Transferring technology to China via joint ventures

02/01/1997

Transferring technology to China via joint ventures

Min Chen, Thunderbird, The American Graduate School of International Management, Glendale, Arizona

Since China opened up to foreign investment in 1979, it has attracted approximately US$26.7 billion direct foreign investment, with a total of 37,000 approved enterprises by 1991. Equity joint ventures accounted for about one-third of the country`s total direct foreign investment, and were favored by foreign investors during the period 1979-1988 [1]. In spite of various difficulties, many equity joint ventures have thrived in China. With a realistic plan and good preparation, one can reasonably expect success in creating and managing a joint venture in China.

The primary Chinese motivations for entering into industrial joint ventures are the acquisition of advanced technology, foreign exchange, and management expertise. While there are many vehicles for the transfer of technology, such as licensing, coproduction, and subcontracting, the equity joint venture is popular because it allows the foreign partner to participate in the Chinese market while maintaining some control over business activities. This article examines several key aspects of creating and managing joint ventures in China, with a focus on issues related to technology transfer.

Preparing for negotiation

One of the first things a potential investor needs to do is to familiarize itself with the legal framework for technology transfer in China [2]. Currently, the Regulations on the Administration of Technology Import Contracts (RATIC), promulgated by the State Council on May 24, 1985, are the most comprehensive. To facilitate and streamline China`s technology import, the Ministry of Foreign Trade and Economic Cooperation (MOFTEC), promulgated a set of rules on January 20, 1988, the Detailed Rules and Regulations for the Implementation of the Regulations on Administration of Technology Import Contracts (otherwise known as the "Detailed Rules").

The two most important laws for those who want to transfer their technology via joint ventures are The Law of the People`s Republic of China on Joint Ventures Using Chinese and Foreign Investments ("The Law") as adopted at the Second Session of the Fifth National People`s Congress, July 1, 1979, and the Regulations Governing the Implementation of the Law of the People`s Republic of China on Joint Ventures Using Chinese and Foreign Investments ("The Regulations"), promulgated by the State Council on September 20, 1983.

Potential investors must pay special attention to relevant tax laws. Several major changes have been made by the government, and more changes are coming. According to the Unified Income Tax Law of 1991, joint ventures must pay a flat 30% income tax on net income to the central government and another 3% to the local government. When the foreign partner of a joint venture remits its share of profits home after tax payment, it no longer has to pay a further remittance tax of 10%.

For joint ventures whose exports exceed 70% of their total output or who are located in the special economic zones or in one of the technology development zones in the open coastal cities, income tax is cut by half to 15%. There will be no tax for the first two profit-making years for joint ventures with a contract for more than ten years, and there will be a 50% reduction of income tax for the following three years. Joint ventures that reinvest their profits in China over five consecutive years will have a refund of up to 40% of the tax payment for reinvestment ("United Income Law") [3].

Like other investments in China, joint ventures must be approved by the relevant governmental institution, depending upon the scale of investment. The most recent rule allows local governments at provincial and municipal levels to authorize joint ventures with less than $30 million in investment.

The first step is for the Chinese partner to present a proposal for the joint venture, either to the foreign investment commission of the local government or to MOFTEC if the investment is greater than $30 million. The foreign side must supply: the legal address of the foreign firm, its scale of operations and business standing, the proportions of the capital investments by the foreign partner (normally no less than 25%), the major proposed products of the joint venture, and the proportions of international sale. These items are spelled out in "The Law" [4]. A feasibility study is then conducted, which normally concludes in a thoroughly detailed report describing the economic significance of the investment, market demand and the scale of the proposed product, necessary resources (including fuel and public utilities), proposed project location and design scheme, environmental protection, implementation plan (including employment and staff training), estimated investment level and manner of raising funds, and estimated selling price and demand for end-products.

One common complaint from foreign partners is that in order to impress them, and perhaps due to over-optimism, some Chinese partners change the feasibility study into a study of the "imagination." Though neither party is contractually bound to it, the feasibility study does have power in two areas. First, in order to deviate from a specification of the feasibility study, the party that wants to deviate must obtain the partner`s consent and the approval of the government. The burden of justification lies heavily on the party that wants the change. Second, throughout the duration of the joint venture, the feasibility study may be referred to in situations where the contract language is ambiguous [5].

