Tax Preference Guideline Provides Objective Scrutiny for High/New-tech Enterprises

The Working Guideline lays out a system that will provide potential applicants with clear information on the application content and format that are required, and a largely objective evaluation process, although its dispute resolution process remains vague and troubling. In view of these processes, it is only prudent for an HNTE application to be submitted by an enterprise that is able to withstand a sustained increase in scrutiny of its qualifications and certain other aspects of its operations.

Objective evaluation criteria and process

The most striking characteristic of the Working Guideline is that it goes to great lengths to achieve objective handling of applications. Key provisions include:

• examination by at least five randomly-selected experts, who are intended not to know the identity of the applicant, and who are required not to withhold different opinions;

• maximum reliance on objective numerical calculations;

• a clear hierarchy of applicable standards; and

• opportunity for the public to view online-published preliminary approvals and to raise objections.

Legal/tax compliance, merger/reorganization and seasonal fluctuations

Another striking characteristic of the Working Guideline is that it provides for heavy sanctions in a surprisingly broad range of events. The Working Guideline, with no further clarification, states (in Section (2) (4)) that disputes “will be resolved in accordance with the Measures” if they relate to the following:

• HNTE status will be cancelled for five years if the enterprise has a major safety- or quality-related accident, is punished for environmental violations or, unsurprisingly, if it engages in tax evasion or has submitted a false HNTE application (Article 15 of the Measures).

• Under Article 14 of the Measures, any merger or other reorganization that changes a HNTE's business, production or technology activities, so that it ceases to meet HNTE qualification requirements, will cause termination of HNTE status “beginning from that year” (apparently even if the change was implemented near the end of the year).

Partial-year fluctuations of expenses or income also appear to be a basis for terminating HNTE status, according to the Working Guideline's provision that disputes, on the ratio of qualified expenses to qualified income, shall be resolved through “verification of the ratio during the time period from the beginning of the qualification period and ending on the date the dispute arises” (Section (2) (4)).

Dispute resolution procedures

The Working Guideline fails to further clarify or detail the Measures general provisions on the resolution of disputes relating to HNTE status. One of the leading group's³ primary responsibilities is specified to be “deciding major disputes arising in the course of the recognition of HNTEs” (Article 6.3 of the Measures). But the Working Guideline does not indicate which categories or sizes of dispute might be considered “major”, or any timing, duties or procedures relevant to the local recognition authority's consideration of disputes or objections, including whether the reports of the first team of experts will be re-examined by the same team, a different team, or any team.

CRITERIA & CONCEPTS

The six categories of criteria for determining HNTE qualifications and related concepts, which were originally set out in Article 10 of the Measures, are covered by varying levels of additional detail in the Working Guideline, as summarized below.

R&D definitions

In order to implement the Measures' numerous provisions relating to the undefined phrase “research and development” (R&D), the Working Guideline (Section (4) (1)) defines:

• “R&D activity” as “ongoing activity to acquire new scientific/technological knowledge (excluding humanities and social sciences), to utilize the same in an innovative way (excluding normal upgrades or direct utilisation of scientific results), or to substantially improve technologies, products or services”; and

• an “R&D project” as “non-repetitious R&D activity with independent financing and personnel deployment, and limited time”.

Core IP definition

“Core intellectual property rights” (Core IP), which must be owned or exclusively licensed according to the Measures (Article 10.1), are further defined in the Working Guideline (Section (5) (1)) to include most types of registered intellectual property, other than certain design rights. Unregistrable know-how and trade secrets, although not countable as Core IP, can be used to satisfy other criteria such as “capacity to convert R&D into products and services” and “management expertise to organize R&D”.

Service industry applicants can benefit from national officials' verbal interpretations of certain questions that are left open by the Working Guideline and the Measures. Notably, a service enterprise can satisfy the Core IP requirement without owning IP relating to the items it delivers to customers, such as software. Instead, the requirement can be satisifed by owning IP relating to its services, in this case software development tools.

Impracticality of the IP licence alternative

Licences do not appear to be a practical alternative to HNTE ownership of Core IP, at least under current interpretations of the Measures. Although in theory a five-year or longer licence of IP could be substituted for ownership, in practice such a licence is unlikely to be feasible for most enterprises. One difficulty would be the large amount of paperwork, administrative costs and potential tax liability that could be entailed by creating licences over the separate registrations that often cover the same intellectual property rights in different jurisdictions. Another difficulty would be that customary multinational corporate operating structures would conflict with the requirements that such a licence be not only exclusive as specified by the Measures but also “worldwide” as specified in Section (5) (1) of the Working Guideline.

These combined requirements are now being interpreted, according to officials' verbal comments, as follows: No other person shall be permitted to use the IP in any jurisdiction, no foreign owner shall be permitted to retain a self-usage right, and no foreign affiliate or other person shall be permitted to receive a sub-licence from the PRC licensee. Under this prohibition, it appears that the only entities permitted to use the Core IP outside the PRC would be foreign branch-type entities of the PRC licensee. But establishing and operating such entitities in foreign jurisdictions would expose the PRC licensee to potentially onerous filing requirements, taxes, lawsuits and unlimited liability.

