Real estate – the tax landscape in China and Hong Kong
Chris Abbiss, Lewis Lu and Jean Jin Li of KPMG China foresee significant changes to the tax and regulatory environment in both Hong Kong and Mainland China over the next 12 months.
Although Mainland China and Hong Kong maintain separate tax and regulatory frameworks, both governments are seeking to address concerns that a bubble is developing in their property markets by using the tax and regulatory systems to try and constrain prices. This similarity, however, disguises a number of critical differences in the markets. China continues to move in a direction broadly focused on modernisation and relaxing controls. For instance, while the introduction of value added tax (VAT) to the real estate sector is likely to result in increased costs and impact internal rates of return (IRRs), it also replaces business tax (BT), an antiquated taxing mechanism, with one more familiar and appropriate to a modern economy. Conversely, Hong Kong, a city founded on the convictions of free trade and with free movement of capital enshrined in its constitution, appears to be moving in the opposite direction, by attempting to control the property market through punitive stamp duty charges. Due to the disparity between the two markets, this article will address Hong Kong and Mainland China separately.
Property tax expansion
Statistics issued in September 2013 in China Real Estate Index System 100 City Price Index, August 2013 show that China's housing prices continue to rise. Average new home prices in 100 major Chinese cities climbed 0.92% in August from the previous month, the price of new homes increasing in 71 cities and decreasing in 29. The price of new homes in Beijing and Shanghai have increased by 12.18% compared with last year.
The Chinese government introduced property taxes in Chongqing and Shanghai on a trial basis in 2010 as part of efforts to cool the property market amid growing public complaints about skyrocketing residential property prices.
The Chongqing trial focused on taxing high-end housing, while Shanghai's programme mainly targeted the ownership of multiple houses. The taxes which ranged from 0.5% to 1.2% were seen as too low to be effective to keep local housing prices in check. This is borne out by the recent new home price increases in Shanghai and Chongqing that demonstrated that property tax at those rates may not be an effective measure to control the price increase.
In 2013, the State Administration of Taxation (SAT) announced several times that it will research the possible expansion of property tax pilot programmes. Large cities facing high home price increases, such as Hangzhou, Shenzhen and Beijing, could be the next ones to implement the tax. The Ministry of Housing and Urban-Rural Development (MOHURD) is also working on a nationwide database of homeowner information that would aid the implementation of the tax. It is expected that the trial programme will be expanded to more cities in 2013.
The first stage of the VAT pilot programme for the modern services and transportation sectors has been implemented in many of the major commercial centres in China and attention is now turning to those industries which are yet to transition from BT to VAT.
It is widely speculated that the construction and real estate sectors will be among the next to transition, probably in mid-2014. Real estate is significant for two reasons. Firstly, in 2011, it represented more than half of the BT revenue collected in China, so the transition from BT to VAT could have a big impact on tax revenues. Secondly, as experience of VAT in other countries shows, real estate is typically one of the more difficult areas to which to apply VAT. Transaction values are often high and there is usually a large number of different taxes already applying to the sector with which the VAT needs to fit, including, in the case of China, corporate income tax, land appreciation tax, stamp duty, land use tax and real estate tax.
The effect of taxation policies on property values evokes enormous interest among the general population, and it is debatable whether passive increases in land values should be included as part of the value add underpinning the concept of VAT.
So far, the government has provided only limited information on its proposals for the real estate sector. Circular Caishui  No 110 announced that construction services would be subject to VAT at the rate of 11%. The taxation of real estate transactions was not mentioned, although it is speculated that these may also be taxed at 11%.
Beyond this basic information, little else has been provided, and given the diverse approaches to VAT on real estate internationally, a range of options remains open. One particular difficulty is that in most countries, VAT liabilities only accrue to entrepreneurs, such as property developers, rather than passive investors. Similarly, sales of second-hand residential real estate are ordinarily excluded from the tax base for VAT purposes. Conversely, in China, BT is levied on all vendors, be they developers, landlords or private individuals, selling or leasing either new or second-hand real estate. As such, the government is faced with a choice of implementing a VAT system which is consistent with international norms, but which may come at a cost to the treasury, or to implement a radically new VAT system requiring private individuals to register for VAT on certain transactions.
