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Legal Issues of Special Concern to Technology Commercialization

Richard Dulik

Covington and Burling

Introduction

Committee Member: You have succeeded in setting up a viable technology company here in Russia. How did you do it?

Russian Entrepreneur: We collected some of the best people in our area of technology and started a company. Now we do contract work for many foreign companies. The hardest part was structuring the company to avoid the tax situation here. We could not just set up the company and pay our employees from the proceeds of the contracts. We would lose most of the money to taxes. Luckily, one of the companies we contract with has very clever lawyers.

Committee Member: What did you do?

Russian Entrepreneur: We had to set up a small foreign company. It is just a shell. We also made sure that all of our employees had credit cards. Our foreign company is paid under our contracts, and we pay our employees by having the foreign company deposit money in each employee's credit card account. Our company here in Russia gets just enough money to pay for the necessary expenses. This arrangement allows us to avoid most of the taxes. Otherwise, we might be losing 70 percent of our income to taxes.

We have no way of determining if this story is true. Nevertheless, it illustrates some of the legal challenges faced by the institutes and technology start-up companies in Russia today. Obviously, the story is about a clever way that one company found to reduce the amount of taxes it was paying. However, it is also about the need to find foreign partners who will tolerate such solutions and for legislation to support research institutes and technology start-up companies.

Companies, wherever they are located, will do what they can to reduce their tax burdens. This is simply good business practice. In the United States, there is



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--> Legal Issues of Special Concern to Technology Commercialization Richard Dulik Covington and Burling Introduction Committee Member: You have succeeded in setting up a viable technology company here in Russia. How did you do it? Russian Entrepreneur: We collected some of the best people in our area of technology and started a company. Now we do contract work for many foreign companies. The hardest part was structuring the company to avoid the tax situation here. We could not just set up the company and pay our employees from the proceeds of the contracts. We would lose most of the money to taxes. Luckily, one of the companies we contract with has very clever lawyers. Committee Member: What did you do? Russian Entrepreneur: We had to set up a small foreign company. It is just a shell. We also made sure that all of our employees had credit cards. Our foreign company is paid under our contracts, and we pay our employees by having the foreign company deposit money in each employee's credit card account. Our company here in Russia gets just enough money to pay for the necessary expenses. This arrangement allows us to avoid most of the taxes. Otherwise, we might be losing 70 percent of our income to taxes. We have no way of determining if this story is true. Nevertheless, it illustrates some of the legal challenges faced by the institutes and technology start-up companies in Russia today. Obviously, the story is about a clever way that one company found to reduce the amount of taxes it was paying. However, it is also about the need to find foreign partners who will tolerate such solutions and for legislation to support research institutes and technology start-up companies. Companies, wherever they are located, will do what they can to reduce their tax burdens. This is simply good business practice. In the United States, there is

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--> a never-ending search by both companies and individuals for loopholes in the tax laws. However, a company that has to do business in ways as complex as those described by the Russian entrepreneur will have trouble finding foreign partners because the possibility that something will go wrong increases the risks of the foreign partners. All other things being equal, potential partners will prefer the least risky situation; and the least risky situation may not be working with a company operating in Russia. Moreover, potential partners may fear the high visibility of Russian research institutes and technology start-up companies as potential sources of foreign exchange. In Russia, where it is difficult to effectively tax significant portions of the economy, these institutes and companies may become potential targets for more than their share of taxes and regulation. The story also illustrates some desirable developments in Russia. Many Russians have adapted quickly to a free market system and are using great creativity to work around legislation that may not be encouraging business development. In addition, much Russian science is of excellent quality and is highly competitive in the international arena. Unfortunately, to a significant extent, Russian science is not currently competitive in Russia itself because of the lack of infrastructure to convert ideas into saleable products. This paper will further examine the above points while discussing the legal environment in which research institutes and technology start-up companies are attempting to commercialize Russian technology. Taxation In addition to illustrating the general environment in which Russian companies operate, the story related in the Introduction specifically highlights tax questions. There appears to be great disagreement among Russians themselves as to the actual tax burden faced by research institutes and technology start-up companies. In the past, there was always great uncertainty about taxes, and the tax situation remains in flux as new legislation is introduced. Regardless, some general comments can be made in light of American experience. Government tax policies have enormous impact on the viability of business investments. Tax environments that are harsh put exceptional pressure on R&D spending because much of the return on investment will come in future years. When tax rates are high, the time value of money makes short-term high returns much more valuable than long-term low to moderate returns. In Russia, we heard many times that rich "New Russians" will not invest in R&D because much higher short-term returns are available from other enterprises. The federal government has tried various tax incentives to encourage companies to invest in R&D in the United States. Many state governments have special programs to subsidize start-up companies in various ways and provide

