New Measures on Foreign Investment in China Real Estate

direct offshore ownership structures Unavailable

A popular method used by many foreign investors to structure their investments in China real estate is the so-called 'direct offshore ownership structure'. Under this structure, an investor uses an entity formed in a jurisdiction with favourable tax treaties with China, such as Bermuda, British Virgin Islands, Mauritius, or others, to directly own real estate in China. Therefore, no company is formed in China to own and hold real estate.

There are numerous attractive features of the direct offshore ownership structure. Firstly, there is the potential for tax efficiency. A company that is formed in China and owned or invested in by a foreign entity, such that it is considered to be a foreign-invested enterprise (FIE) is generally subject to a 33% foreign enterprise income tax rate. On the other hand, an offshore company that directly owns real estate in China, and is properly structured to avoid having a permanent establishment in China, could be taxed at a substantially lower rate on the income derived from the operation of the real estate in China. The offshore company will generally be subject to a business tax (5% of gross rental income), a withholding tax (10% of gross rental income, with a deduction for business tax paid), plus an urban real estate tax (percentage and method of calculation varies depending on location of property).

Secondly, certain regulatory burdens may be avoided. Establishing and administering an FIE in China is generally more time consuming and complex compared with other jurisdictions. For example, FIEs domiciled in China, unlike many offshore entities, may be subject to strict governmental controls and approvals on operational items, ranging from the repatriation of profits, to the repayment of shareholder loans and the incurrence of debt.

Thirdly, the so-called 'trapped capital' in an investment entity may be potentially avoided or limited. Generally, FIEs formed in China have high registered capital or equity contribution requirements. Once the registered capital is contributed to the entity, it is difficult, in most instances, to reduce the registered capital of the entity and return the capital contribution to the investor, until the FIE has actually ceased conducting business and is liquidated. Offshore entities in many jurisdictions do not have the same high minimum capitalization requirements nor are they subject to the same burdensome procedures and requirements for the reduction of the registered capital as FIEs domiciled in China.

Establishing WFOEs

However, with the introduction of the Measures, the direct offshore ownership structure is generally no longer available. Subject to the 'self-use' exception, foreign investors interested in investing in China real estate, in future, will be required to establish an FIE in China, such as a wholly foreign-owned enterprise (WFOE). The establishment of a WFOE is a multi-step process requiring advance planning, governmental approvals and the funding of substantial registered capital. Consequently, foreign investors who previously utilized the direct offshore ownership structure will need to modify their modelling and cashflow assumptions, by taking into consideration the registered capital requirements, debt limitations and tax implications of FIEs in China, which could be substantially different from offshore entities.

Additionally, foreign investors may need to plan for extra lead time to form and structure entities, as the timeframe for forming a WFOE, could be substantially longer than forming a basic offshore company in other jurisdictions. The Measures also introduce some new procedures and requirements, relating to the issuance of the business licence and the certificate for FIE approval, which will require careful planning and coordination with the issuance of applicable land use rights certificates for the subject real estate project.

Self-use exception

As previously mentioned, 'self-use' is an exception to the new prohibition under the Measures on the direct offshore ownership structure. Under the 'self-use' exception, branches or representative offices of foreign entities and foreign individuals residing in China, for work or study purposes for more than one year, are permitted to purchase real estate for their own use. Individual residents of Hong Kong, Macao, Taiwan and Chinese nationals may purchase residential properties for their own use, up to a certain size, according to their living needs. The self-use exception is clearly the PRC government's attempt to allow for the continuing purchase of real estate by individuals and entities for their own habitation, but not primarily for investment purposes. It should be noted that acquiring properties for rental or resale purposes by commercial investors will generally not fall into the self-use exception.

Increased registered capital requirements

In certain circumstances, the Measures also require an increase in the registered capital of onshore ownership entities. PRC law mandates certain minimum registered capital requirements for FIEs involved in real estate ventures. In other words, a certain percentage of an FIE's total investment in a real estate project or investment must be funded in the form of funds from the registered capital (or equity) contributed to the FIE.

The difference between the FIE's total investment and registered capital may be funded by way of third party loans or shareholder loans to the FIE. Under the Measures, the registered capital requirements are increased. Previously, if the total investment of an FIE was over US$30 million, at least 33.3% of the total investment had to be funded by way of funds from the equity investment or registered capital contributed to the FIE. Under the new Measures, however, the minimum registered capital requirement for FIEs is increased to 50% of the total investment, and the total investment threshold triggering the 50% requirement is reduced from US$30 million to only US$10 million.

