Structuring Companies in China: Software Enterprises or R&D Centres?

The PRC government has introduced a number of policies in recent years to spur the development of the software industry. In 2000, the State Council issued the Encouraging the Development of the Software and Integrated Circuit Industries Several Policies(鼓励软件产业和集成电路产业发展的若干政策 ), which were followed by a series of implementing regulations issued by central and local authorities. In order for software enterprises to enjoy certain preferential tax treatment and other benefits, they must meet the following certification criteria as set out in the Certification Standards for and Administration of Software Enterprises Procedures¹ (the Software Certification Procedures):

(1) the enterprise must be an enterprise legal person established in China;

(2) the enterprise's business must be computer software development and production, system integration, application services and other related technical services, and it must derive its main business income from the same;

(3) the enterprise must have either (a) one self-developed software product or own the IP rights for one software product; or (b) supply or provide computer system integration technology services that have passed the qualification/grading certification;

(4) personnel engaged in the enterprise's software development and technical services must be no less than 50% of the total number of enterprise personnel;

(5) the enterprise must have the necessary technical equipment and site(s) for computer software development/technical services;

(6) the enterprise must have the means and capability to ensure the quality of the software products and technical services;

(7) the enterprise's R&D expenses for software, technology and products must exceed 8% of the enterprise's total annual software revenue;

(8) the enterprise's annual software sales revenue must exceed 35% of the enterprise's annual total revenue and the enterprise's revenue from the sale of self-produced software must exceed 50% of the enterprise's total revenue for software sales; and

(9) the enterprise must own its assets free of encumbrances, have standard management and be in compliance with PRC laws and regulations.

With the exception of item (8) above, the requirements for certification under the Software Certification Procedures are relatively vague and leave potential for the enterprise to lobby the relevant officials. Item (8), however, is clearly an objective standard that provides little leeway for manoeuvring. Requiring that the enterprise show annual revenue at specified levels also suggests that an application for certification will be delayed until the relevant figures can be gathered (presumably one year, if not longer given the potential lag time in getting sales rolling). The reader should bear in mind that prior to certification a software enterprise will not enjoy any relief from income tax or duties and VAT on imports. On the other hand, a software enterprise will likely not have any taxable revenue during its start-up phase and therefore availability of income tax exemptions may not be viewed as critical. If a software enterprise plans to import equipment and technology (including software) during the start-up, however, it will want to consider the potential duties and VAT that will be triggered by such imports.

Preferential Benefits

In the past, there was ambiguity under PRC law and in practice as to whether software enterprises were considered "service" or "manufacturing" enterprises for purposes of PRC tax liability. This distinction is particularly important for foreign-invested enterprises (FIEs) because the Chinese government offers manufacturing FIEs, with a term of more than 10 years, a full tax exemption from income tax for the two years commencing from the enterprise's first profit-making year, followed by a 50% tax reduction for the next three years.² These savings are significant considering that FIEs are generally subject to a national enterprise income tax rate of 30% and a local income tax rate of 3% (except for the lower income tax rate provided in certain locations).

According to the Software Certification Procedures, however, software enterprises, foreign-invested or otherwise, must now be certified by the appropriate software industry association to be eligible for these tax benefits. In other words, certification as a "software enterprise" is required for the enterprise to enjoy, for example, the tax breaks we are discussing. Lacking a certification under the Software Certificate Procedures, any analysis of the tax status of a software enterprise must therefore assume that the enterprise will be subject to standard PRC income tax rates and import duties.

In sum, in addition to the other benefits, the tax benefits enjoyed by a certified software enterprise are as follows:

- the enterprise income tax is fully exempted for two years followed by three years' half-reduction for a newly established software enterprise;

- starting from June 24 2000, to the end of 2010, the VAT portion that exceeds 3% (compared to the base rate of 17%) and paid for selling self-developed software products will be refunded to the software enterprise concerned;

- the salaries and training fees paid by the software enterprise may be deducted against the taxable income;

- business tax may be exempted for income from technology transfers, technology developments and associated technical consultations and services; and

- the imported equipment and the associated technology, spare parts or accessories may be exempt from the customs duty and import VAT.