Upon approval of the proposal, both sides can begin to draft the contract for the joint venture. The contract is the key document of the venture and must be in both Chinese and the language of the foreign partner. The contract, according to "The Regulations," should also specify the duration of the joint venture, the sharing of roles and power among the executives, the means to resolve disputes, and the way to dissolve the joint venture.

Contract negotiations can be long-winded. With a tendency to negotiate in a style described by one veteran China trader as, "a blend of the Byzantine and the evangelical," Chinese negotiators often frustrate Westerners unaccustomed to such tactics. Several tactics may be systematically used, such as controlling location and schedule, using weaknesses, using shame tactics, pitting competitors against each other, feigning anger, rehashing old issues, and manipulating expectations. Many Western negotiators leave the table feeling pessimistic about their future partners. Often negotiation continues after the signing of the contract. Therefore, a foreign partner should choose the right negotiators, prepare for time-consuming rounds, and develop a sophisticated strategy before starting negotiation [6].

Negotiation challenges

One major problem during initial negotiations is that the Chinese routinely demand technology that is state-of-the-art. This demand presents a potential dilemma to the Western supplier. Though the Chinese request the "most advanced" technology, they may lack sufficient foreign exchange and have an inadequate infrastructure for complex technology.

Subtle cultural differences can also lead to miscommunications and unexpected issues. A McDonnell Douglas Helicopter executive said that after he explained how easily new model MD helicopters can be maintained, his Chinese friend became annoyed and privately advised him to describe the maintenance as a complicated process to show the "quality" of technology.

The technology must be the most advanced and the most price competitive. Price negotiations on the transferred technology are one of the most daunting challenges to foreign negotiators. The Chinese frequently complain that the valuation of foreign technology is too high, while foreign managers argue that their advanced technology is very expensive to develop [7]. Whoever can convince the Chinese to accept appropriate technology and package the transferred technology in the most competitive way holds the key to a successful negotiation.

Another persistent problem is how to decide on the contribution made to the venture by each partner. The Chinese often insist that foreign partners pay a large sum of foreign cash to the venture. The Chinese side prefers to contribute noncash items such as land, existing buildings, and construction materials. These items can be easily overvalued due to the difficulty in assessing prices accurately. One manager, interviewed in 1994, complained that the value of an out-of-date computer was estimated at close to its original purchase price, even though the foreign partner had to buy one to replace it. To avoid such complications, foreign companies should take advantage of assessments by professional consulting companies.

When investing their technology in a joint venture, the suppliers may have additional complications. Although capitalization of technology is an important element of technology transfer throughout the world, it is often discouraged by Chinese authorities who fear underfinanced joint ventures where foreign partners mainly contribute intangible assets. Chinese firms are subject to various "internal policies" of the government, which often restrict the capitalization of technology to a 15-20% maximum. Although such policies are not publicized, projects that capitalize the majority of the technology tend to slow down the process of approval or even lead to eventual disqualification. Worries about improper capitalization of technology have led the Chinese to be more inclined toward technology licensing when the supplier is a joint venture partner.

The RATIC and its "Detailed Rules" impose strict restrictions on tie-in arrangements. Unless special approval is received, the recipient cannot be required to purchase "unnecessary technology, technical services, raw materials, equipment or products," nor may its freedom to purchase "raw materials, spare parts, or equipment," from sources other than the supplier be restricted. In order to reduce hidden costs for "unnecessary" ancillary services and equipment, stipulations against such arrangements are often included in technology transfer control laws.

Such regulations present a serious problem to potential suppliers because tie-in arrangements provide a major incentive for foreign companies to transfer their technology. It is also often impossible for a supplier to fulfill contractual guarantees requiring that the technology, "achieve the objectives stipulated in the contract," unless the recipient purchases the proprietary spare parts and raw materials required by the application. Therefore, a tie-in arrangement may be necessary to protect the legitimate interests of the supplier. Without such an arrangement, contract provisions would have to stipulate that if inputs are not properly sourced according to the supplier`s specifications, the supplier shall not be liable for problems caused by substandard inputs.

