royalty payments.
• Local ownership of technology innovations  Unlike in the United states, Article 27 of the 2002 PRC Regulations on Technology Import and Export Administration provides that “an achievement made in improving the technology concerned belongs to the party making the improvement.”
• No exclusive licensing  Article 29 of the 2002 regulations prohibits contracts from “restricting the receiving party from obtaining technology similar to that supplied by the supplying party from other sources or from obtaining a competing technology.”
• Other rules  China’s exchange controls, product liability laws, dispute resolution provisions, and other rules regulate the operations of foreign companies in China, and the potential licensor should become familiar with these rules.

In addition, foreign companies should remember that licensing—indeed, all IP—is still relatively new in China. Largely due to inexperience, potential licensees, many members of the judiciary, and local practitioners may still have a relatively undeveloped understanding of IP, licensing, or proper royalty valuation. A good licensing outcome for the foreign party will therefore require effective negotiations and a strong agreement. Effective negotiations are based on flexibility, good translations and translators, and a focus on the need to operate from a position of strength. Good agreements are the result of understanding the relevant IP, tax, and import and export laws, as well as other local rules and regulations that may apply; preparing an agreement with these laws in mind; and including carefully considered payment arrangements, term limits, audit terms, controlling language, and royalty rates.
Consequences of restricting technology transfer

If a technology cannot be transferred by agreement, or the transferee finds the proposed rate too expensive, the technology transferee has three choices:

• Develop the technology  This is typically not a viable option, because the Chinese company usually has an immediate need for the technology it is incapable of creating. The costs associated with developing technology can be considerable, and the foundation is complex. Technology development is a long process, rooted in the development of skills in a technical workforce at the university level and proceeding at all levels thereafter through continuing education. Technological advancement then requires continued development of expertise and skills based on further study and experience—a process that is fundamentally different from redeploying existing technology, manuals, and software.
• Forgo the technology  This unattractive option is unlikely to satisfy the company, unless it is willing to abandon future projects that would also use the needed technology.
• Acquire the technology illegally  Unfortunately, theft of trade secrets is a problem in China. Though it has been most common in the shipbuilding, semiconductor, and information technology sectors, instances of technology theft in other sectors are growing. For example, in 2007, nine people were indicted and five arrested in South Korea for selling vehicle-production technology to a leading Chinese automaker.

A new mindset

Chinese companies are focusing on advanced security systems and human resources management, and consequently calling for stricter treatment of those convicted of trade-secret theft. Though these are critical steps, past experience shows that China must first and foremost recognize that competitive royalty rates offer the proper balance between the Chinese company’s need to acquire advanced technology and the foreign company’s need to receive equitable compensation for its development costs. Not only does this require a change of attitude on the part of Chinese businesses, but it may also require a policy change. It would be wise for Beijing to recognize not only that advanced technologies come at a price, but that there will likely come a time when China will be a net exporter of advanced technologies, and its own companies will expect reasonable compensation for their technological developments.

Until then, China must still import the advanced technologies it needs. The sooner Beijing recognizes the value of honoring requests by foreign technology holders for competitive royalty rates, the sooner China’s technology-driven sectors will develop.

[box]

Royalty Rates as a Tool to Attract Foreign Investment

In the 1970s and 1980s, the governments of many developing countries capped royalty rates to protect domestic companies and encourage domestic innovation. Such practices generally proved counterproductive, however. Ceilings on royalty rates—along with transfer-pricing restrictions—were often set without regard to the actual worth of the technology or costs of recreating it. This ultimately deterred foreign companies from exporting superior quality and advanced technologies, depriving lesser developed countries from potential improvements in productivity, inflows of new capital, and income growth.

Brazil’s experience in the 1970s and 1980s illustrates this point. Acknowledging that the country was behind technologically, the government instituted policies that aimed to catch up with more advanced countries through self-reliance. In an effort to drive domestic development, Brazil capped royalty rates at 5 percent. Though the Brazilian government wanted to help domestic companies negotiate more advantageously with foreign companies, the result was that foreign firms avoided licensing their technology to Brazilian companies and went elsewhere. After years of failed attempts to develop advanced technologies domestically, Brazil still lagged behind the rest of the world. Other countries that offer unfavorable royalty rates in an effort to drive domestic innovation risk the same result.

Similarly, the Indian government at one time saw royalty avoidance as a way of building the country’s technology base. Dr. Pawan Sikka, who worked in India’s Department of Science and Technology, noted that Indian industries shifted in the late 1990s from importing technology to importing the technological products, “so as not only to obtain the tried and tested technology with a demand-market but also to avoid payment of royalty.”

In contrast, empirical data collected by professors of economics and finance Lee Branstetter, Raymond Fisman, and C. Fritz Foley in 2006 that compares foreign-company spending patterns on research and development indicate that “at least some component of increased royalty payments reflects increases in the volume of technology transferred and not merely increases in the price of technology.” A World Intellectual Property Organization (WIPO) study released in 2004 concluded that “[e]xploration of and greater emphasis on … ‘licensing in’ as a way to obtain access to new technologies is recommended.” Most participants of the survey, who formed the basis of WIPO’s study, concluded that intellectual property licensing was the best way for a developing country to acquire key innovative technology.
[/box]

[box]

Industry Snapshot: Restrictive Technology Transfer in the Auto Industry

Foreign auto companies have a long history in China. General Motors Corp. began exporting cars to China in 1922. Ford Motor Corp.’s initial foray into China was even earlier, with a small number of Model T’s exported there in 1913. More recently, companies brought vehicles to China that had little commercial value elsewhere. Today these same companies are introducing modern auto technologies.

Though Chinese auto companies are gaining knowledge about auto manufacturing and business practices, there is evidence that complete transfers of technology are not occurring. This may be seen by the absence of exports of independent Chinese-made cars to Europe or the United States. Generally, foreign cooperation has thus had a modernizing effect on the Chinese auto industry but has not resulted in any real independent product development. This is because foreign firms have not transferred these capabilities with their products.

Kelly Sims Gallagher, professor of Energy and Environmental Policy at Harvard University, has suggested foreign auto firms have transferred only a scattering of technology because of contradictory PRC policies regarding what is desired and what value can be offered in exchange. In 2003, she observed that

The extent of technological modernization has varied substantially among foreign automobile firms and across time. The best explanation for this variation is that Chinese government policies governing foreign investment in this sector have been wildly contradictory over the years, sending different signals to foreign and Chinese manufacturers alike.

China encourages technology transfer to achieve technological leadership, while also seeking to keep royalty rates low. If these two objectives could be brought into alignment, then this contradiction could be eliminated so that more foreign companies would be willing to transfer advanced technology to China.

Thomas T. Moga ([email protected]) is of counsel at Shook, Hardy & Bacon LLP, based in Washington, DC, and is registered to practice before the US Patent and Trademark Office.