China Law Update

China M&A Tax Issues - Installment 3: Mergers and Special Purpose Vehicles

Sheppard Mullin — Tue, 09 Mar 2010 09:26:12 -0800

Mergers

A merger involves two or more enterprises forming a single legal entity through combining their assets and liabilities. In China, the absorption of an existing company or the creation of a new entity are the two methods through which a merger can be transacted. Though the former resembles an acquisition, different tax rules apply if the transaction is recognized as a merger.

For a merger that is considered an ordinary reorganization, tax on assets and liabilities being transferred will be based on the fair market value. Tax losses of the enterprise whose assets and liabilities were transferred (merged enterprise) cannot be carried over to the enterprise to which assets and liabilities were transferred (merging enterprise). The assets of the merged enterprise are taxed based on the transaction price.

If a merger is considered a special reorganization, assets transferred will have the same tax basis as the original tax basis of the merged enterprise’s assets and liabilities. As in an acquisition that is considered a special reorganization, taxable gain will not arise and the original purchase price will be the tax basis for future sales of the transferred assets in the current merger. The merged enterprise’s losses can also be carried forward, though the amount that can be used must be equal to the net operating loss (which is equal to the fair market value of the transferred assets multiplied by the bond yield of the government bond with the longest maturity term at the end of the year that the merger occurred). If the merger occurs through the absorption of an existing enterprise, then the tax incentives of the merging enterprise can be carried over if the merger is considered a special reorganization.

If a transaction can satisfy the requirements of a special reorganization, it might be more tax-efficient to structure it as a merger rather than an asset acquisition, since the losses of the merged enterprise can be carried forward in a merger that is considered a special reorganization while they cannot be carried forward in an asset acquisition that is a special reorganization.

Special Purpose Vehicles

A Special Purpose Vehicle (SPV) is a subsidiary entity of an enterprise established to achieve specific objectives such as isolating the parent company from risk or accumulating tax benefits as a result of treaties between China, in this case, and the SPV’s jurisdiction of incorporation.

In China, no tax liabilities result from the sale of an SPV by its foreign parent; however, the General Anti-avoidance rule in the EITL enables the SAT to remove these tax benefits if it considers a transaction as having no reasonable business purpose. Thus, recent changes in the Chinese tax regulations may cause SPVs to lose their attractiveness as a tax-efficient instrument for equity transfers.

Authored By:

Jennifer Ding
jding@sheppardmullin.com

China's State Administration Of Tax Clarifies Treaty Treatment for Technical Know-How

Sheppard Mullin — Fri, 05 Mar 2010 12:43:28 -0800

On January 26, 2010, the State Administration of Tax (the "SAT") issued another Notice on Issues Concerning Implementing Royalty Clauses in Tax Treaties (Guishuifa [2010] 46, also referred to as "Circular 46"), further clarifying treaty treatment for technical know-how.

Main Points

According to Circular 507 issued by the SAT in 2009, "technical know-how" is "nonpublic information or data that is needed for the production or reproduction of a manufacturing process for a product". Circular 46 states that income generated from technical services provided in the course of transfer of usage rights of technical know-how is regarded as royalties for the purpose of taxation. However, if the licensor of the technical know-how assigns personnel to provide service at the location of the licensee for a duration of time that qualifies as a permanent establishment, according to the applicable tax treaty, the income arising from such permanent establishment will be subject to Article 7 of the treaty concerning taxation of business profits. In addition, the personnel providing such services is subject to the dependent personal service provisions of the tax treaty. The income that is not attributable to the permanent establishment, or that arises from services that don't constitute a permanent establishment, will still be treated as royalties for taxation purpose.

Sometimes the licensee of a technology transfer agreement pays the royalties and fees for the associated technical service in advance when concluding the contract. In that case, according to Circular 46, the rules of royalties shall apply temporarily if it is unclear whether a permanent establishment has been created. Once it is determined that a permanent establishment exists according to the duration of the service the tax treatment of income that arises from the permanent establishment will be adjusted. The business profits attributable to such permanent establishment will be subject to the enterprise income tax, and the income of the personnel to personal income tax.

For technology transfer agreements concluded before October 1, 2009, if the related technical services are performed beyond October 1, 2009 and that income has not yet been taxed, such income will be subject to both Circular 46 and Circular 507. The duration of technical services performed before October 1, 2009 will be used to determine whether such services constitute permanent establishments if they extend beyond October 1, 2009. However, income tax that had been imposed on technology transfers and related technical services before October 1, 2009 under the royalties rules will not be subject to adjustment.

Conclusion

Circular 46 should be read in tandem with Circular 507. According to Circular 507, royalties rules in a tax treaty only apply to resident beneficial owners of a treaty partner. Royalties generated in China by a permanent establishment created by a third-country resident and located within a treaty partner will be subject to the tax treaty between China and the third country. Royalties paid by a permanent establishment or establishment of a third-country resident located within China to a treaty partner resident will be subject to the tax treaty between China and the treaty partner. A permanent establishment created by a Chinese resident within a treaty partner cannot benefit from the royalties clause of the tax treaty between China and the treaty partner, because the Chinese resident located in a treaty partner is not regarded as a resident of the treaty partner state.

Whether the income from technology transfer and the related technical service is deemed business profit or royalty is very important. Business profits from China derived by a foreign enterprise that does not have a permanent establishment in China are actually not taxable according to China's tax treaties. However, royalties earned in China by a foreign enterprise are always subject to taxation (usually around 10%). Guishuifa[2006] No. 35 provides guidance on how to determine whether a permanent establishment exists, and Caishuizi (1999) No. 273 addresses situations where business profits from technology assignment and related technical services are exempt from income tax.

Authored By:

Jingyuan Sun
(212) 634-3094
jsun@sheppardmullin.com

China M&A Tax Issues - Installment 2: Ordinary versus Special Reorganizations in Share Deals and Asset Deals

Sheppard Mullin — Thu, 04 Mar 2010 09:35:20 -0800

Acquisitions: Share Deals

One of the two typical methods in which foreign investors can acquire a domestic Chinese company is through a share deal, which involves buying the shares or equity in the target company. As a result, liabilities will be inherited with the target company since the legal entity remains unchanged. In China, certain restrictions on foreign ownership of domestic companies prevent share deals from being transacted.

In terms of the tax issues involved in a share deal, the EITL dictates that accretions in the value of equity or assets are taxable at the time of realization. VAT or business tax will not be levied on a share transfer. China’s rules on stamp duty, however, require a 0.1% stamp duty on the sale price of the share transfer.[1] Lastly, the target company’s losses are permitted to be carried forward for up to 5 years.

The M&A rules require the fair market value be the tax basis of the equity or assets. If the shareholder is a foreign enterprise, then the tax rate on a share transfer is 10%. For special reorganizations, however, the tax basis of the acquired equity or assets is the seller’s original tax basis in these equity or assets. For example, if the seller originally purchased the target company for $2 million, and the buyer presently acquires the target company from the seller for $3 million, then the buyer’s tax basis is $3 million in an ordinary reorganization but only $2 million in a special reorganization. This difference in tax treatment for special reorganizations prevents any taxable gain from arising and allows the seller’s original purchase price to remain as the tax basis for further sales of the equity or assets.

After a transaction is completed, a buyer’s acquisition expenses cannot be deducted by the target company. These include interest expenses incurred for loans used for the acquisition, which will be capitalized into the costs of the asset according to the EITL Implementation rules. Furthermore, the tax basis of assets of the target company remains unchanged after the deal.

Acquisitions: Asset Deals

The other way in which many foreign investors acquire domestic Chinese companies is through an asset deal, which involves forming a new legal entity in China and acquiring the assets of the target company. The main goal for an asset deal is to minimize risk because unlike in share deals, liabilities are not inherited with assets in asset deals unless the liabilities are attached to assets. As a result of this, asset deals are also not subject to as much legal due diligence as share deals. They also do not need regulatory approval. On the other hand, asset deals are subject to more categories of taxes.

The tax cost of the assets is the purchase price of the assets. VAT on fixed assets is at 17%, while business tax on intangible assets is at 5%. Land-value appreciation tax is levied on assets that are land. Stamp duty is 0.03%-0.05% of the sale price of the transfer of assets. Deed tax of 3%-5% is levied on the sale of land or real estate. Unlike in share deals, the losses of the target company in an asset deal cannot be carried forward.

As with share deals, gains from the transaction are taxable at the time of realization of the asset and foreign enterprises are subject to a 10% tax. The asset receivers in deals that are considered special reorganizations also enjoy the advantage of being subject to the asset transferor’s original tax basis in those assets. Interest expenses connected to the asset acquisition and incurred by the newly established entity will be capitalized and depreciated over the life of the assets.

