Restrictions on Foreign Investment in the Real Estate Industry

It is noteworthy that, in the Circular on Issues Relevant to the Implementation of the <Opinions on Regulating the Entry of Foreign Investment into the Real Property Market and the Administration Thereof > (关于贯彻落实《关于规范房地产市场外资准入和管理的意见》有关问题的通知) issued by the General Office of the Ministry of Commerce (MOFCOM) on August 14 2006 (Circular No. 192), the term "FIE in real estate industry" under the Opinions No. 171 was narrowly interpreted to cover FIEs engaged in the development and operation of ordinary residences, high-grade apartments, villas, hotels, resorts, office buildings, exhibition centers, commercial housing (including shopping, restaurants and entertainment) and theme parks, or engaged in land development for the foregoing real estate development projects. Therefore, companies engaged in the development and lease of factories, plants and warehouses for industrial purposes shall not be governed by the Opinions No. 171.

Establishment of Real Estate Development Company

According to the Opinions No. 171 and the Circular on Further Strengthening and Standardizing the Examination, Approval and Regulation of Direct Investment in Real Property by Foreign Investors (关于进一步加强、规范外商直接投资房地产业审批和监管的通知) jointly issued by MOFCOM and SAFE on May 23 2007 (Circular No. 50), foreign investors and FIEs in the real estate industry are subject to a different set of requirements in terms of capital contributions and government approvals:

1) Any FIE is subject to a debt/equity ratio which is defined by the regulations with reference to the term "total investment amount" and "registered capital". The "registered capital" refers to the total amount of capital to be contributed by the shareholders. The "total investment amount" refers to the total amount of investment required for financing the investment projects to be carried by a FIE, including working capital, and it consists of "registered capital" and third party loans. The ratio of registered capital to total investment required by the regulations represents the minimum amount of registered capital that the shareholders of a FIE shall contribute³. As illustrated below, compared with foreign investments in other industries, the shareholders of a FIE in the real estate industry are required to make more capital contributions and are not expected to rely too much on third parties' loans if the total investment exceeds US$ 10 million:

2) Pursuant to the Opinions No. 171, FIEs in the real estate industry will only be initially granted a temporary approval certificate and business license valid for one year, which can be changed to a term which reflects the period of its expected business operations upon the payment of a land use rights granting fee and the issuance of the State-owned Land Use Rights Certificate. In other words, a FIE in the real estate industry takes the risk of being liquidated within one year as from the date of its incorporation if it is not able to effect full payment of land granting fees and/or to obtain the title to land use rights. With this warning, foreign investors have to make sure that they are able to acquire land use rights within a limited period of time and have capital funds available before they initiate the process of incorporating a FIE;

3) Different from Opinions No. 171, Circular No. 50 sets even more stringent rules in terms of land use rights. According to Circular No. 50, the application for the establishment of a foreign invested real estate company is subject to satisfying the conditions that either the land use rights or the title to properties have been obtained, or an option agreement for the grant of land use rights has been executed with a land bureau, or an option agreement for the purchase of real estate has been executed with the owner of the properties. It is unclear, however, how to acquire land use rights and/or real estate before the establishment of a FIE, which according to the principle of "business existence" under the Opinions No. 171, shall be a pre-condition for the grant of land use rights or the purchase of real estate. Nevertheless, foreign investors are obliged under Circular No. 50 to prove their eligibility in this regard by presenting documentary evidence to the approval authorities. It is expressly set out in Circular No. 50 that approval for the establishment of a FIE will not be granted if one of these preliminary conditions has not been fulfilled;

4) Circular No. 50 restates the requirement in relation to the filing of local approvals with MOFCOM insofar as a FIE is approved by its local bureau of commerce, and it sets forth at the same time the penalties in the event of deviation, i.e. the foreign exchange authorities and the designated banks will not conduct foreign exchange settlements and sales for a FIE if the approval by the local authorities has not been filed with MOFCOM or if the FIE failed to pass annual inspection. In addition, if a FIE has been approved by the local authorities in violation of any applicable law and regulations, rectification shall be made by MOFCOM, and the foreign exchange authorities will not conduct foreign exchange settlements and sales for the FIE. It is interesting to note that Circular No. 50 tends to punish a FIE for any misconduct committed by the local bureau of commerce.

Project Development and Operation of FIEs

Opinions No. 171 and Circular No. 50 both set out restrictions in relation to real estate project development and operations of a foreign invested real estate company. An FIE in the real estate industry is not allowed to seek third parties' loans in or outside of China under any of the following circumstances:

1) its shareholders have not fully paid in their capital contributions; or

2) the FIE has not been granted the State-owned Land Use Rights Certificate; or

3) the capital fund available for a project development has not reached the amount representing more than 35% of the total project investment.