Another significant issue for the sector is the potential impact of timing differences. In most VAT jurisdictions, where a business incurs more VAT on its expenses than it charges on its sales, it is entitled to a refund from the tax authorities. This makes sense as VAT is supposed to be a tax on end consumers rather than businesses and is supposed to tax the value added by businesses in the supply chain rather than taxing transactions per se. However, the Chinese VAT system does not generally allow refunds of VAT (except to certain exporters) and instead VAT credits may be carried forward and offset against future liabilities. If this policy is implemented, this could have a significant impact on the real estate sector where upfront expenditure, either on construction or on purchase, can be high, followed by moderate revenues either from rental or business use. At current yields, this could result in input credits only being recovered over a period of 20-plus years. This could have a significant impact on rates of return and will need to be factored into business models.
Based on previous experience, it is likely that the changes will be introduced quickly, with few transitional relief options. Given the long-term nature of many real estate projects, it is important that investors and developers consider and model potential variables resulting from the introduction of VAT now and prepare for contingencies that may arise. They should also ensure that legal contracts are clear on how VAT will be treated and where the liabilities will fall.
The last 12 months have seen two major changes to the stamp duty rules in Hong Kong, both of which are designed to take the heat out of the property market.
On October 26 2012, the financial secretary announced the introduction of buyer's stamp duty (BSD) on residential properties. The measures took effect from October 27 2012 and imposed a potential additional 15% stamp duty charge on top of the existing stamp duty and any special stamp duty (an additional stamp duty applying on the resale of residential real estate within two years of acquisition). The charge does not apply to Hong Kong permanent residents, but does apply to any transactions in residential property by, for example, all corporations and partnerships, and to any individuals who are not permanent residents.
On February 22 2013, the financial secretary announced a doubling of the ad valorem stamp duty (AVD) rates to a maximum of 8.5%. The increased charges applied to any property (including non-residential property) acquired from February 23 2013. An exception was provided for individuals who are Hong Kong permanent residents for the purchase of a single-owned residential property. The date on which stamp duty becomes chargeable on non-residential property was also brought forward from the date of conveyance to the date of agreement of sale (non-residential property was already taxed at the earlier date).
The Hong Kong Legislative Council has not yet passed either measure, partly due to vocal opposition from various business groups. Nevertheless, the Bills will have retrospective effect if they are passed. It is hard to say whether this increased tax is the sole reason, but sales of commercial property in Hong Kong fell by 80% between February and July 2013.
There are a number of reasons why this uncertainty in the Hong Kong property market is likely to continue over the next 12 months. Firstly, the eventual fate of the two stamp duty bills is still not certain. Hong Kong's chief executive has indicated that he remains committed to active intervention in the real estate markets, but it is clear that he is unable to put together a majority very easily for the bills in their current form. While one can expect that some form of increased stamp duty will be passed, it remains to be seen whether the government is willing to grant any concessions to secure a majority. While uncertainty remains over whether stamp duty will be due at, in the most extreme variation, 4.25% or 23.5%, buyers and sellers are finding it hard to agree the correct valuation for a transaction.
The new stamp duty bills create a new environment for property transactions, which shows a government prepared to interfere with the markets more actively than has previously been the case. By discriminating against non-permanent residents, the government is also for the first time bringing in tax laws designed to favour the permanent resident population. The EU courts have consistently held that using discrimination in the tax system to disincentivise foreign nationals from making investments is a restriction on the free movement of capital. As Hong Kong has a similar clause in its Basic Law, it is disappointing to see the government taking these sorts of steps. However, in Asia the situation is not so laissez faire and a number of countries do discriminate in this manner and in other ways to restrict foreign ownership.