Conclusions

Choosing a deal structure to achieve tax efficiency thus depends on the particular set of circumstances. For example, the tax burden in an asset deal may not be excessive if the target company does not hold a lot of land and thus is not subject to land-value appreciation tax. Finally, in maximizing tax saving opportunities, deductions on interest expense or other tax benefits associated with different financing structures should also be taken into consideration.

Authored By:

Jennifer Ding
jding@sheppardmullin.com

[1] Provisional Rules of the People’s Republic of China on Stamp Duty (Order of the State Council of the People’s Republic of China (No. 11)), article 2 (the stamp duty rules).

China M&A Tax Issues - Installment I: Changes in Tax Rules

Sheppard Mullin — Fri, 26 Feb 2010 11:16:27 -0800

China’s new tax law went into effect in January of 2008. This development has had important effects on tax structures used by foreign investors doing mergers and acquisitions in China. It has influenced the strategies firms employ in pursuing “enterprise reorganization” projects involving domestic Chinese enterprises, including mergers, demergers, share acquisitions, and asset acquisitions. In April of 2009, China’s Ministry of Finance and State Administration of Taxation ("SAT") issued Caishui [2009] No. 59 (the "M&A Rules"). Some of the most significant aspects of the new tax law are described below.

General Anti-Avoidance Rule ("GAAR")

The introduction of the GAAR is contained in three documents: the Enterprise Income Tax Law ("EITL"), the EITL Implementing Regulations, and the Notice of the State Administration of Taxation on Issuing the Measures for the Implementation of Special Tax Adjustments (for Trial Implementation) (“Measures No. 2”). The SAT has also indicated that it will aggressively use the GAAR to target offshore transactions.

Article 47 of the EITL empowers the SAT to make a tax adjustment where a transaction results in a reduction in taxable income or has no reasonable business purpose. There is “no reasonable business purpose” as defined by Article 120 of the Implementing Regulations of the EITL where the main purpose of a transaction is to reduce, be exempt from, or defer the payment of taxes.

Anti-avoidance investigations, according to Article 92 of Measures No. 2, will target the following offenses:

Abusing tax preferences;
Abusing a tax agreement;
Abusing the corporate organizational form;
Avoiding tax through a tax haven; and
Any other arrangement without a reasonable business purpose.

Investigations will follow the principle of “substance prevails over form,” which is outlined in Article 93 of Measures No. 2 and requires that the following issues be considered:

The form and substance of an arrangement;
The time of conclusion and the period of execution of an arrangement;
The manners for realizing an arrangement;
The connections between different steps or components of an arrangement;
The changes of financial status of each party involved in an arrangement; and
The tax results of an arrangement.

Articles 94, 95, 96 and 97 elaborate on the methods through which investigations are conducted and tax benefits are canceled, and on other detailed issues.

Thin Capitalization Rules

The Ministry of Finance and the SAT issued a Notice on the Tax Deductibility of Related Party Interest Payments, known as Caishui [2008] No. 121 (“Circular 121”) on September 19, 2008. The introduction of thin capitalization rules in Circular 121 limits the debt-to-equity ratio allowable for tax deductions for excessive interest expenses incurred by an enterprise from related party debt financing. Specifically, a prescribed debt-to-equity ratio cannot exceed 2:1 for non-financial enterprises and 5:1 for financial institutions. If an enterprise engages in both financial and non-financial services, it must separately account for interest paid to related parties. If it does not, then 2:1 ratio for non-financial enterprises will be applied to the entire amount of the interest.

There are two exceptions to this rule regarding the tax deductibility of interest expense. The debt-to-equity ratio can exceed the stipulated threshold when 1) the financing is at arm’s length or 2) the effective tax burden of the borrower is not higher than that of the domestic entity receiving the interest payment.

The disqualified interest income received by a related party is subject to the Enterprise Income Tax.
The new thin capitalization rules have three immediate effects. First, they reduce the tax efficiency of debt push-downs. Second, they are likely to encourage a shift to local funding sought by foreign enterprises intending to establish an entity in China or to expand operations in China. Third, compliance to these rules will be thwarted by their lack of consistency with the Company Law of the PRC. Specifically regarding the third effect, for foreign corporations with an operating entity in China, the Company Law of the PRC stipulates debt-to-equity ratio requirements as set forth below:

Total Investment	Ratio of Registered Capital to Total Investment	Registered Capital as a % of Total Investment
<= US$3 million	At least 7 : 10	70%
US$3M to < $10M	At least 1 : 2	Higher of 50% or US$2.1m
US$10M to < $30M	At least 2 : 5	Higher of 40% or US$5m
>US$30M	At least 1 : 3	Higher of 33.33% or US$12m

Under these rules, interest payments related to inter-company loans would be tax-deductible. Under Circular 121, however, if the debt-to-equity ratio is not below 2:1 (or 5:1 for financial enterprises) the tax deductions may be violating the thin capitalization rule. Thus, foreign companies with operations in China must seek clarification of these inconsistencies.

Stricter Requirements for Transfer Pricing

An enterprise may be targeted for a transfer pricing audit if it possesses any of the following characteristics:

It conducts a significant number of related party transactions or many types of related party transactions.
It has long-term losses or marginal or fluctuating profits.
Its rofit level is lower than industry norm or other group members.
It engages in transactions with related parties located in tax havens.
It fails to properly report related party transactions.
It fails to prepare required contemporaneous documentation.
It fails to adhere to arm’s length principles.

On inter-company transactions, tax authorities may apply any of the following methods for tax adjustments:

Comparable Controlled Price (CUP)
Resale Price Method (RPM)
Cost Plus Method (CPM)
Transactional Net Margin Method (TNMM)
Profit Split Method (PSM)
Any other method in compliance with the arm’s length principle

The most reliable or reasonable method will be used, and tax authorities have up to 10 years to make adjustments if transactions do not conform to arm’s length standards. Those enterprises subject to transfer pricing audit adjustment will be placed under a 5-year supervision period, which monitors compliance with contemporaneous documentation requirements, changes to operations, operating results, and related party transactions. Interest will be imposed on unpaid tax resulting from transfer pricing adjustments. It includes non-deductible interest and interest calculated on the RMB loan base rate published by the People’s Bank of China for the relevant period plus 5%.

Ordinary vs. Special Reorganizations

Caishui [2009] No. 59 distinguishes between ordinary reorganization and special reorganization. Special reorganizations enjoy roll-over tax liability when the underlying owner has not changed (although the nonequity portion of the transaction will not be rolled-over but rather subject to taxable gain). The following are considered Special Reorganizations:

The reorganization has a bona fide commercial purpose and is not implemented to reduce, exempt, or defer any tax.
The assets or equity transferred in the acquisition is above the prescribed 75% criterion.
The original business of the enterprise remains unchanged during the 12-month period following the reorganization.
The equity consideration is at least 85% of the total consideration.
The main shareholder receiving the equity consideration cannot transfer that equity consideration acquired within 12 months after the reorganization.

Special reorganization tax relief is available to cross-border transactions that do not satisfy the above conditions but occur under the below circumstances:

When a nonresident enterprise transfers shares in a Chinese company to a wholly-owned subsidiary company, regardless of whether the acquiring company is a resident company. If a transfer is to a nonresident company, it must not result in a lower rate of capital gains withholding tax.
When a resident enterprise invests in its wholly-owned, nonresident enterprise in the form of assets or equity interests.

In addition to the above aspects, the new tax law also outlines specifics M&A and liquidation tax rules and places doubt on previously conceived tax benefits from incorporating SPVs in some low-tax jurisdictions.

The next installment will explain the difference in tax treatment between ordinary reorganizations and special reorganizations.

Authored By:

Jennifer Ding
jding@sheppardmullin.com

Beijing Encourages Foreign Investment In Private Equity Fund Management Companies

Sheppard Mullin — Fri, 12 Feb 2010 11:10:11 -0800

After Shanghai allowed foreign private equity and venture capital funds to incorporate in Shanghai in August 2008, Beijing recently became another pioneer in giving legal status to foreign investment funds. On December 20, 2009, Beijing Municipality released a circular entitled Interim Measures on Establishing Foreign Invested Equity Investment Fund Management Enterprises (the "Measures"). The Measures are effective as of January 1, 2010, for a trial period of three years.

Main Points

According to the Measures, foreign investors are allowed to establish wholly foreign-owned equity investment fund management companies, or, alternatively, to establish joint ventures with local companies in the Zhongguancun Innovative Model Zone.

