Common Transactions in China

(I) Technology Transfer

(a) Introduction
China’s foreign investment policy has traditionally placed a strong emphasis on the transfer of technology to Chinese enterprises. Consequently, technology licensing has played and continues to play a major role in foreign investment projects in China. Applicable laws, regulations and administrative practices have also imposed some significant restrictions on the terms on which such technology can be licensed into China.

(b) Applicable Regulations
Prior technology transfer rules and regulations imposed certain onerous limitations on the contents of technology transfer contracts and required centralised government approvals. This approval/registration regime has been further streamlined post-WTO to the effect that many of the previously more onerous existing provisions and practices have been eliminated or further relaxed.

(c) Prior Technology License Terms
Under the prior technology licensing rules, without approval, a technology transfer contract was void. It was also not permitted to include any of the following restrictions or requirements:

(i) requiring the licensee to purchase related raw materials, parts, components or equipment from the licensor at prices exceeding international market prices;
(ii) restricting the export of products produced by the licensee utilising the imported technology; and
(iii) prohibiting the licensee from continuing to use the technology after expiration of the term of the contract (typically, not more than ten (10) years).

In practice, MOFCOM also imposed a cap on the royalty payable under a technology license contract. The general practice was to limit such royalties to not more than 5% of the licensee¡¦s net sales, although additional royalties could sometimes be obtained for separate famous trademark licenses.

On a more positive note, MOFCOM practice was less intrusive on items (i) and (ii) above, so parties had more flexibility in practice to control inputs and sales territories without interference by MOFCOM. On the other hand, MOFCOM routinely imposed its separate judgment on a myriad of commercial terms in a technology license contract, thereby requiring essentially a separate negotiation with MOFCOM on many matters not clearly restricted by the applicable legislation.

(d) New Technology License Terms
Fortunately, China agreed as part of its WTO market access undertakings to eliminate such intrusive approval practices as well as the license term limitations. Unfortunately, under the new PRC Technology Import-Export Management Regulations issued December 10, 2001 (“New Technology Regulations”), there is still some room for interference by MOFCOM personnel.

The New Technology Regulations provide for classification of technology as prohibited, restricted and permitted for import-export purposes. Prohibited technology cannot be imported or exported; restricted technology can be imported or exported only with approval and the issue of a license; and permitted technology can be imported or exported without approval, but registration is required. Since registration is necessary to support remittance of royalty payments under the license, it is important to determine how local COFTEC officials in the relevant local jurisdiction implement the New Technology Regulations as a practical matter.

The New Technology Regulations do contain an important improvement over the prior technology licensing regime in respect of the term of the license. Under the New Technology Regulations, the term is no longer strictly limited to ten (10) years and at the expiration of the license term the licensee no longer has the automatic right to continue to use the licensed technology on a royalty-free basis. This will permit evergreen license arrangements covering continuously updated technology within the scope of the license and will avoid the need to license only a current “snapshot” of the existing technology with all improvements thereto being licensed under separate contracts subject to separate rolling ten (10)-year license terms.

Under the New Technology Regulations, as under the prior licensing regime, the technology import license contract is required to include basic warranties regarding the rights of the licensee to the subject technology and the completeness and ability of the technology to achieve the stated objectives, as well as relatively standard IP indemnity provisions.

In addition, the technology license import contract is not to include any of the following provisions (which represents some improvement in some, but not all areas):

(i) improper tie-in arrangements, including requiring the purchase by the licensee of “unnecessary” technology, raw materials, products, equipment or services;
(ii) requiring the licensee to pay royalties or assume other obligations in respect of expired or invalid patents;
(iii) limiting the licensee’s ability to make improvements or use such improvements (and the intellectual property rights to such improvements made by the licensee are to vest in the licensee);
(iv) restricting the licensee’s right to obtain other similar or competing technology;
(v) “unreasonably” restricting the source of the licensee’s raw materials, components, products or equipment;
(vi) “unreasonably” restricting the licensee’s production volumes, product types or sales prices; or
(vii) “unreasonably” limiting the export sales channels of products manufactured using the licensed technology.

