How to invest in R&D centres

There are a number of ways in which China incentivises research and development facilities. Generally, there are various layers of incentives, starting at the local level and progressing up through the provincial to the national level. Local incentives are not necessarily based on the R&D or the technology alone. The bulk of local incentives comprise those generally available to investments in the area. Incentives, although based on revenue and tax considerations, do not take the form of reduced tax rates. Instead, these incentives represent payments from the local treasury of a portion of locally retained tax revenues. If available locally, technology incentives require governmental certification and this certification process becomes more rigorous as one moves up the administrative hierarchy.

Incentives do not seem to be the sole or even a key driver for investment. For many of our clients, the needs of the on-going operations are more significant than incentive payments. Payment risk is always present and realistically should payment be delayed or denied, investors have little if any effective recourse. Against this background, while one should bargain hard for an attractive incentive package and document it clearly, it may not always be prudent to include the promised incentives for economic modelling and projections.

Investment vehicles

As with any business operation in China, you will need an appropriate corporate vehicle, either an existing one or a new one. Common vehicles include the wholly foreign-owned enterprise (WFOE) or a Sino-foreign joint venture, usually of the equity joint venture type (JV). Short of an R&D entity, there are purely contractual collaborative R&D efforts as well, but the trend appears to be investment in one's own facilities, rather than shorter-term collaborative projects.

The first stop for any R&D investment are the rules governing what types of businesses are prohibited or restricted for foreign investment and what types of technologies may not be imported or may only be imported conditionally. In essence, technology is another layer of prohibited and restricted activities. In restricted industries, investments are allowed but with conditions. The conditions vary, but typically mandate a JV, with the Chinese party in control or holding the leading position. If your activities and technology are neither prohibited or restricted, you are in the clear to proceed. Better still, if the activities are encouraged, you can expect a smoother approval process across the board.

Who will be approving your investment? This will be driven by the dollar amount to be invested and the industry into which your activities are classified. Some investments require additional governmental approvals from the outset, such as certain types of pharmaceutical research activities. One needs to check the rules in each case, but as a general guideline you only need to go directly to Beijing if your total project investment is $300 million or above. If your R&D investment is of that scale, you will need to consider carefully how best to approach the approval process and the required documentation.

According to the numbers, it appears that most R&D centres are in the form of WFOEs. The WFOE provides direct and exclusive control and that is often a key consideration for R&D activities. In certain circumstances, a JV may be required, particularly in restricted industries. If that is the case, you should be prepared for what can be extensive negotiations, best kicked off with a comprehensive letter of intent or similar documentation that covers as many of the deal's fundamental terms and conditions as possible (in both English and Chinese). With either a WFOE or a JV, there are prescribed documents that are needed for approval purposes and the key in each case is devising a scope of business for your vehicle that is broad enough to permit all of its contemplated activities.

In terms of capitalisation, the amount of your total investment drives minimum capitalisation requirements. The smaller your project, the more capital is required. For example, if your total investment is $3 million or less, at least 70% of that amount must be in the form of paid-in registered capital. Different minimum capital rules apply as total investment increases, but at the top end, anything in excess of $30 million still requires committed registered capital over $12 million and one-third of the total investment. Registered capital must be paid-in, although instalments are permitted over a period generally of no less than two years. The difference between total investment and registered capital technically represents the maximum amount of long-term borrowing that will be permitted. This kind of debt is usually provided by way of a shareholder loan, which must also be registered with the foreign exchange authorities.

Other matters will also need to be considered at the planning stage. These include any special permits or licences that may be needed and the possibility that there may be community or zoning concerns. In addition, IP and employment issues are fundamental.

IP and employment issues

As with a R&D centre in any location, employment and IP concerns need careful planning and consideration. China is no exception to this and in some respects presents unique challenges. Understanding these challenges are crucial to the success of R&D centres.

In today's more fluid talent environment and with increasing awareness of the need to protect IP and trade secrets, the prudent approach ensures employees bring with them no secrets and do not divulge any secrets during or following their tenure. Contractual protections with statutory support are available and full advantage should be taken of these. In addition, care should be taken at the outset to limit information within the R&D operations such that few employees, if any, have complete access to works in progress, inventions and trade secrets.

Restrictive covenants, including non-competition and non-solicitation covenants, should not be overlooked. Law and practice on non-compete covenants has developed in recent years and with careful drafting, it should be possible to craft these covenants so that they are likely to withstand future challenges. However, you have to pay for a non-compete covenant and by analogy, it is best to also pay for a non-solicitation covenant addressed at clients or customers. It is also imperative to agree not only on the scope and duration of these covenants up front, but the amount and timing of the related post-termination payments as well. Different locales have differing views on the details of these matters, but the general principles are the same. Restrictive covenants must be reasonable in scope and duration and the compensation should be payable at times and in amounts that approximate the earning capability, or a reasonable percentage thereof of your former employee. However, it is necessary to seek specific guidance from the local authorities on these points prior to entering into employment contracts with key personnel who will have access to sensitive confidential and commercial information.

Patentable inventions represent another hazard. China's patent rules embody the concept of a service invention. There are three types of service inventions: (1) an invention made in the course of employment; (2) an invention made primarily using the materials, technical capabilities or equipment of the employer; and (3) an invention made or perfected in the one-year period following employment, if the invention relates to the prior employment. Ownership of a service invention vests in the employing entity. However, the employee has a statutory right of first refusal to purchase the related patent rights if those rights are later transferred to another party, including a party affiliated with the employer. For example, transfers in connection with a reorganisation of a global patent portfolio or arising from a more general corporate restructuring. Given this statutory right, it is important to agree at the outset how this is to be handled and provide for a current assignment and waiver to the fullest extent possible.

Related to this is another employer obligation – for any service patent, an entity granted the patent and any entity exploiting the patent must either reward the individual inventor or obtain his or her waiver of any reward or remuneration. If there is no waiver and the underlying employment contract does not specify the reward or remuneration, statutory defaults are triggered. The statutory defaults can be prohibitive as they are set by reference to revenue generated by the patent or licensing fees. Accordingly, the well-advised employer will see to it that reward and remuneration for service patents are clearly outlined in the employment contract or a separate written agreement with the employee.

In addition to these specific types of concerns, the usual panoply of employment and workplace management concerns cannot be overlooked. The general landscape in China is very employee-friendly and employers must ensure they meet applicable standards. Policies, procedures and rules are incorporated into generally applicable workplace rules. Violation of any of these can support disciplinary action, including termination in an appropriate case. Management may find itself without effective recourse or exposed to the risk of a wrongful termination claim. The key process here is to proceed with a carefully designed and implemented employee consultation process, seeing to it that all of your key policies, guidelines and compliance matters become part of the workplace rules for the R&D centre.

Growing opportunities

China is now a destination for R&D activities and the investment and regulatory environment continues to grow. Governmental policy seems clear and involves a shift from manufacturing, using technologies and know-how developed by others, to indigenous creation and invention. The talent pool that underpins this shift of direction is growing, and has contributed to exponential growth in the amount spent in China on R&D activities across the board. However, growing R&D capability in China involves careful and thorough planning. It can be done successfully if designed, evaluated and implemented based on a thorough understanding of how to navigate the regulatory and business environment.

Michael Hickman and Lesli Ligorner, Simmons & Simmons, Shanghai