OVERVIEW OF R&D CENTRES

Establishment

A foreign-funded R&D centre may be established as an independent internal department of an FIE, a branch of an FIE, or an independent R&D FIE. The Questions Relating to Foreign Investors Investing in and Establishing Research and Development Centres Circular³ (the R&D Circular) sets out the basic requirements for a foreign investor to establish an R&D centre.

The R&D Circular sets out the threshold requirements for setting up an R&D centre as follows:

(1) it must have funding of more than US$2 million (used for R&D purposes only);⁴

(2) a permanent site, equipment and other necessary conditions and facilities to support the proposed R&D work;

(3) specific R&D focus areas and projects; and

(4) full-time research and management personnel, of whom 80% or more must hold a college degree or higher qualification and are engaged in R&D activities.

Further to the R&D Circular and by way of clarifying its local implementation, in July 2000 the Shanghai government issued the Establishment of Research and Development Organizations by Foreign Investors Tentative Provisions (the 2000 Provisions). In 2003, Shanghai issued the Encouraging Foreign Investors to Invest in the Establishment of Research and Development Organizations Several Opinions (September 15 2003, the 2003 Opinions).⁵ It is worth noting that the 2003 Opinions relax some of the restrictions set out in the 2000 Provisions, thus bringing them more in line with the R&D Circular.

The 2000 Provisions generally require a nexus between the R&D centre's work and the relevant enterprise's business,⁶ while the 2003 Opinions allow and even encourage R&D centres to participate in the municipal government's important R&D projects, assume R&D work entrusted by other organizations, enterprises and individuals, conduct cooperation with other scientific institutions, universities and enterprises, or even open up its laboratory and experimental base to the society and provide services (presumably with fees).⁷

The 2000 Provisions state that R&D centres established as internal departments are not entitled to the preferential tax benefits otherwise available to R&D centres, while the 2003 Opinions do not have such explicit restrictions.

What causes confusion, however, is that the 2003 Opinions do not stipulate whether they supersede or repeal the 2000 Provisions. An informal consultation with the relevant Shanghai authorities reveals that the 2000 Provisions are still effective and should be used in conjunction with the 2003 Opinions; in case of conflict, the 2003 Opinions will prevail. As such, pending the explicit invalidation of the 2000 Provisions, it can be assumed that in Shanghai R&D centres in the form of internal departments may still be excluded from tax benefits available to other R&D centres. Nevertheless, in practice, local authorities may be flexible and willing to accord such benefits to these internal departments.⁸

Scope of Activities

Pursuant to the R&D Circular, R&D centres may carry out research, testing and development in the areas of natural sciences and related science and technology, including basic research, product application research, high-tech research and research for the public interest. The R&D Circular goes on to provide that R&D centres may transfer their "achievements in their own research and development" (generally referred to herein as R&D Products) and engage in cooperative R&D with domestic scientific research institutes by way of entrustment or joint development.

Further guidance as to what an R&D centre is permitted to do is supplemented by reviewing those activities that the R&D Circular specifically prohibits:

- R&D with respect to projects in which foreign investment is prohibited pursuant to the Foreign Investment Industrial Guidance Catalogue;

- technology trading not related to the R&D centre's own R&D products; and

- production activities other than interim testing to support the R&D activities.

The R&D Circular also confirms that training centres will not be deemed R&D centres, although the R&D Circular does not prohibit training per se.

Preferential Benefits

The R&D Circular provides that R&D centres may enjoy the following tax benefits:

- customs duty and import VAT are waived for equipment imported for internal use, within the approved total investment or for technical renovations and auxiliary technology, accessory and spare parts;⁹

- business tax is waived on income derived from transfer of self-researched and developed technology, technology development and associated technical consultations and services; and

- income tax is reduced where an R&D centre's technology development costs have shown an annual increase of 10% from the preceding year.¹⁰

Shanghai's 2003 Provisions also set out the following additional tax benefits:

- customs duty and import VAT are waived for royalties of the imported software;

- customs duty is waived for articles and certain household appliances brought into China by expatriate staff working in an R&D centre, subject to certain limitations;