It remains to be seen how the above items will be implemented in practice by the relevant local COFTEC officials. Given the use of the qualifying terms “unnecessary” and “unreasonably” in items (i), (v), (vi) and (vii) above, these elements should be flexible enough that the current standard practice of deferring to the commercial agreement of the parties will be continued. However, the absence of qualifying terms in clauses (ii) and (iii) creates some uncertainty as to the position that will be taken as a practical matter by local COFTEC officials if the parties agree to terms inconsistent with these requirements. It is also possible that local COFTEC will be more intrusive in the approval context and less intrusive in the registration context, but this remains to be seen.

(II) Distributors and Value-Added Resellers

(a) “Buy Local” Trend
As discussed, the procedures for conversion of RMB, purchase and remittance of foreign exchange can be cumbersome. This is particularly true for cross-border service contracts. Consequently, many China-based customers, including FIEs, prefer to ¡§buy local¡¨ whenever possible in order to pay for goods and services in RMB. In addition, with the continuing crack-down on smuggling, some purchasers of imported goods have also opted to ¡§buy local¡¨ to avoid direct participation in the import process. Because of the time and expense required to set up an FIE to supply the goods or services on a domestic sale basis, many foreign companies have instead opted to appoint domestic distributors or sub-contractors.

(b) Trading and Distribution Requirements
The selection of a local distributor in China requires a 2-step analysis of import rights and distribution rights. Both import-export trading rights and wholesale and retail distribution rights have been tightly controlled in China.

Under long-standing pre-WTO policy in China, most domestic Chinese companies do not have direct import rights and so must purchase imported goods through a licensed trading company under a 3-party contract. FIEs, on the other hand, have import-export rights but these rights are primarily with respect to the purchase of components for their own use and the sale of their own products.

Controls over trading (import-export) rights have now been gradually relaxed over a post-WTO phase-in period. Instead of a handful of monolithic state corporations there are now several thousand domestic companies to choose from. All FIEs, which currently enjoy import rights, were granted export rights for third-party products sourced in China, commencing at the end of 2003. All domestic enterprises will be granted full direct import and export rights by the end of 2004. So, the prior trading restrictions will soon be eliminated completely.

However, trading rights are not the same as distribution rights. A party may import goods for its own use but not be licensed to distribute such imported products in China. Pre-WTO not all domestic companies and only a handful of trial trading FIEs were granted the right to distribute third party products on a buy-sell basis.

Moreover, prior to WTO, foreign investment in distribution enterprises was limited to the handful of trial trading FIEs. This will change as a result of China’s WTO market-access commitments, which provided that minority foreign-owned joint ventures were permitted to engage in distribution services starting from the end of 2002, majority foreign-owned distribution joint ventures were so permitted starting at the end of 2003, and distribution WFOEs will be so permitted by the end of 2004.

(c) Value-Added Resellers
If a manufacturing FIE does not obtain distribution rights, a separate distribution FIE may be set up. However, as an alternative a manufacturing FIE may be engaged as value-added reseller since the resulting product may be considered to have been ¡§made¡¨ by the FIE. The PRC government has yet to establish or enforce clear guidelines as to minimum value-added input criteria. For domestic companies it will still be necessary to confirm that the proposed distribution activity falls within its approved business scope as stated in its business license, although a domestic company with relevant manufacturing rights or a systems integration scope of business can also be engaged as a value-added reseller as described above.

(d) Security of Payment
Another critical aspect in selecting a distributor will be security of payment. The common practice is to require the distributor (or import-export company, as the case may be) to open a letter of credit drawable upon presentation of shipment documents. However, not all qualified distributors will have the financial capability to open a letter of credit. Even when they do, in some cases they may still insist on cross-border payment terms that match the domestic payment terms received from the local purchaser. This is an important issue that should be managed carefully.