High- and New-Technology Enterprises: Updated Preferences, Qualifications and Trade-Offs

The key documents implementing these changes, issued on April 14 with effect from January 1 2008, are the following:¹

• High- and New-Technology Enterprise Assessment Administration Measures (the Measures), and

• Catalogue of High- and New-Technology Industries Specifically Supported by the State (the Support Catalogue).

Foreign investors' evaluation and implementation of HNTE establishment and related structuring and activities will also be affected by:

• separate continued support for software and integrated circuit (IC) industries, and

• income tax and business tax exemptions for joint research and development activities and other cost-sharing arrangements.

Levelling the Playing Field

Foreign ownership is being phased out, and geographical location is being reduced, as a factor in tax preference qualification. Corporate income tax preference opportunities, which were previously available to the many foreign-invested enterprises (FIEs) which qualified as “production-oriented”,² are now limited mainly to HNTEs – whether foreign-invested or domestically-invested. The Shenzhen, Zhuhai, Shantou, Xiamen and Hainan special economic zones, and the (Shanghai) Pudong New Area (the Special Zones), which previously granted indefinite preferential income tax rates to FIEs, now only grant additional preferences to HNTEs.

Remaining Income Tax Preferences

Rather than the current standard corporate income tax rate of 25%, a HNTE enjoys a rate of 15% and, if located in a Special Zone, enjoys (for profits generated from business operations within any Special Zone) a two-year income tax exemption and a three-year preferential rate of 12.5%,³ starting from the first “revenue generating” year.⁴

Supported Sectors

The “supported” industrial sectors in which an enterprise can qualify for HNTE status now expressly include the service sector for the first time and have been reorganized and made more detailed, with 51 categories and 218 activities specified in eight sectors. (See Table 1 showing comparisons between sectors in the 2008 Support Catalogue and in the previous version issued in 2000.) The changes are an indication of changing development priorities, with the most dramatic change being the addition of “high-technology services”, a sector which is of increasing importance to PRC economic planners.

Table 1

Grandfathered: Software Production, IC Design and IC Production

Outside the general framework set out above, a separate circular⁵ has preserved all preferences for the software production, IC design and IC production industries that were introduced under the pre-2008 income tax law, including income tax exemption for VAT rebates, “two-year exemption and three-year half-rate reduction” income tax holidays commencing from the first profit-making year, other income tax rate reductions, training expense deductions, accelerated depreciation and reinvestment refunds.

Intellectual Property Rights Ownership; Joint Development

The most fundamental change under the Measures is their general requirement that “core intellectual property rights” (relating to critical core technology for “main products or services”) must be under a HNTE's ownership. Certain non-ownership arrangements may be “otherwise permitted” (at the discretion of the relevant authorities), and one specified exception is that a HNTE may hold merely an exclusive license with a term of at least five years. The required geographical scope of this exclusivity is not specified in the Measures. (The word “worldwide”, which had appeared in a pre-promulgation draft, is omitted from the final Measures). But the door is open to requiring this exclusivity to be worldwide, which would result in substantial complexity and expense where the licensed intellectual property needs to be sub-licensed back to users in other jurisdictions.

The Measures do not address the consequences of intellectual property being jointly owned by a HNTE applicant and one or more affiliate or other persons. Such joint ownership is permitted by the PRC's laws governing patents and other intellectual property and has recently been encouraged by exemptions, from business tax as well as income tax, of cost sharing payments for the joint development and/or procurement of intangible assets, and for the joint provision and/or procurement of related services.⁶ This is particularly attractive in comparison with the tax treatment of reciprocal cross-licensing which, even if there is no cash consideration exchanged, is subject to taxation of the cash value of each intangible interest licensed by each party.

R&D Expenses

Research & Development (R&D) expenses of a HNTE must reach higher levels for smaller companies, must be maintained over rolling three-year periods, and must be incurred at least 60% inside the PRC.⁷ Such expenses must, as a percentage of revenue over the most recent three fiscal years (or over the enterprise's entire operating history if shorter), exceed the following sliding⁸ scale:

• 6% of revenue if revenue is below Rmb50 million;

• 4% of revenue if revenue is between Rmb50 million and 200 million; or

• 4% or (if located in a designated high- and new-technology zone) 3% of revenue if revenue is above Rmb200 million.

Potential applicants for HNTE status need to clearly document all potentially eligible expenses, and should also categorize them clearly. No definition of R&D expenses is specified in the Measures. The most detailed public indications of what types of expenses are likely to be eligible – and ineligible – are two circulars issued in 1996⁹ and 1999¹⁰ respectively. They indicate that ineligible expenses include those for the purchase or license of technology from other persons, and those incurred in performance of R&D activities under contract on behalf of another person. They also indicate that expenses are eligible if incurred on the following activities:

• new product design

• technology process formulation

• equipment testing and calibration

• trial-production of raw materials and semi-finished products

• technology books and materials (purchase or development)

• mid-stage experiments

• research employee remuneration

• research equipment depreciation

• joint R&D programs

• outsourced R&D

Revenue Source

Revenue of a HNTE must be derived at least 60% from high- or new-technology products or services.