The Measures set the following requirements that shall be met in order to set up a foreign invested equity investment fund management enterprise ("FIEIFME"):

(1) A FIEIFME must be established in the form of limited liability corporation, and is allowed to use "fund management" in its name. In addition, a FIEIFME may be established as a partnership or other non-corporation forms where national policy permits.
(2) A FIEIFME must have registered capital of no less than 2 million US dollars, which should be contributed by the investors pursuant to Chinese laws and regulations.
(3) A FIEIFME must have at least two senior managers with at least two years' experience in this industry or related industries, good personal credit record, no record of wrongdoing in the past five years, and no ongoing economic litigations.

Existing foreign-invested enterprises that meet the above criteria and have no record of wrongdoing in the past five years and no ongoing economic litigations can convert to become a FIEIFME.

As stated in the Measures, the scope of business of FIEIFMEs is limited to "non-security equity investment fund managing and consulting with authorization from other equity investment funds."

FIEIFMEs that are registered in Beijing, and equity investment funds established by those FIEIFMEs are entitled to the beneficial treatments offered by the Circular On Promoting Development Of The Equity Investment Fund Industry, issued by Beijing Municipality.

The Measures also apply to individuals and enterprises from Hong Kong, Macau and Taiwan.

Conclusion

Since the Chinese central government has no nationwide rules regarding the legal status of foreign-invested equity investment funds, many foreign investment funds have to do business in China through representative offices or by providing consulting services. The central government has given special permissions to major cities such as Beijing, Tianjing and Shanghai to give legal status to foreign investment funds, and the government will learn from local experience in regulating such funds. However, foreign exchange issues of FIEIFMEs are still left unregulated, when ths issue of cash flow in and out of China is of the highest importance. How the Chinese government controls and regulates foreign exchange of FIEIFMEs will deeply affect the market.

Authored By:

Jingyuan Sun
(212) 634-3094
jsun@sheppardmullin.com

China Issues Opinions on Encouraging Technology Exports

Sheppard Mullin — Thu, 04 Feb 2010 10:03:10 -0800

On December 7, 2009, the Ministry of Commerce and the Ministry of Science and Technology jointly announced their opinions on encouraging technology export ("opinions"). Opinions on encouraging technology export focus mainly on three areas: implementing preferential policies, closer international cooperation and improvement of the related public administration. The aim is to support enterprises in their export of well developed industrial technologies.

Implementing preferential policies

According to article 3-6 of the “opinions”, financial and insurance products will be provided for scientific research organizations which undertake foreign scientific research projects as well as science and technology enterprises which intend to expand their businesses overseas.

Implementing the existing fiscal and taxation policies, and full using the relevant foreign trade and economic support policies to support the export of technology.
Meeting the technical characteristics and the actual needs of export enterprises of products and insurance, credit insurance, broadening financing channels for enterprises to expand the financing capacity.
Encouraging multinational companies to establish R & D institutions in China, and Commissioning R & D institutions to develop technology.
Encouraging universities and research institutes to undertake research and development through operations to train personnel, and improving research and development capabilities to develop the international market.

Closer international cooperation

In addition to international cooperation, events will be organized to provide opportunities for technology export according to article 8,9 of the “opinions”.

Playing a global and regional economic cooperation to contract projects work together in promoting co-operation with developed countries, while strengthening cooperation with developing countries to further promote international technical cooperation.
Increase the maturity of our industry, technology, intellectual property rights; relying on domestic and international well- known exhibition to promote the development of technology export.

Improvement of the related public administration

According to article 10,11 of the “opinions”, the government is expected to provide wider and better intellectual property rights protection to encourage the development of technology export service providers.

To establish technology export service platform, and to help companies access to international technology market information through information gathering, policy advice, technical resources and technical supplies.
To establish a database of intellectual property rights and public information service system to support the export of technology, and increase technological export enterprises the ability to resolve intellectual property disputes abroad.

Opinions on encouraging technology export will maintain a steady growth of foreign trade, and optimize the export structure, promote the rapid growth of technology exports to improve the technology exports as a proportion of trade in technology. Meanwhile, the "opinions" also provides policy support to promote the export of mature industry technology. China also seek for the improvement of fiscal, monetary and tax policies to promote the management and protection of intellectual property, construction, service system for the export of technology and trading platform for enterprises.

Authored By:

Melody Weng
mweng@sheppardmullin.com

SAIC and Ministry of Public Security Issue Stricter Rules for Foreign Representative Offices

Sheppard Mullin — Fri, 29 Jan 2010 10:09:21 -0800

By Jennifer Ding

China’s State Administration for Industry and Commerce (“SAIC”) and Ministry of Public Security issued a joint Notice on Further Administration of Registration of Foreign Companies’ Resident Representative Offices (the “Notice”) on January 4, 2010, in light of increased problems with foreign representative offices providing counterfeit registration materials and violating rules regulating their business operations in China. The Notice heightens the scrutiny over registration procedures, personnel structure, and operations of foreign representative offices, which the issuing administrations claim will enhance the enforcement of current regulations and help maintain economic and market order. There is no direct requirement in such Notice that the new restrictions established will be applied to foreign representative offices of certain professional-services firms (including law firms) and liaison offices of foreign-invested enterprises. A summary of changes outlined by the Notice is as follows:

Additional Requirements for Registration and Renewal

In order to register a representative office in China, a foreign company must provide an apostilled certificate of incorporation from its jurisdiction of incorporation indicating that it has been in existence for at least 2 years. This certificate must be notarized, certified by the appropriate national or regional government authorities of the company’s country of incorporation, and authenticated by the Chinese embassy or consulate with competent jurisdiction in such country. Documents describing the company’s financing structure and capital capabilities, as well as evidence of the company’s creditworthiness, must also be submitted.

In order to renew a registration certificate, a foreign representative office must provide documentation demonstrating its permission to continue business operations as granted by the relevant authority overseeing its jurisdiction of incorporation. It must also provide a new apostilled certificate of incorporation each time it renews its registration certificate.

Unlike previously, where a registration certificate could be valid for up to 3 years depending on local regulations governing each representative office in question, the Notice now uniformly limits the validity of a registration certificate to 1 year for all foreign representative offices. For certificates that have been issued and have passed the 1 year mark, holders must go to the local SAIC branch for a renewed certificate.

Limit on the Number of Representatives

The number of representatives a foreign company can appoint in its Chinese representative office must be in accordance to the number that its type of business requires. Although this definition is unclear, the Notice states that generally, the number cannot exceed 4 individuals, including the chief representative. Existing offices that have more than 4 individuals currently can only decrease that number and are not permitted to add more foreign representatives.

Field Checks on Operations

Local SAIC branches will now conduct field checks on foreign representative offices within 3 months after they have obtained registration certificates. If a foreign representative office is found to have provided fake registration materials or changed its address without updating the change on its registered documents, it will be punished immediately by rules that apply to each respective violation. Representative offices that are found engaging in direct operations and collecting fees will be treated as illegal operation without registration and punished accordingly (including fines, termination of China visa and even criminal liabilities).

Conclusion

As the SAIC collaborates more closely with the Ministry of Public Security to regulate the activities of foreign representative offices, foreign companies must be conscientious about official procedures for registering their foreign representative offices, renewing their registration certificates in a timely manner, and conducting operations according to Chinese law. Further, the compliance and legal department of such foreign representative offices need to be fully aware of the possible time consuming issue of the said renewal procedure, since the notarization and authentication procedures mentioned above may take more than 3 weeks in extreme cases.

An electronic version of the official Notice can be found here.

For more information, please contact:
Todd Bissett
Managing Partner
Sheppard Mullin Shanghai Office
tbissett@sheppardmullin.com

China's State Council Publishes New Implementing Rules For The New Patent Law

Sheppard Mullin — Fri, 22 Jan 2010 10:04:18 -0800

The third amendment of Chinese Patent Law went into effect on October 1, 2009, and since then there has been a need for new rules detailing its implementation. On January 18, 2010, the Chinese State Council published the third revision of the Implementing Rules For Patent Law (the "Rules"). The Rules are set to take effect on February 1, 2010.

Main Points

Security Check

The new Patent Law allows Chinese individuals and entities to file patents in foreign countries before obtaining Chinese patents. The new Patent Law follows the U.S. foreign filing system and requires applicants whose invention or utility model is made in China to submit the invention or utility model for a security check before filing outside of China.

The Rules define "inventions or utility models made in China" as "inventions or utility models in which the substance of the technical plan is completed in China." Therefore, where an applicant's invention or utility model fits the definition, the applicant, Chinese or Foreign, has to go through the security check before applying for patents outside of China. The Rules provide details regarding procedures for the security check. If the patent administration authority does not provide the Security Check Notification within the prescribed period, the applicants can file their patents in a foreign country directly.

