United States: How to Transfer Technology from the US to China

Article by Zhu (Julie) Lee & J Bruce Schelkopf

Almost all foreign companies doing business in China have concerns about their intellectual property rights being compromised. While these concerns appear to receive heightened scrutiny with respect to China, many of the resulting risks are similar to those faced everyday by these same companies across Asia as well as the rest of the world. However, recent concerns voiced by governmental entities and foreign companies have elevated the awareness of the unique difficulties faced particularly by foreign companies with respect to procedures, presence and enforcement efforts in China.

Fortunately, various legal and practical measures, in concert with a focused business strategy, can be taken to reduce IP infringement in China. Although such measures are beyond the scope of this article, the creation and deployment of the right solution for a business is premised on first understanding the differences and similarities between US and China legal issues.

This article discusses the various US and Chinese legal issues that a company should consider both before and after it decides to transfer its technology to China, including the development and execution of a corporate plan to protect, audit and improve its technology. The transfer of US technology to China must comply with both US export control regulations and the import and export control regulations of China. In addition, the foreign company transferring the technology needs to conduct sufficient due diligence to ensure that the recipient in China has the legal capacity to enter into a technology transfer agreement. Moreover, while the parties are free to specify that foreign law governs a technology transfer agreement, such agreements cannot violate certain mandatory provisions of Chinese law that may affect the underlying interests of the parties. Furthermore, Chinese law must always be considered in negotiating the ownership, development and use of any improvements to the transferred technology.

Any US company considering the transfer of technology from the US to China must comply with all US export control regulations. The US has established a complex system of export controls that regulate the export of goods, technology and services from the US and the reexport of US-origin goods, technology and services from other countries. The two principal sets of US export control regulations are the Export Administration Regulations (EAR), which govern the export and re-export of commercial and dual-use items (items designed for commercial purposes that may have potential military or nuclear applications), and the International Traffic in Arms Regulations (ITAR), which regulate the export, re-export and transfer of defence articles and technology. Both the EAR and the ITAR employ categorical definitions and requirements based on the type of goods, technology or services sought to be transferred.

Under both the EAR and ITAR, information or technology published in an issued patent or in a published patent application is considered to be in the public domain and, therefore, is not subject to US export controls. Such published information may be exported to China and other countries without obtaining an export licence. However, patent applications subject to US secrecy restrictions are required to obtain licensure from the United States Patent and Trademark Office before any foreign filing or disclosure may be made. Still other technology, patented or not, is likely to be subject to the EAR if it relates to commercial or dual use items, or the ITAR if it relates to defence items.

All US products and technology are subject to the EAR, but not all are subject to the ITAR. As a result, in some instances, the export may be permitted so long as a licence is obtained. In many cases, the export is permitted and no licence is required under either the EAR or ITAR.

A first step to determine whether a licence is required is to determine whether the technology to be exported is the subject of the stricter regulations of the ITAR. If the technology relates to defence articles as defined under the ITAR, it is likely subject to the ITAR regulations and restrictions. Since technology subject to the ITAR is defence-based, all such subject technology requires a licence for its exportation or re-exportation to all countries other than the United States. For example, defence products that may be the subject of ITAR regulations include technology that has been designed or modified for military use, as well as certain services such as servicing an original commercial product that is now part of a military application. Similarly, a US business’s interest in showing a foreign company’s employee, while in the US, its products that were specifically designed or modified for a military use, may require that a licence be first obtained, if available. However, licence applications for technology subject to the ITAR may be prohibited or generally denied to certain foreign countries, including China, due to an arms embargo in force or geopolitical factors.

As defined under the EAR, most goods, technology and services are permitted to be exported to China without a licence; in operation, licences are required for only a small percentage of typically high-tech or sensitive items and activities that have potential dual use applications and are not subject to the ITAR. Nevertheless, it is important that a business intending to transfer technology to China first determine whether it needs to obtain an export licence or is subject to other export restrictions under the EAR, such as reporting and shipping documentation requirements. Such determination is generally made based on four factors: (1) the classification of the type of technology to be exported, (2) the destination country to which the technology will be transferred, (3) the identity of the end user who will receive the technology being transferred, and (4) the use by the end user to which the technology will be put after the transfer is completed.

The EAR’s general stated policy with respect to exports and reexports to China is "to approve applications, except that those items that would make a direct and significant contribution to electronic and anti-submarine warfare, intelligence gathering, power projection, and air superiority receive extended review or denial". It should be noted that notwithstanding this general policy, the Department of Commerce is considering a new proposed rule that may, among other things, impose additional licence requirements on certain exports intended entirely, or in part, for military end-uses in China.

