Dealing with intellectual property (IP) in China according to an American Chamber of Commerce in China survey ranks among the highest priorities for multinationals in China.
The tax implications of IP planning are complex and they have been redefined by the new tax law in China, which became effective on January 1 2008. The law is brief (about 11 pages) and to clarify its implementation, State Administration of Taxation (http://www.chinatax.gov.cn/n6669073/index.html) (SAT), either independently or jointly with the Ministry of Science and Technology and the Ministry of Finance, have issued circulars.
Special legal considerations
A trade mark or patent has to be registered in China before it can be enforced. US registration is not sufficient. China adopts a first to file and not a first to use system. Even if you have been using your trade mark for several decades, the Chinese pirate who registers that mark in China first will own it and you may end up paying to get it back. Companies should register their brands comprehensively and as early as possible to avoid being taken by surprise. When registering trade marks, companies should register the English and Chinese versions of their brands.
Simultaneous international registration is possible. China is a signatory to the Paris Convention for the Protection of Industrial Property and the Madrid Protocol. You may make use of these international procedures to register your trade marks in several countries at the same time.
Viagra in China
Viagra is a case study in how a company can lose control of its own name in China. The vast majority of PRC consumers have a limited knowledge of foreign languages and will identify products solely by their Chinese name. If the company itself does not develop a Chinese mark, Chinese consumers will usually come up with a Chinese nickname. When Pfizer’s famous Viagra drug was sold in China, Pfizer used Wan Ai Ke as its Chinese brand. Pfizer then registered this mark and used this mark on its product packaging. However, the Chinese consumers and media popularly referred to the drug as Wei Ge (Big Brother). When Pfizer tried to register the Wei Ge mark, it discovered that a Chinese drug company called Guangzhou Welman had already applied to register the Wei Ge mark for its own drug (which has the same function as Viagra). Pfizer then sued Guangzhou Welman for trade mark infringement and unfair competition. In 2007, the Beijing Court held that Guangzhou Welman had registered the Wei Ge mark in accordance with proper procedures and were not liable for trade mark infringement. This judgment means that Pfizer does not own Viagra’s most commonly used Chinese name.
Starbucks protection of trade marks
The Starbucks case is a landmark case in which a Chinese court declared a foreign trade mark as a well known trade mark in the PRC. Starbucks had registered the Chinese transliteration of STARBUCKS (pronounced as Xing Ba Ke in Chinese). A Chinese company had set itself up as Xingbake and operated two shops in Shanghai. Starbucks sued Xingbake for trade mark infringement and sought to declare its registered mark as well-known. The court awarded judgement to Starbucks and ordered among other things, damages and the correction of the enterprise name against the defendant Xingbake.
Louis Vuitton and the patent-trade mark nexus
In China, there is a certain degree of overlap between trade marks and design patents. So you need to register product designs and packaging as trade marks and design patents at the same time.
In 2003, a Wuhan businessman named Wang Jun obtained a design patent for a handbag which featured four of Louis Vuitton’s registered trade marks. Wang subsequently offered to sell the design patent to Louis Vuitton for $17.5 million. In 2004, Louis Vuitton filed an action with China’s State Intellectual Property Office (SIPO) to invalidate Wang’s patent. The SIPO ruled that Louis Vuitton did not provide sufficient evidence and refused to invalidate Wang’s design patent. In 2007, Beijing Court ruled in favour of Louis Vuitton.
G2000 and comprehensive registration
An unusual feature of the Chinese trade mark regime is the use of sub-groups within a class of goods or services. As a result, you can own a trade mark covering “clothes” while another person can own the same trade mark covering “ties and scarves”. This will not happen in most other jurisdictions.
A Hangzhou businessman named Zhou Hua registered the trade mark 2000 for gloves, belts, socks and ties in 1997. A Hong Kong company named G2000 registered the G2000 mark for handbags and straps in 1997. G2000 set up shops in China in 2005 and sold clothes, bags as well as other fashion accessories. In 2008, Zhou successfully sued G2000 for trade mark infringement in Hangzhou, and G2000 was ordered to pay Rmb20 million ($2.9 million) in damages. This is the largest amount of damages that a court has ever awarded in a trade mark infringement case.