Generic Resources

According to Article 5 of the new Patent Law, no patent will be granted for an invention based on genetic resources if the access or utilization of the said genetic resources is in violation of any law or administrative regulation.

The Rules define "genetic resources" as "any material that is obtained from the human body, animals, plants or micro-organisms, contains a genetic function unit, and is of actual or potential value." In addition, the Rules clarify that "an invention based on genetic resources" refers to "an invention based on the genetic function of genetic resources." The Rules also give guidance on how to disclose information regarding genetic resources. When filing patent for an invention based on genetic resources, an applicant must provide an explanation in the application and file an authority form.

Compulsory Licensing

According to the new Patent Law, a compulsory license may be granted if the patentee, after a certain period, fails to sufficiently exploit its patent without any justifiable reason, or the patentee is found to be monopolizing the patent and the compulsory licensing is for the purpose of eliminating or reducing its adverse effect on competition.

According to the Rules, a patentee "fails to sufficiently exploit" its patent where the patentee (or licensee) does not satisfy domestic needs for the patented product or method in either method or scope of exploitation.

Since the new Patent Law extends the availability of compulsory licensing to patented medicines for the benefit of public health, the Rules define the scope of "patented medicines". "Patented medicine" refers to any patented product, or any product directly based on patented methods, in the pharmaceutical industry that is necessary for resolving public health issues, including active ingredients necessary for the manufacture of such products and diagnostic devices necessary for the use of such products." In order to ensure compliance with TRIPS and relevant international treaties, the Rules require the patent administration authority to make sure their decisions in compulsory licensing conform to the provisions of the relevant international treaty to which the People’s Republic of China has acceded.

Authored By:

Jingyuan Sun
(212) 634-3094
jsun@sheppardmullin.com

Is Law Enough for Regulating P2P Technology?

Sheppard Mullin — Thu, 14 Jan 2010 13:08:55 -0800

On December 8, 2009, the largest Bit Torrent ("BT") download base, BTChina, was shut down by the State Administration of Radio, Film, and Television ("SARFT") for "lack of Certificate". SARFT explained that the regulation of Internet audio-visual services is a long-term project. Until the site resolves its piracy issue it can not be re-opened. According to a CCTV report on December 17, 2009, SARFT announced that it had shut down more than 700 websites, including nearly 30 of the BT download sites. This incident raises deep concern among Chinese netizens: why did the Chinese government suddenly intensify efforts to crack down BT sites? Does this mean that the peer-to-peer (P2P) download technology will meet its end in the near future?

Public interest and copyright protection

The development of the P2P technology has profoundly changed the model of information delivery on the Internet. P2P file-sharing has become the main approach to sharing information on the Internet. Using the new generation of P2P technologies, individual users can share files with each other without accessing the server. For business enterprises, there is a huge opportunity for the P2P technology, and various business models have been developed based on the P2P technology. Before the development of P2P, the transition from analog to digital technology, the expansion of Internet bandwidths, and the advancement of compression technology laid the foundations for change. As a result, the P2P technology triggered large-scale file-sharing and reproduction, and the dissemination of such products on the Internet became increasingly more common. It cannot be denied that the P2P technology has brought many benefits to the public: it saves consumers significant costs to obtain files, satisfies the individual needs of consumers, provides a platform for innovators, and promotes the diversification of entertainment products. At the same time, however, a large number of copyrighted works on the Internet are now freely copied and distributed, imposing huge financial losses on copyright owners . Thus, the development of the P2P technology has posed an unprecedented threat for copyright owners. The balance between copyright protection and the public interest has therefore been upset and the copyright regulatory system on the Internet now faces new challenges.

Countermeasures in Chinese Law

In regards to protection legislation in the field of digital works, the State Copyright Administration issued Provisions on the Copyright of Digital Products (now defunct) as early as December 9, 1999, which confirmed that digital products made from existing works, regardless of the form in which the existing works were expressed and finalized, are subject to the Copyright Law of the PRC. Moreover, it stipulated a collective management system for digital works.

Interpretations of the Supreme People's Court on Several Issues Concerning the Application of Law in the Trial of Cases Involving Copyright Disputes over Computer Network was promulgated by the Supreme People's Court on November 22, 2000. It has been revised twice and has become the most commonly used basis for the application of Chinese copyright laws. It therefore already stipulated the rules regarding the liabilities of Internet service providers before the amendment of the Copyright Law of the PRC was even adopted.

The State Copyright Administration and the Ministry of Information Industry issued Measures for the Administrative Protection of Internet Copyright on April 29, 2005, which initially stipulated the Safe Harbor system. In addition, Interpretation of the Supreme People's Court and the Supreme People's Procuratorate Concerning Some Issues on the Specific Application of Law for Handling Criminal Cases of Infringement upon Intellectual Property Rights and Reply of the Supreme People's Court and the Supreme People's Procuratorate on Relevant Issues concerning Audio-visual Products Involved in the Handling of Criminal Cases of Infringing upon Copyrights were promulgated by Supreme People's Court and the Supreme People's Procuratorate on December 22, 2004 and September 26, 2005, respectively. They state that the dissemination of others' literary works, music, film, television or video products, computer software, and other works to the public through information networks shall be deemed “reproduction and distribution” as prescribed by Article 217 of the Criminal Law.

Regulation on the Protection of the Right to Network Dissemination of Information, which was promulgated on May 18, 2006 and came into effect on July 1, 2007, further clarifies the "Notice and take down" regime and became an important legal basis for relevant, follow-up cases.

In the specific P2P infringement cases, such as Zhengdong Record v. Shijiyueb, Busheng v. Kuro.com.cn, Boshengfangan, Dizhi Culture v. Baidu, Huang Yimeng, Zhongkai Culture v. Shulian, and so on, the attitude of the Chinese Courts is quite similar to that of U.S. Courts. Generally speaking, Chinese Courts support the claims of infringement against P2P service providers.

Heated debates regarding P2P technology arise each time the Chinese government promulgates new laws and regulations concerning P2P infringement, and each time P2P service providers are sued in Chinese Courts,. People always question whether free downloading via P2P technology would come to an end. However, P2P technology was withstood the test each time. In fact, P2P technology has become increasingly mature and file-sharing has enjoyed a broader user group. Therefore, SARFT’s stringent measures against BT websites this time are highly likely to produce the same result.

Solutions

As a matter of fact, laws regulating P2P infringement will encounter the following bottlenecks: first, since P2P infringement is covert and collective by nature, either for service providers or for copyright owners, the costs of copyright protection on the Internet are still high; second, since the application of P2P technology is broad and private, it is difficult to distinguish legal downloading behaviors from illegal ones; and third, P2P technology develops quite fast and, relatively speaking, the law can not always keep up with the pace of technological progress. P2P technologies prohibited by existing laws will soon be replaced by more advanced P2P technologies. For example, in order to circumvent the law, center-type P2P technologies (such as Napster, BitTorrent) has give way to distributed P2P technologies (such as Grokster, Kazaa).

The traditional regulation model is aimed primarily at infringement in real space. In cyberspace, however, new regulations that attempt to regulate online copyright infringement may not be effective. The copyright system, which has adapted to the development of technology since the Gutenberg era, has lost its self-adaptability in the digital age, and internal adjustments can no longer meet the needs of copyright owners. Therefore, a new kind of mechanism is needed, stemming from a broader perspective, to protect copyrights as well as to safeguard the public interest.

In my opinion, online copyright protection should vary depending on the type of copyrighted work. Different online copyright licensing models should be adopted, taking consideration of four elements: law, architecture, market, and norms. Among them, the law, which is the core element, not only regulates network behaviors directly, but also indirectly regulates network behaviors by influencing the other three elements.

Conclusion

In sum, with the development of the P2P technology, traditional legal protections no longer meet the needs of copyright protection in cyberspace. The absence of state regulatory supervision in the past few years is one of the causes for the proliferation of such infringements. While state regulatory agencies use legal means to shut down illegal network services, they should combine considerations of architecture, markets and norms to guide users, and encourage business enterprises to establish a legal servicing system. Only through this way can the balance between copyright protection and public interest be restored.

Authored By:

Tony Shen
86.21.2321.6035
tshen@sheppardmullin.com

China Clarifies Concept of "Beneficial Owner" in Tax Agreements

Sheppard Mullin — Thu, 14 Jan 2010 12:36:30 -0800

On October 27, 2009, the Chinese State Administration of Taxation (“SAT”) issued a Notice, "How to Understand and Determine the 'Beneficial Owner' in Tax Agreements" (Circular No. 601, hereinafter referred as to the “Notice”). This Notice clarifies the definition of beneficial ownership for purposes of avoiding double-taxation and appropriately reducing tax burdens.