- for an R&D centre established as an independent legal person, R&D expenses may be deducted against taxable income;

- fees and charges relating to land use and real estate transactions will be refunded or waived under certain conditions;

- multiple-entry visas or landing visas are available to foreign employees;

- certain technical and management staff, their spouses and children under 18 years of age can be registered in Shanghai as permanent residents. Other employees can apply for Shanghai municipal resident certificates;

- an independent foreign exchange account is allowed for special purposes for a R&D centre that is established as an internal department of an FIE;

- improved, convenient and efficient customs clearance services will be provided; and

- more effective protection of intellectual property rights will be provided to R&D centres.

Also, according to related policies in Shanghai, the R&D centre of a multinational company may be recognized as its regional headquarters in Shanghai, and may enjoy certain benefits in and of itself.

COMPARING SOFTWARE ENTERPRISES AND R&D CENTRES

Approval Procedures

An important difference between establishing a software enterprise and an R&D centre is their respective approval procedures. Specifically, the establishment and registration of a "pure" software enterprise - that is, a software enterprise without an R&D branch or department established in accordance with the R&D Circular - with a total investment amount under US$10 million or even US$30 million, is carried out at the district level in cities like Shanghai and Beijing, while the establishment of an R&D centre requires, according to the R&D Circular, provincial level approval and registration.¹¹

District level authorities tend to be much more flexible and efficient than their counterparts at the provincial level. One should anticipate that if a foreign investor wishes to establish itself as a software enterprise, the application can be approved fairly quickly, with a relatively broad business scope.

Capital Requirements

The establishment of a pure software enterprise is also not subject to the steep capitalization prerequisites necessary for establishing R&D centres. For example, while an R&D centre, established under the R&D Circular, must be funded with not less than US$2 million, software enterprises may be capitalized with as little as US$200,000.

Preferential Tax Benefits

As discussed above, a software enterprise, upon certification, may enjoy the "two years exemption and three years half-reduction" tax breaks on the enterprise income tax, as well as other tax benefits with respect to the business tax and VAT.

An R&D centre, however, will generally be subject to an income tax at a base rate of 33% (subject to reduced rates available in certain locations). Also, as "service" enterprises, they will not qualify for income tax breaks, except for those income tax reductions under certain conditions (as set out in the "Preferential Benefits Enjoyed by R&D Centres" section above).

A comparison of various tax benefits for software enterprises and R&D centres is given below.

CASE STUDY

Based on the foregoing, we now present a hypothetical situation and review the legal implications in turn. Assume that a company has three primary options for structuring its PRC entity:

(1) a software enterprise with an internal R&D department;

(2) an R&D centre; or

(3) a software enterprise with an internal R&D branch to be established in the future.

If the first option is chosen, certain implications stemming from relevant PRC laws and regulations will have to be understood, namely:

- under Shanghai legislation, internal R&D departments may be excluded from enjoying benefits otherwise enjoyed by R&D centres; and

- the R&D department must be funded with at least US$2 million.

If a company chooses the second option (establishing an R&D centre), the following points will have to be taken into account:

- the R&D centre will be considered a "service" enterprise and, as such, it will not be permitted to carry out general production or qualify for the significant income tax breaks available to manufacturing enterprises;

- it is ambiguous whether PRC law would permit a company to "convert" such a service entity into a manufacturing entity or expand the R&D centre's business scope to support its slated software/hardware production plans;

- the establishment of an R&D enterprise will trigger provincial-level approval that will, as noted above, increase the time and complicate the procedure required to get the PRC entity established; and

- the R&D centre must be funded with at least US$2 million.

Finally, bearing in mind the preceding comparison between software enterprises and R&D centres, establishing a software enterprise with an internal R&D branch to be established in the future may be the preferred option for a company. This approach will permit a company to have the best of both worlds: it can take advantage of the preferential polices and flexibility available to both R&D centres and software enterprises. First of all, a company can avoid, at least initially, the provincial-level approval and registration and thus have its PRC entity up and running relatively quickly. Such promptness is certainly advantageous for the company, as it can immediately begin carrying out business in China, finalize the lease arrangements for its office, and begin recruiting employees and developing its business. Second, initial capitalization can be relatively low, at least until the R&D branch is established.¹² Finally, the software enterprise can later establish an R&D branch - a move that will provide added flexibility in terms of its business scope.

