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China's new Corporate Income Tax Law, effective January 1, 2008, offers a reduced 15% corporate income tax rate - compared to the regular rate of 25% - for “high and new technology enterprises” (“HNTE”). As of mid-April 2009, approximately 16,000 enterprises have obtained certified HNTE status. A majority of these enterprises are domestic Chinese companies, but some local subsidiaries of multinational corporations have also been certified. As described by Fuli Cao (Jones Day, Beijing), there are several critical factors to be considered in assessing whether a Chinese subsidiary of a U.S. or other non-Chinese group can and should apply for HNTE status.

Qualification

The applicant company must be a China resident enterprise (exclusive of Hong Kong, Macau, and Taiwan) that has been established for at least one year. The applicant must be engaged in at least one of the eight fields which receive key support from the national government:

• Electronic Information Technology;

• Biology and Medical Technology;

• Aerospace Technology;

• New Materials Technology;

• High-Tech Services;

• New Energy and Energy Conservation Technology;

• Resources and Environment Technology; and

• Technology Transformation of Traditional Industries.

More than 200 sub-categories of technology, products, and services are listed in the guidance issued by the Chinese government. An applicant must fall into one or more of these listed areas. Further, the applicant's current-year income from high and new technology products (services) must be at least 60% of the total revenue of the enterprise. Importantly, the HNTE must own the proprietary IP rights of the core technology in connection with the main products (services) of the enterprise. At least 30% of its staff must have a college or university diploma, and at least 10% of the staff must be involved in R&D. The enterprise must have ongoing R&D activities. R&D expenditures for the prior three accounting years must reach a certain percentage of the enterprise's sales revenue, as follows:

Additionally, the authorities use a “score card” system to grade applicants. The score card comprises four sections; to qualify for HNTE status the applicant must score more than 70.

Ownership of Core IP

One of the main reasons a relatively small number of foreign-owned enterprises has obtained HNTE status is the requirement for core IP. An HNTE must own the proprietary IP rights of core technology in connection with the main products (services) of the enterprise. Typically, multinational companies choose to own all of their IP (including the IP used in China) in an IP holding company outside China - sometimes in the home country of the parent company and sometimes in an offshore haven location. As a result, the Chinese subsidiaries generally do not own any IP.

Accordingly, if a Chinese subsidiary of a multinational company meets all the other requirements and is considering applying for HNTE status, its foreign owner may consider the following options to move IP to China.

1. Transfer Certain Chinese IP to the Chinese Subsidiary

For purposes of the HNTE application, patents (including inventions, utility models, and some industrial designs) and registered copyrights for software are commonly used as evidence of IP rights. The patents and copyrights must be granted or registered with the Chinese authorities. A foreign owner of Chinese patents can transfer Chinese patents to its Chinese affiliate, although the patents granted in other jurisdictions need not be transferred to China. Similarly, a China registered copyright of software can be transferred to a Chinese subsidiary.

2. Five-Year Exclusive License

As an alternative to the transfer of patents, a foreign patent owner can grant its Chinese subsidiary an exclusive license for a minimum of five years. According to the regulations, the Chinese licensee must be granted the worldwide exclusive rights to the IP for the licensed period. It may be difficult for multinational companies to grant such worldwide exclusive licenses, unless the technologies are primarily for the China market.

Clearly, multinational companies need to balance the potential tax benefits of HNTE status against issues of control of IP. Such control becomes even more significant where the Chinese operating companies are joint venture companies. In such situations, the Chinese partners might have legal or practical access to the technologies owned by the joint venture. Furthermore, the transfer of IP to the joint venture may drive up the value of the joint venture company, with benefits accruing to the Chinese partners.

Transfer Pricing

According to the regulations, the HNTE can obtain core IP through purchase or donation (contribution). For HNTE purposes, payment of consideration for the IP transfer is not required. However, under China transfer pricing rules (and the rules of most other developed countries), related-party transactions must be conducted on an arm's-length basis. Technically, the Chinese tax authorities could consider a donation of IP, without payment, as income to the Chinese subsidiary. In practice, however, the tax authorities might not make a transfer pricing adjustment, because payment of less than fair market value would also reduce the tax deductions of the Chinese subsidiary. On the other hand, the tax authorities in the transferor country may require that the transferor include fair compensation in its income under the transfer pricing rules in the transferor country.

Further, HNTE status may affect the existing transfer pricing policy for the Chinese subsidiary. If the Chinese subsidiary is a contract manufacturer, it may justify a low profit margin. If the subsidiary owns IP and conducts R&D activities for itself, the Chinese subsidiary generally would be required to have higher margins than a simple contract manufacturer.

Global Impact

Before applying for HNTE status, multinational companies should analyze the global impact of the potential Chinese tax rate reduction. Such tax rate reduction may or may not provide significant benefits, after taking into consideration the tax liability of all relevant affiliates. For example, the following table illustrates Chinese taxes on cash repatriation in the forms of dividends and royalties from a Chinese subsidiary to its U.S. parent company:

As illustrated above, it is more tax efficient for a cash repatriation in the form of a royalty from the China tax perspective. However, if the Chinese subsidiary generates large profits, HNTE status should reduce overall China taxes.

Furthermore, the parent's home country tax must also be considered. For example, if a U.S. parent pays U.S. income tax at 35% and can credit foreign taxes, and the company's policy is to repatriate cash back to the United States as soon as possible, the reduced Chinese tax rate would not benefit the company because the potential Chinese tax benefits will be offset by an increase of U.S. tax. However, if the cash is retained in China for business expansion, the reduced Chinese tax rate may generate substantial tax benefits, assuming the Chinese subsidiary's income is not Subpart F income and is not taxed currently in the United States.

Should You Apply for HNTE Status?

A company should perform a preliminary self-assessment to determine if it should apply for HNTE status. The company may need to consider the following issues among others:

• Is the entity in question likely to qualify for HNTE status?

• If the current business model does not qualify, are there changes that can be made, such as transferring IP to a Chinese entity or undergoing corporate restructuring?

• What are the implications of changing business models or corporate restructuring, including the impact of cash repatriation (royalty vs. dividends)?

• A company should consider whether an entity will be able to maintain eligibility after an initial HNTE certification. An initial HNTE certification does not guarantee a reduced tax rate in the future. Repeated reviews are required and enterprises must continue to meet the qualification requirements in order to obtain certificate renewals.

This commentary also will appear in the September 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Nee, 957 T.M., Business Operations in the People's Republic of China.