How a changing geopolitical climate is affecting licensing

Foreign companies licensing technology to China have entered a new ‘push me/pull you’ phase. China’s revised technology transfer regime, the country’s improving system for IP rights and tax incentives have helped to ‘pull’ foreign companies into the Chinese market to license to subsidiaries or unrelated parties.

At the same time, US regulatory and tariff considerations have emerged to ‘push’ these companies into third-country markets, where they may be able to manufacture products with lower duty rates if they qualify as being “substantially transformed” in that new country.

This article is the second piece in a two-part special looking at how an altered trade dynamic between the United States and China is changing the IP landscape. Part one, “Licensing intellectual property in a changing trade environment”, was published in issue 97 of IAM.

Liberalisation of China’s tech transfer regime

Chinese legal and policy reforms now provide increased flexibility for foreign licensors that are negotiating technology transfer transactions from overseas to China. These new laws and policies offer opportunities to restructure existing licence agreements and reduce some of the trade risks already noted. Chinese liberalisation efforts were accelerated in response to the 301 investigation into China’s forced technology transfer policies, including filing a World Trade Organisation (WTO) case regarding the country’s regulation of inbound technology transfers. The WTO case, which was filed by the United States, has now been suspended in light of the legislative reforms that China has made to its tech transfer regime. However, a parallel broader case filed by the European Union has not been suspended.

Among the changes to the regime is the elimination of the prior non-negotiable requirements in the Administration of Technology Import and Export Regulations (TIER), which require that:

• foreign licensors indemnify Chinese licensees against third-party risks;
• Chinese licensees own improvements to any transferred technology; and
• Chinese licensees have reasonable access to foreign markets.

Table 1. US/China licensing on the rise

There have also been legislative changes to improve the condition of tech transfers to China. The Foreign Investment Law now mandates that technology transfer cannot be made a condition of foreign investment approval. In addition, amendments to the joint venture regulations have abrogated provisions that required ownership by Chinese joint ventures of technology licensed to the joint venture by a foreign party after a 10-year period had elapsed. Other legal changes have also facilitated tech transfer to China, including a reduction of the negative list of prohibited investments and the opening up of certain sectors of the Chinese economy (eg, new energy vehicles) to majority or exclusive foreign investment. Finally, there remain tax incentives through tax credits and the recognition of ‘high and new technology enterprise’ status to transfer technology into – or develop technology in – China. Taken together, these steps should serve to encourage further foreign technology transfers to China, as well as to promote technology development there.

Previously, TIER extended to a range of activities including for-profit licensing, non-profit licensing, scientific collaboration and open source licensing. The indemnity requirement was particularly problematic for smaller start-ups seeking to license their technology to large Chinese companies, particularly in litigation-dense areas such as telecoms technology. The impact on non-profit licensing was documented in an appendix to the 301 report, where the University of California, Berkeley stated that it had declined to directly license technology to China because these requirements – particularly ownership of improvements – were inconsistent with standard practice at Berkeley, as well as the university’s mandate to promote the dissemination of technology. A Government Accountability Office report on clean energy research similarly highlighted serious concerns about the ability of the US government to own any improvements to US-licensed technology when research is conducted in China.

While TIER should no longer apply to newly negotiated licences, its retroactive impact is uncertain. The amendments do not require the invalidation of offending terms in previously concluded licence or collaboration agreements. It is also unclear how the Chinese courts and antitrust authorities will handle licensing practices that were previously considered illegal per se under TIER. What is more, many TIER provisions are consistent with China’s emerging practices under its anti-monopoly law regime.

US-China licensing is changing

It is important to recognise that technology licensing is also a relatively small part of bilateral trade. US technology exports to China amounted to about $5.6 billion in 2017. The low volume of US licensing revenue is a sharp contrast to China’s high-tech manufacturing prowess for technologies that likely required the acquisition of others’ technologies, including patents from the United States or other countries. One rough benchmark used by the USPTO was to compare the percentage of China’s share of high-tech exports with the percentage of its share of US licensing revenue. In recent years the gap has narrowed, although it still suggests that there is a large percentage of unlicensed exports. In 2016 China exported 22% of the world’s high-tech products, but only purchased 6.3% of US technology. Nonetheless, there is a shrinking gap between the two benchmarks. On a more positive note, the purchase of US technology in China grew from $246 million to $5.7 billion between 2004 and 2017.

