China: Key pointers in drafting a merchandising agreement in China

Last Updated: 23 July 2014
Article by Cecilia Lou and Vincent Yu

Merchandising the image of TV or movie character has become a common practice since long ago. Right owners not only use merchandising as a way of publicity but also benefit from the sales of merchandise. In China, laws are silent on rights to merchandise. Nevertheless, right owners can still harness the existing IP and civil rights regime to establish merchandise agreements for purposes of collecting royalty and enhancing publicity. This article provides some of the key pointers in crafting the merchandise agreements.

LICENSOR

Licensors need to double confirm whether they have right to enter into the merchandise agreements. Licensors can be the copyright owner, trademark owner, design patent owner, or a licensee of the right owners. In the last scenario, it is advised for licensor to obtain a license to sublicense and enforce the right. For example, a movie studio may need to get a license from the actor to explore actor's image in the movie. Also, overseas right owners may need to grant a merchandise right to the distributor or agent in China. In all, licensors should avoid situation where their right to dispose or license is limited.

LICENSED PROPERTY

The agreements need to clearly specify the property to be licensed, which is preferably listed and displayed in the attachments. Licensor may also need to ascertain that the licensed property is protected in certain formalities, such as design patent or trademark. Particularly, unregistered trademark may be licensed out via way of copyright license if such logo meets the originality requirement and is copyrightable. In this situation, licensee should not display the "registered trademark or ®" symbol during use of the unregistered trademark though it may be registered overseas.

LICENSED PRODUCT

The agreement should describe completely the licensed merchandise, including dimensions, material, colors and quality. Normally, the licensor will want to limit the licensee's rights to the specified merchandise only, and will want the right to pre-approve any changes in that merchandise. In the meantime, the licensee may want an option or a right of first refusal in the event the licensor decides to license the property right for other product lines or to grant other rights.

GRANT OF RIGHTS

Licensor should clearly identify the nature of license, i.e. exclusive, sole or general. If it is sole license, only licensee and licensor can exercise the right. If it is an exclusive license, only licensee can exercise the right. Under either scenario, licensor is refrained from granting license to any third party.

Further, the agreements should specify which activities the licensee can perform, such as manufacturing, sales, promotion, and export. If the license is only limited to manufacturing and export, the agreements should also include the distribution chanel of the manufactured product.

ROYALTIES

Royalty is the core of merchandise agreements and can be in different forms, such as fixed fee, running royalty, and base plus running royalty. If licensor wants to simplify the process of collecting royalty, it will be advisable to choose fixed fee, which is predictable and stable. Licensor and licensee need only agree on the payment term and time. Nevertheless, fixed fee may not be a good choice for licensor who wants to maximize revenue and profit.

Running royalty and base plus running royalty involve the determination of base and royalty rates. Royalty rates can range from 2% to 20% of the licensee's net receipts. During negotiation, the profit margin in the particular industry itself will need to be taken into consideration. For example, food industry tend to yield a lower loyalty rate than fashion due to the generally low profit margins in the food industry. Further, a licensor may want to include royalty rate escalators based on the number of units sold or the amount of net sales proceeds received.

Royalty-base can be determined freely. Usually the net sales of licensed products is chosen as royalty base. The starting point for determining net sales is usually the wholesale price of the licensed products. The problem comes in identifying items that will be permitted to be deducted from the wholesale price to net sales, such as credits for returns and discounts etc. Any deductions that are allowed should be reflected on sales invoices or other records that can be easily audited by the licensor. The licensor may want to limit deductions as much as possible, and may want to put a cap on the total amount that can be deducted.

THE TERRITORY AND CHANNELS OF DISTRIBUTION

The license agreements should clearly specify the areas and channels of trade in which the merchandized goods can be sold. Generally, the territory will be limited to countries in which the licensee has a physical presence. Meanwhile, grant of right should also be limited, such as the right to export. The channels of trade in which the licensee can sell merchandise should match the brand's or character's image. For example, if the licensor is a film studio and the licensed products are toys, the channels should be limited to department stores instead of low-end shops.

