Huijun Ma and Jiong Zhang of Zhong Lun Law Firm explain the laws and challenges of real estate & construction in the PRC, the investment and financing methods for real estate projects and the progress of REIT rules.

1. What important legislation and policies on foreign investment in the real estate industry have been issued in China during the past year? What major legal changes have there been in the construction sector?

On May 13 2013, the State Administration of Foreign Exchange implemented the Circular Concerning the Issuance of the Measures for the Administration of Foreign Debt Registration (Hui Fa [2013] No.19) and the Circular on the Issuance of the Provisions for Foreign Exchange Control in Connection with Direct Investment in China by Foreign Investors and Complementary Documents (Hui Fa [2013] No.21), setting forth the principles for management of the overseas debt of foreign-invested real estate enterprises and providing in principle for the oversight of registration, account opening and change, the receipt and payment of funds and the settlement and sale of foreign exchange in the course of direct investment in China by foreign investors, thereby further promoting direct investment in China by foreign investors. After that, the Circular on Issues Relevant to Exchange Control in Connection with Overseas Investment/Financing and Round-trip Investment by Residents in China Through Special Purpose Vehicles issued on July 4 2014 makes relatively large revisions to provisions on the scope of special purpose vehicles, round-trip investment, etc., simplifying cross-border capital transactions effected by domestic investors through special purpose vehicles; the Circular on Issues Relevant to the Pilot Project for Reform of the Method of Administration of the Conversion of Foreign Exchange Capital by Foreign-invested Enterprises Implemented in Certain Regions issued on July 15 2014 implements voluntary conversion for the foreign exchange registered capital of foreign-invested enterprises, better satisfying and facilitating the operational and fund application needs of foreign-invested enterprises.

Furthermore, through the issuance of policies and regulations, the National Development and Reform Commission, Ministry of Commerce and other relevant authorities have reformed the method of administration of foreign-invested projects and further simplified the foreign investment examination and approval procedure. Additionally, with respect to the overall upward trend of foreign investment in the real estate industry, the relevant authorities will further strengthen risk prevention.

Legislation in the construction sector has been relatively active, with some of the key events including:

  • Following on 1999, the Ministry of Housing and Urban-rural Development (MOHURD) issued the new model construction contracts that have been progressively implemented and come into use nationwide. As compared with the 1999 version which applied fixed pricing, the 2013 version applies the bill of quantities pricing method. This model contract further strengthens the function of the supervisor in project management and implicitly recognises its right to comprehensively represent the owner in performing the contract. Additionally, it adds the owner payment guarantee, price fluctuation adjustment and other such systems. On the whole, this version places more emphasis on protecting the contractor's interests.
  • Following on 2008, the MOHURD has again updated the 2013 version of the bill of quantities pricing code. As compared to the 2008 version, this version favours the use of unit price contracts rather than total price contracts. Furthermore, the code provides for price management throughout a project, and expands the management scope of the pricing code into the contract field. This not only leads to ossification of the pricing management method, but may also give rise to disputes if the owner's price management approach differs.
  • Revision of the statutory bid invitation scope and criteria that have been used since 2000 has been completed and submitted to the State Council for approval. Based on the publicly available documents, the current revisions will reduce the scope of projects for which statutory bid invitations are required, with projects that do not involve the investment of state-owned funds removed from the category of projects requiring an invitation of bids, and do not permit local governments to re-expand the scope, thus giving private investors the right to select the project procurement method at their own discretion.
  • The Supreme People's Court is currently drafting a new judicial interpretation applicable to construction project contracts. From the information that has been released to date, the judicial interpretation may be leaning more toward fundamental legal principles such as respecting the autonomy of will of the parties and the relativistic nature of contracts.

2. What should be of most concern to foreign investors carrying out project construction in China?

From our observations, what most vexes foreign investors in the course of construction is the comprehensive intervention of the government in the invitation and submission of bids and in contracts. The construction authorities in China have, by way of the model construction contracts and the mandatory use of the model contract, always vigorously intervened in the current market situation that favours the owners in the allocation of project risks. The model contract, contrastingly, leans toward protecting the interests of the contractors when it comes to the allocation of risks. Furthermore, the construction authorities have expanded the contract record filing system into a review system, further restricting owners' free expression of intent in the bid invitation documents. In practice, owners will often evade review by the construction authority by executing black and white contracts. The inconsistencies in these black and white contracts, however, often become a point of conflict between the employer and the contractor. This has become one of the most prominent legal risks in China's construction projects.

3. In recent times, what means of investment have domestic real estate private funds used? What are the special characteristics of each investment method?

The investment methods available to real estate private funds are equity investment, debt investment and hybrid investment.

