China high technology transfers

As we have been writing pretty much since the US-China (and to a lesser extent — but soon to be much greater extent — the EU-China) trade war started, the new normal for China will go beyond imposing tariffs. Other measures will be adopted by the U.S. government (and by the EU) to address the issues of forced technology transfer and intellectual property theft. One of those measures is prohibiting the transferring of key technologies to China pursuant to proposed U.S. federal rules. With the initiation of rule-making by the U.S. Department of Commerce, it is clear the new normal has gone beyond the prediction phase; it is already happening.

So what is going on with the proposed rules? On November 19, 2018 the U.S. Bureau of Industry and Security published a notice of proposed rule-making to identify emerging and foundational technologies. These technologies would then be subject to various restrictions on transfer to foreign persons, particularly persons located in China.

The rule-making is mandated by the recently adopted Export Control and Reform Act of 2019 (ECRA), adopted on August 13, 2018. The process is mandated by Congress and is a core component of U.S. national policy. The rule-making and the subsequent control measures have not been dictated by the current administration. A change in the administration or in the composition of congress will have little to no impact on this core policy.

What will happen is that the proposed controls on the transfer of emerging and foundational technology will be extended to include prohibitions on investment by foreign persons in U.S. high tech companies. This will be done by applying the same definitions of emerging and foundational technologies to controls both inbound and outbound investment as currently administered by CFIUS. This will be done through the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) which was adopted on the same date as the ECRA.

Welcome to the new normal.

The proposed rule-making is designed to identify emerging and foundational technology to be subject to licensing by the Bureau of Industry and Security. The media have mostly focused on the inclusion of artificial intelligence in the list of proposed technologies, but the list goes far beyond AI and actually covers virtually every innovative technology currently being developed in the United States. Go here for the full listing of 14 technology categories,

It is important to get clear on what the rules are designed to do and what they are not designed to do. Press reports have stated that the new rules would prohibit exporting physical devices that embody foundational technology. The suggestion has been that exporting smart phones from the United States that use Siri technology would be prohibited. In the same way, exporting video games that incorporate AI game techniques would be prohibited.

These statements are incorrect. The rule-making is based on Section 1758 of the ECRA. Unlike other sections of ECRA, Section 1758 does not apply to the export of physical items. Section 1758 applies only to the transfer of emerging and foundational technology. It does NOT apply to the export of devices that incorporate such technology.

Section 1758 is very clear on this point:

1758 (b) (4) (C) ADDITIONAL EXCEPTIONS.—The Secretary shall not be required to impose under paragraph (1) a requirement for a license or other authorization with respect to the export, reexport, or in-country transfer of technology described in paragraph (1) pursuant to any of the following transactions:

(i) The sale or license of a finished item and the provision of associated technology if the United States person that is a party to the transaction generally makes the finished item and associated technology available to its customers, distributors, or resellers.

(ii) The sale or license to a customer of a product and the provision of integration services or similar services if the United States person that is a party to the transaction generally makes such services available to its customers.

The new rules under Section 1758 will not prevent U.S. companies from selling high tech products to Chinese person. What will be restricted or prohibited is the transfer of the underlying technology to Chinese persons.

These rules will have a major impact on technology companies dealing with China. Currently and under the new rules, Chinese companies are generally free to purchase high-tech products from U.S. manufacturers and service providers. But U.S. companies have mostly had little success in direct sales to Chinese persons/entities. Chinese persons/entities will usually only purchase from Chinese companies, so U.S. companies are forced to transfer to Chinese entities to make their sales. After these “forced transfers,” the technology is then “assimilated” for the benefit of the Chinese side.

ECRA Section 1758 is designed to end the forced technology transfer regime, at least for emerging and foundational technologies. Since virtually every technology of any interest to a Chinese buyer will fit into that category, Section 1758 has the potential to eliminate nearly all technology transfers to Chinese persons/entities. However, Section 1758 will not prevent Chinese persons/entities from purchasing high technology goods and services from U.S. companies through normal cross border sales transactions.

Most countries in the world (See Europe, the United States, Australia, Canada, almost all of Asia and of Africa) do business this way. The impact will be that Chinese persons/entities will be forced to behave in a more standard way in the global market economy.

On the other hand, most technology transfer projects currently being considered between U.S. companies and Chinese persons/entities will be impacted by the proposed licensing of emerging and foundational technology transfers. Even technologies not within the current very broad listing could eventually be pulled into coverage. Though all of this is in the preliminary rule-making stage, the outlines of the policy are clear and virtually inevitable. This means that every U.S. company considering technology transfer to Chinese persons must consider the impact of this licensing regime. And like I said, the EU is making similar moves. See EU moves to protect interests against predatory China in the Financial Times. 

This is the new normal.