A China-U.S. Joint Seminar on Patent Licensing and Technology Transfer was jointly hosted by SIPO and USPTO at SIPO’s China Intellectual Property Training Center in Beijing on April 15, 2015. The focus of the program was on contractual and non-antitrust aspects of technology transfer. Program speakers included an economist discussing the economic reasons for licensing and current trends, an accountant on tax planning for licensing transactions, Chinese and American lawyers and officials, as well as wide spectrum of company representatives primarily in the IT sector, but also including the life sciences.
Here are my personal, general observations of the points made by the speakers:
To begin, speakers addressed difficulties in understanding the data on technology transfer. According to China’s Statistical Yearbook on Science and technology (2007-2014), the value of technology import contracts into China was 41.09 billion USD for 2013, nearly triple of what it was in 2005. Patent license fees accounted for 15.4% of the total and proprietary technology was 37.7%. Technology consultation and services were 29.7%. However, many speakers also noted the difficulty in collecting comprehensive data. Moreover, payment mechanisms such as extensive use of tax havens and transfer pricing in licensing technology further distorts data on bilateral technology flows.
Several speakers introduced the range of regulations in China affecting technology transfer. These regulations included the Contract Law, Technology Import /Export Regulations, rules on registering patent licenses, restricted areas of technology trade, license registration rules, and taxation rules.
Many foreign speakers expressed concerns about obligatory provisions of China’s Technology Import/Export Regulations (“Regulations”), including provisions regarding whether the foreign licensor needs to indemnify a licensee against third party infringement, as well as other provisions on grant-backs, no challenge clauses, etc. Article 24 of the Regulations was noted several time by Chinese and foreign speakers alike, including its conflict with article 353 of the Contract Law, which would give authority to negotiate indemnities if the contract did not involve a technology import into China. Several Chinese speakers thought that the Contract Law, as superior legislation, may govern any conflict between the two. However there were significant contrary arguments, including the fact that the Regulations were both more recent and more specific (I tend to side with this argument). Many felt that these Regulations were out of date and not suited to China’s current circumstances, particularly in light of China’s desire to become a technology trade player, as well as the difficulties of mandtory indemnity provisions in technology imports from start-up companies or in litigtion dense technologies (such as smart phones).
There was a general consensus of a need for more information on the impact of indemnity/grant back and other clauses on licensing transactions. The Regulations are a source of concern even if they are of uncertain legal impact. One speaker noted that the uncertainty caused by the Regulations had generated considerable legal work over the years. Some speakers noted that they thought it would be helpful if the courts provided additional guidance on the Technology Import/Export Regulations and the Contract Law provisions on technology contracts in order to achieve greater assurances about how best to structure technology transfer agreements.
A few speakers suggested that an appropriate strategy in handling mandatory indemnities is to conduct a freedom to operate analysis and negotiate risks, perhaps by reducing them to a liquidated amount in a contract. Another speaker thought that a way to bypass the warranty provisions of the Regulations is by arbitrating outside of China under New York or other foreign law. However, there was also concern expressed about whether arbitral decisions would still be governed by Chinese policy, or arbitral awards might not be enforced within China. Many speakers noted that choosing foreign law could lead to uncertain results. Moreover, if enforcement of some kind is needed in China, choice of foreign law may be sub-optimal as Chinese courts will not enforce foreign judgments and it will be impossible to obtain preliminary injunctions or other immediate relief. Note that I have discussed the issue about using foreign choice of law in technology transfer contracts elsewhere on this blog, as well as problems that arise if US law is used to enforce the contract in the United States.
Another proposal of a speaker at this program was, where possible, to change the cost of the technology to zero and place more value in to service contracts. However, one speaker thought this alternative also posed risks, including the possibility of being considered a joint infringer in the event a law suit is brought against the “licensee”/ purchaser.
The Regulations also appear to have an uncertain jurisdictional scope. One speaker mentioned that one way to avoid application of Chinese law is by licensing foreign technology to an overseas subsidiary of a Chinese company, and then having this company license the technology back to China. Another speaker suggested that transactions such as these might not be viewed as an import of technology into China which should be governed by the Regulations. At the same time, regulatory officials have viewed a transfer of technology within China by a foreign-invested company to a Chinese company as a technology import notwithstanding that the transaction occurred solely within China.
Speakers discussed difficulties in differentiating improved licensed technology which belongs to the licensee and the actual licensed technology under China’s mandatory grant back regime. Another source of concern was determining when the technology has caused infringement if the licensed technology was proprietary in nature and was to be maintained as a trade secret.