Because the rules governing US export controls are complex and subject to change, a business should consult an expert in the area prior to transferring any technology to China. Before a business has made a determination that the transfer of its technology to China does not require a licence, or before it has obtained a required licence, the business should be careful about disclosing information to its Chinese business partners or foreign-national employees, even during meetings in the United States. These issues, in particular, present a greater level of risk for many US businesses who employ or routinely work with foreign nationals, as the release of technology to a foreign person (someone who is not a US citizen or permanent resident alien) is "deemed" to be an export to the person’s home country, even if the release occurs in the United States. If the transfer of technology requires a US export licence, merely sharing information related to the technology with a business partner or potential business partner who is Chinese (or another nationality) by any means (including by telephone, fax, email and face-to-face conversations) is considered a "deemed export" to that person’s home country, even though it took place inside the US, and may be subject to the licensing requirements.

China’s Regulations on Administration of Technology Import and Export, effective January 1 2002 (the Technology Regulations), govern the import and export of technologies into and out of China. Under the Technology Regulations, "import and export of technologies" is broadly defined to include acts of transfer through trade, investment or economic and technological cooperation, of technologies from inside China to outside China, and vice versa. "Acts" includes transfer of rights to apply for patents, transfer of licences for the implementation of patents, transfer of technical know-how, technical services and other forms of technological transfer. Thus, most transfers of technology by US companies to China will be subject to the Technology Regulations of China.

The Technology Regulations classify technologies into three broad categories:

1. prohibited technologies: technologies that cannot be imported into or exported out of China;
2. restricted technologies: technologies the import and export of which must be approved by the relevant governmental authority prior to the import or export, and the relevant technology transfer agreement must be submitted to the relevant governmental authority; and
3. permitted technologies: technologies that can be imported into or exported out of China without prior governmental approval, but the parties need to register the technology transfer agreement with the relevant governmental authority. With respect to permitted technologies, though the failure to register a technology transfer agreement does not affect the effectiveness of the agreement, failing to do so may have other adverse consequences such as the inability of the Chinese licensee to make royalty payments in foreign currencies.

China has issued the Catalogue of Technology of Which China Prohibits or Restricts the Import (First Batch) (the Technology Import Catalogue) and the Catalogue of Technology of Which China Prohibits or Restricts the Export (the Technology Export Catalogue) which list the technologies that are classified as prohibited or restricted technologies for import or export purposes, respectively. Any technology that does not fall within either the prohibited or the restricted category is, at present, considered permitted technology.

The Technology Export Catalogue should be considered early by a foreign business investing in China for a few reasons. As discussed below, Chinese law mandates that ownership of improvements to licensed technology made by a Chinese licensee belong to the Chinese licensee. The assignment or licence by the Chinese licensee of such improvements to the non-Chinese licensor will be subject to China’s export control regulations. In addition, non-Chinese companies wishing to establish a research and development facility in China and use the result of such research outside China will need to comply with China’s export control regulations.

Generally, when a non-Chinese company transfers technology to China, the parties to the transfer agreement can agree that non- Chinese law, such as the laws of the state of California, govern the agreement. However, notwithstanding the choice of foreign law, in order for the agreement to be enforceable in China, certain mandatory provisions of Chinese law must be considered. A foreign transferor should carefully structure its technology transfer agreement to make sure that the agreement complies with such mandatory provisions. The Technology Regulations provide that a technology import contract cannot contain provisions:

1. requiring the transferee to accept incidental conditions unnecessary for the technology import, including the purchase of unnec- essary technology, raw material, products, equipment or services;
2. requiring the transferee to pay for, or undertake obligations relating to, a technology whose patent right has expired and has been announced as invalid;
3. restricting the transferee’s improvement of the technology provided by the transferor, or restricting the transferee’s use of the improved technology;
4. restricting the transferee’s acquisition of any technology similar to, or competitive with, the technology provided by the transferor;
5. unreasonably restricting the transferee’s channels or sources for the purchase of raw material, parts, components, products or equipment;
6. unreasonably restricting the quantity, variety or price of products produced by the transferee; or
7. unreasonably restricting the transferee’s export channels for products manufactured by the transferee using the transferred technology.