Background

China has signed a number of tax arrangements with foreign countries or regions, including Hong Kong and Macau Special Administrative Regions. The Notice states that the definition of the “Beneficial Owner” will be applied to determine whether a taxpayer qualifies for certain benefits of double taxation regarding dividends, royalties and interests specified by relevant tax arrangements.

Major Points

The term “Beneficial Owner” under the Notice refers to a person who has the right to own and dispose of the income and rights or properties generated from the aforesaid income. The Notice further highlights that the “Beneficial Owner” may be an individual, a company or any other organization which is engaged in substantial business operations. An agent or conduit company[*] is not a “Beneficial Owner”.

The Notice adopts a rationale of “Substance over Form” that focuses on the purpose of tax treaties, namely avoiding double taxation and preventing evasion of taxes. Moreover, the Notice enumerates seven situations that are unfavorable to determining “Beneficial Owner” status for applicants:

Where the applicant pays or distributes to residents of a third country (region) the total or majority of the income (for example, 60% or more) within a fixed period (for example, within twelve months after the income is received);
Where the applicant never or rarely performs other business operations except for the holding of properties or rights generated from the income;
Where the applicant is an enterprise, but has less assets and personnel, and is smaller in scale than would proportionately match its income;
Where the applicant rarely has or does not have a right to control or dispose of the income or the properties or rights generated from the income, nor bears little or no risk;
Where the other party (country or region) to the tax treaty either 1) imposes no taxes on, 2) exempts tax from, or 3)imposes extremely low taxes over the relevant income.
Where except for the loan contract from which interests originate and are paid, there exists another loan or deposit contract between the creditor and a third party, which entails similar amounts, interest rates and dates of commencement as the loan contract itself;
Where there exists another contract between the applicant and a third party on the right to use or own a copyright, patent or technology apart from the contract, from which the royalty is generated and under which it is paid.

Therefore, SAT will make a comprehensive analysis of the aforementioned factors to determine whether the applicant will be regarded as a “Beneficial Owner”.

Conclusion

The Notice demonstrates SAT's serious attitude on recognition of a “Beneficial Owner”. Since more and more offshore special purpose vehicles (“SPVs”, offshore investment vehicles) have been set up in jurisdictions whose tax treaties with China would lead to a preferential policy regarding avoidance of double taxation, SAT promulgates the Notice to facilitate avoidance of double taxation for multi-national taxpayers on the one hand, and to prevent "tax treaty shopping” on the another hand.

Authored By:

Willow Wei
86.21.2321.6000
wwei@sheppardmullin.com

[*] In Article 1 of the Notice, SAT specifies and emphasizes that the term “conduit company” refers to a company which is usually established to dodge or reduce taxes, and transfer or accumulate profits. Such a company is only registered in the country of domicile to satisfy the organizational form as required by law, but does not engage in substantial business operations such as manufacturing, distribution or management.

China Finalizes Merger Control Measures

Sheppard Mullin — Thu, 24 Dec 2009 09:28:12 -0800

Since enacting China's Anti-Monopoly Law (AML) in August 2008, China has been making efforts to update its antitrust laws. The Ministry of Commerce (MOFCOM) published draft regulations on the notification of mergers between enterprises, and on the examinations of mergers between enterprises for comments in January and March, 2009.

On November 27, 2009, The Anti-Monopoly Bureau of MOFCOM finally published the Measures for the Review of Concentrations of Business Operators ("Review Measures") and the Measures for the Notification of Concentrations of Business Operators ("Notification Measures"). Both will take effect on January 1, 2010. Together with the Provisions of the State Council on the Standard for Declaration of Concentration of Business Operators ("Declaration Provisions"), the two Measures will provide basic guidelines for companies that are involved in transactions with notice requirement under the AML.

Main Points

Notification Thresholds
Article 3 of the Notification Provisions provides for the notification thresholds of concentrations of business operators. The Notification Measures define the revenues "within China" as revenues from transactions in which the purchaser of products or services provided by the business operator is located in China. The Notification Measures confirm MOFCOM's practice of aggregating the party's group revenue in calculating concentration. According to Article 5 of the Notification Measures, the revenue for a "business operator"(the party) in a concentration should include the revenue of the party, the party's subsidiaries, business operators which directly or indirectly control the party, and other subsidiaries of its parent companies. If the parties in a transaction jointly control an entity, its revenue from transactions with any third party should also be included. Article 7 of the Notification Measures provides that when a business operator acquires parts of one or more business operators, the revenue only of the part(s) being sold should be included in the concentration. In order to prevent parties from circumventing the review, transactions made between the same buyer and seller within two years which do not reach the thresholds will be aggregated in concentration reviews.

The Definition of Control
Following the European method, Article 20 of the AML defines a "concentration of business operators" as: (1) a merger of business operators, or (2) a business operator acquiring control over other business operators by acquiring their equities or assets, (3) a business operator acquiring control over other business operators or exerting a decisive influence on them by contract or by any other means. Therefore, the definition of "control" is critical in deciding which transactions between business reporters should be reported to and reviewed by the antitrust agency. However, the important article defining "control" in the second draft, as well as the article about minority shareholder rights, have been deleted from the Notification Measures, a big disappointment to lawyers and business operators.

The deletion of the proposed definition of "control" will give MOFCOM great discretion in reviewing acquisitions between business operators and will in fact include more transactions under the scrutiny of MOFCOM.

No Guidelines on Joint Venture
The draft version had confirmed that two or more business operators jointly establishing a new entity can qualify as a concentration under Article 20 of AML. Discussions were focused on whether limited collaboration other than a "full function" joint venture should qualify as a concentration. The Notification Measure completely omits the provision in the draft regarding joint venture.

Required Documents
The Notification Measures have a broad list of documents that must be submitted to MOFCOM. The required documents include: (1) a notification introducing the parties and the transaction; (2) a statement that explains the concentration's possible effect on competition in the relevant market; (3) transaction documents and (4) the financial accounting report of the last fiscal year. Confidential version and non-confidential version of the documents must be submitted both in hard copy and in electronic form (in a DVD). Translations are required for documents in foreign languages.

Procedures of Reviewing
According to the Review Measures, MOFCOM can require documents from the parties and other relevant entities or governments when reviewing a transaction. MOFCOM may hold a hearing regarding a reported transaction at its own initiative or at the request of relevant parties. It can invite the parties, experts, and people from relevant companies, business associations and governments to give their oral or written opinions.

Under the Review Measures, MOFCOM must give written notice at the completion of the notification, the beginning of the initial review period, and the initiation of the second-phase review. Parties to a reported transaction have the rights to defend their transaction in writing. MOFCOM should review the defense and make decisions to approve or prohibit a transaction in a timely manner.

Conditional Approvals
Remedial Conditions on a notified transaction can be proposed either by MOFCOM or by the parties. MOFCOM can impose structural conditions or behavior conditions, or both on a concentration. The conditions must be practical and have the potentiality in limiting the harms of the transaction on competition in the relevant market.

Conclusion

Like much of Chinese legislations, the two Measures are vague and have left a lot of discretions to the antitrust authorities. The Measures have excluded details that were in the previous drafts. The uncertainty created by the Measures may enable MOFCOM to review minority shareholdings, joint venture and other transactions with limited control rights. On the other hand, after laying the foundation for merger control, MOFCOM may provide more details to limit its discretion and provide more certainty by new guidelines such as the Interim Measures on Collecting Evidences regarding Suspected Monopolistic Concentrations between Business Operators Not Reaching the Notification Thresholds which is in the stage of public consultation now.

Authored By:

Jingyuan Sun
(212) 634-3094
jsun@sheppardmullin.com

China's Supreme Court Drafts Guidelines For Adjudicating Disputes Involving Foreign Investment

Sheppard Mullin — Tue, 15 Dec 2009 13:59:25 -0800

On November 23, 2009, China's Supreme Court launched public consultation on draft Regulations on Issues in Adjudicating Cases Involving Foreign Invested Enterprise Disputes (Part 1) (the "Guidelines"). The Guidelines provide detailed rules regarding dispute resolution for foreign investors based on the court's experience in real cases.

Main Points

The Supplementary Agreements of Joint Venture Contracts
Under the Chinese law, contracts that establish or amend a foreign investment enterprise (FIE) will take effect only when approved by a competent government authority. In practice, investors often deliberately leave some terms out in the joint venture contract in order to simplify it to obtain faster approval. They then put detailed terms into the supplementary agreements. The Guidelines stipulate that as long as the joint venture contract is approved and the supplementary agreements do not make "material changes" to the approved contract, the court shall not rule such agreements ineffective. “Material changes” include changes in registered capital, company type, term and scope of the enterprise, amount of contributions by shareholders, methods of contribution, mergers and divisions, and share transfers.

