Acquiring investment real estate in China

This is the second in an occasional series of articles about real estate law in the People's Republic of China (PRC).

The first article 'Ownership of Land in China' focused on a general overview of real estate law in the PRC and a brief outline of the bid process for acquiring land use rights. As that article demonstrated, the process of acquiring land use rights for development is not particularly easy for foreign investors. A more expedient way for a foreign investor to enter the PRC real estate market may be through acquiring property that has already been developed. This approach, however, also raises problems, especially since reforms were introduced in the PRC to cool the overheated real estate market in 2006/2007.

This article sets out the major issues a foreign investor may face when considering purchasing investment property in the PRC.


The PRC real estate investment market was very popular with foreign investors between the years 2000-2006. Prior to the introduction by various PRC governmental agencies in July 2006 of circular Jian Zhu Fang [2006] No. 171 (Circular 171), foreign investors were able to acquire and directly hold property via an offshore special purpose vehicle (SPV).

In this structure, the foreign investor did not need to observe the minimum registered capital and other regulatory requirements which apply to a PRC incorporated entity.

It also meant that once applicable income taxes had been paid on revenue from the property, that the remaining cash surplus generated from the property could generally be easily remitted out of China.

Transferring the ownership of the property could be relatively easily effected (at least to another foreign investor) by way of a share sale of the offshore SPV.

Circular 171 and other measures

Circular 171 changed the position in several respects.

One of the key changes introduced was that a foreign investor is no longer able to acquire property in the PRC directly for any non-self-use purposes. Under the "business presence" principle set forth under Circular 171, foreign investors now have to establish a foreign invested real estate enterprise (FIRE) in the form of Sino-foreign joint venture company or wholly foreign-owned enterprise to acquire any real estate in the PRC for investment purposes.

Circular 171 also restricted the maximum debt to equity ratio of a FIRE to 1:1 where the total investment exceeds US$10 million. The FIRE is also prevented from taking on indebtedness until:

(i) its registered capital has been fully paid up;
(ii) the land use rights certificate has been obtained; and
(iii) at least 35% of the project's total investment has been paid in.

If the foreign investor enters into a joint venture with a Chinese party, Circular 171 also prohibits any investor being guaranteed fixed returns in the joint venture contract or any other documents.

Further circulars followed in 2007, which tightened up the procedure for registering FIRE's (requiring a time consuming and potentially unsuccessful filing with the central Ministry of Commerce - Circular 50) and also prohibited such companies approved on or after 1 June 2007 from being able to register foreign debt with the State Administration of Foreign Exchange, essentially making it impossible for foreign debt to be used (Circular 130).

Effect of increased barriers to entry

The combined effect of these Circulars saw a dramatic slump in foreign investment in the PRC real estate market as the approval process for setting up a FIRE can be prolonged, and requires a substantial up-front equity capital injection.

Assuming the investor has the equity to meet the strict debt to equity ratios, the ability to take on foreign debt to fund the development/operation of the onshore project has been removed.

Whilst debt from PRC banks can be obtained, it is often practically difficult for foreign investors to obtain this, though if they do, we understand it may be possible to exceed the 1:1 debt equity ratio depending on the attitude of the local bank.

'Trapped cash' is also a major issue due to these reforms. PRC companies (including foreign invested ones) are bound to make certain statutory contributions to reserve funds and employee funds which deplete distributable profits. Distributable profits may also be reduced by non-cash expenses such as depreciation.

As foreign debt (including shareholder loans) is now prohibited, FIRE's lost an effective option to remit cash to its foreign shareholders (although they are still entitled to pay dividends after taxation and other deductions). The FIRE may ultimately withdraw its equity investment in any voluntary liquidation of the company or on a registered capital reduction (for which it is difficult to obtain approval).