For investors wishing to invest in the Hong Kong property market, the case for investing through a corporate shell is stronger than ever. Hong Kong does not have any look-through provisions for raising stamp duty on the transfer of land-rich companies, so the sale of shares in a special purpose vehicle only attracts a stamp duty of 0.2% in the case of a Hong Kong company (or 0% in the case of a British Virgin Islands or Cayman Islandsd company) rather than rates of up to 43.5% in the case of a short-term asset transfer. There are some potential downsides with undertaking share transactions. Firstly, due diligence costs are likely to increase as the buyer will take on the historic risks and tax exposures of the vendor. This may be particularly relevant where the vendor is a property developer. Secondly, for tax purposes, it is harder to get tax deductions for increased leverage. Thirdly, with new properties, capital allowances may only be available on the developer's cost. These matters will need to be weighed against the stamp duty savings, but given the how high stamp duty costs, we ultimately expect to see more share transactions rather than direct asset purchases over the next year.
8th Floor, Prince's Building
10 Chater Road
Central, Hong Kong
Tel: +852 2826 7226
Fax: +852 2845 2588
Chris Abbiss has extensive experience on tax issues in the property and infrastructure industries. He advises a number of significant funds and investment advisers on fund structuring, the structuring of pan-Asian real estate investments and efficient investment management structures. His 20 years in tax practice include experience in New Zealand and the UK as well as Hong Kong.
His recent experience has included taxation structuring for a number of pan-Asian and country-specific real estate and infrastructure funds and advising on the fund/asset management and investment advisory structures for these funds; providing real estate infrastructure and private equity investment structuring advice into a number of Asia Pacific (Aspac) countries including advising sovereign and pension investors; advising on efficient remuneration/carry structures for fund stakeholders; and providing tax advice on the establishment of a number of Hong Kong real estate investment trusts.
As Hong Kong is a key Aspac hub for the funds industry, Chris acts as single point of contact, coordinating KPMG's Aspac services to a number of fund industry participants. This includes regional coordination of local country tax compliance for pan-Asian funds utilising project management technology.
Chris is a member of KPMG's global financial services taxation steering group and chairs KPMG's international real estate funds taxation network. He is a past chairman of the New Zealand Institute of Chartered Accountants's tax committee.
Tax Partner in Charge of Central China
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1266 Nanjing West Road
Shanghai 200040, China
Tel: +86 21 2212 3421
Fax: +86 21 6288 1889
Lewis Lu is the tax partner in charge of Central China in KPMG China. He has been involved in many China tax advisory engagements across a wide variety of industries, particularly real estate and financial services, with extensive experience in advising multinational clients on their investments in China. He assists many foreign investors in structuring tax-efficient entry and exit strategies, on the acquisition of existing PRC entities and in discussing tax policy matters with the tax authorities.
Lewis is a member of the Canadian and Ontario institutes of chartered accountants and a fellow of the Hong Kong Institute of Certified Public Accountants.
Jean Jin Li
9th Floor, China Resources Building
Shenzhen 518001, China
Tel: +86 755 2547 1128
Fax: +86 755 8266 8930
Jean Jin Li has more than 10 years experience in the China tax practice. She is stationed in Shenzhen and has previously worked in the US and Shanghai.
Jean has extensive experience in China tax consultancy. With her strong accounting, auditing, taxation and legal background, she advises clients on their investment and development plans, business structures, M&A transactions, share transfers, liquidation processes and transfer pricing strategies, as well as foreign exchange aspects of business operations. Jean maintains good relationships with both tax and investment related authorities.
Jean has extensive experience in real-estate tax matters. She has advised many companies in the sector on tax efficient holding structuring, tax-free restructuring, business operation restructuring, tax dispute resolution and on addressing tax issues in the initial public offering (IPO) process.
Jean is a certified public accountant and also holds a lawyer practitioner qualification in China.