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--> tax advantages. These programs are often successful in encouraging companies to operate in those states. The philosophy behind these programs is that the government is willing to forego some short-term income from taxes and fees to create long-term growth that will produce jobs and strong, innovative companies that have a future. Similarly, universities often enjoy tax advantages in the United States as nonprofit organizations, while government entities or quasi-government entities may not pay any tax at all or enjoy reduced taxes. It must be noted, however, that the U.S. tax code is notoriously complex and by no means a necessarily good model for Russia. In practice, determining whether a university must pay federal income taxes on income derived from certain activities may be quite difficult. For example, a university may have to pay income tax on activities that appear to be unrelated to the university's tax-exempt educational, charitable, or scientific purposes. An introduction to this complex subject can be found in Kertz and Hasson's article, "University Research and Development Activities: The Federal Income Tax Consequences of Research Subsidiaries and Joint Ventures," Journal of College and University Law (Vol. 13, No. 2). The U.S. government does not tax itself; the income earned by government entities ultimately is controlled by the U.S. Congress and may or may not be spent by these entities. Naturally, this method of operation requires a complex budgeting process to ensure that entities are able to spend sufficient funds (whether derived from the U.S. Treasury or from earnings) to fulfill their assigned missions. It is unclear whether a similar and effective system is currently operating in Russia, given the many complaints that institutes had insufficient funds to regularly pay livable wages and that income from foreign sources, such as research grants, was subject to substantial taxes. Start-ups and institutes may become targets in Russia for taxes because their incomes can be monitored by the government; the institutes, in particular, have less flexibility to creatively structure themselves to avoid taxes. The Russian government does not appear to have efficient mechanisms to tax personal income, and therefore, gains little income from the job creation process that is so widely encouraged in the United States. The taxes and other financial burdens currently placed on institutes and start-ups in Russia is unclear. It therefore would be very useful to calculate the entire cost burden of government taxes and other fees under the existing and proposed tax legislation that would be faced by a hypothetical start-up company. Whatever the result, the tax and fee burdens must be manageable or institutes and start-ups will cease to exist. Then the government will lose both the short-term and potential long-term income. One additional consideration may be unique to the current situation in Russia. Because of the elimination of a substantial portion of the infrastructure capable of developing and producing high-technology mass-market goods, the relatively sophisticated technology of research institutes must be marketed primarily overseas, a point discussed in greater detail below. Generally, a

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--> country's ability to produce technology products keeps pace with its ability to carry out research to develop those products. Since the Russian research capabilities currently cannot be used on a significant scale domestically, the institutes must market, to a large extent, outside Russia. As a result, they probably incur costs not borne by research organizations in other countries. Therefore, to be competitive, Russian institutes must bear lower taxes, fees and other burdens than those found in other countries, not higher as now appears to be the case. Contractual and Business Matters Many Russian institutes are conducting scientific research that is equal to or better than the work of their counterparts in other countries. Unfortunately, the production infrastructure—including established manufacturing companies, venture capitalists, and start-up companies that normally would be expected to convert scientific research into successful products—is only now beginning to develop in Russia. The political and economic changes during the last 10 years may have severely damaged Russia's scientific establishment, but they have virtually destroyed significant portions of Russia's industrial production capabilities, particularly in the area of high-technology goods. We frequently heard that many production facilities operating during the Soviet period had become antiquated and unable to compete directly against the more modern facilities found in many other countries. When thrust into competition with those more modern facilities, the Russian facilities had been forced to close since there was apparently insufficient investment capital available to fund modernization. Consequently in some industrial sectors both sophisticated new technologies and potential consumers of that technology are present but the production infrastructure is absent. Therefore, a current natural market for the scientific products of institutes and start-ups in these sectors is overseas—particularly in the advanced economies of the United States and Europe, where high-technology product development and production facilities are readily available. The marketing of technology and products overseas is, however, a substantial task. For example, one Russian institute director described his institute's experiences with competitive contracts in the West. The institute had submitted a series of proposals, apparently in response to competitive Requests for Proposals (RFPs), but had won no new business. The officials of the institute were frustrated, felt that there was discrimination against Russian organizations, and resolved not to compete for foreign business again. Russian institutes and start-ups must face many hurdles in entering the international marketplace. First, Russian institutes, perhaps due to a long history of responding to explicit government requirements for products or results, may