In addition, the foreign exchange authorities will not approve the foreign exchange settlement for any foreign currency loans under the above circumstances.

Circular No. 50 emphasizes the principle of a "project company". A FIE in the real estate industry is only allowed to operate and engage in project development within the scale and business scope as approved by the authorities. To develop any new parcel of land or any new real estate project, or to engage in any new business operation, which are not within its existing business scope or within the scale of development previously approved, it has to obtain the approval of government authorities. In addition, foreign investments in high grade real estate properties shall be under stringent control, according to Circular No. 50.

Industry Practice indicates that sometimes joint venture partners reach agreements among themselves to guarantee the return of one party's investment in a joint venture company. An arrangement of this kind has been deemed as a loan by its nature, according to the judicial opinion of the Supreme People's Court of China⁴. The regulations adopted recently reiterate this principle and prohibit similar terms and conditions in a joint venture contract, articles of association or share sale agreement in relation to the real estate industry.

M&A in the Real Estate Industry

Apart from the restrictions mentioned previously, the regulations recently adopted by the government authorities have also set special rules addressing the issues in relation to mergers and acquisitions (M&A) in the real estate industry. According to Opinions No. 171, M&A in relation to a FIE or a domestic enterprise through either a share deal or an assets deal (i.e. assignment of development projects) requires the approval of MOFCOM or its local bureau of commerce, and the foreign investors must issue guarantee letters to commit their adherence to the terms and conditions in a State-owned Land Use Rights Grant Contract and those requirements set out in the approvals and permits which have been issued to the target companies, including the Construction Land Planning Permit (建设用地规划许可证) and Construction Project Planning Permit (建设工程规划许可证). By establishing these rules, the government authorities intend to minimize the impact of M&A on the implementation of any existing real estate development project.

Circular No. 50 highlights the control over acquisition of and investment in domestic real estate enterprises through so-called "reverse investment". The term "reverse investment" refers to the investment activities conducted by Chinese citizens in China, including acquisition of domestic enterprises, through an offshore company acting as a special purpose vehicle (SPV). According to Circular No. 50, overseas investors shall not evade the governmental approval on foreign investment by acquiring controlling interests in a domestic real estate company through SPVs.

As to the acquisition of domestic real estate enterprises or the acquisition of the equity held by a Chinese investor in a FIE, Opinions No. 171 and Circular No. 192 both set forth a few pre-conditions for government approval. Foreign investors are required to make proper arrangements for the employees and any bank loans of a target company. In addition, foreign investors shall effect payment of the consideration in one single installment with its own funds within three months as from the issuance of business license when a domestic enterprise is acquired by foreign investors, or as from the date when a share sale agreement comes into force in the event a Chinese shareholder transfers to the foreign investors its equity interests in a FIE. Compared with the Provisions for the Acquisition of Domestic Enterprises by Foreign Investors (关于外国投资者并购境内企业的规定)⁵ , the payment terms under Opinions No. 171 and Circular No. 192 are much more demanding. It is particularly emphasized that any foreign investors with "bad records" are not allowed to engage in the acquisition of real estate enterprises in China.

Conclusion

The Chinese real estate market seems to be an attractive destination for foreign capital today. The lure of higher return on investment in the Chinese real estate market has attracted foreign investors in recent years. With the regulations adopted by the Chinese government, foreign investors are not only required to finance real properties to a large extent by themselves, but are also required to acquire or prove their ability to acquire land use rights before they apply for the establishment of a FIE. In addition, any approval by the local bureau of commerce shall be subject to re-examination of the central government if it is not in line with the applicable laws and regulations, and any new development project to be carried out by a FIE shall be subject to governmental approvals as well.

Endnotes

1. Philip Zhang, L.L.B of Wuhan University, L.L.M and Ph.D of University of Geneva, is a senior partner of Boss&Young Shanghai Office, and can be contacted at [email protected]. The author thanks Mr. Damien Charlton, partner of Ward Hadaway of the United Kingdom, for his pre-reading and valuable comments.

2. This does not include overseas Chinese and the citizens from Taiwan, Hong Kong and Macao.

3. Tentative Provisions on Sino-foreign Equity Joint Ventures Ratio of Registered Capital to Total Investment (关于中外合资经营企业注册资本与投资总额比例的暂行规定) promulgated by the State Administration for Industry and Commerce on March 1 1987.

4. Solutions to Certain Issues in Relation to the Hearing on Partnership Agreements (关于审理联营合同纠纷案件若干问题的解答) issued by the Supreme People's Court of China on November 12 1990.

5. Article 16 of the Provisions for the Acquisition of Domestic Enterprises by Foreign Investors promulgated by MOFCOM and other governmental agencies in 2006.