Avoiding China IP Licensing Pitfalls
In recent years, our law firm has represented dozens of businesses licensing their intellectual property (IP) to companies in China, covering a wide range of sectors from product manufacturing and distribution to entertainment. Despite their sophisticated IP licensing experience, many businesses are often unprepared for many common pitfalls in China IP license transactions.
This post explores some of the common pitfalls companies face when licensing IP to Chinese businesses.
Exclusivity and the License Territory
One of the most important considerations in any IP license agreement is defining the license’s territory. The territory specifies where the licensee is permitted to use the licensed IP. In some cases, a territory may be exclusive, meaning the licensor cannot license its IP to other parties within that territory. In other cases, it may be non-exclusive, allowing multiple licensees to have overlapping territories.
Most of the time, territory negotiations revolve around the question of exclusivity. However, licensors must consider that poorly defined territory provisions in a license agreement could lead to a torrent of lawsuits between and among different licensees.
For example, imagine a licensor grants an exclusive license to a company with Hong Kong as the territory. Now, imagine the same licensor grants another exclusive license to a company with “the People’s Republic of China” as the territory, mistakenly thinking this only includes Mainland China and not Hong Kong.
If the second licensee begins to sell licensed products in Hong Kong (and it probably would), you might see claims by the first licensee against the second, and claims by both licensees against the licensor. This is the worst possible outcome.
These situations happen frequently in China IP license transactions. Businesses outside China often do not realize that companies within China regard the PRC to include Hong Kong, Macau, and even Taiwan. Our colleagues have even seen Chinese companies try to include wholly unrelated South Pacific nations into territory definitions!
Therefore, IP licensors need to be as precise as possible when defining the applicable territory.
IP licensors also need to consider politically sensitive issues regarding territory. It is not uncommon to see a definition of territory that reads something like, “the People’s Republic of China, including Hong Kong, Macau, and Taiwan.”
Licensors that try to modify the language to refer to Taiwan as a completely separate nation usually face an uphill battle during contract negotiations, depending on the exact language proposed. There are ways to thread the needle, but they can be dicey, especially for licensors unfamiliar with negotiating China contracts.
NNN Provisions
The Importance of Non-Disclosure, Non-Use, and Non-Circumvent (NNN) Provisions in China
When it comes to protecting IP in China, standard non-disclosure provisions (NDAs) used elsewhere are rarely effective. See China NDA Agreements: Still Worthless After All These Years.
Chinese companies may have a broader understanding of what constitutes confidential information. This is where NNN provisions become crucial.
Why NNN Agreements Matter More in China
NNN agreements go beyond the scope of traditional NDAs, which primarily focus on safeguarding trade secrets. An NNN agreement offers a more expansive protective umbrella for confidential information. Here’s how:
- Protects Against Competitive Use: It prevents the Chinese company from using your information to gain a competitive advantage.
- Stops Them from Going Around You: It restricts them from directly accessing your resources or clients, even if the information itself isn’t classified as a trade secret.
Our firm recommends that companies entering into IP licensing agreements with Chinese counterparts have a well-drafted NNN agreement or NNN provisions in place. This agreement should clearly define what information is considered confidential and contractually obligate the Chinese company to protect it. It should also prevent them from competing with your business or bypassing you to reach your customers or contacts.
Not Every Transaction Needs a Standalone NNN
Not all IP licensing deals in China require a separate NNN agreement or NNN provisions within the license agreement. However, whenever confidential information is exchanged, or there’s a potential risk of the Chinese partner misusing IP or information to circumvent its counterparty, NNN provisions or an NNN agreement become essential.
By including comprehensive NNN protections, the non-Chinese business is taking proactive steps to safeguard its valuable IP in the Chinese market. For more on the importance and the nature of China NNN Agreements, check out China NNN Agreements: The Ten Most Asked Questions Answered.
Withholding Tax Deductions
Licensees in China will almost always try to negotiate a provision that allows them to deduct taxes that the Chinese government requires them to withhold before making royalty payments to the licensor. These provisions may seem innocuous, but they can pose significant and costly problems. In our experience, the amount of tax withholding required can be somewhat arbitrary and subject to change. We’ve heard of cases where as much as 40 percent of a royalty payment was withheld for tax purposes, though it often can be much less.
A Chinese company is usually better suited to reduce these withholdings with the Chinese government than a non-Chinese company would be. Consequently, many IP license negotiations center around whether the licensee can deduct these taxes. When licensees insist on deductions, negotiations often focus on setting caps on deductions. Failing to negotiate these provisions can leave the non-Chinese entity essentially responsible for large sums of taxes in China.
Invoicing
In a typical license agreement, royalty payments are calculated based on the licensee’s sales (e.g., a percentage of sales or a fixed fee per unit sold). This means that the licensee usually provides sales records and calculations to the licensor, along with a concurrent royalty payment based on the agreed calculation. However, this process often differs in China IP licensing transactions.
Many banks in China prohibit Chinese companies from paying non-Chinese businesses without an invoice. This means that the licensor must issue periodic invoices to the licensee to receive payment. As a result, the companies often end up with a cumbersome procedure where the licensee issues a royalty statement, and then the licensor issues an invoice based on that statement before being paid.
As you can imagine, this can significantly delay payments to the licensor. This is especially true if the licensor provides an invoice that the bank deems insufficient (which can easily happen). Therefore, licensors need to account for potential payment delays when negotiating payment provisions within an IP license agreement.
Force Majeure
Force majeure provisions allow one party to suspend its contractual performance obligations in the event of a defined event outside its reasonable control. For example, a distributor may delay a required delivery if a hurricane makes it impossible to safely transport goods.
When drafting China IP license agreements, we often encounter provisions (sometimes not explicitly styled as force majeure provisions) that prohibit the licensor from penalizing the Chinese licensee if governmental regulations or requirements delay the licensee in making payments. While this may seem innocuous, it can lead to significant issues.
We’ve seen numerous situations where a Chinese business claims it cannot make payment due to some governmental restriction, yet demands that its foreign counterpart continues to provide services or goods. A clause like the one mentioned above is virtually guaranteed to cause problems.
There are ways to mitigate these issues. Many licensors push to exclude force majeure-type provisions altogether. If that’s not possible, they carve out payment from force majeure obligations or specify that if the Chinese entity can’t pay, the licensor won’t perform. For more on force majeure clauses in Chinese contracts, check out Do Not Let Force Majeure be a Major Force In Your China Contract.
Dispute Resolution
Dispute resolution provisions in international contracts are complicated. I recently wrote a post about the importance of these provisions, which you can find here. This issue becomes even more complex in China. Failing to consider governing law, language, and venue in a Chinese IP license is virtually guaranteed to lead to expensive disputes conducted in a foreign language, putting the licensor at a serious disadvantage.
Conclusion
Licensing IP to a Chinese company can be lucrative, but navigating China’s licensing legal landscape can also be complicated and risky. Provisions that seem reasonable or innocuous in your home country may lead to expensive China problems if not properly negotiated. But by understanding key considerations like territory definition, NNN agreements, and financial clauses, you can minimize your risks.
