Barriers to entry

Foreign investors have been
investing heavily in setting up R&D offices in China despite an Inadequate provision of lax
incentives.

In recent years. foreign companies have been building up their
research and development activities in China. Accord-ing to the Ministry of Commerce,
there are more than 201) R&D branches of multina-tional corporations in China, involving
the likes of Motorola, IBM, Lucent, GE, DuPont, P&G, GM, Volkswagen and
Intel.
Most are situated in the big cities. Beijing is the most popular location for the
IT sector and US companies, while European compa-nies in the automotive and chemical
sectors prefer Shanghai. R&D centres in Guangzhou and Shenzhcn are generally found in
the IT and electronic sectors. The Ministry of Coin-merce estimates that, in the next five
years, the number of R&D centres will double.
There are several factors behind
this rapid expansion. First, R&D offices help to expand market share by introducing new
products that satisfy local needs. For instance, the Chi-nese versions of Windows
developed by Microsoft Beijing R&D Centre have been very successful in the local
market.
Second, there are plenty of universities and institutions in the big cities
where it is easy to and high quality researchers and engineers. Labour costs are also low
coin-pared with other parts of the world. In the software industry, for example. the average
labour cost in India is twice that of China. Third, the Chinese government has provided
policy incentives to foreign investment in R&D, mainly in the form of tax
incentives.
The Catalogue of Guidance on Foreign Investment Industries,
promulgated by the Ministry of Foreign Economic & Trade Cooperation (Moftec, which was
merged into the Minisny of Commerce in April 2003). classified foreign investment into four
cate-gories – encouraged, permitted, restricted and prohibited. The latest revision to the cat-
alogue in April 2002 promoted R&D from 'permitted' to 'encouraged' foreign invest-ment.
The new eategonsation means that. whatever the total investment size. setting up an R&D
centre only needs government approval up to provincial level,' approval from the central
enverument is no longer necessary. In April 2000, Moftec issued a notice that specified the
permitted forms of foreign-invested R&D; incorporated as a limited liability company, or a
department or
branch office of a limited liability company.
Under the Moftec
notice, foreign-invested R&D centres must engage in research, devel-opment and
experimental activities in the area of natural science and related scientific fields. They may
conduct research in basic science, applicable science and high technol-ogy. The notice
prohibits them from engag-ing in any manufacturing activities for com-mercial purposes
and technology trade activ-ities. except the transfer of its own research products to other
parties.
Basically, there are two types of operation model for an R&D centre to
transfer its research products. If it decides upon the research activity. the research product
may be transfeired to any party. The alternative is when the foreign parent company
instructs its R&D centre to conduct research, for which it would be paid expenses plus a
rea-sonable profit. Here, the intellectual property ownership of the research product would
belong to the foreign parent company.
In both these cases, the R&D centre is
subject to the provisions of China's Administration Regulation on Technology Import &
Export. If the research product involves freely transferred technology. it may be transferred to
any foreign company. Howev-er, if it falls into the category of export-restricted technology. an
export licence is required before the transfer can be made.
The government has
granted certain tax incentives to foreign-invested R&D centres.
Import duty When
an R&D centre imports equipment, instruments or spare parts for its own use, import duty
and import-related VAT on such materials are exempted. To be eligible for exemption, the
value of the imported material may not exceed the sum of the centre's total investment. The
imported material must also not feature in the Cata-logue of Imported Material without Tax
Exemption for Foreign-invested Projects, issued by Customs in 1997.
When
equipment, instruments or spare parts are imported to replace or repair exist-ing
equipment, import duty and import-relat-ed VAT are waived no matter what the value. The
funds used to import equipment and spare parts may come from its revenues. reserves or
depreciation, but not from a loan.
When an R&D centre acquires intangibles from
foreign companies, which are list-ed in the Catalogue of the State High and New
Technology, it is granted relief to pay import duty and imported-related VAT on royalties paid
by the centre in connection with the acquired intangible.
Turnover tax Any act
involving the trans-fer of technology or the provision of techni-cal consultancy services is
subject to 5 per -cent turnover tax. R&D centres are exempt from paying this
tax.
Income tax An R&D centre has to pay income tax at a rate of 33 per cent if it is
not located in a special economic zone such as Shenzhen. or a high-tech industrial zone,
such as Suzhou Industrial Park. However, if its research or experimental expenditures –
increase by at least 10 per cent on the previ-ous year. half of such expenditures are
deductible from its taxable income.

Remaining
obstacles
Although the Chinese government has tried to reduce the tax burden for
R&D centres in order to attract more foreign investment in -this area. the current tax
incentives are wide-ly considered to be insufficient. For instance, -while foreign-invested
manufacturers enjoy a two-year exemption period and then a three-year reduction in
income tax. there are no such inducements for R&D centres.
Moreover. they face a
problem when it comes to turnover tax exemption. Currently. -they are required to pay
turnover tax at the outset. and then file an application for exemption and reimbursement
with the tax -authorities. When reviewing the application. the tax authorities require an
appraisal report -from the government agency in charge of sci-ence and technology. The
R&D centre has to go through a complicated and lengthy process to get the appraisal
report from the government agency. Some would rather pay -the turnover tax than go
through such a labo-rious procedure.
Another problem involves the fact that
computers and automobiles are not exempt -from import duty and import-related VAT,
which significantly increases the cost burden-for R&D centres in the computer and auto-
mobile sectors. They need to pay these taxes when importing advanced computers or-
automobiles as samples for research or trial manufacture purposes.

This
article was written by Yue Tang of the Jun He Ian- firm in Beijing. Set 01) in 1989,jun He is
one of the top China-hased Iaw firms with some 130 attorneys in Beijing, -Shanghai.
Haikon, Dalian and New' York.