According to US census data, the vast majority of US technology licences to China had historically been to related parties (eg, parent to subsidiary). Today, most Chinese licences involving payments to the United States are to unrelated parties. The turning point, which preceded the Trump administration’s arrival in Washington DC, may have been due to an improving IP environment in China, including an increase in SEP litigation, which began around 2016. As Chinese courts do not disclose settled cases, the exact number of SEP and SEP-related cases litigated in China in the past several years is difficult to determine.

Additional contributions to technology transactions may have arisen from the actions of several US and foreign companies exploring licensing Chinese technology in and outside of China, including through patent pools. A good example comes from Chinese mobile phone company Xiaomi. In 2017 Xiaomi joined several patent pools administered by pool-formation specialist Via Licensing. The pools related to mobile audio and long-term evolution data transmission. This brought Xiaomi into a group of patent licensees that use the pool’s bundled licence to pay reasonable royalties to patent owners without the high cost of individual negotiations or litigation. Joining pools is becoming more common for Chinese companies, including as patent licensors. Although a conventional form of technology/IP collaboration, it is noteworthy in the current trade environment for being low-key, effective and apolitical or potentially balanced among foreign and domestic licensors and licensees.

Chinese companies are also actively participating in standard-setting organisations (SSOs). In the much-discussed area of 5G mobile phone technology, companies such as Huawei have become major holders of SEPs. As with patent pools, participation in SSOs represents a crucial form of cross-industry, global collaboration. Holders of SEPs become stakeholders in important standard technologies, and these patents give them a claim on a portion of the royalties generated from the standard. Participation in patent-intensive standards groups represents a significant step forward in the IP-related sophistication of Chinese companies. These companies now participate at the highest levels in the crucial, high-stakes process of securing, enforcing and potentially profiting from standards-related patents.

Both Huawei and ZTE have been subject to US government scrutiny and Huawei was recently placed on the export control entity list. Under the terms of a recent relaxation of the original standards licensing policy involving Huawei, the US government appears to have recognised that patents themselves are disclosed documents and not subject to export control regulations when issued. Instead, the Bureau of Industry and Security has advised that foreign parties are prohibited from disclosing proprietary technology as part of the standards-development process without obtaining a US export control licence for US controlled technology.

China has also taken steps to help improve IP protection, which may contribute to higher IP valuations in the long run. These steps include:

• the establishment of a new national appellate IP court, which has jurisdiction over technology contracts;
• the relatively stable and liberal treatment of software, fintech and genetic inventions; and
• the continuing availability of injunctive relief without an eBay-type doctrine to limit the availability of injunctions.

The courts and legislative authorities have also taken steps to increase damages determinations through increased statutory or punitive (quintuple) damages. However, damages calculations still remain low.

China’s own data suggests a similar uptake in the monetisation of IP rights. Patent office data on assignments, licensing and pledging revealed 15,229 patent contracts in 2017 – an increase of 54.8% on the previous year, with transaction value increasing by 9.5%. Invention patents constituted 9,705 of those contracts – an increase of 64.1%. Invention patents constituted approximately 60% of the value of all patent transactions. However, we do not have detailed trade data from China’s Ministry of Commerce on cross-border licensing or the assignment of IP rights to compare with US census data.

Table 2. Percentage of US licensing receipts from unaffiliated entities

Licensing SEPs in China

The increase in unrelated party licensing transactions from the United States may be due to the waning of China’s historical antipathy towards foreign SEP assertions. The macro origins of this change likely stem from China’s increased potential as a contributor to newly emerging standards, such as 5G. Although neither the Patent Law nor the Anti-monopoly Law have been amended during this period, the changes have been reflected in other legal doctrine. On 26 April 2018 the Guangdong Higher People’s Court promulgated the Trial Adjudication Guidance for Standard Essential Patent Dispute Cases (the so-called ‘Guangdong Guidance’), which highlights some of this change in approach. The Guangdong Guidance adhered to the basic framework of the Beijing Higher People’s Court’s Guidance for Patent Infringement Determination 2017, which itself appeared similar to the basic framework set forth by the European Court of Justice in Huawei v ZTE, as well as in the recent decisions of Iwncomm v Sony in Beijing and Huawei v Samsung in Shenzhen. Taken together, these approaches embody a fault-based conduct-evaluation framework.