Contribution by Shareholders
Under the Guidelines, the court will check whether contributions, other than those in cash, are actually made to the FIE. If the party has transferred those contributions such as buildings and equipment but has not yet changed the title at the registration authority, the court should order it to change the title. If the party fails to change the title or provide such contributions, the court should regard this as breach of contract, and require such party to make the contributions and to pay for damages if any.

Transfer of Shares
If the transferor does not go through the approval procedure after the share transfer agreement is executed, the transferee can request that the court join the FIE as a third party and order the transferor to obtain the approval. In addition, the transferor should return the amount of the purchase price and recover the damages incurred to the transferee if the failure to obtain approval is the transferor's fault.

In the case where the transfer of shares is completed and the buyer is acting as a shareholder in the FIE, if the seller sues for the unpaid purchase price, the court should order the seller to obtain the approval from the government. Only when the transfer of share is approved will the court order the buyer to pay the purchase price. This confirms what is happening in practice, and hinders the freedom of contract in transferring shares of FIEs.

Rights of Preemption
Article 8 of the Guidelines provides shareholders of a joint venture with the statutory right of preemption when one shareholder intends to sell its shares to a third party. Those shareholders can claim preemptive right within the prescribed period even after the share transfer agreement is approved by the government. As long as the shareholders can prove that their preemptive rights are being violated, the court can declare the share transfer agreement void. It should be noted that the seller and the buyer do not have such right.

Share Pledge Contract
A share pledge contract is a legal instrument by which a person gives shares he/she holds in the FIE as a hypothecation to his/her creditor. Unless otherwise required by the property law, registration is not a prerequisite for a share pledge contract to be valid. However, the shareholder and the FIE still need registration to confront a third party in good faith.

Investment Trust Agreement
In an investment trust agreement, one party agrees to make the contribution and enjoy the rights and benefits as a shareholder while the other party agrees to be the nominal shareholder. According to the Guidelines, the court shall recognize such trust agreement as being valid unless it violates the mandatory requirements of the laws and administrative regulations, and is against the public interest.

According to the Guidelines, the court should not support the actual investor's request for shareholder status in the FIE unless an approval of change of shareholder is obtained before the court debates in the first trial. The court should support the nominal shareholder when it requests that the actual investor should perform its obligations under the investment trust agreement, pay its commission, or pay the dividends if it is not covered in the investment trust agreement. If the actual investor requests that the FIE to pay dividends or respect other shareholder rights according to the investment trust agreement, the request will not be supported by the court. However, the court will support the actual investor's request to terminate the investment trust agreement and the request that the nominal shareholder pay damages if it fails to perform its obligation under the trust agreement.

The guidelines also give instructions of what to do after the investment trust agreement is declared void.

Other Issues

When two or more foreign investors form a wholly foreign-owned entity (WFOE), most of the time they choose the laws of their home countries as governing law in the joint venture contract in order to minimize the legal risks in China. Such choice of law will not be enforceable, according to the Guidelines.

The Guidelines extend their authority to investors from Taiwan, Hong Kong and Macau, and Chinese citizens residing outside of China.

The Guidelines have the retroactive effect to all cases that have not reached final verdict.

Conclusion

The Guidelines provide detailed rules regarding foreign investment disputes and are, to some extent, aggressive in the scope of application.

It is time to wait and see how the Guidelines will be modified by public opinion, but they will undoubtedly shape the behavior of investors of FIEs

Authored By:

Jingyuan Sun
(212) 634-3094
jsun@sheppardmullin.com

China Issues Hospital Complaint Rules (for Trial Implementation)

Sheppard Mullin — Tue, 15 Dec 2009 10:52:10 -0800

The Chinese Ministry of Health (“MOH”) announced the promulgation of the Hospital Complaint Rules (for Trial Implementation) (the “Rules”) on November 26, 2009. The Rules aim to improve the management of hospital complaints and reduce medical accidents and negligence.

Background

In China, issues regarding hospital management and the mitigation of medical accidents have attracted more and more attention from both medical industry experts and civilians. Usually, patients' complaints for medical accidents are not well-handled by hospitals or other medical entities. Because of this, the number of medical negligence litigations is climbing annually. Hoping to streamline hospital complaint management, the trial implementation of the Rules is regarded as a precedent in the area.

Major Points

The Rules will be applied to all kinds of hospitals in China, including foreign-invested medical entities. Patients and their families or relatives can provide opinions or suggestions regarding medical treatment, medical equipment and medical environment to hospitals, according to the Rules.

Moreover, the Rules underscore that medical personnel must respect the right of privacy, right of acknowledgement and right of decision of a patient. Important information in the course of medical treatment must be recorded to the medical history of the patient in a timely, complete and accurate manner. Additionally, medical histories with significant information of medical treatment must be acknowledged and signed by the patient or his family.

The Rules also specify that hospitals and health administrations must use intermediation in hospital complaint management. The Rules require not only that the complaints department in a hospital deal reasonably with patient complaints, but also any other office or department of the hospital. For any complaint which may be related to medical security, a hospital must immediately take remedial steps. As to the complicated complaints, a hospital must respond with its opinion and report the resolution to a complainant within five (5) working days.

Conclusion

Since the promulgation of Interim Measures for the Administration of Foreign-invested Joint Ventures, foreign-invested medical entities have played an important and active role in the Chinese medical industry. The Rules are of great importance for these medical entities to foster their operations in China. Meanwhile, the implementation of the Rules is also a signal from MOH that mitigation of medical litigations and protection of human rights of patients will be significantly highlighted in China.

Authored By:

Willow Wei
86.21.2321.6000
wwei@sheppardmullin.com

Protect Your Internationalized Domain Names

Sheppard Mullin — Wed, 09 Dec 2009 09:26:38 -0800

At the 36th Annual Meeting of the Internet Corporation for Assigned Names and Numbers ("ICANN") on October 30, 2009, the ICANN board finally approved the new Internationalized Domain Name ("IDN") Fast Track Process. IDNs have been a topic of discussion since before ICANN's inception. It has taken years of intense technical testing, policy development, and global cooperation to prepare the Fast Track process for its launch. On November 16, 2009, ICANN officially opened the IDN Fast Track Process to allow countries that use non-Latin based languages to also apply for top-level domains that reflect their country's name in local scripts such as Chinese, Korean, Arabic, etc.

".中国" Domain Names

With the full support of representatives from the internet industry, including Microsoft, Baidu, Alibaba, Taobao, Firefox, OPERA, Sina, and Tencent, China Internet Network Information Center ("CNNIC") formally applied for ".中国" (meaning ".CHINA") as an IDN on the same day. It is estimated that Chinese domain names would be internationalized in the beginning of 2010. So far, over 90% of PRC government authorities and key Mainland universities, over 95% of media websites, over 50% of the top 100 local enterprises in China, and over 40% of the top 500 local enterprises in China have already registered their own ".中国" domain names.

".中国" domain names have great value for the majority of internet users, as well as for enterprises. For more than 300 million internet users, it will add an optional access mode while for 1 billion people who don't have access to the Internet, it will lower the thresholds of access, learning and use of the internet. Moreover, it will allow domestic enterprises apply for domain names which directly using Chinese brand names. At the same time, it will help foreign enterprises localize foreign brands.

Cybersquatting Activities

".中国" domain names can make a positive impact on the Chinese internet system. However, this also inevitably raises the risk for cybersquatting activities. Why are cybersquatting activities so popular in China? There are three major reasons:

First, the registration fee for one domain name is inexpensive in China, roughly around RMB 150. If a cybersquatter registers a domain name and sells it successfully, he would probably earn thousands of RMB, or even more.

Second, in practice, CNNIC only performs a preliminary examination rather than a substantial examination to determine whether a proposed domain name has infringed upon others’ prior rights.

Last but not least, it is relatively hard to punish cybersquatters under the existing Chinese legal framework. According to Rules for CNNIC Domain Name Dispute Resolution Policy, a complaint must satisfy the following three requirements: (1) the disputed domain name must be identical with or confusingly similar to the complainant's name or mark in which the Complaint has civil rights or interests; (2) the disputed domain name holder must have no right or legitimate interest in respect of the domain name or major part of the domain name; (3) the disputed domain name holder must have registered or used the domain name in bad faith.