The RATIC and other related Chinese laws also prohibit suppliers from placing restrictions on quality, price, or region of sale and export. Similar provisions prohibiting constraints on scope and volume of production, as well as price fixing, are expressed in the technology transfer regulations of many developing countries. An export restriction is clearly "unreasonable" if it prohibits the recipient from exporting to a market where the foreign supplier has no presence. However, suppliers do have legitimate cause for protecting their existing markets. Fortunately, Chinese authorities often accept restrictions that prevent direct competition with the supplier`s own products in their home market [8].

Intellectual property can be a vexing issue unless proper measures are negotiated to secure protection. The Memorandum of Understanding (1992) and the Agreement on Intellectual Property Protection (1994) have significantly improved the environment for the protection of investors` intellectual property. Nonetheless, RATIC allows a Chinese recipient to simultaneously use other foreign suppliers` technology. Various provisions in technology transfer laws of other developing countries challenge the validity of clauses restricting the recipient`s use of competing technology. This restriction is perceived to hinder the recipient from making a reasonable selection of appropriate technology.

When the Chinese recipient cooperates with a direct competitor of the foreign supplier, it is extremely difficult to maintain trade secrets. The turnover rate of Chinese employees in joint ventures, especially at the managerial level, is fairly high due to the shortage of experienced personnel. Careful contract drafting is crucial to giving the supplier proper protection.

Once the contract is approved, the Chinese side will need to petition the local office of the Administration of Industry and Commerce for a venture license in order to begin operation. The joint venture is not officially recognized until it receives this license. Upon granting of this license, the joint venture will need to contact the tax agency, get registered in the customs office, and open accounts in foreign and local currencies. After the completion of all these activities, it can begin its operations and recruit workers.

Conclusion

Despite stories of hardships, a recent survey [9] shows that 60% of joint ventures in China report a =10% return on investment (ROI). Nearly a third reported a ROI of at least 18%. Although such returns would be considered small by venture capitalists in the US, the average ROI of 11.6% is respectable for China-based international businesses. Only 12% of sampled firms appear to be losing money.

When more US companies do their homework and are well prepared for ventures in China, a higher percentage of success can be expected. Since 1990, the Chinese government has significantly clarified its investment policies and promulgated a series of laws and regulations. Attracting foreign investment has become part and parcel of its long-term development strategy. Ventures involving the transfer of technologies, especially high technologies and those prioritized in the development program, will be particularly welcomed in the years to come.

Acknowledgment

This article is excerpted from the author`s book, Managing International Technology Transfer, published in 1996 by International Thompson Business Press, ISBN 0-415-13323-8.

References

1. Beijing Review, p. 42, March 23-29, 1992.

2. R.J. Goosen, Technology Transfer in the People`s Republic of China: Law and Practices, Martinus Nijhoff Publishers, Dordrecht/Boston, 1987.

3. J. Peck, The China Business Review, pp. 12-15, Sept.-Oct. 1991.

4. A.K. Ho, Joint Ventures in the PRC, Praeger, New York, 1990.

5. H.H. Fischer, East Asian Executive Reports, pp. 9-16, May 1993.

6. M. Chen, The China Business Review, pp. 12-16, March-April 1993.

7. E.J. De Bruijin, X. Jia, Research-Technology Management, pp. 17-22, Jan.-Feb. 1993.

8. J.A. Cohen, D.G. Pierce, The China Business Review," pp. 44-49, May-June 1987.

9. L. Stelzer, M. Chunguang, J. Banthin, The China Business Review, pp. 54-56, Nov.-Dec. 1991.

MIN CHEN is an associate professor of International Studies at Thunderbird, The American Graduate School of International Management. 15249 N. 59th Avenue, Glendale, AZ 85306-6000; ph 602/978-7001, e-mail [email protected].