FEATURE: Watching under the stars

It was 2013 when China’s political leadership began its anti-corruption crusade in the country. Almost two years later, the reins have only tightened, with a continuing increase in regulatory oversight and enforcement across key sectors.

The real estate industry hasn’t been let off the hook either. Regulatory reforms such as tax compliance acts are underway to enforce tax obligations on investors both buyers of real estate assets held locally in China as well as overseas property investments by Chinese nationals and domestic institutional investors. Action is being taken against property developers with excessive leverage, with a recent example being the city government freezing some assets of the Shenzhen-based Kaisa Group Holdings following its default on a loan payment. To further curb them from amassing land, land registration records are being overhauled.

Andy Yeo, partner at the global law firm Mayer Brown cites a report on corruption inspection tours released on a state disciplinary committee’s website in October last year, according to which 28 of 31 provinces in China reportedly had corruption linked to real estate activities.

“They [government] are now going to focus on a lot of real estate transactions and deals in connection with the grant of land, transfer of land, development, construction and subsequent sales – all phases of property development where there is a lot of room is for corruption,” he says.

Taxing offshore income

In July last year, China agreed in substance to comply with the US Foreign Account Tax Compliance Act (FATCA), a system designed by the US to enforce tax obligations on Americans holding foreign financial accounts. As of now, Singapore remains the only Southeast Asian country that has officially signed the agreement to share tax information with the US.

Patrick Yip, national financial services tax leader for Deloitte China explains that China has in turn asked for a reciprocal exchange of information clause, which would help its government get account information of the Chinese citizens using US banks.

Such an arrangement would help the Chinese authorities in its crackdown on corruption.
“Before FATCA, a lot of corrupt officials held on to real estate units in China as part of a reward for awarding land to a developer,” says Yeo. “They might get people to pay them in their US accounts. Now they run the risk of their accounts in the US being disclosed to the Chinese government.”

If signed, this tax compliance system would only indirectly impact Chinese institutional investors such as insurance companies. Particularly attractive to wealthy Chinese nationals is the EB-5 immigration program in the US, which awards visas to all those who invest $500,000 to $1 million in a U.S. business. If the investment creates at least ten jobs, a permanent green card is issued.

David Ellis, partner at law firm Mayer Brown, says that some of the Chinese insurance companies, who are also asset managers, are trying to aggregate money from such clients to set up a retail fund, which would be invested in US real estate. Though this trend is not mainstream yet, he expects the flow of private wealth into the overseas market getting affected with the implementation of FATCA.

Transparency and accountability is being enforced in the home turf too. In early February this year, China’s State Administration of Taxation (SAT) issued an amendment to Circular 698, which deals with the tax treatment of an indirect transfer of assets by a non-resident enterprise.

Any foreign investor looking to invest in China has to do it through the creation of an offshore structure called a wholly-owned foreign enterprise (WOFE), subject to the government’s approval. Previously, in the event of the investor selling the offshore company, which owns a real estate holding entity in China, he was obliged to pay a capital gains tax. The new amendment makes the buyer in the transaction responsible for paying the tax, not the seller. The buyer, who could be any domestic entity in China or a foreign institution, is now required to withhold an enterprise income tax of 10 percent from the amount paid to the seller. In US, the tax rate is 20 percent.

Legal experts say that with this provision the Chinese authorities can ensure that there is no tax evasion. “It doesn’t matter if you are selling an offshore company. You are trading an asset in China and you are subject to a capital gains tax,” says David Blumenfeld, partner at law firm Paul Hastings.

Mayer Brown’s Yeo explains the rationale: “Once the seller has disposed his interest in the asset, how will the Chinese government track him?” he says. “After the deal, it is the buyer who ultimately becomes the owner of the Chinese asset. [Since] the only hold that authorities have within their jurisdiction is the entity within China, they have made the buyer responsible.”

Ellis, however, sees offshore transactions becoming harder and riskier for the purchaser post this change. “The difficulty is that the 10 percent tax is calculated not on the purchase price but the gain made by the seller (i.e. the difference between the acquisition cost and their disposal cost), and how the purchaser will not know how much this gain is,” he says.

The government is also attempting to create more transparent land records. China currently lacks a nationwide property registration system, with multiple agencies being in charge for properties under their respective divisions. In August last year, a draft regulation was published on the establishment of a national property registration scheme in three years’ time, which would require title registration in all Chinese cities to feed into one standard database.

In Yue’s view, this could prevent hoarding of properties and provide a more accurate assessment of the supply and demand situation.

The effect of all these changes has largely been positive. Foreign and domestic investors are firming up their due-diligence processes and being more cautious about who they partner with locally.

“Everyone in China is focused on compliance and on making sure they do not do anything that inadvertently violate rules,” says Paul Hastings’ Blumenfeld.