New Regulations Restrict Foreign Investment in PRC Real Estate

Since 2004, the Chinese regulators have enacted a raft of measures designed to slow down investment in the real estate sector. In 2004 and in 2005, China imposed limits on real estate lending. Earlier this year, measures were introduced to limit the number of luxury housing projects being developed. The latest development in China’s ongoing attempt to protect the sector from overheating is the introduction of restrictions on foreign investment in real estate projects.

The New Regulations

In July 2006, six Chinese ministries jointly issued the Opinions on Regulating the Entry of Foreign Investment in the Real Property Market¹ and, in August 2006, two Chinese ministries jointly issued the Matters Relevant to Foreign Exchange Administration in the Real Estate Market Circular². The regulations will have sweeping effects on foreign investment in the sector. Under the new regulations:

1. Foreign individuals and foreign entities may not purchase real estate in China, except in certain very limited circumstances; and
2. Investment in the property sector by foreign investors must be channelled through a foreign-invested property investment enterprise (FIPE) established in the PRC.

Setting up an FIPE – Capitalisation Requirements

While it was previously possible to invest in property in the PRC without having to establish or invest in a company incorporated in the PRC, under the new regulations, foreign investors are required to set up an FIPE. An FIPE can be a wholly foreign-owned enterprise or a Sino-foreign joint venture, either newly established or created by acquisition.

Foreign investors are required to comply with specific capitalisation requirements when establishing an FIPE. PRC laws provide that a property investment company can be established with a registered capital of as little as US$175,000. However, the minimum registered capital requirements for an FIPE will be much higher than those applied to a wholly domestically invested property investment company. In practice, an FIPE that is established in Shanghai or Beijing must have a registered capital of at least US$5m while an FIPE established in second-tier cities must have a registered capital of at least US$2m.

The new regulations also state that the registered capital must be fully contributed before the FIPE can borrow any funds. In practice, this means that the foreign investor’s contribution will generally need to be fully contributed in the initial stages of the project with the result that such funds cannot be efficiently deployed until the FIPE identifies suitable property investments.

Lending Restrictions

The new regulations impose additional restrictions on debt financing. In particular, the debt to equity ratio for an FIPE cannot exceed 1:1 which means that for every dollar of debt injected, the investors must invest one dollar of equity.

Although these restrictions will effectively limit the amount of offshore debt invested in PRC property projects, it is unlikely that they will successfully prevent the borrowing of renminbi (RMB) amounts in excess of the mandatory debt to equity ratio. Whereas offshore debt must be registered with the State Administration of Foreign Exchange (SAFE), local RMB debt is not subject to such foreign exchange controls. As a result, Chinese lenders frequently provide RMB debt to foreign invested enterprises in excess of debt to equity ratios. As a result, it is likely that RMB denominated debt will continue to flow into the property sector.

In addition to the requirement for the registered capital to have been fully paid in, the new regulations also provide that an FIPE cannot borrow until after:

1. The FIPE has obtained the title documents for the property to be acquired; and
2. The FIPE’s paid in registered capital exceeds 35% of the total value of the property development project.

The main impact of these restrictions is that the FIPE cannot use debt to acquire land for a project. Again, it remains to be seen how this will be enforced in practice for RMB denominated debt, given willingness of local banks to lend to foreign investors.

Registration of Leases of Property Owned by Offshore Entities

As a side effect of the new regulations, the Shanghai authorities are currently not registering leases of property owned by offshore landlords (unless the leased property is owned by a landlord’s FIPE).

If Shanghai authorities maintain this position, Shanghai office blocks held by offshore entities will need to be transferred to an FIPE in order to remain competitive. Such a property transfer would subject offshore owners to an increased tax burden, which is likely to flow through in the form of increased rents in Shanghai.

Conclusion

Prior to the new regulations, property investments did not have to be channelled through an enterprise established in China. Foreign investors were generally able to escape onshore regulations and minimise onshore tax by structuring their investment in PRC property through an entity set up offshore. The new regulations have closed this door and, as a result, foreign investment in the PRC property sector will now need to be performed through an entity set up in China.

1. The Opinions on Regulating the Entry of Foreign Investment in the Real Property Market were issued by the MOFCOM, the MOC, the SAFE, the PBOC, the SAIC and the NDRC on 11 July 2006.

2. The Matters Relevant to Foreign Exchange Administration in the Real Estate Market Circular was issued by the SAFE and the MOC on 1 September 2006.