At the 2014 World Economic Forum in Davos, Chinese Premier Li Keqiang announced China’s plan to encourage mass innovation and “foster a new engine of growth” for the Chinese economy. As policymakers grapple with China’s economic slowdown, this new model will be crucial to the successful transformation to a consumption-driven, service-based economy.

Foreign company research and development (R&D) activities play a significant role in China’s plan to move up the value chain. According to a 2013 KPMG analysis, multinational companies operate at least 1,300 R&D centers in China, out of more than 1,600 R&D centers total, and these numbers have grown significantly in recent years. This expansion has occurred even while companies remain concerned about protecting their intellectual property rights (IPR) in China. Why do foreign companies conduct R&D in China? What options exist for those companies looking to expand this area of operations—and help drive China’s new engine?

How are US companies conducting R&D in China?

US companies have a significant R&D presence in China, spanning the transportation, aviation, information technology, life sciences, manufacturing, and other sectors. In late 2014, the US-China Business Council (USCBC) interviewed more than 30 member companies on their IPR and R&D activities to gain a better understanding of the motivations, common structures, and research focuses for multinational R&D centers in China, as well as company best practices on key issues like IPR and human resources.

Why are foreign companies building R&D in China?

The very size of the China market is a strong factor guiding company decisions on how to structure their R&D facilities. USCBC estimates that the China market is valued at around $350 billion. For more and more companies, strategies for tapping into that market are an integral part of overall global commercial strategies and operations. Companies are not in China purely to take advantage of cheap labor and production costs just to export back home or to secondary markets. Instead, companies are looking to tailor products to Chinese tastes, with the intent to “be in China, for China.”

China’s large and increasingly sophisticated talent pool is another common reason behind the rapid expansion of R&D outfits. Several USCBC members indicated that R&D operations are increasingly reliant on local talent. Hiring locally not only cuts down on relocation expenses, but also provides companies with experts who already understand local market tastes and trends. Several companies noted the advantages of hiring haigui, or Chinese returnees who pursued higher education opportunities abroad before coming back to work in China. The quality of domestic talent has benefited from top-level attention as well; in 2010, the State Council launched the National Plan for Science and Technology Talent Development (2010-20), which aims to strengthen and cultivate talent for R&D personnel in the business sector. Other companies noted that while haigui may be an important talent group to scout, Chinese who have pursued education domestically have many skills to offer.

How have foreign company R&D activities developed?

Multinational R&D activities are not new to China, but how R&D has developed in recent years is reflective of China’s changing economy. In the past, many foreign companies set up R&D operations to support global R&D development, translating or adapting existing global technology for Chinese language users. Increasingly, in-country company R&D activities are driven by the idea of localizing and creating products tailored specifically for the China market. Companies are looking to capitalize on the strong ability of Chinese researchers not only for their technical ability, but also for their innate understanding of local Chinese consumer tastes and trends.

In conversations with USCBC, companies did not indicate a “dominant” structure that represents the majority of R&D outfits in China. In fact, the ways that companies are conducting their R&D operations have become more diversified over time. Some companies noted that the majority of their R&D work is guided by a global strategy, with China-based R&D facilities working in tandem with other regional or global teams to support product development for use in the company’s home market. Other companies, however, said that their China-based R&D facilities have evolved to focus on true local R&D activities that generate intellectual property (IP) and specifically target the China market. In a few cases, companies indicated that products developed in China are now being used for retail operations in other emerging or developing markets, particularly those in Asia or Africa.

USCBC also learned from these discussions that as companies increasingly rely on local talent to support Chinese R&D, university agreements are becoming an important pipeline for talent recruitment, development, and retention. Companies who have opted to explore university partnerships stated that this route can be an effective “corporate branding” strategy. Company-sponsored textbooks, research laboratories, courses, and internship programs are all ways to bolster the company name and profile among engineering and polytechnic students entering the workforce. One company’s representative noted that being involved in university partnerships has allowed the company to monitor, cultivate, and groom talent to join its R&D operations after graduation. By playing an engaged and active role in talent development, not only has this company enhanced its relationship with the university and the local government, but it has secured a reliable and competitive workforce for its local operations.

Another company representative indicated that the company’s China R&D strategy developed in response to differing levels of technological maturity between America and China in certain industries. Within this company’s sector, Chinese consumer demand for a certain technology was much greater than the demand for a similar technology in the American market. What made sense was tapping the local Chinese R&D teams to build on the existing technology to design products specifically meant for use in China. This company ultimately created new forms of technology that were independently developed from their existing (Western-based) R&D outfits, to address consumer needs in China.

China’s current R&D environment

By all measures, Beijing is paying more attention to the factors that encourage innovation and creativity. According to a recent report released by the Ministry of Science and Technology (MOST), total R&D in China in 2013 (the most recent figures available) stood at 1,184.6 billion RMB ($193.6 billion). These numbers indicate that R&D intensity—or the amount a country spends in science and technology as a percentage of GDP—reached 2.08 percent, just shy of the 2.2 percent goal for R&D intensity set in the 12th Five-Year Plan (2011-2015). This brings China closer to R&D levels in a number of developed nations. The OECD Science, Technology and Industry Outlook 2014 calculated US R&D intensity in 2012 at 2.79 percent, with 4.36 percent in South Korea, 3.35 percent in Japan, and 2.07 percent in the European Union.

