Legal and policy changes in China have greatly changed what is at stake

Asia is seen as the engine of the global economy, and China, while continuing as a hot spot for investment in comparison with Europe and other regions, has encountered increased competition for foreign investment from its neighbors.

China's Ministry of Commerce says that in the first 10 months of this year inbound investment fell 3.45 percent compared with the corresponding period last year. Emerging economies such as India and Vietnam have improved labor-cost-effectiveness relative to China, which is proving attractive to multinational companies. Some foreign-invested enterprises in China have also encountered challenges to their profitability as the costs involved in labor, raw materials and operational all rise.

Confronted with these challenges, foreign and local companies with investments in China are seeking to adapt and adjust their commercial strategies and adopt effective measures to raise revenue and reduce tax burdens to increase profits.

Among such measures, shifting a corporate group's research and development center to China may help companies to generate increased intellectual property assets in China, and also allow multinational companies to take advantage of the Chinese government's various R&D incentives. Such incentives reflect the Chinese economy's gradual shift away from manufacturing toward innovation and the development of intellectual know-how.

In the past, due to a lack of qualified technical personnel and weak intellectual property protection, foreign-invested companies might have had doubts about setting up R&D centers in China. From a tax perspective, before the new Corporate Income Tax Law was implemented in 2008, many of the tax incentives the government granted to foreign invested companies were not related to R&D, giving the enterprises little motivation to set up R&D centers in China.

The situation is now significantly different. With more than 6 million university graduates every year, China is the biggest provider of science graduates in the world, with a pool of highly competent technical personnel available to work at companies developing improved products and processes in China.

In recent years multinational companies such as Dow Chemical, Philips, Nestle, Bosch and Shell have set up R&D centers in China. The Shanghai administration of commerce says that by July more than 300 foreign-invested R&D centers have been set up in Shanghai, with many others in economic centers such as Beijing, Guangzhou and Chengdu. This represents progress for foreign companies with a production base in China because such R&D centers can improve operational efficiency and increase the speed at which research results are transformed into real-world applications. Moreover, these centers can better cater to the needs of local markets and improve the quality of products and services globally.

In addition, the implementation of intellectual property policies and guidance, such as the 12th Five-Year Plan (2011-15) on National Intellectual Property Development and the 12th Five-year Plan on Patents, have increased the confidence of foreign-invested companies conducting R&D in China.

The current reform of the tax system is another key factor that encourages multinational companies to improve products and processes, enhance productivity and set up R&D centers in China. Though the 2008 Corporate Income Tax Law eliminated tax incentives previously available to foreign-invested companies, the Chinese government has maintained its fiscal support for R&D.

Additionally, the reform of value-added tax offers potential tax benefits to enterprises carrying out R&D activities. Many services that were previously subject to business tax are now subject to value-added tax. As a result, the tax burden of many foreign-invested enterprises may fall considerably. For example, R&D activities such as technical consulting and technology licensing that were previously subject to business tax are now subject to value-added tax, but the key difference is that foreign-invested enterprises can now offset their value-added tax payable. This ultimately means more money in the hands of the taxpayer.

Encouraging and fostering R&D activities is also now a national policy, and is a key tenet of the 12th Five-Year Plan. Such R&D incentives include:

A 50 percent R&D "super deduction" in addition to the actual expense deduction for R&D spending. So if a company spends 10 million yuan ($1.6 million; 1.26 million euros) on eligible R&D it will receive a net benefit of 1.25 million yuan (12.5 percent benefit for every eligible cost);

A preferential corporate income tax rate of 15 percent (the standard rate is 25 percent) for companies recognized as a High New Technology Enterprise;

A preferential corporate income tax rate of 15 percent for companies recognized as an Advanced Technology Service Enterprise, with qualified incomes exempt from business tax;

Exemption from import customs duty and value-added tax on qualified R&D equipment imported by R&D centers.

As R&D is very widely defined for tax purposes in China, the scope of activities that may qualify for the incentives, in particular the R&D super deduction, is broader than most companies appreciate.

R&D activities potentially eligible for Chinese government incentives in various industry sectors could include:

New techniques or methodologies to extract minerals from complex ore bodies.

Improvements to water use and irrigation technologies.

Development of innovative functionality and improved approaches to solving software problems.

Application of engineering principles, previously developed in the aerospace industry, in, for example, the automotive industry.

Computer-aided engineering and simulation software developed as part of a larger R&D project in any industry.

Development of new processes and technologies to minimize adverse environmental impacts across all industries.

Development of new compounds with improved therapeutic properties.

Development of non-destructive testing techniques to analyze material fatigue with pharmaceutical products.

Application of off-the-shelf software products in new and previously unproven ways.

However, due to the somewhat complex nature of the R&D rules and regulatory approval procedures, many companies fail to identify all eligible R&D activities and miss out on, potentially, very significant tax savings every year. Moreover, the failure of companies to accurately identify and record eligible R&D expenses may create additional obstacles.

In these situations it is possible that the tax authorities may challenge R&D incentive claims that have been lodged.

In the broader context, the relative cost of performing R&D in one country versus another, net of available R&D incentives, is critical when evaluating where and under what circumstances R&D activities should take place.

Similarly, in planning how intellectual property will be created, it is critical to consider tax consequences, the arrangements under which intellectual property is created, where it will be used, how it will be paid and where it will be owned.

Entities undertaking R&D in the region should be aware that tax authorities are also focusing on transfer pricing issues arising from the development, ownership and compensation for use of intellectual property. Transfer pricing provisions in Asian countries are complex. They apply to the economic, legal and tax aspects of transfers of technology, and products or services based on technology, to related entities. These provisions may encourage companies to locate some of their research and development activities in one country rather than another. Indeed, in Australia, China, India and Japan there has recently been an increase in transfer pricing audits by regulators.

Given the scope of activities potentially eligible for the various research and development incentives, companies conducting or planning R&D activities in China should ensure they are well versed in the rules for each incentive program, and also understand the broader business and tax implications of the R&D investment.

The author is director and leader of China R&D Tax Practice, KPMG China. The views do not necessarily reflect those of China Daily.

(China Daily 11/23/2012 page11)