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Recent press reports suggest that the Chinese government is cracking down on real estate investments in the county by foreign companies. What is the current situation?
Starting in mid-2005, the People’s Republic of China (PRC) government feared a Tokyo-late-1980s-style real estate investment bubble. To counter this, it took a series of cooling measures. The effects speak from themselves – in the first four months of 2007, real estate investment in Shanghai alone decreased by 45.25 per cent compared with the same period in 2006.
In light of these events, some press reports have claimed that foreign investment in China is now dead – but that actually isn’t the case. The basis for the allegation appears to be that foreign parties must now first form or acquire a PRC entity to invest, and cannot invest in their capacity as a foreign party from outside China. However, this distinction does not in fact bar investment – it simply imposes an additional requirement before the investment can take place.
What is true is that the latest Categories of Industries Guiding Foreign Investments - often referred to as the “Foreign Investment Catalogue” – reflect the increased scrutiny afforded to foreign investment in this sector. The newest version came into effect in December 2007, and lists no category of foreign investment in real estate that is actively “encouraged”. Previously, affordable housing was. It’s thought that the sale and lease of second hand property is now classed as “restricted”. The only real estate investment category where foreign investments are, by default, “accepted” are likely to be development projects. These would typically include the development of new projects involving retail, office, residential or a mixture of the same.
Under applicable regulations, foreign real estate investments in the “restricted” category involving investment of up to US$50 million must obtain approval from the local branch of the National Development and Reform Commission (NDRC) where the project is situated. For investments over US$50m, permission will be required from both the national NDRC and State Council.
Besides the need to form a local PRC entity, what are the key restrictions on Chinese real estate investments?
When forming a new real estate development company, a foreign-invested entity can only obtain a one-year Approval Certificate. During that year, the newly-formed entity must pay off in full the land use grant fees, and also obtain a land use grant certificate. If it does not do this within the year, the entity will not be to renew its Approval Certificate or its business license. This new rule is designed to prevent companies from delaying or procrastinating about paying until the value of the project has increased.
It has also become more difficult for foreign companies to merge with, or acquire, a domestic Chinese partner. Stricter approval requirements and processes have been introduced, and the purchase price for any acquisition must be paid in a lump sum within a short period after the transaction is approved. Before foreign investment in a real estate project company can take effect, the local counterpart of the Ministry of Commerce of the People's Republic of China (MOFCOM) must report the transaction to MOFCOM.
In addition, Circular 130 states that all foreign real estate companies registered after June 1, 2007 are banned from using foreign debt to fund their projects and operations. Thus, funding for such projects must come from equity or locally-financed sources.
What are your recommendations on how to structure real estate investments into China?
It’s more important than ever before to conduct a thorough investigation and analysis of the relevant PRC government policies. Does the project satisfy important planning criteria? Does it advance strategic economic or social aims? Do the relevant agencies overseeing the project agree? These issues, and any potential roadblocks, need to be confirmed at the outset of the process. Investors should not rely on their own interpretation of the regulations – they must also confirm whether or not the relevant agencies agree with them.
A robust legal, accounting and financial due diligence is required to avoid nasty surprises late in the process. It’s always possible that the seller hasn’t fully paid all land use rights grant fees, or hasn’t properly accounted for taxes owing in the transaction. If this has happened, it could block or reconfigure the economics of the transaction.
Unless investors have a strong government relations capability, either in-house or through outside consultants, they may wish to consider only pursuing projects that are fully entitled for development, rather than undertaking the land auction process.
Because of heavy transaction costs associated with transfers of real estate, most acquisitions are structured as acquisitions of equity in project companies rather than as acquisitions of real estate. For foreign investors, there are important tax planning considerations that should be taken into account, looking ahead to an eventual disposition of the project. Investors should structure their investment activities by taking into account not only PRC tax consequences, but also cross-border planning considerations. To achieve this, they should considering using intermediate tax-haven jurisdictions as a planning tool.
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