The special characteristics of each investment method are:

  • equity investment: is an investment in equity, with high risks and high returns; places particular emphasis on increasing the value of the investee enterprise and its market prospects; partial control of the enterprise and participation in the enterprise's operations, management and major decisions are allocated in proportion to the equity investment percentage; extra dividends are realised through the sale of equity by way of the divestment mechanism; divestment methods are diverse, mainly including IPO, M&A, equity repurchase, management buyout, etc.;
  • debt investment: includes medium and long-term debt financing and short-term loan financing (e.g. bridge investment); safe with relatively high returns, short terms, high liquidity and relatively numerous restrictive policies;
  • hybrid investment: equity and debt-structured investment portfolio (e.g. mezzanine financing), using convertible bonds and other such investment instruments to realise portfolio financing; has the features of both equity and debt financing; the debt investment shares make up the majority, with a small quantity of equity investment, giving debt financing an "equity" flavour; is helpful in reducing risks, stabilising returns, reducing financial costs and optimising the fund structure.

4. What taxes apply to real estate private funds organised as limited partnerships?

Real estate private funds organised as limited partnerships are usually established along the lines of the "investors (GP and LP) – limited partnership fund – management company" model, with the tax burdens on the relevant legal entities as shown in the following table:

Investor level

General partner

Natural person: individual income tax, imposed at the rate of 20% on investment returns or returns on equity transfer; operating returns taxed at a five-stepped progressive rate of between 5% and 35%.

Legal person: enterprise income tax, investment returns exempt from tax.

Limited partner

Natural person: individual income tax, imposed at the rate of 20% on investment returns or returns on equity transfer.

Legal person: enterprise income tax, investment returns exempt from tax, other income taxed at the applicable rates, the usual rate being 25%.

Limited partnership fund level

"Apportion first, then tax", no enterprise income tax.

Fund management company level

Business income: business tax and surcharges.

Operating income: enterprise income tax.

5. At present, what financing channels are generally available to real estate enterprises in China? What are the special characteristics of each of the financing channels?

Presently, the main financing channels available to real estate enterprises in China and their respective special characteristics are as set forth below:

  • bank loans: used to be the most important financing channel available to real estate enterprises; financing costs are low and risks small; however, state regulatory policies are strict, and many enterprises cannot, at certain stages, satisfy loan conditions;
  • bond financing: the requirements with respect to real estate enterprises seeking financing are relatively stringent, putting it beyond the reach of small and medium-sized real estate enterprises; the number of enterprises currently using this financing method is quite small;
  • cooperative development: real estate enterprises can attract funds and advanced management methods from other enterprises; however, only relatively strong real estate enterprises with relatively good creditworthiness can use this method; for small real estate enterprises this method is almost impossible;
  • trusts: this method is flexible, but the amount of funds that can be raised is relatively small, state regulation is relatively strict, liquidity is poor and the occurrence of a crunch in realising the trust product increases the difficulty in adopting this financing method;
  • listing: the amount of funds that can be raised is large, the proceeds may be used in perpetuity as registered capital, eliminating the pressure on the enterprise for repayment at maturity; however, the enterprise initially needs to input a great quantity of listing costs, and there is a great deal of uncertainty as to whether the listing will succeed;
  • private real estate investment funds: few policy restrictions, relaxed regulatory requirements, flexible investment method, but the investment term is relatively long;
  • REITs: the scope of properties for which this financing method can be used is relatively broad, the amount of financing proceeds is relatively large, and there are certain tax advantages; to date, due to a lack of relevant legislation, the form of REITs on China's capital markets has not yet taken shape;
  • asset management plans of securities brokerages and dedicated asset management plans of fund subsidiaries: broaden enterprises' financing channels, and satisfy enterprises' financing needs; however, the financing costs are relatively high, subject to relatively strict regulatory policies.

6. What is your take on the most recent developments and the timetable for REITs in China?

In recent years, the industry authority and practice circles in China have been actively and progressively advancing system building and business practice for REITs, and have achieved certain progress.

In terms of system building, the central bank has completed the Measures for Administration of the Offering of Real Estate Trust Beneficiary Certificates on the Interbank Bond Market (Draft for Comments) and the China Securities Regulatory Commission (CSRC) has completed the Measures for the Administration of the Pilot Projects for Real Estate Investment Trusts (Draft for Comments), but to date neither has been officially promulgated.

In terms of business practice, in August 2012, Tianjin Real Estate Trust Group Co., Ltd. registered and offered in China the first asset-backed notes having immovable property as their underlying assets. In January 2014, the CSRC approved the establishment by CITIC Securities of the CITIC Qihang Specific Asset Management Plan, a product which has been deemed in the industry as the first equity version quasi-REITs product (note: as compared to standard REITs products in foreign countries, it lacks elements such as a public offering and tax breaks).

According to a source close to the regulators, the CSRC has completed the drafting of REIT related rules and the stock exchanges have completed the relevant trading procedures and listing rules for REITs. However, certain policy restrictions (e.g. double taxation) on the release of REITs in China have yet to be substantively resolved. Accordingly, there is as yet no authoritative timetable for the arrival of the specific rules for REITs, however, comprehensively considering market demand and the development of system building and business practice, there remains a possibility that the specific rules will be issued in the near future.

Originally published in China Law & Practice Annual Review, 2014.

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