Aside from the direct effect on the investor of these measures, the extra time and uncertainty involved means foreign investors are at a disadvantage when bidding in time critical sales. The dearth of foreign buyers has also reduced the liquidity of the commercial market (the market is already fairly illiquid due to a lack of local institutional money and relatively low market transparency), a situation which may further discourage foreign investors concerned about exiting the market in the future.

Restrictions on foreign investment in certain real estate projects

The PRC government approach towards foreign investment in different sectors is documented in the Foreign Investment Industrial Guidance Catalogue (Catalogue), which is updated by the Ministry of Commerce from time to time. The latest version was issued in 2007.

The Catalogue identifies three categories of foreign investment encouraged, restricted and prohibited.

Investments in the encouraged category are subject to relatively little government interference, however, investments in the restricted category are subject to various controls and investments in the prohibited category are not allowed. Certain kinds of real estate investments (for example, the construction and/or operation of luxury hotels, villas, high-end offices and international convention centres) are in the restricted category.

In addition, the Catalogue also specifies that certain types of properties may only be developed or invested in by a joint venture between the foreign investor and a Chinese party.

When looking at categories of property for acquisition, the foreign investor should be aware of these restrictions and the possibility that full ownership in the project/property may not be possible.

Asset or share acquisition

As in most other jurisdictions, buying real estate in the PRC can be structured by way of a share acquisition of the project company (which owns the land use rights or the project) or by taking an asset transfer of the property or project under development.

There are of course differing advantages and disadvantages in structuring any deal as a share or asset acquisition. Despite these issues, it is rare in China for acquisitions to be structured other than as a share acquisition. In an asset acquisition of real estate in the PRC, the tax costs are much higher than on a share sale.

Typically, the seller would be subject to income tax on the capital gains, business tax (of between 3-5% on the appreciation in value), land value appreciation tax (a further tax on the taxable gain on a sliding scale), deed tax (ranging from 3-5% on the total transfer value, payable by the buyer only) and stamp duty (ranging from 0.05% - 0.1% of the consideration).

By contrast, an equity acquisition is generally only subject to income tax on the capital gains and stamp duty.

When acquiring the investment property by way of asset acquisition, the foreign investor will be required to incorporate a FIRE. If the foreign investor intends to undertake a share acquisition of a domestic project company, it will have to take account of the specific provisions of the Interim Provisions on the Takeover of Domestic Enterprises by Foreign Investors (the M&A Rules) which apply to such takeovers, and specialist advice should be sought on the impact of these rules.

The M&A Rules set forth certain specific requirements in respect of the acquisition of a domestic enterprise, including, that the transaction price must be based on a valuation conducted by a qualified assets valuation institution in China and that the total amount of the transaction price must be paid within a stipulated timeframe up to one year after the onshore project company has obtained its updated business licence.

The ideal way to achieve a relatively straightforward transaction is for the new foreign investor to purchase an offshore SPV from an existing foreign investor which holds the property via a subsidiary FIRE. Such an approach will of course only work in the situation where the target project company is the only subsidiary of the offshore SPV.

Light on the horizon?

During the midst of the financial crisis, there was a great deal of speculation in the PRC that the rules restricting foreign investment in real estate would be eased in an effort to revive the depressed market.

In June 2008, the Ministry of Commerce issued Circular 23 under which the Ministry of Commerce allocated its power of reviewing the filing application under Circular 50 (see above) to its branches at the provincial level in order to expedite the filing process.

Some local authorities (notably in Tianjin) have offered some incentives locally in an attempt to attract foreign investors, but these do not circumvent the main problems listed above.

The effect of the PRC government stimulus package has been to re-inflate the property market, and as such substantive reforms of the restrictions now seem unlikely in the near future.

With this background, whilst the rewards and obvious potential can be extremely enticing, investment in the PRC real estate market requires a long term approach, sufficient capital and a good understanding and acceptance of the inherent risks involved.

Norton Rose's Beijing and Shanghai offices are available to assist in advising on these risks and the processes to be complied with.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.