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By Simon Luk, Susan Finder and Peter Luan
This article was first published by PharmAsia News in July 2007.
Pharmaceutical research and development (R&D) centers in China represent a “win-win” situation for both foreign pharmaceutical companies and the Chinese government. The Chinese government, with its macroeconomic objectives, encourages foreign companies to establish R&D centers in China — by providing regulatory advantages to those foreign companies. Such advantages are not provided to foreign companies operating solely offshore.
Many major pharmaceutical companies have established R&D centers in China, primarily in Shanghai or nearby cities, to claim a part of the world’s ninth largest pharmaceutical market, take advantage of lower cost clinical trials in China and leverage developments with highly trained but relatively low-cost research staff. By the end of 2006, AstraZeneca, Eli Lilly, GlaxoSmithKline, Novartis, Pfizer and Roche all had established or committed to establish R&D centers in China. These companies expect that their China centers will account for a substantial proportion of their corporate research globally.
Medium-sized foreign pharmaceutical companies now are considering whether they should move some of their R&D to China. This article will identify some of the regulatory advantages R&D centers can enjoy, and then look at some of the major issues to keep in mind when contemplating the establishment of a center — such as government procedures and labor issues — as well as identify areas where Chinese regulations are in flux.
Regulatory Advantages of an R&D Center in China
To encourage foreign pharmaceutical companies to establish manufacturing and R&D centers, the Chinese government provides certain regulatory advantages to such entities in critical areas, particularly the approval of new medicines and the performance of clinical trials.
Under current law, if a foreign-invested R&D center applies for the approval of a new medicine, provincial level approval by the food and drug authorities is required, whereas if a foreign company applies for approval of a new medicine, approval by the national level State Food and Drug Administration (SFDA) is required. This system is expected to remain in place, although the drug registration regulations currently are being overhauled. Moreover, foreign companies cannot act as applicants for clinical trials, but foreign-invested R&D centers can do so, provided the R&D center meets certain criteria.
Many foreign pharmaceutical companies are attracted to conducting clinical trials in China for several reasons. One principal reason is cost. Additionally, the enormous population of China provides a “deep and broad patient pool” for all types of medical conditions. The relatively low salaries of doctors and nurses in China, in comparison with the developed world, means that conducting a trial in China could cost significantly less than it would if it were conducted elsewhere. Further, there is less patient suspicion of clinical trials in China than in the United States, and the uneven nature of medical insurance coverage in China means that a substantial pool of patient volunteers may be motivated by the prospect of access to otherwise unavailable medical treatment. Finally, patient litigation is less of a concern in China, both because of strict controls on class actions and limitations on damages.
Government Procedures
Pharmaceutical R&D centers are classified by the Chinese government as an encouraged investment, which not only means that foreign companies can wholly own and operate these centers, but also gives such companies other privileges in the import of equipment and certain tax preferences.
Companies should bear in mind that a China-based R&D center cannot be a shell company without substantive operations. R&D centers are required to have:
• defined research and development projects;
• fixed premises; and
• apparatus and equipment required for scientific research and the other conditions required for scientific research.
Investment in research and development must be set at no less than US $2 million. Additionally, such centers must have dedicated management and scientific research personnel, with personnel directly engaged in research and development required to hold at least undergraduate degrees representing a minimum of 80 percent of the center's staff. In the establishment review process, Chinese authorities from the local branch of the Ministry of Commerce (MOFCOM) will monitor the materials submitted to them to determine whether the proposed operation meets the requirements.
Wholly Owned Entity Versus Joint Venture
The legislation covering the establishment of R&D centers by foreign investors permits such centers to be formed either as a joint venture or as a wholly foreign-owned enterprise (WFOE). Many companies prefer to establish a WFOE, to be able to control the management of the center and better protect their intellectual property. Pfizer and GlaxoSmithKline are among the companies that have established, or are in the process of establishing, WFOE R&D centers. Other companies, especially those with long-standing manufacturing joint ventures, have established joint venture R&D centers. The pros and cons of establishing a WFOE R&D center versus a joint venture raise many of the same issues as they do for manufacturing — decisions concerning business operations and particularly expansion of operations are simpler if there is a single investor involved, rather than two or more investors that may have different business goals.
