Property tax: Where does it go from here?

The Chinese real estate market has experienced phenomenal growth over the past five years. Housing prices in Beijing and Shanghai have surged by more than 110% since 2007. Today, a high-end home in prime areas of Beijing and Shanghai can cost upwards of $20,000 per square metre.

However, skyrocketing real property prices have raised concerns about a housing bubble in China due to excessive speculation by investors. Fears of an asset bubble have led the central government to announce several administrative measures over the last two years to try and temper breakaway housing prices. These include:

• tightening eligibility criteria for multiple home purchases (property purchase limit);

• raising central bank reserve requirements for commercial banks and;

• hiking borrowing rates.

In a 2010 proposal on China's 12th Five-Year Plan (5YP), the Chinese Communist Party suggested that one of the tax reform areas is to study and promulgate a property tax system in China. The rationale of some policy advisers in using property tax as a mechanism to cool down the real estate market in China is that it would increase the costs of holding real estate inventory and force investors to push more unoccupied real estate properties to the market for sale.

It was contemplated that property tax reform would start in selected regions first and if successful, would be expanded to other parts of the country. On January 28 2011, Shanghai and Chongqing began trial measures to collect property tax from individual residents for the residential properties they owned in these cities. The trial measures in Shanghai and Chongqing have been in place for more than a year.

The property tax reform measures in Shanghai and Chongqing were prepared and issued by the municipal governments there and therefore differ from each other in their specific provisions. The key terms for each city are summarised below.

In Shanghai, property tax is levied on individual owners of residential properties located in Shanghai if either of these two situations applies:

• Residential property (including second-hand property and newly constructed property) is purchased by a resident household of Shanghai after January 28 2011. Before the purchase of this property, the Shanghai resident household already owns at least one residential property in Shanghai (Situation 1)

• Residential property is purchased by a non-resident household of Shanghai after January 28 2011 (Situation 2).

In Situation 1, the resident household may be partially or fully exempt from property tax on the new purchase if the following applies: after dividing the total living space of the household in Shanghai, taking into account the newly purchased property and the pre-existing residential properties in Shanghai by the number of people in the household, the average living space per person in the household is no more than 60 square metres. If the average living space per household is more than 60 square metres, the portion of the aggregate excess that is caused by the purchase of the new property is subject to Shanghai property tax. The living space here refers to the construction space, a term used by Chinese real estate developers in measuring the size of real properties in China.

If Shanghai property tax applies, the applicable tax rate is as follows:

• If the transaction price of the property per-square-metre is less than two times the average selling price of all newly built properties in Shanghai in the preceding year, the applicable tax rate is 0.4%.

• In all other cases, the applicable tax rate is 0.6%.

In Chongqing, the property tax measures are implemented in nine districts in the metropolitan area (the nine districts). Property tax will be levied on individuals purchasing or owning these types of properties in Chongqing:

• Detached houses that are owned by individuals.

• High-end residential property (including second-hand property and newly constructed property) is purchased by an individual after January 28 2011. A property is high-end if its transaction price per-square-metre is at least two times the average selling price of all newly built properties in the nine districts in the preceding two years.

• A property purchased by a non-resident after January 28 2011, if before this purchase, a non-resident owns at least one real property in Chongqing. A non-resident is an individual who is not registered as a resident in Chongqing, who does not own a business in Chongqing, or who is not employed in Chongqing.

If Chongqing property tax applies, the applicable tax rate is as follows:

• If the property is priced lower than three times the average price of all newly constructed properties on a per square metre basis in the nine districts during the two preceding years, the tax rate is 0.5%.

• If the price of the property is between three times and four times the average price of all newly constructed properties in the nine districts during the two preceding years, the tax rate is 1%.

• In all other circumstances, the tax rate is 1.2%.

The results published by market research institutions show that in Chongqing, the number of potential buyers for high-end residential properties has dropped 30% to50%; the prices of taxable properties have also decreased 10.48% since the trial measures took effect. Data released by the Shanghai Statistics Bureaus suggest that the average price of newly constructed residential properties has decreased 5.4% to Rmb13,448 ($2,137) per square metre in 2011.

However, the scope of the property tax pilot programme is quite limited and as such, a broad range of properties is not subject to property tax. For example, 90% of residential properties in Chongqing are ordinary properties, which fall outside the scope of the trial measures.

In addition, the amount of property tax revenue collected to date is insubstantial compared with the overall fiscal revenue in the two cities. And other policies besides property tax, such as the property purchase limit in Shanghai and the rising borrowing rates in Chongqing, may have also contributed to the price declines.