In 2010, the State Council launched the Strategic and Emerging Industries concept, which identified the innovative development of seven industries—including energy efficient and environmental technologies, high-end equipment manufacturing, biotechnology, new energy vehicles, and others—as key drivers of China’s development. Recently, the State Council released the National Intellectual Property Rights Strategy (2014-2020), laying out specific goals to promote more IP creation and commercialization, among other provisions to enhance IPR protection.

China has also used various regional clusters, pilot programs, and demonstration zones to consolidate R&D activity into specific areas of the country. Buoyed by local government support, advanced infrastructure, and preferential policies covering taxes and R&D expenses, these areas have developed into technology incubators for domestic and foreign companies alike. Examples of these zones include Zhongguancun Science Park in Beijing, Zhangjiang Hi-Tech Park in Shanghai, and the Tianjin Economic-Technological Development Area, although MOST figures suggest that higher-than-average R&D intensity activity is also concentrated in Jiangsu, Guangdong, Zhejiang, Shandong, and Shaanxi provinces. Despite the R&D concentration along China’s east coast, several USCBC members have noted their R&D operations are located throughout China’s interior regions as well.

How can companies seek partnerships to grow local R&D capabilities?

The central-level push for R&D is helping to create new synergies for foreign companies. As localization plays an increasingly important role, forging partnerships with local stakeholders has become a key strategy for many US companies seeking to increase their R&D activities in China. Partnerships can form with local universities, local industry players, or even local governments—all of which are guided by Beijing’s mandate to boost R&D intensity.

Companies indicated in their discussions with USCBC that the most common partnership involved joint agreements with local universities. Several companies noted that the most useful partnerships were with specialized schools that focus on certain industries or sectors, such as engineering-specific schools. While some of these institutions are not as well-known as Peking University or Tsinghua University, these specialized universities tend to focus on research or training in very specific sectors, such as hydraulic engineering, automation, or other technical fields, which may be useful to companies operating in related industries. The faculty at these institutions may also provide valuable information services to multinational partners. One company representative noted that the company’s expansive, cross-regional network of university partnerships provides ready access to a range of experts from different institutions, all of whom can advise on technical issues that may arise.

Not only do companies engage with these experts on issues related to operations, they can also leverage these relationships as part of the company’s overall government affairs strategy. Several companies noted that their university partnerships enhance the ability to influence local government policy decisions, as local officials often rely on input from these university experts on technical matters. Companies further noted that they use these academic partnerships to demonstrate the value of their company’s operations and investments to the local government and community, as a guiding force for local innovation and talent development—as well as a source of employment for new graduates.

Universities are not the only partners that foreign companies seek in China. Partnership agreements with think tanks and local government agencies or affiliated institutions bring foreign companies into a wide range of discussions on topics of mutual interest and benefit. For example, one company is working with a local think tank to mitigate post-harvest loss among farmers in China. In another example, one member company shared with USCBC that it is interested in working with local branches of the Ministry of Industry and Information Technology (MIIT) and MOST to influence standards setting for their industry.

Some companies have also noted that they can use their local partnerships to enhance their relationship with a Chinese joint venture (JV). This may be especially useful in sectors that have restricted or capped foreign investment, and thus require partnership with a local Chinese company for market entry. One company discussed a collaborative JV research center that it developed with their JV partner—a Chinese SOE—in an industry where foreign investment is restricted. Both sides have forged an effective working relationship under the structure of their agreement: the US company contributes technical knowledge and engineering expertise, and its JV partner provides personnel, capacity, and capital. Under this agreement, the US company is able to focus its local R&D efforts by taking advantage of the local talent and expertise provided by its partner. While negotiations are still required to determine how jointly developed IP products are registered, owned, and ultimately used, the US company believes that this local partnership overall has been beneficial to its China operations.

What government incentives can foreign companies access?

The Chinese government has launched a series of initiatives over the past few years as part of a greater push to attract more foreign R&D to China. In comparison to other innovative economies, which use non-discriminative tax incentives to foster and support R&D programs, the bulk of Chinese incentives offer tax deductions and preferential tax rates for R&D activities. These policies are generally couched in a variety of national tax incentives:

In addition to national tax programs, USCBC has identified two specific incentive programs that focus on promoting innovation for both domestic and foreign enterprises:

  • High and new technology enterprise status  The High and New Technology Enterprise (HNTE) program offers a 15 percent reduced tax rate for qualified companies that apply for and receive HNTE status, regardless of the company’s investment type and where the company is headquartered. To qualify for HNTE, a company is required to own the proprietary IP rights of the core technology used in its products and services or exclusively license them to its Chinese subsidiary. Generally, the HNTE certificate will be valid for three years once approved and can be renewed for an additional three years.
  • Technology advanced service enterprise program  The Technology Advanced Service Enterprise (TASE) program, which originally offered qualified companies a 15 percent reduced corporate income tax rate through 2013, has been extended through December 2018. TASE-qualified companies can also deduct employee training expenses by up to eight percent of total wage expenses and can apply with relevant authorities to receive a business tax exemption for income from offshore services outsourcing. Currently, only enterprises operating in one of 21 designated major cities and municipalities are eligible to apply.

