Tempered TIER tantalises US-China trade war thaw

August 2019  |  COVER STORY  |  GLOBAL TRADE

Financier Worldwide Magazine

August 2019 Issue

Costly and predictable, the US-China trade war has continued to escalate in recent months, with the US raising tariffs and China vowing to retaliate in kind – despite the Chinese offering an olive branch designed to warm relations between the two superpowers.

China’s attempt at rapprochement was made in April 2019 in the form of amendments to its technology transfer policy – the primary legislation regulating technology transfers in and out of China being the Administrative Regulation on Technology Import and Export (TIER) – long the source of US criticism, as well as a general concern among developed economies.

Indeed, in March 2018, the US Trade Representative (USTR) published a scathing report – ‘Section 301 Report into China’s Acts, Policies, and Practices Related to Technology Transfer, Intellectual Property, and Innovation’ – which portrays the Chinese state as being dedicated to the systematic acquirement of technology assets from the US, utilising unfair technology transfer rules and protectionist industrial policies, among other strategies.

“China’s technology transfer regime has long been rooted in the heart of China’s foreign direct investment (FDI) policy and remains fundamental to China’s transformation to an innovative economy,” says Dr Weihuan Zhou, a senior lecturer at the University of New South Wales (UNSW) Faculty of Law. “The regime is primarily built on laws and regulations relating to foreign trade and investment, inter alia, the Foreign Trade Law, the three principal legislations on FDI – now superseded by the new Foreign Investment Law – and TIER.

“For the US, the regime has had the effect of forcing transfer of technology by foreign investors to their Chinese partners,” he continues. “The USTR collected abundant evidence to show that ‘forced’ technology transfer occurs through foreign ownership restrictions, and non-transparent and discretionary decision making in China’s FDI approvals system. Thus, the US’s claim is based on both the law and the practice. However, this claim is not uncontroversial.”

Having refused to yield to criticism of its technology transfer policy for many years, China’s recent volte-face could be considered surprising. However, the reality is that the country has always been under pressure to alter its stance on TIER due to its entrenched desire to grow its tech-based economy.

Also forcing China’s hand were the legal complaints launched by both the US and China at the World Trade Organization (WTO) in 2018. “Amending TIER was also a concession to the US government from a WTO dispute perspective,” says Geoffrey Odlum, president of Odlum Global Strategies and a former US diplomat. “This was not sufficient, however, to stop the Trump administration from imposing a 25 percent tariff on $200bn of certain Chinese imports in May 2019. Trade talks reportedly collapsed because Beijing removed details outlining the obligations it was required to meet as part of reaching a deal to end the trade war.”

For Mr Robinson, the reality is that Chinese growth simply cannot happen without the US and US companies. “The TIER restrictions were just as bad for Chinese companies as they were for foreign companies,” he asserts. “Many deals have been abandoned when a Chinese company was unwilling to pay the increased costs associated with a foreign company automatically having to issue full indemnity, as well as giving up marketing and improvement rights.

“These mandated requirements cost Chinese companies whether or not the Chinese companies actually want these provisions,” he continues. “The Ministry of Commerce of the People’s Republic of China’s (MOFCOM’s) only excuse for why it had these restrictions was that ‘they are not actually enforced very often’. This provides no solace or relief to foreign investors. In fact, they can be enforced, so the Chinese party has to pay for them. This has been a large burden for many Chinese companies.”

According to Dr Zhou, China’s TIER amendments are in response to long-lasting US pressure, as well as an action intended to de-escalate the trade war. “However, it is also in China’s own interest to do so as it needs to strengthen IP protection so as to attract high-quality FDI and create an environment for innovation,” he adds.

The trouble with TIER

Before venturing into the scope of the TIER amendments, it is instructive to examine the regulation in its previous incarnation in order to understand why major economies, particularly the US, have long criticised it, and why its revision has been so welcome.

“Licensing is the primary means by which technology flows into markets,” explains Erick Robinson, a partner and head of the China practice at Dunlap, Bennett & Ludwig. “The challenge to parties negotiating a licensing agreement is to find terms that are mutually beneficial, so that agreement is in the interests of both sides. In the context of high technology and associated IP, it is critical that the parties have great flexibility in arriving at mutually beneficial terms as the market and circumstances demand.

“Unfortunately, the Chinese government mandated certain conditions be a part of any licence of technology into China, regardless of whether those terms are in the parties’ contract or specifically contradicted by contract,” he adds. “TIER required foreign licensors to fully indemnify Chinese licensees, surrender ownership to any improvements and not prohibit the marketing rights of those licensees.”

Drilling down, there are three key areas in which TIER has historically restricted the ability of parties to reach an agreement. First, in terms of indemnity – i.e., which party should bear the burden if the licensee’s right to the licensed technology is challenged by a third-party – TIER inflexibly imposed all indemnity risks on the foreign licensor. Second, with shared rights, TIER made it unclear whether a licensor would be able to share in technology improvements developed by the licensee, with the result that many companies chose to avoid China completely. Third, TIER’s prohibition of licensing agreements which “unreasonably restrict the export channels of the licensee” meant licensing parties could not freely negotiate the allocation of their market rights.

“With TIER now amended to remove these restrictions, it will be easier for both Chinese and foreign companies to do technology-related transactions,” adds Mr Robinson. “Essentially, the new TIER makes forced technology transfer illegal, while also lowering barriers for foreign firms to enter the domestic market. So, while China’s removal of market entry restrictions for foreign investors is a positive move toward ensuring that domestic and foreign firms ‘are treated as equals’, it remains to be seen whether Beijing’s promises of fair treatment, market access and protection for IP rights will be enough to generate a steady inflow of high-tech investment.”

