Outsourcing and Intellectual Property

A common concern when sourcing overseas is protecting intellectual property. This article examines sourcing and piracy as well as steps that can be taken to reduce the risk product will be copied.

Due to the many different types of products available in the world, the uniqueness of a product does not in itself make it attractive to those who seek to profit by copying the ideas of others. Products such as the following are most attractive for those engaging in piracy:

1. High tech goods or other products that require expensive research and development to create. They are appealing targets for copying because the one copying the product does not have to invest in research and development costs.

2. Products such as computer software, DVDs and music are attractive piracy targets since they can be copied inexpensively and those copying them are not paying the true production costs.

3. Famous brand names are piracy targets since those copying them are not paying the advertising and other costs that established the brand and its premium pricing.

Less established products that do not fall into the above categories are also victims of piracy. This happens because someone recognizes a unique product or idea that they think will sell exceptionally well. Since the top three types of piracy listed above are primarily a concern for major corporations, this article will focus on the copying of less established products.

Many people mistakenly assume this type of piracy is driven by manufacturers in the country where the goods are being sourced, such as China. In actuality, most manufacturers will not begin production unless they have assurance of receiving payment. Furthermore, they are not in the business of marketing products or predicting future product trends. Therefore, the piracy of less established products is usually driven almost entirely by competitors and others in the countries where the goods are marketed. It is thus unlikely the type of goods this article focuses on will be copied unless a competitor is determined to do so.Outsourcing and Intellectual Property

Steps to reduce piracy
While piracy of less established products in China is less frequent than most realize, preventative steps should nonetheless be taken when sourcing overseas. These preventive steps include the following:

• For products with a high risk of piracy, follow the steps from the RFQ (request for a quote) phase. This can be done by first breaking down the product and only seeking quotes on its components. The product can then be shown to more manufacturers since none of them will see the big picture.

• Ask any potential manufacturer for a list of their customers to ensure they are not supplying product to a competitor.

• Even though China is not a legal-based society, a simple, direct NDA (non-disclosure) agreement, translated into Chinese, helps eliminate misunderstandings and ensures the manufacturer understands permissible procedures.

• Register brand names as soon as possible. China and some other countries are based on “first-to-register” rather than “first-to-market.” The process, which generally costs less than a few thousand U.S. dollars, can be made much easier with local English speaking attorneys who can usually be found at reasonable rates.

• If the product is very sensitive, the components can sometimes be produced by different suppliers who do not see the entire product. Then, the final assembly or packaging can be carried out at a secure facility either in China or in the country where the goods will be marketed. However, this approach will almost certainly increase costs and can only be used when profit margins are wide.

By understanding the types of goods usually copied and the reasons copying is performed, one can better implement the necessary precautions to prevent theft of intellectual property.

VAT and China Sourcing

Since a nation’s value added tax (VAT) has a direct impact on price and profits, it is important to understand the VAT of the country where manufacturing and products are sourced. The following describes China’s VAT and how it affects China sourcing.

The mechanics of the VAT and its application to China sourcing
While VAT works differently in various countries, it is basically a tax paid on the value added to a product as it moves down the supply chain to the end user. For example, the raw materials for a widget are purchased by a manufacturer and a tax is paid. Then, when value is added to the materials by turning them into a widget, a tax is paid on the added value. Finally, a tax is paid on the additional added value of the widgets when they are sold to the final consumer.

For example, if the VAT is 10% and the manufacturer pays $50 for materials, then $5 is paid to the government. If the manufacturer then sells the widgets for $80, a total of $8 will be paid to the government ($3 additional dollars because $5 was already paid). If the widgets are next sold to the final consumer for $100, the government will have collected a total of $10 (an additional $2 since $8 has already been paid). VAT can also be viewed as a type of sales tax that is paid in part before the goods reach the final end user. Because the tax is paid periodically during the production/sales process, it is more difficult to avoid than a regular sales tax.

In China, the VAT rate is 17% on most goods. However, the government often refunds at least part of the VAT when the goods are exported. The amount refunded varies with the product, and the Chinese government uses the VAT as a tool to influence industry. Usually, the refund is highest on those goods for which the government wants to encourage production (e.g. higher value-added products) and lower or non-existent on products the government is less interested in having China manufacture. An example of this was seen in 2007 when the VAT system was changed and VAT refunds for many high-energy, high-polluting goods were greatly reduced or eliminated.

In its most simplified form, the VAT refund for an exported product works as follows. If the VAT rate is 17%, and the refund rate is 10%, and a $17 VAT is paid, then $10 would be returned to the exporter while the government would keep $7.

The importance of understanding VAT when importing
Importers who do not understand the VAT system are exposing themselves to the following potential problems and extra costs:VAT China Sourcing

  • The best pricing starts with transparency. When breaking down pricing, comparing suppliers and negotiating, it is critical to know the supplier’s true cost. Without an accurate breakdown of costs with the VAT rate clearly stated, the supplier has more room to manipulate the price.
  • Some manufacturers may not tell the purchaser about the VAT refund or they may tell the purchaser the refund was at a lower rate that they actually received and then will pocket the difference (it is also sometimes possible to negotiate the customs classification and therefore the VAT rate). To fully obtain all cost savings due through VAT refunds, every importer needs to be fully aware of the classification and rebate for the products purchased.
  • If a manufacturer lacks the proper import-export rights or VAT processing abilities, they may be forced to rely on third parties who will likely inflate the price and make the relationship with the manufacturer more complicated.
  • In a gray area of the law, some suppliers are able to avoid the VAT for smaller orders. While this will give the purchaser a lower price in the short term (although this increases the risk the goods will be trapped in China without proper documentation to export them), the importer will suddenly be hit with the tax when their business grows and the order size reaches a point where the VAT cannot be avoided. The tax increase will likely be greater than any discount from larger order quantities.

Therefore, when doing business in China or any nation with a VAT, is imperative to know the classification and VAT for every product and ask the supplier to outline their VAT policies. Doing so will enable the purchaser to avoid unexpected costs or other problems while getting the best price possible.