Moreover, the Contract Law of the People’s Republic of China (the Contract Law) provides that any technology contract that illegally monopolizes technologies, impedes technological progress or infringes upon technological results of others is null and void. A "technology contract" is a contract made by the parties to define their rights and obligations for technology development, transfer, consultation or service. Pursuant to the Chinese Supreme People’s Court’s interpretation (the Supreme Court Interpretation), the term "illegal monopoly of technology and impeding of technological progress" includes, in addition to the prohibitions relating to import of technology set forth in the Technology Regulations, the unequal rights of the parties relating to the exchange of improved technology, such as requiring a party to provide its improvements to transferred technology to the other party without compensation, to assign its improvements to transferred technology to the other party without mutual benefits, or to grant the non-improving party the exclusive or joint right to enjoy the improved technology without compensation to the improving party.

Furthermore, Chinese law limits the ability of a foreign licensor to disclaim its liabilities in connection with the licensed technology. For example, Chinese law requires that the foreign licensor "guarantee" that the licensed technology be complete, correct, effective and reach the specified technological target. In addition, the foreign licensor is required to "guarantee" that it be the legal owner of, or the party with the right to license, the technology. If the Chinese licensee infringes upon another party’s right by using the licensed technology pursuant to the licence agreement, the licensor is required to bear the responsibility for such infringement.

Successfully transferring technology and conducting business in China require a strong awareness, direct involvement and express compliance with both US and Chinese laws that are subject to change. Properly preparing for technology transfers and assessing potential companies in China positioned for receiving the technology require investigative due diligence activities and often also set forth the need for expertise familiar with the business environment in China. However, transferring technology to China can be a successful and integral part of a US company’s strategy to expand its markets, lower its costs, and gain additional capability in improved technology. It is an opportunity that should be further explored openly by many US companies as to do otherwise may result in certain US companies missing the opportunities in China.

In the US, a company can generally engage in any lawful business and may expand the scope or markets of interest in which it pursues business. In China, however, a company can only engage in an approved scope of business. The scope of business that is ultimately approved for a company in China is under the direction and control of the governmental approving authority at the time of the company’s registration. The ability of a company in China to expand thereafter beyond its original scope of business cannot occur unless it first obtains approval from the authority. As a result, a Chinese company’s business is quite specific and limited. Therefore, as part of a foreign transferor’s due diligence on a transaction with a Chinese transferee, the transferor should investigate and assure itself that the transferee-to-be will not violate the provisions of its business licence, articles of association or other organizational documents.

When licensing a technology to a Chinese business partner, the non-Chinese transferor will generally want to be granted back the rights to the improvements developed by the Chinese licensee; however, Chinese law creates significant uncertainties in this area.

The Technology Regulations provide that during the term of a technology import contract, ownership of improvements to transferred technology belongs to the improving party. Thus, if a Chinese licensee makes improvements to the technology licensed by a foreign licensor, the improvements belong to the Chinese licensee. Under the Supreme Court Interpretation, the foreign licensor cannot require the Chinese licensee to assign the improvements, or grant an exclusive licence to use the improvements, to the foreign transferor without compensation. However, there is no definitive guidance as to what constitutes adequate or reasonable compensation. In practice, the foreign licensor can try to deal with the ownership and use of a Chinese licensee’s improvements to transferred technology using themes from one of the following three methods or a variation of them.

First, the foreign licensor may wish to negotiate a non-exclusive licence to use the improvements in China and in jurisdictions in which the licensor does not conduct business and an exclusive licence to use the improvements in jurisdictions in which the foreign licensor does business. To increase the chance of such a provision being enforced in China, the foreign licensor should consider paying a fee for the exclusive licence to use the improvements. Second, the parties could agree that the foreign licensor and the Chinese licensee are co-owners of all improvements to the licensed technology and arrange use permissions based on such co-ownership. Again, the foreign licensor should consider paying a fee for the co-ownership or consider a joint operations arrangement.

Third, the technology transfer agreement could provide that the Chinese licensee agrees to assign all improvements to the licensed technology to the foreign licensor for a fee. A variation of this approach, which probably has a higher likelihood of being enforced in China, is that the Chinese licensee agrees to give the foreign licensor the right of first refusal with respect to the licensee’s improvements. If the foreign licensor is interested in a specific improvement, the licensee will then assign the improvement to the licensor for a fee.

To deal with the uncertainties resulting from lack of guidance on the amount of adequate compensation, aside from seeking informal provincial guidance where available, a foreign licensor may wish to consider limiting the geographical area in which and the purposes for which the Chinese licensee can use the transferred technology. Presumably, without the underlying technology, the transferee will not be able to fully employ the improvements.

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.