In economic centres such as Shanghai and Chongqing, increasing fiscal revenue is not the main goal of imposing property tax. Instead, a property tax is regarded as more of an economic balancing tool in controlling the overheated residential property market, especially for the high-end residential property market. So far, the trial measures have to some degree, depressed transaction volumes and the prices of high-end residential properties in Shanghai and Chongqing.

Though the scope of the reforms on taxable properties is somewhat limited, the property tax trial measures have had an impact on the decisions of real estate investors and had some effect in containing speculative activities. Potential investors now may need to take into consideration the holding costs when they make investments in residential properties and the likelihood that such tax costs might increase in the future when tougher and more comprehensive property tax regulations are issued.

The central government has explicitly expressed its intention to ask more cities (three to five) to adopt property tax trial measures in 2012. However, it is not prepared to expand the property tax programme nationwide yet.

It is anticipated that Shenzhen and Guangzhou could be the most likely cities to follow Shanghai and Chongqing and implement a property tax system on individual real estate owners. The real estate markets are quite mature in those cities, so the local tax authorities are better-positioned to begin the trial.

Hubei and Hunan provinces are also prepared to operate property tax programmes. Beijing was initially reluctant to authorise a pilot programme last year. However, it has recently changed its attitude and publicly expressed its intent to make property tax reform a priority. The property tax pilot programmes in these cities will heavily incorporate the experience gained from the trials in Shanghai and Chongqing.

Under the trial measures in Shanghai and Chongqing, the imposition of property tax only applies to newly purchased properties (with the exception of owners of detached houses in Chongqing, who also need to pay property tax).

This policy of targeting newly acquired properties rather than existing properties is inconsistent with the principle of fairness in taxation. In general, a property tax should apply to all property owners regardless of whether the properties are newly bought versus existing, or high-end versus ordinary. The principle of fairness, however, is not violated if certain exemptions are accorded to properties that meet the basic needs of living spaces for the owners.

The Chinese government is setting up a monitoring system that links key information on real properties in 40 cities. Once the system is up and running, it would be feasible to examine the real estate assets owned by individuals in different cities by name and national ID number and retrieve the title certificates as well as the purchase agreements. Such a system will be integrated with IT platforms from the fiscal, tax, banking and public security authorities and will facilitate the implementation of property tax for both newly purchased and existing properties in the future.

According to article 4 of the Shanghai property tax trial measures, the tax base to compute property tax will initially be the transaction price. After the initial phase of the reform, a valuation figure approximating to the market price of the property should be used as the tax base and will be subject to periodic adjustment for the same property. Chongqing also adopts a similar approach.

The transaction price method is vulnerable to manipulation. In the past, even among unrelated parties, it was common that individuals prepared more than one contract. Besides the real contract, one shadow contract with an artificially low transaction value was often executed between the parties for tax purposes. Therefore, to ensure the property tax system achieves its policy objective, the pilot programmes should move to the fair market value method as soon as possible.

However, property valuation in China is still at a nascent stage. The standards and the expertise of property appraisers still require substantial refinement. The challenge in the future is to develop a government regulated real estate appraisal system that can effectively support the property tax regimes.

Tax exemptions are provided for in the trial measures in Shanghai and Chongqing. The exemptions are granted depending on:

• when the purchase was made (that is, purchased before or after the implementation of the trial measures);

• what type of property was bought (for example, detached houses and high-end residential properties in Chongqing); and

• what the average living space for the purchasing household is (for example, the 60 square metre per person threshold in Shanghai).

China has travelled a tough road in pushing property tax reform thus far. The key argument raised by the opponents of the reform is that a blanket property tax without considering the size of a household unfairly taxes low-income families. In addition, retiring home-owners with fixed stipend are also concerned that property tax would create additional expenses for them without granting them the corresponding benefits.

For the property tax reform to proceed smoothly, it is important to design an exemption system that waives property tax for minimum living space. For example, regardless of whether a new home purchase is made, if the average residential space of a household in a particular city is within a threshold limit, no property tax should be imposed. Such a policy would help gather the support for a nationwide implementation of the property tax in the future, and more accurately aim the intended targets of property tax, that is, speculative real estate investors who often own scores of properties in one city for future resale.

There are debates as to the fairness of collecting property tax from individual property owners. Land in China belongs to the State. When a real estate developer wants to build commercial or residential projects on a piece of land, it needs to pay a fee to acquire the land-usage rights over a specified period (for example, 40 years or 70 years) and pass the fee on to the property owners through the sale price. Such land usage fees constitute a critical part of many local governments' fiscal revenues, which explains why local government are extremely reluctant to take concrete actions that would dampen overheated local real estate markets. Some argue that since the government already collects a de facto property tax in the form of the land-usage right, asking individual homeowners to pay an annual property tax would create double taxation.