Conclusion

With the upcoming approval of ".中国" domain names, the use of purly Chinese domain names will become popular not only in China but also among overseas Chinese. Therefore, both Chinese enterprises and foreign enterprises are encouraged to take appropriate measures to guard against all types of cybersquatting activities on ".中国" domain names.

Authored By:

Tony Shen
86.21.2321.6035
tshen@sheppardmullin.com

The Administrative Measures for the Establishment of Partnership Enterprises in China by Foreign Enterprises or Individuals Will Take Effect On March 1, 2010

Sheppard Mullin — Wed, 02 Dec 2009 17:12:48 -0800

On November 25, 2009, China’s State Council issued the long-awaited Administrative Measures for the Establishment of Partnership Enterprises in China by Foreign Enterprises or Individuals (the “FIP Measures”). The FIP Measures will take effect on March 1, 2010.

Major Points

The FIP Measures permit foreign individuals and enterprises to establish a partnership with either foreign investors or Chinese individuals or enterprises. The FIP Measures also apply to individuals and enterprises from Hong Kong, Macau and Taiwan. According to the Q&A session held by the Legislative Affairs Office of the State Council, foreign investors are also allowed to join an existing partnership as new partners. In addition, a partnership with both Chinese and Foreign partners can continue its business when all the foreign partners withdraw from the partnership.

The FIP Measures are silent regarding minimum contributions from foreign investors, and allows them to make their partner contributions in either freely-convertible foreign currencies or in Yuan.

It is worth noting that partners are permitted to assign an agent or representative to register the partnership at the local administrative department for industry and commerce, if they agree to do so unanimously. Approval from the Ministry of Commerce, a must-have to set up other forms of foreign invested enterprises, is not required for partnership according to the FIP Measures. However, aside from the documents required by Measures of the People’s Republic of China for the Registration of Partnership Enterprises, a written proof of compliance with foreign investment policies is required at the time of registration. Foreign individuals and enterprises should refer to the Foreign Investment Guidance Catalog before registering the partnership. If the partnership business is in an industry subject to government approval, such approval should be obtained by the partnership.

The FIP Measures leave open hot issues regarding investment funds in the form of partnerships. According to the FIP Measures, partnerships whose core business is investment will be subject to other relevant regulations, if any. This issue may be resolved by the proposed Provisional Measures for the Management of Equity Investment Funds, currently being drafted by the National Development and Reform Commission.

Authored By:

Jingyuan Sun
(212) 634-3094
jsun@sheppardmullin.com

Changes to China's "Value Added Tax" as of October 2009

Sheppard Mullin — Tue, 24 Nov 2009 10:41:48 -0800

In October, 2009, two regulations were issued regarding value added tax (VAT) treatment in China. One regulation clarifies the value added tax (VAT) treatment of certain asset reorganizations between publicly traded companies (PTC) and their holding companies. The other exempts foreign-owned research and development (R&D) centers from taxes on imports of listed equipment and grants foreign and Chinese-owned R&D centers full VAT refunds on purchases of certain domestically made equipment.

VAT Treatment Regarding Certain Asset Reorganization

On October 21, 2009, China's State Administration of Taxation (SAT) issued Guoshuihan [2009] No. 585 ("Circular 585"), clarifying the value added tax (VAT) treatment of certain asset reorganizations between publicly traded companies (PTC) and their holding companies.

1. Under Guoshuihan [2002] No. 420 (Circular 420), transfer of a company's ownership, which is defined as transfer of all of the company's assets, creditor's rights, liabilities, and labor resources, is not subject to VAT. However, according to the newly released Circular 585, if a PTC transfers its assets, liabilities, and other relevant rights and obligations to its holding companies during an asset reorganization while remaining publicly traded, the income on the transferred assets related to the asset reorganization will be subject to VAT. Such transfers will not fall into the listed transfers under Circular 420.

2. Circular 585 states that the disposal of fixed assets in the course of an asset reorganization will be subject to the VAT treatment prescribed in Caishui [2008] No.170 (Circular 170), Caishui [2009] No. 9 (Circular 9), and other relevant provisions. Companies should refer to Circular 190 and Circular 9 for details of the VAT on incomes from transferring fixed assets.

3. If a holding company of a PTC invests in another company the tangible assets acquired in an asset reorganization, the holding company is subject to VAT treatment since the contribution of those assets are treated as taxable assets for VAT purposes.

VAT Treatment Regarding Research and Development Centers

On October 10, 2009, the State Administration of Taxation, the Ministry of Finance and the General Administration of Customs jointly issued Caishui [2009] No 115 (Circular 115), exempting foreign-owned research and development (R&D) centers from taxes on imports of listed equipment and granting foreign and Chinese-owned R&D centers full VAT refunds on purchases of certain domestically made equipment.

Different criteria were set for foreign-owned R&D centers established before September 30, 2009 and after October 1, 2009 to be qualified for the preferential tax treatment in Circular 115. Foreign-owned R&D centers who meet the criteria will be eligible for exemption of custom duty on listed equipment imported by December 31, 2010. Qualifying foreign and Chinese-owned R&D centers will also be eligible for full VAT refunds on purchases of listed equipment. The equipment under Circular 115 refers to equipment, fillings and instruments made in China for scientific research, education, and development.

Circular 115 will effect purchases and imports made from July 1, 2009, to December 31, 2010. Detailed rules on tax refunds will be formulated by the Ministry of Commerce and SAT.

Authored By:

Jingyuan Sun
(212) 634-3094
jsun@sheppardmullin.com

China Appeals WTO Ruling Against Chinese Import Restrictions on Publications and Entertainment Products

Sheppard Mullin — Wed, 11 Nov 2009 09:55:32 -0800

On September 22, 2009, China made its last-minute appeal of the August 12, 2009 World Trade Organization ("WTO") panel ruling on Chinese publication and entertainment distributions restrictions, invoking "public morals" as a defense. The case was brought to the WTO by the United States in April 2007, attracting extensive attention from both sides. The appeal again escalates the trade tensions between the two partners, following the United States' imposition of tariffs on tires from China and appeal of another WTO ruling on China's protection and enforcement of intellectual property rights.

The Panel Report

The 460-page panel report largely upheld the United States' claims that China was not providing enough access for imports of publications and audio-visual products, as promised under WTO agreement. The report called on China to bring certain measures in compliance with WTO rules. It is the first time a the WTO panel has ruled on trading rights and "public morals" defense of GATT Article XX, the exception clause of General Agreements on Tariffs and Trade.

Trading Rights and GATT Article XX

The case mainly focused on China's commitment under China's Accession Protocol on trading rights. Trading rights, i.e., rights to import and export, are not included in the Uruguay Round Agreements and only apply to countries that acceded to the WTO after it was founded in 1995. The panel found that while China has the right to regulate trade in a manner consistent with WTO guidelines, it should ensure that all Chinese enterprises, including foreign-invested enterprises registered in China, to have the right to import goods. The panel found that the requirements that publishing entities be wholly state-owned with suitable organizations and qualified personnel, and must conform to the State plan were inconsistent with China's obligation under WTO. China's restriction on rights to import hard -copy cinematographic films for theatrical release and master copies for audiovisual products imported for publication were inconsistent with its trading rights commitment.

China invoked the "public morals" provision in the exception clause, GATT Article XX, to defend the above-mentioned measures. The panel stated that "public morals" will be defined on a national, country-specific basis as in US-Gambling. However, the panel found that the above-mentioned measures failed to satisfy the "necessity standard" under the Chapeau of Article XX because the U.S. has identified less-restrictive measures to achieve the same objectives such as allowing private firms to import goods and the government to review their content. After weighing the contribution of the measures to protect public morals against the restrictive impact on trade and availability of alternatives, the panel found those measure to be inconsistent with WTO rules and China's commitments under the WTO.

National Treatment and Market Access

China's measures "prohibiting foreign service suppliers from wholesaling imported reading materials" were found to be adversely modifying conditions of competition, and thus in violation of Article XVII (the national treatment provision) of the General Agreement on Trade in Services ("GATS"), since Chinese suppliers were allowed to do so. Another measure prohibiting foreign investment in sound recording distribution was found to be inconsistent with China's market access commitment under GATS Article XVI. The panel also found that, regarding reading materials, the subscription regime and sub-distributors regime for imported books, which are different from those for domestic books in Article 41- 43 of the Publications Regulation, were inconsistent with China's national treatment obligation under GATT Article III: 4.

Conclusion

The WTO's Appellate Body will have two to three months to reinvestigate the U.S.-China dispute, and it may uphold, modify or reverse the panel ruling.

The Appellate Body's decision may impact the market conditions in China for foreign companies in the publishing and entertainment industries who plan to invest in China. More importantly, if the WTO requires China to conform the measures which give exclusive trading rights to wholly state-owned entities to current WTO rules, China's domestic companies who want access to this market will also require their "trading rights" in the future.