Approval Process
The establishment of an R&D center requires approval by MOFCOM, generally at a local level, with prior approvals required from the environmental and other authorities. Companies wishing to build a large-scale R&D center that requires a large tract of land, particularly in the Beijing and Shanghai areas, may encounter delays because of the Chinese government’s tightening up of investment in real estate.
Even before the issuance of State Council directives in mid-2006 imposing restrictions on foreign investment in the real estate sector, the more sought-after development zones in Beijing and Shanghai already had started to restrict land use by foreign investors. For example, the proposed foreign investment project is required to exceed a certain minimum investment amount and the plot ratio and building density must meet certain minimum standards. However, foreign investment officials take a favorable attitude toward R&D center projects, and establishment procedures can generally be completed within three to six months.
Challenges Posed by the New Corporate Income Tax Law
The tax status of a newly established R&D center is uncertain because of the overhaul of the tax law applicable to foreign-invested companies. For many years, foreign-invested companies (FIEs) in China, including R&D centers, have enjoyed various types of tax holidays in China, particularly ones based on the location of the enterprise. Starting Jan. 1, 2008, a new Corporate Income Tax Law (New CIT Law) will be applicable to both domestic companies and FIEs, under which a uniform income tax rate at 25 percent will apply and most geographic preferences will be abolished. Although the New CIT Law does provide tax incentives for companies engaging in high-technology industries and R&D of advanced technology, details of this treatment have not yet been determined by the State Council and it is unclear how pharmaceutical R&D will be affected.
Labor Issues
For many foreign investors, the relatively lower cost of labor is one of China’s major attractions. Pharmaceutical companies may find it easy to recruit quality research staff who have graduated from top Chinese universities, at a significantly lower cost than in the U.S. or EU markets. Labor law in China is an area that is in flux. A draft Labor Contract Law under consideration by the national legislature is expected to be strongly pro-labor. A few of the provisions included in the draft legislation include: the payment of severance pay to employees whose contracts expire and whom the employer chooses not to renew; shortening the permissible probationary periods; and imposing various restrictions on non-compete agreements.
Changing legislation, the dynamic job market and increasingly rights-conscious employees will require foreign companies with operations in China to remain watchful. We discuss some important issues below, including employment termination, non-competition clauses, and dispute resolution.
Termination of Employment Contracts: Statutory Severance
With a few exceptions, a company cannot terminate an employee without proper cause. If an employer improperly terminates the employee’s contract, the employee can require the employer to pay his salary for the remaining term of his contract in addition to extra compensation equal to 25 percent of the unpaid salary.
Employers must send a notice to employees 30 days prior to any termination. The labor authorities normally hold the view that employers cannot circumvent this notice by paying the employee one-month’s salary in lieu of notice, but as a matter practice, the authorities will not challenge the termination if one month’s salary is paid to the affected employee.
An employer who terminates an employee also is required to pay statutory severance. The basic standard is “one-month’s salary for each year’s service.” If the employer wants to encourage an employee to leave, additional payments above and beyond the statutory minimum are made.
Non-competition Clauses
Foreign-invested pharmaceutical companies in China generally insert non-competition clauses into their employment contract templates to try to limit the ability of key employees to work for rivals. Chinese law allows companies to incorporate such clauses into employment contracts, but provides that the company must compensate the employees if they are required to comply with the non-competition clause. Relevant regulations do not clearly set forth the criterion for compensation. However, local requirements, in many areas, and market practice, in other areas, may dictate that the compensation should not be less than one-third of the employee’s annual salary for a one-year period.
Additionally, enforcement of a non-competition clause may be practically difficult, as it may require taking an enforcement action against the former employee. Suing a former employee involves legal fees, as well as substantial company time and effort to assemble the relevant documents and attend the court hearings, with the risk that the court may not uphold the non-competition clause.
Resolution of Labor Disputes
Chinese law strongly encourages the mediation of labor disputes between employers and employees. If mediation fails, either party can bring the dispute to the Labor Arbitration Committee. The arbitration is not final, and the parties can appeal the arbitral award to the court, which will make a final decision concerning the dispute. It should be noted that in many cases, the Labor Arbitration Committee and the courts have favored the employee.
Conclusion
The establishment of an R&D center in China presents opportunities for foreign pharmaceutical companies, such as greater access to Chinese clinical trials, the ability to market products on the Chinese market, and lower labor costs. However, pending legislation in the areas of tax, labor and pharmaceutical regulation are in flux, presenting challenges and uncertainties for the foreign investor.