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--> not have much experience in producing proposals that compare favorably to those produced by companies in the West. Second, according to many Russians, few Russian products are produced in compliance with recognized international product standards. We were told that many Russian products in certain fields were equivalent or superior to those marketed in Western Europe but that selling Russian products was virtually impossible because they did not comply with the very detailed European Union product standards. To compete internationally, Russian companies recognize that they must both understand the new standards and demonstrate that they are capable of producing products to those standards. Third, Russian executives may have little experience in highly competitive environments, where companies expect to lose a substantial majority of contract competitions. The effort expended by companies on a particular proposal must take into account the chances that the company actually will win a contract. The company should not have high expectations of winning any particular competition. Fourth, Russian companies in highly competitive markets may lack a thorough understanding of competitive pricing. Companies in these markets must understand both whom they are competing against and what the competitors are bidding. Many consulting firms can supply this type of information. For example, it is not uncommon in some industries for consultants to conduct "blind benchmarking studies" wherein competitors supply pricing information to consultants with the understanding and appropriate assurances that the sources of the information will not be identified. Russian companies must be prepared to obtain such information if they hope to succeed in competitive markets. Fifth, few Russian companies leverage their purchasing requirements to obtain assistance and concessions from their suppliers. It would be appropriate for Russian companies that make substantial purchases of equipment or supplies from overseas suppliers to require suppliers to provide them with various forms of business assistance as part of a deal. For example, the Russian company, in return for placing a large order with an American computer manufacturer, could require the manufacturer to help the Russian company set up a modern procurement department. Finally, the "command economy" mindset may have encouraged many Russian executives to adopt a passive operating style, whereby they expect opportunities to come to them. By contrast, American executives spend substantial amounts of time networking, marketing, visiting potential customers, and otherwise promoting their companies. Particularly in these early stages, as Russian companies emerge into the international marketplace, the leadership of the institutes and start-up companies must devote substantial time to visiting potential customers and seeking out new opportunities and applications. When funds are scarce, travel may appear to be an unnecessary expense, but it may

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--> more than pay for itself by generating opportunities for long-term business relationships. Fortunately, the problems mentioned above are easily corrected. Over time, the executives of institutes and start-ups will gain experience with the competitive contracting system, international standards, and the art of marketing products and services. Also, relatively inexpensive training could be useful. Executives can be taught how to allocate resources efficiently, seek out market opportunities for their products or services, and write effective proposals. Intellectual Property Given the constant stream of controversies in the United States over the appropriate scope of intellectual property protection, the satisfaction of Russian specialists with current Russian intellectual property law was surprising. On the other hand, there was also uniform concern that Russia did not have effective mechanisms for enforcing intellectual property laws. In truth, such laws are inadequate by definition if they cannot be enforced. Attempts at enforcement usually bring to light defects in the underlying legal structure. Russian specialists generally stated that the only way to enforce intellectual property laws was to bring suit. However, such action is rare because of its high costs and the uncertainty of the outcome. Therefore, intellectual property laws are widely ignored. Naturally, much depends on the nature of the technologies or products involved. Where the technologies are evolving rapidly or are easily concealed from reverse engineering, such as with some integrated circuits and complex industrial materials and processes, there is much less need to rely on the legal system for intellectual property protection. Products that are easy to duplicate, such as certain software, audio and video tapes, and other information products, are very vulnerable to piracy and generally must be protected through legal means. With respect to enforcement of U.S. intellectual property laws, American specialists probably would make comments similar to those of Russians, although they would reach the opposite conclusion about the effectiveness of this enforcement. In the United States, enforcement is also primarily done through the courts, an expensive and uncertain process. For many smaller companies, intellectual property litigation is termed "Bet the Company" litigation because defeat will certainly drive the company into bankruptcy. Merely obtaining U.S. patent protection for a single invention can cost between $5,000 and $15,000, and litigation of patent infringement costs millions of dollars. In litigation, case-deciding decisions may be made by judges or juries with little understanding of the complex legal and technical issues involved, hence the great uncertainty regarding the outcome of many cases. Why then, if the Russian and the American criticisms of approaches to enforcement are the same, do U.S. intellectual property laws serve as effective

