Lilly Sees Payoff In China By Boning Up On Tax And Patent Law

SAN FRANCISCO - Adept management of tax, patent and government relations issues particular to China can help Western pharmaceutical companies reap the benefits of working in the vast, developing market while avoiding pitfalls.

"You work so hard to create value for companies and the last thing you want is to have the tax man come and take it away from you," said Rickey Pate, Eli Lilly's director of global tax services, during an update on these issues at the Drug Development China Conference in San Francisco Sept. 17.

"At Lilly we like to think of the tax department as the revenue enhancement department, because we keep more of what we make by wisely looking at tax issues," he said.

On July 11, Chinese tax authorities published guidance clarifying terms for qualifying as a high new-technology enterprise, a preferential status created under national tax reform legislation last year (Also see "Insider Analysis From Jones Day: New Patent Approach Is Needed For Pharmaceutical Research In China" - Scrip, 26 Mar, 2008.). Approved on the provincial level, HNTEs are eligible for a 15 percent tax rate instead of 25 percent.

Though the lower tax rate holds allure, the HNTE vehicle is unlikely to be useful for U.S. companies for a number of reasons, Pate said. For one, the approval process for getting the new technology label is complex, involving provincial tax authorities as well as finance and science/technology bureaus.

Also, multinationals would be required to place intellectual property rights worldwide in the China-based HNTE.

"It is difficult to envision many companies- particularly U.S. companies but also European companies- that would choose to put all IP in China," he said.

But the real clincher for U.S. companies against the HNTE model is that royalties paid to a Chinese affiliate would be immediately taxed at 35 percent in the U.S., in accordance with the 'Subpart F' rules. And dividend income paid by Chinese affiliates would be subject to a 35 percent tax rate in the U.S.

"You get a double whammy from the U.S. government," Pate said. "If you are a U.S. company, none of this works, even though the tax rate is low in China."

From the point of view of the tax department, the "cleanest way" to structure R&D operations in China, is by working "arms-length" with third party contract research organizations on a fee-for-service or cost plus percentage markup basis, Pate said.

"If there are two unrelated parties, Chinese tax authorities assume the compensation arrangements are arms length and they will not attempt to challenge the relationship," he said. "From the tax standpoint, maybe not the operational standpoint, it's a very safe way to go," he said.

When R&D is managed through a foreign, wholly owned Chinese affiliate, Chinese authorities require parent companies to prove that compensation is managed as if it were at arms length. This determination is made through comparisons of rates paid to subsidiaries with market norms for unrelated companies.

"If the Chinese authorities determine compensation is not arms length, they will help you out- they will make an adjustment to your income tax and you will owe more money."

Joint venture deals are also subject to the arms-length principles.

Presently, foreign companies operating in China need to obtain market data on their own to judge the payments, whereas Chinese tax authorities themselves are unlikely to have to access to databases of going rates across China.

"Most taxation is done at the regional level. Don't let this cause you to not worry about it. These people will be trained- maybe not this year, but in years to come and you need to be prepared for these kinds of audits," Pate said.

Patent Law Tests Innovative Companies' Patience

Meanwhile, legal problems continue for innovative companies in the area of patent protection enforcement.

After passing its own patent legislation in 1987 and expanding protection in 1993, China went on to join the Patent Cooperation Treaty and the World Trade Organization, adopting the agreement on trade related intellectual property rights.

Like other foreign companies, Lilly is concerned about the lack of transparency in procedures and the "perceived favoritism" toward local companies in courtroom patent disputes, Pate said.

"In many cases, the law will say one thing, but the courts interpret it somewhat differently," he said.

Although China technically bars generic companies from relying on safety and efficacy data from the innovator company for six years, in accordance with TRIPS, in reality companies can get around this provision in a shorter time period.

Innovative companies would like to see China's State FDA hold off on approving generics until patent issues are resolved.

Exceeding norms in the U.S., Japan and European Union, high turnover of employees in China remains troublesome for foreign companies (Also see "Accelovance’s Stephen Trevisan And Robert deGroof On China’s Clinical Research Landscape: An Interview With PharmAsia News (Part 2 of 2)  " - Scrip, 19 May, 2008.).

"What is the risk of an employee leaving and inadvertently taking intellectual property? You can have a very serious scientist who gets a better job someplace else. Even though he has no intention of breaching the law or violating IP of his former employer, human nature is human nature and he will think of new compounds with that old background in mind," Pate said.

Rights of Chinese scientists involved in drug discovery work need to be considered upfront, to avoid problems if a compound should turn into blockbuster material.

"If you have not negotiated with your scientist and are not certain what the laws are, it creates a great deal of risk," Pate said. "Lilly has to come up with a clear definition of what is owed to the inventor if that inventor is Chinese," Pate said.

"China's proposed Third Amendment to the Patent Law should make it clearer that agreements between companies and employee inventors should be controlling. Let's hope that is the case," he added.

Industry has had the opportunity to comment on the proposed legislation, weighing in over controversial compulsory licensing provisions, among other matters (Also see "Insider Analysis From Jones Day: What Does the 3rd Amendment to China’s Patent Law Mean to Pharmaceutical Companies?" - Scrip, 22 Jul, 2008.).

Crackdown On Corruption Abroad

Those doing business in China must also be aware of certain aspects of U.S. law governing business abroad. The Foreign Corrupt Practices Act prohibiting influence of foreign officials has been increasingly applied in this decade (Also see "China Expanding Anti-Corruption Drive Across Health Sector" - Scrip, 1 Sep, 2008.).

According to the law, U.S. companies are required to keep thorough records and to establish strong internal controls to prevent corrupt intent toward foreign officials in commercial matters.

Among other companies that have been investigated relatively recently for possible violations in China are GE, Lucent, Fidelity and Schnitzer Steel Industries.

"China did not significantly appear on the [FCPA] radar screen until 2004," Pate said.

The involvement of government officials in many aspects of business in China and the massive expansion in industry heighten risk.

"People from the U.S. spending time in China realize it is a highly relationship-oriented culture- it is not what you know but who you know, your relations with key people. There is nothing wrong with that but it creates potential for problems down the line," Pate said.

Pate noted the scale of corruption in China, with almost 150,000 investigations and 115,000 party members punished in 2005 alone. In the six years prior to 2005, one million officials were punished for corruption and former head of China's State Food and Drug Administration Zheng Xiaoyu was executed for this crime in 2007 (Also see "China Pharmaceutical Association Official Sentenced To Seven Years Imprisonment For Corruption Charges" - Scrip, 7 Jan, 2008.).

When doing business in China, it is necessary to investigate business partners and be aware of any government links.

"You have to do a lot more due diligence, China is large and a lot of people are related to each other. It is not a real violation to just have a family member in government, but it does create a perception of impropriety," Pate said.

Given the high standards in Securities and Exchange Commission circles today, the perception of impropriety is all that is needed to raise a red flag, he said.

- Emily Hayes ([email protected])