Key amendments

Having laid out the regulation’s historical issues, the question is the extent to which the amends assuage prior criticisms. In essence, what advantages does the new TIER now afford investors? In its ‘US-China ‘Trade War’ and Liberalisation of China’s Technology Transfer Rules’ report, Clifford Chance notes the removal of the following, previously applied inbound technology arrangements.

First, Article 24(3) on mandatory third-party infringement indemnity. Prior to the amendments, TIER required a foreign technology owner to indemnify a Chinese counterparty where the use of its technology infringed third-party IP.

Second, Article 27 on improvements made by a licensee vested in the licensee. TIER previously restricted parties’ freedom to contract for the ownership of improvements to technology licensed by a foreign technology owner. Instead, it provided for ownership by the Chinese licensee that makes the improvements, with no regard to the legitimacy of grant-back arrangements.

Third, Article 29 on licensee restrictions. There were a number of broadly worded restrictions which could not be imposed by a foreign licensor in a technology import contract with a Chinese licensee, including: (i) purchase of unnecessary technology, equipment or service; (ii) payment for expired or invalid patents; (iii) restrictions on the licensee’s rights to improve technology or to use improved technology; (iv) restriction on procurement of similar or competing technology; (v) unreasonable restrictions on source of equipment or materials used by the licensee; (vi) unreasonable restrictions on production volumes, models and sales price; and (vii) unreasonable restrictions on export channels for products made with licensed technology.

“Meanwhile, the relevant amendments contemplated in the Foreign Investment Law essentially require that the transfer of technology must be voluntary based on commercial rules, and explicitly prohibits all levels of government and their officials from forcing technology transfer through administrative means,” says Dr Zhou. “The changes to TIER removed the most controversial mandatory requirements on foreign investors, which were designed to protect the rights of Chinese parties to a technology transfer agreement. The revised regime, at least on its face, emphasises voluntary negotiations by FDI partners on the use of foreign technology and provides higher protection for foreign IP holders.”

In Mr Robinson’s view, the most problematic aspects of TIER in its previous guise were those mandating full indemnity for the benefit of Chinese companies, as well as ownership of marketing and improvement rights – regardless of any contract provision or other agreement between the parties to the contrary. “Removing these limitations results in free commerce, which will certainly increase tech-related deals between Chinese and foreign companies,” he believes.

“For technology companies exporting to China, the amendments are welcome steps that under normal circumstances would likely lead to increased technology sales to China,” adds Mr Odlum.

Investment impact

As with any legislative overhaul, the proof is in the pudding. But for the moment, high-tech investors are monitoring how strictly the amendments will be implemented.

“Whether Chinese authorities will strictly implement the law according to the spirit of the new TIER regime remains to be seen,” says Dr Zhou. “It is likely they will formulate regulations to provide detailed rules for the implementation of the Foreign Investment Law. When promulgated, these rules will provide a clearer guidance for authorities and, consequently, more confidence for foreign investors and their governments.”

For Mr Robinson, the removal of the investment limitations imposed by TIER will result in free commerce, leading to more tech-related deals between Chinese and foreign companies, as well as increased IP and capital investment in China. At the same time, he gives short thrift to the suggestion that China may renege on its TIER liberalisation agenda.

“There should be no fear of China reviving TIER restrictions after it removes them,” believes Mr Robinson. “The provisions hurt Chinese companies as much or more than foreign companies by making international transactions much more expensive, and preventing transactions outright in many cases due to cost and risk of mandated indemnification. Furthermore, enforcement of TIER has been very rare, and such enforcement would be through Chinese courts. If China ever reinstituted the TIER restrictions, no one would ever work with China or Chinese companies again. China and Chinese companies already have a big trust issue. If China reneged, the country would never recover.

Recent developments may spark a surge in investment in the months and years ahead. “My forecast is that US technology companies, while still wary of the prospect of a worsening trade war, will take full advantage of the TIER amendments – which came into effect immediately – to increase sales of some types of technology to China, especially technologies not likely to be captured under new export control restrictions forthcoming from the US Department Commerce,” suggests Mr Odlum.

TIER today – thaw tomorrow?

While the trade war remains ongoing – although the G20 Osaka summit in July saw president Trump promise there would be “no further tariffs for the moment” – the TIER amendments represent a significant boon for US interests, as well as Chinese companies.

“The amendments to the Foreign Investment Law and TIER occurred before the latest round of tariff escalation,” points out Dr Zhou. “This suggests that technology transfer is merely part of the various issues in the US-China bilateral negotiation and is unlikely an adequate solution by itself.

“There are many other issues to be solved, such as state-owned enterprises and industrial subsidies, which are at least equally important as the issue of technology transfer,” he continues. “The end of the trade war would likely require a compromised solution to all these major issues.”

For his part, Mr Robinson does not believe the changes to TIER will have much of an impact on an escalating trade war. “Yes, the US has been seeking these changes for more than 15 years, but they are common sense, and the changes benefit Chinese companies as much or more than US or other foreign companies,” he adds. “The Trump administration seems to have pocketed Chinese concessions at no cost to its own negotiating position, and continues to pressure China for other concessions as the price for reaching a trade deal,” points out Mr Odlum.

Trade war thaw or not, the tempered TIER represents a positive move toward reversing the deteriorating state of US-China relations – an action that could also prevent the world being tipped into a new era of dangerous ideological and geopolitical competition.

© Financier Worldwide

BY

Fraser Tennant