Weak enforcement of IP rights
There are three main types of enforcement measures in China and unfortunately none of them have much teeth to them.
(i) Administrative actions
This is the most common enforcement method. Such actions are carried out by administrative authorities such as the local Authority for Industry and Commerce (AIC) or Technical Supervision Bureau (TSB). These authorities have the power to confiscate infringing products and administer fines, but do not have the power to award damages. Administrative fines are usually low and are insufficient to deter offenders.
(ii) Civil litigation
Civil litigation is becoming increasingly popular among foreign companies as a method of protecting their IP rights. The remedies include injunctions and damages. Damages awarded in IP infringement cases vary from Rmb20,000 to Rmb500,000, depending on the seriousness of the infringement. Once again, the amounts are too small to deter.
(iii) Criminal enforcement
The third type of enforcement action is criminal enforcement for serious cases of IP infringement. Such enforcement actions are carried out by the Public Security Department (PSB). Criminal sanctions include criminal fines, imprisonment and confiscation of illegal products. Criminal actions are difficult to set in motion due to the high thresholds involved.
The new transfer pricing guidelines
China issued its basic transfer pricing regulations in 1998 in the form of Circular (Guoshuifa) 59. Ten years later in a landmark development, the State Administration of Taxation (SAT) is poised to issue “the Draft Administrative Guidelines on Special Tax Adjustments (draft guidelines) integrating transfer pricing, anti-avoidance controls, controlled foreign company (CFC) rules and financial reporting requirements. The draft guidelines, which are designed to take effect as of January 1 2008, are a transformational legislative event. They supersede past notices, affirm prior positions and introduce a set of new obligations. The guidelines elevate the level of compliance, complexity and risk facing overseas investors and are a wake-up call for those multinationals who had taken a laissez-faire approach to tax in China. The New Enterprise Income Tax (EIT) Law combined with a significant step up in audit activity presents a real challenge to a multinational hoping to introduce a new or higher royalty rate. In recent months, a number of taxpayers seeking to step up their payment of fees or royalties have run into headwinds and the question, “Why are you now changing your policy when your business is still the same?”
Challenges on paying royalties out of China
In China, the royalty issue is complicated by the following issues:
Non-trade remittances such as royalties and fees are subject to foreign exchange controls issued by the State Administration of Foreign Exchange (SAFE);
Historically there were caps placed by the Ministry of Commerce (MOFCOM) on payment of technology royalties – these are now lifted but registration is still necessary;
Because of withholding tax and business tax (BT) considerations, foreign invested enterprises (FIEs) in China have traditionally undercharged on royalties; and
Chinese tax authorities are unwilling to accept royalty payment in situations where a FIE earns below-benchmark profits.
Customs duties on royalties
Customs remains an issue in China although duty rates have declined dramatically since China joined the WTO in 2001. Duty rates remain high on consumer and luxury products. In China, the Customs bureaus have focused on trade mark royalties as a possible source of understating valuations. Thus, for example, the following royalty may be dutiable: A trade marked product (for example, a pair of shoes) is imported into China for $10 and resold as is but with the importer also paying a $5 trade mark royalty. Customs may insist on charging duties on the entire $15 valuation.
The General Administration of Customs Order No 148 in 2006 said that royalties that the buyer needs to pay directly or indirectly to the seller (or relevant party) shall be included in the dutiable value of imported goods, unless i) royalties are irrelevant to the goods; or iii) payment of the royalties does not constitute conditions for the goods to be sold within the PRC territory.
Chinese marketing intangibles
On September 11 2006, the biggest tax settlement in US history occurred and it involved transfer pricing. The Internal Revenue Service (IRS) found that the US subsidiary of GlaxoSmithKline (GSK) overpaid its UK parent company for drug supplies between 1989 and 2005, mainly its blockbuster drug, Zantac. GSK paid $ 3.3 billion back in taxes and counted itself fortunate because if the case had gone to court their total exposure was about $16 billion.