The Guangdong Guidance approach to determining fault on the part of a licensor or licensee is also establishing norms for companies at risk of being sued in Guangdong, which includes the innovation and high-tech manufacturing hot-bed of Shenzhen. For example, the Guangdong Guidance mandates that licensors of patents encumbered by obligations imposed by standards organisations to license on FRAND terms or similar must provide a notice to the implementer listing the scope of the patent right in accordance with “commercial practices and trading habits”. The licensor must also provide a claim chart to the implementer after the implementer expresses a willingness to enter into negotiations, and must not delay, make an “obviously unreasonable” licensing fee offer or engage in other obstructions or interruptions of negotiations without justified reasons. Taken together, this means that a prospective licensor must develop an approach that fully documents the reasonableness of its behaviour. Foreign licensors should consider having appropriate documents or other evidence of meetings notarised to satisfy Chinese evidentiary requirements, including providing written summaries of matters in contention, and ensure that significant evidentiary matters are not bound by confidentiality agreements or protective orders.

In developing Guangdong-consistent negotiating strategies, foreign licensors should carefully consider how the Guangdong and other courts consider concepts of licensor delay in light of the rapid growth in the country’s telecoms sector, short product cycles, the continuing growth of China’s economy and the use of shortened litigation timeframes by Chinese litigants to jump ahead of overseas litigation that may have been filed against them. On their face, the Guangdong Guidance also appears inconsistent with the spirit, if not the letter, of China’s civil procedure rules and practice, which permit the courts to indefinitely delay making decisions on foreign-related cases. Foreign companies now face a possible whipsaw of, on the one hand, being compelled to hurry up when they license or risk being accused of a lack of good faith and thereby losing the ability to enforce their rights, while, on the other hand, being forced to slow down when they litigate in China or risk being accused of delay if a Chinese plaintiff is able to convince a Chinese court that expeditious negotiation was reasonable in the circumstances. The guidance may not bind the newly established national Appellate IP Court, but it is likely to continue to be influential in its decision making and binding on Guangdong first-instance courts.

Litigation challenges for foreign parties

China’s rapidly growing and highly litigious IP environment may also pose challenges. According to the recent Supreme People’s Court report “Intellectual Property Protection by Chinese Courts in 2018”, Chinese courts heard 334,951 civil, administrative and criminal IP cases in 2018. This was a rise of 41.19% over the previous year – a huge volume and relative increase. First-instance civil patent cases increased by 35.53% to 21,699. Technology contract cases increased at a less rapid rate of 27.74% to 2,680 cases. Despite Guangdong’s efforts to establish norms for SEP litigation and improve the environment for IP commercialisation, the 2018 data suggests that it is not on track. Overall IP case filings did increase to 101,809 cases in Guangdong (up 37.42%). However, foreign-related cases constituted only 1,514 of this total – a rise of 12.71% and about 1.5% of the IP docket. Nonetheless, anecdotally, many foreign companies seem to be more interested in litigating cases in China than in prior years.

The improved environment for technology licensing may help to mitigate some of the other challenges that foreign tech companies face from US regulations and pressure on their supply chains. Foreign licensors should closely examine their licence agreements to ensure that they benefit from the flexibilities afforded by the new regulatory regime and investigate whether they should restructure their agreements with current partners in China or in third countries in light of disrupted supply chains and unstable tariff treatment for goods exported from China. The emergence of China as an important technology licensor may also facilitate new opportunities for collaboration through standardisation or the creation of patent pools.

Intellectual property and the disrupted supply chain

The imposition or threat of escalated tariffs on the auto, steel and aluminum industries around the world and on a wide range of goods from China, as well as threats to countries and regions such as Mexico and the European Union, may require companies to change supply chains in order to minimise potentially punitive duties. The relocation of supply chains from China is part of a technological restructuring or decoupling that threatens to have long-lasting implications and at this point appears to be linked to an increasing tide of technological nationalism affecting many countries. Indeed, many US companies had already begun the process of changing supply chains to reduce the impact of increased production costs in China and the punitive tariffs are now a further incentive. The renegotiation of licence agreements to minimise duties should be contemplated as part of that process.

Companies can reduce Chinese tariff risks in two principal ways:

• by relocating manufacturing from China to change the country of origin of the product; and
• by reducing the valuation of goods exported from China through adjustment of inputs into the manufacturing process, including IP-related inputs, to reduce the dutiable value.

Companies looking to derive benefits from restructuring supply chains using restructured licence agreements are more likely to produce products that are IP or licence intensive. In fact, there is a significant overlap between supply chain-intensive goods and IP-intensive goods. Professor of economics at the Australian National University’s Arndt-Corden Department of Economics and Crawford School of Public Policy Prema-chandra Athukorala has developed a list of components that are supply chain-intensive, which encompass the entire spectrum of manufacturing trade based on entries in the UN Broad Economic Classification Registry and the product list in the WTO Information Technology Agreement. When matched to the US Census Bureau, these goods encompass certain broad categories of imports, including office machines and equipment, telecoms and sound recording equipment, electrical machinery, road vehicles, professional or scientific instruments and photographic apparatus.