Numerical calculations of four required categories

The Working Guideline, in Section (6), details a highly standardized numerical approach to the four categories of requirements originally set out in Article 10.6 of the Measures. On a scale of 100 points, a successful applicant must obtain at least 71 points. Within each category, the maximum number of points that can be obtained is summarized as follows:

1. Through “Core IP sufficiency”, a maximum of 30 points by holding one core invention patent or six other⁴ Core IP items;⁵

2. Through “capacity to convert R&D into products and services”, a maximum of 30 points by newly using in production more than four scientific/technological achievements;⁶

3. Through “management expertise to organize R&D”, a maximum of 20 points by doing five of the following: formulating a project initiation report; establishing an accounting system; implementing combined production and R&D activities; establishing/installing the enterprises' R&D institution, facilities or equipment; or establishing an appraisal and award system for researchers' performance, and;⁷

4. Through “growth of sales and total assets”, a maximum of 20 points (10 points for the sub-category of sales and 10 points for the sub-category of total assets) by achieving an average growth at or above 35% in each sub-category.⁸

Eligible expense categories and accounting

In order to meet the requirement in Article 10.4 of the Measures that an HNTE must meet minimum ratios of R&D expenses to sales revenues, the Working Guideline sets out detailed definitions of eligible R&D expenses,⁹ and requires them to be recorded in “special HNTE recognition auxiliary accounting books”, in accordance with a sample spreadsheet format.¹⁰ This format is designed to facilitate not only the calculation of eligible internal expenses (100% creditable for the purposes of obtaining recognition) and external expenses (80% creditable for the purposes of obtaining recognition), but also the allocation of expenses to the categories of:

1. R&D personnel remuneration and related expenses;

2. direct expenses (including allocable overhead, excluding investment in fixed assets);

3. depreciation and long-term deferred expenses;

4. design expenses;

5. equipment testing expenses;

6. amortization of intangible assets;

7. payments to other persons for R&D services (separately listing payments to entities outside China); and

8. other expenses (generally limited to 10% of total R&D expenses).

Definitions of relevant personnel and income

The minimum ratio of science and technology personnel and R&D personnel to total workforce is specified by the Working Guideline to be based on personnel who work in (and generally those who have an employment contract with) the enterprise for at least 183 days within the year of calculation.

The “income derived from high-tech products ([or] services)”, which must be at least 60% of total revenue under Article 10.5 of the Measures, is required by the Working Guideline to be generated through technological innovation or R&D activities.

PROCEDURES

Procedures detailed by the Working Guideline are mainly to be implemented by the applicant, by the local recognition authority, and by experts that it engages to handle technical examination. Procedures are detailed for first-time applications and renewal applications. Dispute resolution procedures are left relatively vague.

Application and examination procedures

A first-time application entails the following key steps (as detailed and illustrated in a rough flow chart in Section (2) of the Working Guideline):

1. The applicant must engage an “intermediary agency”, which is qualified and registered by the local recognition authority, to prepare a special audit report on the applicant's relevant expenses and income.

2. The applicant must make an online submission of a registration form in order to obtain a log-in ID and password from the local recognition authority.

3. The applicant must go online again to fill out an application, fill in various data forms, attach evidence of the data, and attach the special audit report.

4. Within 60 days of receiving the application documents, the local recognition authority is to make a determination of whether to reject or grant preliminary approval.

5. Fifteen days is the period of online publication of the preliminary approval. (Implementation of online publication is not expressly allocated to a particular department.)

A renewal application entails submitting a re-examination application form “within” three months before expiry of the three-year term. After this expiry, any application will be regarded as a new application rather than a renewal application.

TRENDS

Local government officials will find it more difficult to use HNTE and other tax preferences to attract investment or to reward friends or local power players. PRC residents who were inclined to inject intellectual property and other assets into offshore companies will find that HNTE qualification criteria, along with other legal changes, now encourage a more PRC-centered corporate structure.

Foreign investors and multinational groups will find that, in order to enjoy future HNTE status and related tax preferences, a PRC affiliate will need to host a larger portion of its group's worldwide R&D activities and IP ownership. For this purpose and for other reasons, the PRC affiliate and its foreign parent will need to increase their efforts to comply with PRC laws (especially on environmental protection, safety, quality and tax) and to develop strategies to improve protection and exploitation of an increasingly PRC-centered portfolio of R&D-generated technology and IP.

Endnotes

1. Guo Ke Fa Huo (2008) No. 362, promulgated by the Ministry of Science and Technology, Ministry of Finance and State Administration of Taxation.

2. See High- and New-Technology Enterprises: Updated Preferences, Qualifications and Trade-Offs by Neal Stender and Qingsong (Kevin) Wang, in CLP June 2008.

3. The structure of the leading group, and its general office, which the Measures provide shall be formed jointly by the the Ministry of Science and Technology, the Ministry of Finance and the State Administration of Taxation, are further detailed in the Working Guideline.

4. Other IP items can include design patents, utility model patents, software copyrights, proprietary rights to integrated circuit layout designs, or new plant varieties.

5. Holding five of such other items results in the second highest grade, and so on.

6. The second highest grade can be achieved by using more than three achievements, and so on.

7. The second highest grade can be achieved by completing four eligible actions, and so on.

8. The second highest grade results if average growth is at or above 25%, and so on.

9. These definitions supersede – at least for the purpose of HNTE qualification – the 1996 and 1999 notices that were referenced in our June 2008 article on the Measures.

10. A different expense format is normally used to calculate R&D expenses eligible for a “super-deduction” under other provisions of the Enterprise Income Tax Law and its Implementation Rules.