Property tax is not a new tax in mainland China. Under the Interim Regulation of the PRC on Real Estate Tax (the Interim Regulations), individual property owners in mainland China should be subject to property tax for properties used commercially.

However, real properties owned by individuals for self-use have been exempt from property tax. Technically, the property tax reform measures in Chongqing and Shanghai are not consistent with the Interim Regulations and therefore lacks legal basis. Work is now underway to modify the Interim Regulations. The final release date of the revised regulations is still unknown.

In China's tier-one cities such as Beijing and Shanghai, demand for rental properties usually outpaces supply. If property tax is applied to all real estate, including existing and newly purchased, the incremental costs arising from property tax on the owners may ultimately be passed on to the tenants. Therefore, the imposition of property tax may indirectly drive up rental costs and increase the financial burden of tenants, who may already be in a financially worse-off position than property owners.

It is expected that when the property tax reform is launched nationwide, the tax will not only be imposed on newly purchased properties, but also on existing ones. Such a feature would present a tremendous challenge to tax administration and enforcement in mainland China. In contrast, the trial measures in Shanghai and Chongqing mainly seek to collect property tax from new purchase transactions.

Based on the capability of tax enforcement, it would be difficult to identify a mechanism to effectively collect tax on existing properties owned by individuals. An expansion and upgrade of the government's IT system and databases are in urgent need. In addition, each city may have its own unique problems to address. For instance, many residential real properties in Beijing are owned by government-invested enterprises and the Beijing government is grappling with the issue of whether to grant special relief to those properties without compromising the fairness of the property tax programme.

As stated in the first section, the central government dropped a massive bomb in 2011 to hold back the rapid rise in real estate price, that is, the "property purchase limit" policy. Specifically, residents and non-residents in major cities are restricted from buying additional properties even if they have the financial means, unless they meet stringent qualification criteria. The property purchase limit policy is criticised for contravening the principle of the free market and only temporarily suppresses the underlying force that drives the real estate market.

A long-term solution is a more market-oriented approach such as a property tax regime to influence investment patterns in the Chinese real estate market. When the property tax system becomes well established, property tax should provide an important source of government revenue and serve to reduce local governments' reliance on land-usage fees. This will help put local governments in a relatively neutral position when it comes to regulating the Chinese real estate markets. Therefore, an appropriately designed and well-established property tax regime will play a positive role in fostering a healthy residential property market in mainland China.

Jennifer Weng
		Tax partner KPMG China 50th Floor, Plaza 66 1266 Nanjing West Road Shanghai 200040, China Tel: +86 (21) 2212 3431 Fax: +86 (21) 6288 1889 Email: jennifer.weng@kpmg.com Jennifer Weng specialises in providing PRC tax advisory services to clients in the real estate and logistics industries. She assists multinational clients to formulate entry and exit strategies in relation to their PRC investments. Jennifer regularly undertakes due diligence work and restructuring projects, and frequently assists foreign multinationals in discussing tax policy matters with PRC tax authorities. Jennifer had been seconded to the international corporate tax group of the KPMG New York office for one year to assist with US companies focusing on various international tax projects for US companies.

Tracy Zhang
		Tax partner KPMG China 8th Floor, Tower E2, Oriental Plaza 1 East Chang An Avenue Beijing 100738, China Tel: +86 (10) 8508 7509 Fax: + 86 (10) 8518 5111 Email: tracy.zhang@kpmg.com Tracy Zhang joined KPMG China's Beijing office in 1996. In 2006, she was seconded to the Qingdao office and was the head of the local tax practice. From April 2007 until July 2008, she worked with both the international corporate tax practice in KPMG New York as well as the financial services practice in KPMG London, respectively. Tracy is a PRC regulatory and tax specialist on China investment related issues. Since 2004, she has been functioning as one of the leaders of the financial services tax team in KPMG Beijing, looking after domestic and foreign financial services, private equity and real estate clients. She has also been involved in: developing structures for foreign investments into China; tax due diligence reviews in connection with M&A transactions; and advising on cross-border transactions.

Jean Jin Li
		Tax Partner KPMG China 9th Floor, China Resources Building Shenzhen 518001, China Tel: +86 755 2547 1128 Fax: +86 755 8266 8930 Email: jean.j.li@kpmg.com Jean Jin Li has more than 10 years of experience in the China tax practice and has worked in the US, Shanghai and Shenzhen, where she works now. 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 the customs and foreign exchange aspects of business operations. Jean also maintains good relationships with both tax and investment related authorities. Jean is a certified public accountant and the holder of a lawyer practitioner qualification in China.