The reader should recall, however, that even under this preferred option, the software enterprise will still be subject to two main concerns: (1) certification by the appropriate authorities before it can enjoy certain preferential tax benefits; and (2) that such certification may be delayed for a minimum of a year given the requirements concerning annual sales revenue as mentioned above in the discussion of software enterprise certifications.

The authors would like to thank Brianna Tom of their office for her contribution to aspects of this article.

Endnotes

1 Issued on October 16 2000.

2 Further details of these benefits are given in Article 73 of the PRC Foreign-invested Enterprise and Foreign Enterprise Income Tax Law Implementing Rules, promulgated by the State Council on June 30 1991 and effective as of July 1 1991.

3 Issued on April 18 2000. For a fuller discussion of the R&D Circular, see Tang & Bunnell, "Why FIEs Should Set Up an R&D Centre?" China Law & Practice, June 2000, 14(5), pp. 18-21.

4 See Article 4(2) of the R&D Circular, which requires that funds for R&D centres established as branches or independent departments be listed as a separate item in the relevant FIE's budget, and be accounted for separately.

5 Beijing municipal government also issued its regulations in 1999 and 2002 to encourage set up of foreign-invested and locally funded R&D centres.

6 The 2000 Provisions set out the following list of permissible activities for an R&D centre: R&D in respect of technology and products related to the enterprise; technology transfer in respect of R&D products; technical services and consulting related to the transfer of technology developed by the R&D centre; projects related to the enterprise co-developed with domestic research academies and institutions on a commission or joint development basis; and interim production of R&D items/projects related to the enterprise.

7 The Encouraging the Establishment of Scientific and Technological Research and Development Organizations in Beijing Provisions, issued on August 26 2002 by Beijing municipal government, also encourages R&D centers to open their laboratory or experimental bases to society and to provide reasonable services for fees.

8 The 2000 Provisions also impose the following additional restrictions on R&D centres that are established as internal departments of FIEs: they may not engage in any R&D not related to the relevant enterprise; the R&D work of internal departments must comply with "state industry policies" and the department must have the "necessary" conditions for the R&D work; no less than 10 personnel must be engaged in R&D work in the internal department and personnel engaged in R&D work in the internal department must not represent less than 80% of the total staff of the internal department; and R&D centres established as internal departments would also be subject to the catch-all "other conditions as may be imposed by the approval authority" provision.

9 Specifically the R&D Circular states in its annex that equipment imported for self use and auxiliary technology, accessories and spare parts (excluding products listed in the Import Goods Not Exempt from Taxation for Foreign Investment Projects Catalogue as well as vessels, airplanes, special vehicles and construction machinery), provided that they fall within the scope of laboratories or pilot testing of a smaller scale than that required for production, are exempted from import duty and tax. Where self-owned funds are used to carry out technological renovations, equipment for self-use and its auxiliary technology, accessories and spare parts that are imported within the business scope as originally approved in accordance with the General Administration of Customs, Import Tax Policies Relevant to Further Encouraging Foreign Investment Circular [Shu Shui (1999) No.791] and meet the conditions as set out above, are exempted from import duty and tax.

10 Subject to approval by the tax authority, 50% of the technology development costs actually incurred may be deducted against the taxable income for the then current year.

11 Under the R&D Circular, to establish an R&D centre as an internal department or a branch of an FIE, the application will be approved by the original approval authority for the establishment of the FIE, or the FIE must only complete a filing for the record with its original approval authority to establish an internal R&D department provided that the FIE's current business scope includes "research" and "development".

12 If an R&D branch is to be established, a company may want to consider including the mandated R&D US$2 million investment in its total investment amount so it does not need additional approval to increase its total investment/registered capital when it proceeds to establish the R&D branch. Under this structuring approach, a company should ideally only contribute the funds required for the software production and postpone contributing the R&D-related funds, subject to statutory capital contribution guidelines, until the R&D branch is established.