Authored By:

Jingyuan Sun
(212) 634-3094
jsun@sheppardmullin.com

Multinational Companies Could Face Stricter Transfer Pricing Investigation By Chinese Tax Authorities

Sheppard Mullin — Fri, 06 Nov 2009 13:50:15 -0800

In the beginning of 2009, the Chinese government set a target for annual tax growth of 8.2%. Due to the financial crisis, tax revenue has dropped 10.3% in the first quarter and 6% in the first half of the year compared with the same periods of last year. Therefore, China’s State Administration of Taxation ("SAT") has started to put more emphasis on tax inspection. Tax inspection is a regular function for the SAT, and a common practice internationally. But now China is expanding its scope.

The latest tax revenue report, which was issued by Ministry of Finance on Nov. 3, 2009, indicates that although the tax revenue has dropped in the first quarter and the first half of 2009 compared with the same periods of last year, the tax revenue in the first three quarters of this year increased by 2.2% compared with the same period of last year. However, tax revenues still fall short of the target. Therefore, it is estimated that tax inspection efforts will intensify.

To avoid paying taxes, multinational companies transfer profits through transfer pricing in order to achieve "virtual loss". Their practice is becoming the focus objective of Chinese tax inspection authorities, Currently, SAT is taking a general census of the tire industry and the revenue assignments have already been made to local tax authorities.

The New Rules

In order to strengthen tax investigation efforts this year, the central government has issued a number of laws and regulations. For transfer pricing investigation, the most important rule is Guo Shui Fa [2009] No. 2, entitled Implementation Measures of Special Tax Adjustments (Trial) (“Circular 2”).

Based on the previous relevant provisions of transfer pricing, Circular 2 specifies conditions of selecting the supervision and investigation processes.

The most remarkable provision of Circular 2 is Article 29, which states that transfer pricing investigations shall focus on the following enterprises:

Enterprises with a considerable amount of affiliated transactions or more kinds of affiliated transactions;
Enterprises with longtime losses, slight profits, or leaping profits;
Enterprises with profits lower than the average of the same industry;
Enterprises with a profit level which obviously does not match the functions performed and risk assumed by the enterprises;
Enterprises engaging in transactions with affiliates in a tax haven;
Enterprises that fail to file their affiliated transaction declarations or prepare the contemporaneous documentation as required; and
Enterprises that obviously violate the arm’s-length principle.

With regard to transfer pricing, Circular 2 differs from the “Procedures for the Taxation Administration of Business Transactions between Affiliated Enterprises” in the following respects:

Circular 2 expands the scope of the focus enterprises;
Circular 2 has more stringent investigation and evidence collection standards, and the scope of data providers, whose liability is emphasized, becomes wider;
The procedures are more clear in the transfer pricing rules;
Circular 2 intensifies the penalties for transfer pricing investigation;
Circular 2 extends the duration of follow-up management from three to five years.

Conclusion

In sum, there are indications that Chinese tax authorities will ramp up the transfer pricing investigation, and that the multinational companies are facing new risks. To deal with these new risks, multinational companies should pay attention to the following issues:

Be aware of the triggers of transfer pricing investigation, which may be long-term losses or low profit;
Take the inquiry by tax authorities seriously;
Since the related parties are usually offshore, the burden of supplying information may pass on to the company under investigation;
Multinational companies should develop proper negotiation strategies to take advantage of the negotiation with tax authorities.

Authored By:

Tony Shen
86.21.2321.6035
tshen@sheppardmullin.com

Two Anti-Monopoly Cases Are Settled in China

Sheppard Mullin — Fri, 30 Oct 2009 16:36:04 -0800

Since the Anti-Monopoly Law of China (the "AML") came into effect in August 2008, attention has been focused on its enforcement and effect on the Chinese market. While the public doubts the government has motivation in enforcing the law robustly against state-owned giants, individuals and private firms have been actively bringing private actions in court against these business giants. Chongqing Insurance Association, China Mobile, China Netcom, Baidu, Shanda Interactive Entertainment, and Sinopec have been defendants in the first batch of anti-monopoly litigations.

Two cases settled in October

The anti-monopoly case brought against China Mobile has been settled, according to Zhou Ze, the plaintiff in the case and a lawyer in Beijing. Zhou Ze filed suit in Beijing alleging that China Mobile abused its dominant market position by charging extra monthly fee for contractual plans which provide essentially the same service as pre-paid plans. Zhou Ze claimed that China Mobile applied dissimilar prices to counterparties with equal standing and imposed unreasonable trading conditions without justifiable cause, and thus was in violation of Article 17 of AML. Zhou sought compensation for 1200 yuan for the additional monthly fees he was charged for the last two years and termination of the different charges.

China Mobile, the largest Chinese mobile carrier, has agreed to pay 1000 yuan to settle the law suit without accepting liabilities. The settlement is regarded as a victory in challenging the state-owned business giants and, according to Zhou Ze, many China Mobile users want him to represent them in similar cases.

In Shanghai, the Shanghai No. 1 Intermediate People's Court has dismissed a law suit brought by Beijing Sursen Electronic Technology Co. against Shanda and Shanghai Xuanting Entertainment Information Technology on the grounds that the plaintiff did not provide sufficient evidence to prove its allegations. The court also found that the defendants were justified in protecting their intellectual property rights by asking their commission writers to stop writing similar works for Sursen. The Court's decision, alleged to be the first decision in a private damage suit under AML, has encouraged dominant firms to properly protect their intellectual property rights and, to some extent, has eased worries that AML may interfere with the protection of intellectual property rights.

Conclusion

It is not clear at this stage whether a flood of anti-monopoly litigations will emerge and how private actions will alter corporate behaviors in China. In any case, detailed rules and technical definitions are needed to provide further guidance in the enforcement of AML. Now that the Ministry of Commerce issued a regulation defining "market" under AML in July, the People's Supreme Court plans to draft an interpretation about detail rules of civil procedure in antitrust cases.

Authored By:

Jingyuan Sun
(212) 634-3094
jsun@sheppardmullin.com

Preparing For Domestic Carbon Trading In China

Sheppard Mullin — Mon, 26 Oct 2009 13:52:23 -0800

China has played a leading role in cutting greenhouse gas emissions and providing carbon credits under a United Nations-backed trading scheme. According to the World Bank, China was involved in 73% of deals made under the Kyoto Protocol's Clean Development Mechanism (CDM) in 2007, and 84% in 2008, ranking first in the world. Under the CDM, if developed countries invest in clean energy projects in developing countries, they can receive Certification of Emission Reduction (CER) in return. They can then sell the CERs for profit, or use them to meet the emission targets under the Kyoto Protocol.

However, the government's conservative policies and financial strategies have made it difficult for the investors to advance the carbon offset commodity market. While CERs have been developed into more expensive financial products and derivatives in the world market, Chinese exchanges and brokerages are not allowed to trade CERs in the local markets. At the bottom of the global carbon-trading chain, the Chinese enterprises do not know enough to price the carbon credits, or to identify reliable buyers. The country is now afraid of losing pricing power in the carbon market.

The Local Carbon Market Is To Be Established Soon

In August 2009, over 800 tons of carbon credits generated during the Beijing Olympic Games were sold to the Shanghai-based Tianping Auto Insurance at $5 Per ton through China Beijing Environment Exchange (CBEEX). The CBEEX is a pioneer in this field and has cooperated with BlueNext, Europe's largest carbon credit exchange, to build a trade platform for potential European investors to purchase credits generated by Chinese renewable energy projects.

Now, Tianjin is paving the way to launch what could become Chin's first domestic carbon market, according to the Financial Times. After more than a year of preparation, The Tianjin Climate Exchange (TCX) was unveiled on September 25, 2009. The TCX, a joint venture between Chicago Climate Exchange, the municipal government of Tianjin and the asset management unit of PetroChina, has started recruiting members for a cap-and-trade scheme which it expects to begin in six to twelve months. TCX members include institutions such as CNPCAM, Tianjin Economic-Technological Development Zone, the Industrial and Commercial Bank of China, and the Construction Bank of China. Although there has been no clear legal framework for domestic carbon trading in China, and the government has not given a clear signal of approval, TCX plans to go beyond the framework launched by CBEEX and to establish a cap-and-trade scheme. Since China does not have a national cap on emission until 2012, the TCX's scheme will be voluntary, similar to the situation when Chicago Climate Exchange was launched in 2003.

Authored By:

Jingyuan Sun
(212) 634-3094
jsun@sheppardmullin.com