Personnel Qualifications Extended

Employee qualifications now apply to all HNTEs (including the labour-intensive enterprises that previously enjoyed a relaxed standard).¹¹ Accordingly, each HNTE must have a workforce which is at least 30% comprised of science and technology personnel possessing at least college or university academic qualifications, and is at least 10% comprised of science and technology personnel engaging in research and development of high- and new- technology products or services.

Undefined Additional Requirements

More general (and still undefined) requirements will also be applied. The Measures state that a HNTE must have the management expertise to organize R&D, the capacity to convert R&D into products and services, a sufficient quantity of self-owned intellectual property rights, and a sufficient growth rate of sales and total assets. More details on these requirements will be specified in a Working Guideline for the Recognition and Administration of High and New Technology Companies, which is to be issued in the future.

Previously Qualified Enterprises

Previous HNTE qualifications will not be “grand-fathered”. Previously-qualified enterprises must make new applications and, until their HNTE status is confirmed under the Measures, must use the new standard income tax rate of 25% in their quarterly provisional income tax filings and payments.

Effects on Tax-Planning and IP Protection Strategies

Foreign investors assessing the effective value of qualifying a PRC subsidiary as a HNTE need to estimate the direct costs of satisfying qualification requirements, and the indirect costs of concentrating intellectual property ownership in a particular PRC subsidiary. The HNTE, in consideration for selling products, providing services and/or licensing intellectual property to related companies, must charge prices sufficiently high (under transfer pricing rules) to reflect the value of its intellectual property and other assets. The gross amount of most licensing and service fees will be subject to business tax (normally 5%), which (unlike the VAT applicable to most product sales) is not refundable or creditable to the payer.

Protection of intellectual property will also require updated strategies by those foreign investors that increase the quantity and value of R&D and intellectual property ownership inside their HNTEs or other PRC subsidiaries.

Trends

The above changes reflect the PRC's reduced need for foreign investment and an increased need to guide both domestic and foreign investment into particular sectors. The new regulatory structure permits relatively quick adjustments to reflect future changes the PRC may need. This points to a future in which foreign and domestic investors, intellectual property developers and technology users will increasingly need integrated and adaptable tax-planning and intellectual property strategies.

*About the Authors

Neal Stender is a partner in the Hong Kong and Shanghai offices of Orrick, Herrington & Sutcliffe LLP. Qingsong (Kevin) Wang is a senior tax consultant in the Beijing office of Orrick, Herrington & Sutcliffe LLP.

Endnotes

[1] Issued on April 14 2008, retrospectively effective from January 1 2008, by the Ministry of Science and Technology, the Ministry of Finance (MOF), and the State Administration of Taxation (SAT), after approval from the State Council, in a joint circular Guo Ke Fa Huo (2008) No.172.

[1] FIEs may still enjoy previously approved production-oriented preferences during a phase-out period of up to five years.

[1] “Half of the standard rate (of 25%)”.

[1] “First revenue-generating year” (“自取得第一笔生产经营收入所属纳税年度起”) is different from the “first profit-making year” (“自获利年度起”), which was the phrase used in the previous production-oriented income tax holiday, and continues to be used for income tax holidays for enterprises engaged in software production, IC design and IC production.

[1] See Caishui [2008] No.1, jointly issued on 22 February 2008 by the MOF and the SAT.

[1] See the Implementation Rules of the PRC Corporate Income Tax Law, Article 112; the PRC Corporate Income Tax Law, Article 41, and Guo Shui Han [2004] No.470 issued by the SAT.

[1] Expenses incurred in the PRC's free-trade zones will be counted, while those incurred in Hong Kong, Taiwan and Macao are not contemplated to be counted.

[1] Revenue during the most recent year will determine an enterprise's position on the sliding scale.

[1] The Notice on Accounting and Tax Issues Related to Promotion of Enterprise Technology Advancement, issued on April 7 2006, by the MOF and the SAT财政部, 国家税务总局关于促进企业技术进步有关财务税收问题的通知

[1] The Notice on Issues Related to the Deduction of Technology Development Expenses from Taxable Income for Foreign-invested Enterprises, issued on September 19, 1999, by the SAT. (国家税务总局关于外商投资企业技术开发费抵扣应纳税所得额有关问题的通知)

[1] The previous rules set a lower standard for labour-intensive companies, which only require 20% of employees to possess such qualifications.