The licensor should pay attention to the sale of products from licensee to its affiliated companies at prices below market price. This will influence the royalty based on the sales and licensor will lose control of the resale of the affiliated companies due to the exhaustion doctrine.

NOTICE OF OWNERSHIP

The agreement should require the licensee to include proper copyright and trademark notices on the merchandise, such as "© Copyright Reserved" or "®". The licensor's publicity could be enhanced through merchandising.

STATEMENTS AND PAYMENTS

If the merchandise agreement is based on the running royalty, the licensee should report the sales volume to the licensor and calculate the royalty. Licensee needs to provide quarterly report or semi-annual report. Payments are typically due thirty days after the end of each quarter or 6 months. The meaning of "finishied sale" should be specified in the agreement in case of ambiguity. Moreover, the time of licensee's internal approval to complete the payment should be communicated to the licensor before execution of the merchandising agreement. If practically licensee requires longer time to process payment than what has been stipulated in the merchandising agreement, the licensee may breach the contract.

TAX AND FOREIGN EXCHANGE

China adopts tax withholding system. Generally, income tax rate for foreign company is 10%. When the licensees transfer loyalty outside China, they must provide a certificate of tax payment to the bank. If there is any agreement about avoiding double taxation policy between China and foreign licensor's country or region, licensors may require licensee to provide tax payment certificate to deduct tax within licensor's own country or region. The licensor is suggested to locate in Hong Kong with appropriate arrangements of ownership and license. According to Article 12 of Specification of Arrangements the Mainland of China Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income Order, the tax charged shall not exceed 7% of the gross amount of the royalties. Thus, licensors should make ownership arrangement when entering into the long-term merchandising agreement to save a part of tax.

In the past, license recordal certificates should be provided to pay overseas royalties, such as trademark license recordal certificate, copyright license recordal certificate. But pursuant to the Detailed Rules of Implementation of the Guidelines for Foreign Exchange Administration of Trade in Services executed from September 1, 2013, the licensor may exchange the money with contract(agreement) and invoice(payment notice).

AUDIT RIGHTS

If the merchandise agreement is based on the running royalty, the licensor should have the right to audit the licensee's books and records to verify sales and royalty reports. Considering the trade secret, the licensee may want to impose a limit within which the books and records for any particular accounting period can be audited. The licensor needs to request with a lengthy advance notice.

INDEMNIFICATION AND INSURANCE

Licensors concern mostabout the product liability since they do not control manufacturing and sale of products. Customers usually will sue the licensor to increase likelihood to get damages. Thus, licensors will want the licensee to indemnify it against any claims of product liability arising out of the sale or use of the licensed products.

For licensees, they worry that the licensed property a third party's license. They will want indemnification against infringement claims arising out of their use of the licensed property. The licensees may want to request the licensors to indemnify for the loss due to any infringement or disputes.

LICENSE TERM

In most cases, it is to the licensor's advantage to have a shorter rather than a longer term. If the licensing arrangement is successful, a shorter term will give the licensor an opportunity to re-negotiate a higher royalty rate before renewing the license agreement. As a compromise, the licensor and the licensee may agree to a short initial term with an automatic renewal if certain sales or royalty targets are met, or, alternatively, to a longer term with an automatic termination if specific sales or royalty targets are not met.

SALES AFTER TERMINATION

Some products may still be left after the termination of the agreement. If the licensee is prohibited from distributing any licensed products remaining, his interest will be harmed. Generally, the licensor will repurchase the goods or identify the licensee's sell-off period. The licensor may want to include additional safeguards in the agreement to prevent the licensee from overmanufacturing in anticipation of termination.

CONCLUSION

Merchandise licensing can be profitable for both the licensor and the licensee. A well-executed licensing program can provide the licensor with additional income, publicity and recognition, and can provide the licensee with an opportunity to profit from the goodwill associated with the licensor's properties. Before entering into a license transaction, the licensor and licensee should agree on the terms of the license, and should sign a written license agreement to serve as the road map for their relationship.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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