The SAT has often cited the GSK case and certainly this issue has particular resonance in China where many FIEs spend aggressively to create local brand names that are then owned by the parent. Shanghai may be the only city in the world where the taxi driver does not understand when your request to take him to the city’s most famous hotel (the Grand Hyatt) because he only knows it under its local name (Jin Mao Kai Yue).
Since the Chinese entity has taken the deduction the question arises whether the economic ownership of the local brand name is in China. Also, it should be noted that the SAT has often challenged royalty payments on the grounds that the local affiliates are spending heavily on marketing and so additional payments as royalties are not warranted.
Getting high and new technology tax preferences
Previously, reduced tax rates (for example, 15%) could be obtained in China by locating in one of the scores of tax zones or by securing export oriented or technologically advanced status. Now reduced rates and holidays will be extremely difficult to secure for any entity setting up in 2008. The main exceptions are provided under Articles 27 and 28 of the New EIT Law.
Sector holidays: Per Article 27 of EIT Law and Articles 86 to 90 of the detailed implementing rules (DIR) of the new EIT Law, five types of preferred sectors (for example, environmental, energy, conservation, basic infrastructure and agriculture) can get a six-year holiday (three years at zero and three years at 50% reduced rate).
High / New Technology Enterprises (HNTE) reduced rate: Per Article 28 of EIT Law and article 93 of the DIR, it is possible for HNTE to get a reduced tax rate of 15% subject to meeting certain conditions
To provide clarification, the Ministry of Science and Technology, the Ministry of Finance and the State Administration of Taxation jointly issued a circular, Guo Ke Fa Huo No 172 on April 14 2008 identifying the process to get HNTE status. The sectors identified are:
Electronic information technology (for example, software)
Biological and new pharmaceutical technology
Aviation and aerospace technology
New materials technology
High technology services
New energy and energy conservation technology
Resources and environment technology
High and new technologies for traditional industries innovation
Being in these sectors is not enough. To qualify entities should also own independent intellectual property rights of key technologies of their main products (services) gained through independent research and development, transfer, donation or acquisition in the recent three years, or through exclusive permission for over five years. There are also specified requirements as to minimum R&D levels. All in all, it appears that these incentives are going to be for local Chinese companies and not multinationals (a switch from the past).
Technology cost sharing – a new option
China in the past had no formal laws or regulations on technology cost sharing arrangements (TCSA) but the SAT did deal with TCSAs in Guoshuihan No 470 issued in the form of a reply to the Shanghai Municipal State Tax Bureau. The case concerned a European firm with a FIE in Shanghai which wished to participate in a CSA. SAT approved the CSA subject to the following stipulations:
China FIE should receive specified intellectual property ownership rights and benefits;
China FIE should not pay royalties; and
Evidence regarding the cost sharing pool and allocations must be provided.
The New EIT Law at article 41 specifically endorses cost sharing and more detail is provided in chapter 7 of the draft guidelines. Unfortunately, at this point there are still more questions than answers on how this will finally play out and investors should stay tuned. These cost sharing payments will be deductible but there is no clarification as to the withholding and business tax implications.
The SAT is clearly encouraging TCSAs since this is in harmony with the national goal of promoting more local ownership of technology. But this attitude may not be reciprocated by the foreign investment community. Multinationals may regard the TCSA as a double-edged sword and conclude that the tax benefits may not be sufficient to outweigh concerns about safeguarding the IP.
Knowledge, experience, connections
When it comes to IP, many multinationals discover they are not in Kansas anymore. Experiences gained elsewhere are a poor guide in finding the right strategy to protect and exploit IP in China. Local knowledge, experience and connections are important.
A broad-based approach is also recommended since commercial and tax considerations may conflict with the main goal of safeguarding the IP. Multinationals are most effective and creative in dealing with these issues when the team includes representatives from the legal, commercial and tax departments. Intangibles are the company’s crown jewels and their protection, commercial exploitation and tax optimisation demand special strategies – especially in a country like China which is emerging as the world’s economic superpower.