These broad categories correspond to two-digit Standard International Trade Classification (SITC) codes, notably 75 (office machines and equipment), 76 (telecoms and sound recording equipment), 77 (electrical machinery), 78 (road vehicles), 87 (professional or scientific instruments) and 88 (photographic apparatus). There is a significant overlap between these codes and the North American Industry Classification System (NAICS) code categories that the USPTO considers above the mean in its metric for IP-intensive products, such as NAICS Codes 334111 (electronic computer manufacturing), 334210 (telephone apparatus manufacturing) and 334511 (search, detection, navigation, guidance, aeronautical, aeronautical system and instrument manufacturing), which encompass SITC Codes 75220, 76411 and 7783. It would thus appear that many of the companies most likely to face supply chain disruptions may also have the opportunity to restructure their licence agreements in light of the changing trade environment.

Changing the country of origin of a product and licence agreements

A recent US Chamber of Commerce survey revealed that approximately 40% of respondents were considering relocating manufacturing to outside of China, with Southeast Asia the most preferred destination (25%). During the past year, Vietnam experienced a 40% increase in exports, equal to nearly 8% of its gross domestic product. Vietnamese data also showed that foreign direct investment rose by nearly 70% year on year in the first five months of 2019 – the highest such increase since 2015. The greatest share of this has been exports to the United States. In addition, the principal areas affected appear to be electronic goods, furniture and travel goods.

Under US law, an import is deemed to originate from an exporting country if it is wholly the product of that country and directly exported to the United States, or if materials and components from third countries have undergone a “substantial transformation” in the exporting country. Certain higher standards may apply under free trade agreements or preferential tariff arrangements. Under longstanding US case law, ‘substantial transformation’ generally means that components must be transformed into a product having a different “name, character or use” (Anheuser Busch v US, 207 US 556 (1908)). Unless manufacturers are careful, declaring these products as originating from a third country when there has been no substantial transformation in the exporting country could constitute customs fraud, with the imports viewed as originating from China despite the company having undergone an expensive relocation process. There are also significant incentives for whistleblowers to report on customs fraud.

According to longstanding customs practice, minimal changes in packaging or labelling in a third country are unlikely to result in the substantial transformation of Chinese-origin goods in a third country. Generally, of the three Anheuser Busch tests, a change in name is the least convincing to Customs or the courts. Establishing a so-called ‘screwdriver’ operation where only minimal processing is applied to imported components will also generally not suffice.

If products are subject to anti-dumping or countervailing duties, the US government may impose other restrictions in order to minimise the risks of circumvention of duties. In addition, different rules attach to determining the extent to which US technology used to manufacture products overseas is subject to US export controls.

Substantial transformation cases are highly fact-specific. In certain instances, however, migrating IP ownership may help. If a key component of a product is copied or embedded into a product (eg, software or cultural content), it may change the name, character or use of the product, and may result in the substantial transformation from a memory device to a cultural or business product. Similarly, if an essential component is manufactured in a country other than the country of final manufacture, the product may be deemed to originate from that country. Even if the software rights are not determinative in transforming the goods, the additional value added to the manufacturing in that country can help advance the argument for substantial transformation.

Reducing dutiable value

If relocation of manufacturing is not possible, a second strategy is to restructure IP ownership in China to reduce the valuation of the goods as imported. Companies that import goods from unrelated parties usually pay duties based on the ‘transaction value’, which is defined as “the price actually paid or payable for the merchandise when sold for exportation to the United States”, plus certain enumerated additions. Among those additions are ‘assists’, which are defined as “any royalty or license fee related to the imported merchandise that the buyer is required to pay, directly or indirectly, as a condition of the sale of the imported merchandise for exportation to the United States” (19 USC §1401a(b)(1)(D)). If these goods originate from China and are within the purview of the Trump tariffs, the royalties will be taxed at new duty rates established by the Trump administration. In such circumstances, a company may find it advantageous to restructure its IP rights to minimise the dutiable value.