Other programs, such as the Strategic and Emerging Industries (SEI) program released in 2010, reflect the government’s shift towards incentivizing development in certain industries where policymakers would like to see greater innovation.

USCBC member companies have also indicated that they have taken advantages of locally offered incentives (independent of the national tax incentives, or the two main incentive programs) to support their R&D outfits. Some companies report having received support at the local level, either in the form of direct subsidies or various grant programs that may be available in a specific locality. One company said that the local Shanghai government has approach it with instructions on how to apply to a certification program offering qualified companies subsidies for smart energy use. Another company discussed its experience negotiating with local authorities on lump sum investment-project packages, which include various land rebates and tax incentives.

However, despite these policies many of the measures promulgated by the Chinese government have had less impact than desired. The SEI program, while perhaps initially promising, has offered few tangible benefits to foreign companies due to lingering concerns on requirements for local IP settlement, and remaining questions on whether foreign firms can qualify for SEI benefits.

As a result, actual company experiences with R&D incentive programs vary greatly. Some USCBC members have noted that they do not pursue these incentive programs, either because they are unsure of the technical requirements needed to qualify, feel that they would not be allowed to take advantage of these programs, or feel that they have enough resources to operate without R&D support measures. Companies have also noted that despite encouragement—and, at times, pressure—by the local government to participate in incentive programs, these incentives may require untenable choices. USCBC previously identified the HNTE program as particularly challenging in evaluating the payoffs of participation. For example, a company seeking to qualify for HNTE status might have to change its IP management or personnel structures, a costly and lengthy process. As a result, the potential benefits of receiving the HNTE tax break may be lower than the actual costs of qualifying for HNTE in the first place.

Other USCBC member companies have noted specific problems in how R&D programs are structured that actually dis-incentivize participation. HNTE is again cited as a problematic because it inherently treats foreign and domestic companies differently. One requirement of HNTE is that companies must own the proprietary IP rights of the core technology used in their products and services in China (or they must grant a global exclusive license of this IP to their Chinese subsidiaries for five years). This presents a de-facto bias against foreign companies that manage their global corporate IP structure based on commercial considerations and international best practices, as it forces them to readjust these structures to fit Chinese industrial policy goals. USCBC members are also concerned with qualification criteria that relate to IP settlement. Recently, several USCBC members noted the increasing strictness of enforcement by local regulators, making applying for requalification difficult after the initial HNTE certification expires.

However, many USCBC member companies still successfully conduct R&D activities regardless of their qualifications for any of these programs. While these incentive programs can provide benefits to qualifying enterprises, many USCBC members noted their R&D activities have been established independent of considerations for these local incentives, and are driven more by their overarching corporate strategy than a more specific goal of taking advantage of various tax breaks in China.

What are the risks of expanding R&D in China?

Innovation in China will continue to grow, but this expansion is not without challenges. Foreign companies, generally, are looking to expand their presence in China, and that requires understanding Chinese consumers and creating products that serve the local market. Companies are looking to take advantage of China’s transformation to an innovative, consumption-driven, “moderately-well off” society. In turn, China is looking to attract companies with the technological know-how to help policymakers achieve this “China dream.”

However, while the landscape for in-China R&D can present significant opportunities for US firms to better compete vis-à-vis domestic or international rivals, significant operational challenges must still be considered. Chief among these concerns is how US companies can best protect the IP that is created, developed, and shared by local R&D outfits in China. In USCBC’s 2014 Business Environment Survey, almost 50 percent of member company respondents indicated that they “hold back” on R&D due to concerns about how IP is treated and protected. The 2014 survey also tagged IP concerns as a top priority issue for USCBC member companies, with member companies ranking IP enforcement as the number two issue for doing business in China. The absence of legislation clearly defining and protecting “trade secrets,” along with worrisome draft legislation on service inventor remuneration, leave a number of questions for how companies can best protect their core technologies.

From a policy perspective, as well as a talent and collaborative framework perspective, the future of Chinese R&D indeed looks promising. Before looking to expand their R&D in China, companies should consult with their legal teams to ensure that they understand the lingering challenges with China’s IP protection regime, however. This is especially important if a company chooses to engage in a local partnership to expand R&D activities. There are strong long-term synergies to be realized, though companies must be realistic when it comes to planning for contingencies where they might face real threats to the IP that they transfer, share, or generate in China. Still, as American companies look to serve an increasingly sophisticated class of Chinese consumers , they will need to understand the differing choices, tastes, and trends that make the Chinese market so unique. As the Chinese economy continues to mature, in-country R&D outfits will remain key engines of growth for many foreign companies truly looking to be “in China, for China.”

[author] Nick Marro ([email protected]) is business advisory services manager at the US-China Business Council’s Beijing, China office. [/author]

(Photo by Novartis AG via Flickr)

Posted by Nick Marro