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--> deterrents in the United States? It is probably because the prohibitive costs and uncertainty of American intellectual property litigation actually strengthen the impact of intellectual property laws. The threat of a devastating lawsuit is always present. Despite the potentially serious consequences of losing, suing is culturally acceptable in the United States. Further, the rewards for winning or settling a lawsuit can be very large. U.S. intellectual property law may not only provide the winner with compensation for any damages suffered but also with substantial "bonus" money (punitive damages) that is intended to punish the loser for wrongdoing. This money provides not only the incentive to sue but the means to pay for the suit as many attorneys will accept a percentage of the winnings (contingency fees) as their sole compensation. Some other countries encourage suits by requiring the losing side to pay the legal costs of the winning side. On the other hand, the threat of litigation encourages the vast majority of potential suits to be settled out of court through payments, cross-licensing, or other agreements. The uncertainty of litigation also encourages settlement because incorrect decisions can be made even in very clear cases, and appeals are as uncertain and expensive as the original suit. Thus, the mere potential for a suit is an incentive for companies to resolve their differences between themselves. The possibility that a suit could bankrupt a company is never taken lightly. But the U.S. legal and business systems soften the impact of bankruptcy. In the absence of criminal wrongdoing, the individuals involved may simply find jobs elsewhere, while the company itself may be reorganized and remain in business. Development of an effective legal system is important to the revival of the Russian economy but is likely to occur slowly. As a result, the market for the products of institutes and start-up companies lie outside Russia. Well-developed foreign legal systems can provide Russians with intellectual property protections when they market internationally. Contracts and companies may be structured so that they operate within Russia but rely only minimally on the Russian legal system. Conclusions Perhaps the single most important step the Russian government can take to support the research institutes is to clearly define the institute's position in modern Russian society. The leaderships of institutes cannot plan for the future when the ultimate existence of their organization remains in question. Current attempts to partially fund large numbers of institutes will only perpetuate the present situation, in which many highly educated and competent scientists are not paid enough by the government to survive and have no access to the equipment they need to perform useful research. Institutes that may have the capability to flourish as independent businesses need the opportunity to be able

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--> to do so, and institutes that have remained fully functional should, of course, be encouraged to continue with their work. We learned that the Russian government is undertaking a program to certify institutes as legitimate research establishments. Such efforts undoubtedly will result in some dislocations of personnel, and programs must be developed to aid such persons. However, using some institutes merely as mechanisms for delivering partial financial support and social services to scientists is pointless and a serious waste of resources. Even direct financial aid to unemployed scientists, channeled perhaps through the Russian Academy, would be preferable because a clear distinction could be made between funds that are supporting actual research and funds that are providing social services. The government must provide an environment in which well-managed institutes and start-up companies can flourish. The most difficult challenge may be to explicitly relax control of the institutes and the production facilities. The institutes, after all, were home to some of the Soviet Union's most closely guarded secrets. In modern Russia, the institutes are highly visible to the government and obvious targets for taxes and controls. Legislation that could affect new start-ups, particularly tax and import/export controls, should be specifically evaluated for its impact on investment, business development, and entrepreneurship in Russia. As noted above, many of the institutes that we visited consider current Russian intellectual property laws adequate, but they add that the Russian legal system as a whole cannot be used to effectively protect intellectual property rights. The challenge is to develop a legal system that is accessible to individuals and small private entities and that can be seen to operate at least honestly if not predictably. This problem, which goes well beyond the scope of the committee's study of technology commercialization, should be considered well worth a separate study. International contracting practices, business development, entrepreneurship, and standardization pose less serious problems. Facility in these areas can be taught. The solution, in one sense, is as simple as identifying appropriate people at the institutes to receive training and ensuring that they receive proper training. Because many scientists are not sure how they are expected to operate in the new environment and some, at least, hope for a return to the more structured environment of the past, the real challenge is to reorient and restructure the institutional leadership so that entrepreneurial personalities can rise to the top and lead their organizations into the future.