One way to reduce assists is to conduct design work in the United States. The cost of design work conducted in the United States for manufacturing or 3D printing in China may not be dutiable as an assist. Licences to US trademark rights are also not considered assists, but are generally considered non-dutiable US selling expenses. Importers may therefore wish to ensure that trademark costs are not incorporated into the price paid for the merchandise. In appropriate circumstances, it may also be more advantageous to pay licensing fees directly to third-party licensors than to have the manufacturer incorporate the licensing fees into the costs of goods sold to an importer. This strategy may be helpful for IP and licensing-dense high-tech imports, and could help to support patent pools managed by third parties.

Assignment of IP rights to the US importer rather than payment of running royalties to a Chinese manufacturer may also, in appropriate circumstances, eliminate the assist if the payment is not considered to be a condition of sale. However, assigning IP rights to a Chinese entity is not without risk. Royalty payments would likely incur a 10% withholding tax rate under relevant US-China tax treaties and practice. Transferring the intellectual property outright to a Chinese group may lead to complex transfer pricing implications, potentially requiring more of a multinational’s profits to be booked in Chinese entities. There may be other considerations as well, such as tax incentives available in China for ownership of core intellectual property for high-tech enterprises. In the end, the accountants we spoke to suggested that commercial considerations will likely prevail over tax considerations.

Software licensing can also offer opportunities to revalue products. If the software is not sold with the medium, but rather the customer is granted only a right to use, it may not be factored into the valuation of the product. In certain instances, imported embedded software products may also be valued based on the carrier medium only, rather than the software.

Customs laws and regulations regarding these valuation assists are quite complicated and will require the assistance of experts in customs valuation. It may be necessary to obtain a ruling from customs authorities to ensure that the country of origin is accurately declared and that valuations declared on entry into the United States that incorporate IP rights held by foreign parties are accurately reported to reflect the price actually paid or payable. Customs’ overall approach is to ensure that the fair value of a transaction between unrelated parties is dutied. At the same time, US design and engineering work is generally exempt from duty calculations, as are US selling costs (eg, trademarks). However, even if there is certainty at the time over the valuation of the imported goods, these valuations may change according to market circumstances and will need to be periodically re-evaluated.

With the reform of TIER and other Chinese technology investment laws, there may be an opportunity to restructure licence agreements. Transferring IP ownership from the manufacturer to a third-country partner or the importer may be considerably less expensive than moving hard manufacturing operations. If the transfer of the technology or a key high-tech component helps to contribute to the creation of a substantially transformed article, it may enable that article to qualify for a non-Chinese country of origin. Given the IP density of many products in the international high supply chain and the relaxation of China’s licensing regime, there may be numerous opportunities to restructure licence agreements in order to minimise costs and reduce regulatory uncertainties through coordination among advisers in Customs, trade, tax and intellectual property.

Separate from these foreign efforts to restructure supply chains in China, Chinese companies are also looking to relocate some of their industrial operations to countries that are part of the Belt and Road Initiative. In addition, US companies may be seeking to restructure their sales to China in order to minimise Chinese tariffs on US imports. Different countries also have different taxation and customs regimes that can affect the ultimate value of any restructuring. Customs concepts of ‘substantial transformation’, ‘transaction value’ and ‘assists’ will vary from country to country and should be taken into account when addressing global exports.

The imposition or threat of imposition of high tariffs on Chinese-origin goods, as well as on goods originating from other countries, is forcing companies based in China that export to the United States to reconsider their supply chain structure. My recommendation is that companies weigh all competing considerations before developing an expensive new supply chain. In the interim, they may also wish to consider ways to reduce the valuation of goods being directly imported from China and to leverage the increased flexibilities afforded by China’s tech transfer regime to restructure their licensing arrangements.

Implications for IP owners

There are a number of steps that rights holders can consider to mitigate new export control risks, as well as risks to their supply chain. Many of these involve restructuring intellectual property. The new technology transfer regime in China may provide an opportunity for revising existing processes to create a more optimised licensing arrangement that reduces trade-related risks.

At Berkeley, we are actively engaging with a range of companies that depend on licensing as a key component of their business model, to better determine how to adjust to the rapidly changing bilateral environment. We look forward to hearing more from the industry and the non-profit sector on these issues.

The author is grateful for the advice and assistance of Philip Rogers, Joyce Guo and Robert Merges of UC Berkeley, Jeannette Chu of PwC and Conrad Turley at KPMG, as well as the many friends and supporters of the Berkeley Center for Law and Technology, Asian IP Project, for their comments and questions on various aspects of this article, including their participation in the 10 April 2019 programme on Practical Issues in CFIUS and Export Controls at Berkeley Law School.