Judicial settlement agreements and covenants not to sue were also discussed as alternatives to license agreements. For example, under what circumstances when one settles a litigation would such an agreement no longer constitute a technology transfer agreement? Is a covenant not to sue not a technology transfer agreement? I had the opportunity to raise the question of whether the Regulations governed settlements of technology infringement cases of a senior Chinese judge at another conference – and the quick answer I received is that the answer is — unclear.
Speakers were generally optimistic about future prospects of enforcing audit clauses particularly in light of recent changes in China’s civil procedure law, judicial practices, and proposed changes to China’s patent law regarding production of documents and provisional measures.
Former Chief Judge Rader of the CAFC also provided a useful update on US case law involving no-challenge clauses, and smallest saleable unit as a basis for calculating damages. He noted that in fact in some cases he now believes the market value of the infringing product should prevail, although the SSU doctrine was originally of his creation.
The role of registering contracts with MofCOM or assignments with SIPO was discussed, as well as MofCOM’s continued supervision of contracts when it registers a contract. Several speakers also discussed an earlier MofCOM (or perhaps MofTEC) notice which established an “unoffical cap” of royalties equalling 5% of net sales. The experience of several speakers was that MofCOM will not say that there is a 5% cap, and that the contract needs to be “fair and reasonable.” One speaker thought that this unofficial cap was not necessarily a deal breaker, although there remains a persistent belief that 5% is fair and reasonable. This cap is of especial concern as data from the Licensing Executive Society suggests that average royalties for high tech sectors are 6%, and for life sciences about 5%.
Tax planning in licensing was also discussed, including indirect licensing from tax havens such as Belgium, Holland, Luxemburg and Ireland, as well as advantages to owning IP or technology locally in order to benefit from local Chinese incentives (such as High and New Technology Enterprise or R & D deductions). An accountant noted that transfer pricing is of increasing concern in China – imposing a burden on licensors and licensees to prove that a transfer is priced at fair value. It is likely that going forward third country licensors may not be able to obtain special incentives unless one controls and orchestrates the IP from the onward entity. Moreover, a State Administration for Taxation Announcement (no. 16) provides that if you are paying from China to an overseas entity and the entity just owns the legal rights but doesn’t conduct substantive activities, the tax deduction may be completely denied, and they will reopen 10 years of tax returns. This Announcement builds upon a previous announcement (146) of 2014.
China’s High and New Technology Enterprise program offers numerous incentives but also contains numerous restrictions, including regarding IP ownership, sufficiency of R & D conducted in China, and percentage of R & D of total turnover or percentage of profits derived from HNTE profits. An accountant noted that this deduction is of declining use due to aggressive tax auditing when the incentives are used. Moreover, there is a tension between transfer pricing and HNTE status. One speaker noted that changes to the HNTE program are due in 2015. This speaker noted that there is also an R&D super deduction is available, which is more readily obtained, but is also a strong audit risk. Another HNTE risk is that if a company is developing core IP further and your original IP is no longer necessary, one could lose HNTE status. Moreover, licensors may risk establishing a permanent establishment in China, particularly if the licensor is engaged in onshore trading.
All speakers and attendees I spoke with believed that this topic is nonetheless of increasing importance. One academic privately noted to me that she thought licensing was not adequately discussed in academia, and that there was not enough focus by industry and government. Attendees were also unanimous in wanting to see more programs of this nature going forward.
The preceding is an unofficial summary and should not be construed as a substitute for professional legal advice. I hasten to add that one should also seek a tax professional for advice on tax planning.
Update of May 4, 2020: Scott Kennedy of CSIS published a blog concerning US government data on licensing transactions with China. I completely agree with Scott’s suggestion that data such as this can be used to support a less anecdtoal approach to issues around IP licensing, including legitimate, forced and stolen technology. Difficulties exist in US government data, including the nomenclature used, the possibility of licensing through tax havens and avoiding direct payments to the United States by licensors, lack of clarity around defined categories related to technology such as what constitutes an industrial process or an affiliated entity, and how to evaluate other country’s data – particularly China. I also agree with Scott that when the increase is compared to China’s role as a high tech exporter, there appears to be a dramatic shortfall. Moreover, since US companies license their technology to China for global and not just local (territorial use), US licensing receipts should also account for sales from China to global markets in addition to the United States.