As a consequence of the Measures, foreign investors involved in large-scale real estate projects or ventures need to commit a larger equity investment up-front. Also, investors' ability to leverage investments with financing has been reduced. Clearly, by increasing the registered capital requirements, the PRC governmental authorities are attempting to curtail speculative real estate investments and ventures, by making it more difficult for investors with limited cash resources available for equity investments to invest in real estate projects and ventures.

Curtailing access to debt financing

Access to financing is an important consideration for most investors in assessing and implementing investment strategies in real estate projects and ventures. The availability of easy credit, however, is also viewed as contributing to the speculative and overheated condition of the real estate market.

Under the Measures, access to credit is curtailed until certain investment and project thresholds are met. A real estate FIE will not be permitted to obtain offshore or onshore financing and SAFE will deny conversion of foreign currency loans to renminbi, unless and until:

(i) the required registered capital of the FIE has been fully paid-up;

(ii) the FIE has obtained the land use right certificate for the property that is the subject of the enterprise's investment, and

(iii) the capital of the project in the case of a development project has reached 35% of the total project investment.

Like the increased registered capital requirement, the provision limiting access to debt financing until certain threshold requirements are met, is designed to curb speculative investment in the market by making it more difficult for investors, with limited equity financial resources, to proceed with projects. Certain minimum equity investments to pay in registered capital and to pay land grant premiums, in order to secure land use right certificates, will be required before bank financing may be accessed.

Prohibiting guaranteed fixed returns

In addition to leverage, another technique utilized by many foreign investors in joint venture (JV) real estate transactions between foreign and domestic investors, which are structured as cooperative JVs (as opposed to another form of JV known as an equity JV, which has less flexibility), is the creative structuring of the JV's allocation of distributable profits and priority of payments, with respect to the availability of a JV's cashflow. For example, one of the JV participants may be entitled to a preferred return in the form of allocating all distributable profits from the JV, until such participant earns a certain pre-determined fixed percentage internal rate of return on its investment. The other JV participant will not receive any distributable profits until the preferred investor has received its pre-determined return. There are numerous variations on this preferred return structure utilized in transactions.

The Measures dictate, however, that neither foreign investors nor domestic investors in a foreign-invested real estate enterprise (FIRE) may now be permitted to enter into any contracts, articles of association, equity transfer agreements or any other documents in connection with a FIRE that guarantees a 'fixed return' to any party.

Prior to the introduction of the Measures, there were no such restrictions under applicable PRC laws and regulations. Unfortunately, the Measures do not elaborate on what constitutes a guaranteed 'fixed return'. Consequently, it is difficult to assess the implications of this provision stated in the Measures. Does the no fixed return provision of the Measures apply to the somewhat common arrangements like those described above, where a transaction participant is provided a fixed preferred return, or does it only target special arrangements where a party is guaranteed a payment or return, which has no link to distributable profits or the economic performance of a venture?

Increased scrutiny and regulatory oversight

Under the Measures, many types of real estate related transactions involving foreign investors are required to be subject to increased scrutiny and regulatory oversight. Any transfers of equity interests and the projects of FIREs, and any mergers and acquisitions of domestic real estate enterprises involving foreign investors will be subject to strict regulatory oversight and approvals by applicable governmental authorities. Submission of various information and materials will be a part of the approval process.

In addition, in the case of acquisitions by a foreign purchaser of a domestic real estate company or a domestic party's interest in a Sino-foreign joint venture, the foreign purchaser must meet all of its acquisition payment obligations in one up-front payment. Moreover, under the Measures, relevant governmental authorities are instructed to increase supervision and closely monitor the activities of FIREs to ensure they strictly perform in accordance with all applicable land grant contracts, planning permits and other governmental approvals. Governmental authorities are also charged with the task of monitoring and supervising FIREs to ensure compliance with laws and regulations and do not, for example, engage in any illegal sale activities such as stockpiling real estate assets and manipulating property prices. Local governments are required to refrain from issuing new preferential policies on FIREs and are directed to correct and amend such preferential policies that are currently in effect.

While the lump sum payment requirement, in connection with acquiring domestic real estate companies or domestic-party's interest in a Sino-foreign joint venture, is a new requirement, many of the Measures' provisions relating to various oversight and approval requirements are not necessarily new specific requirements imposed on governmental authorities, but rather statements that governmental authorities should be more serious and diligent in enforcing existing laws and perhaps exercise more caution when approving transactions.

Cooling the real estate sector?

The Measures have generated mixed reactions in the foreign investment community. Some market participants have viewed the Measures as no more than a jingoistic statement of the PRC authorities against foreign investors, who have been playing an increasing role in the China real estate market. Proponents of this view contend that in reality, foreign investors make up only a very small component of the overall market and the Measures are therefore not necessary. Any measures to cool foreign investment are unlikely to have any significant impact on the overall market. Other foreign investor market participants have taken a different view. They view the Measures in a broader context