I Legal Analysis of REITs in China
REITs (real estate investment trusts), are real estate investment and financing products that are currently widespread. REITs have advantageous functions in the real estate market in that they can effectively channel funds to real estate companies, diversify the risks of real estate mortgages and loans, and provide a convenient way for minority investors to invest in the real estate industry. However, due to legal obstacles, REITs have not developed well in China.
II Introduction: Origins and Development of REITs in China
REITs are a type of trust plan in which funds from specific investors are collected through the issuance of securities and invested in income-producing real estate. REITs implement a capital investment plan on real estate managed by professionals in which holders of REITs can acquire the income of business operations, for example, sales and lease of properties in the form of dividends proportionately.2 It is worth noting that the terms trust and fund have specific legal definitions under Chinese law. It is not necessary for REITs to adopt the forms of trust or fund under Chinese law. A wide range of legal vehicles can be adopted, for example, corporation, collective trust or contractual fund.
REITs originated in the United States in the 1960s and were later introduced and developed in Australia, Europe, Japan and Hong Kong through statutory laws. REITs, as a financing product, can greatly reduce the cost of property possession for real property developers, provide an effective method of financing and a convenient way for minority investors in the real estate to share income, reduce the financial risk as the consequence of mortgages provided by the bank, and ensure the sustainable development of the real estate industry. Considering the advantages of REITs, the Chinese government has established the REITs system and has run pilot projects. The innovative nature of REITs was discussed, particularly during the period of economic structural reform, which focused on the control of the real estate market. On 14 February 2007, the China Banking Regulatory Commission (CBRC) lent its support to the idea of trust investment companies engaging in innovative business, namely through the use of REITs.3 During 2008, the real property price first dropped and then went up, and it was because of this that the State Council, the People’s Bank of China (the Central Bank) and the CBRC issued regulatory documents on the piloting work of REITs.4 Since 2010, the government has been enforcing a stringent readjustment and control policy over the real estate market through the restriction on the sales and mortgages of real property. As a result of this policy, the banks tightened their mortgage and loan policies and the financing costs for real estate companies increased. The fund shortage in the real estate market significantly affected the sales of real property. Under such circumstances, the Chinese government re-emphasised the development of REITs in 2014.5
III Functions of REITs in the Chinese market
The success of REITs in developed countries and areas such as the United States, Australia, Japan, Singapore and Hong Kong indicates that the characteristics of REITs products are in accordance with the development of the economy and can play an important role in the sustainable development of a real estate industry.
Currently, the financing methods available for Chinese real estate companies are limited and primarily rely on bank loans to real estate developers, collateralised mortgages or financing through private equity funds. Although the financing cost of bank loans is low, it is subject to government policy to a large extent. Once the government imposes stringent control over the real estate market, the availability and conditions for bank loans will be greatly affected, and so will the cash flow of real estate companies. Since lending banks generally require a collateralised mortgage, the ability of real estate companies to finance themselves further becomes impaired.
Additionally, REITs play an important market function in China. As a financing method that has an equity nature, REITs are stable and expedient for the professional operation of real estate projects and investment and will not result in the change of the control power of real estate developers over project companies or projects. Moreover, REITs are also relatively desirable investment products for minority investors as they have flexible trading channels and stable fluidity.
Iv Legal Obstacles to the Development of REITs in China
Comparing the experience of REITs in a mature market and the reality in China, the obstacles faced by REITs in China can be categorised into three aspects.
i Lack of systematic statutes
The development of REITs in China are faced with obstacles inherent in the legal system. In mature markets, such as Hong Kong and Singapore, the systematic regulations, which regulate the requirements and procedures for the public offering of REITs, have been promulgated. However, no such similar regulations have been issued in China. In relation to trusts, there is a law (the Trust Law) and regulations issued by the CBRC.6 In relation to securities, there is a law (the Securities Investment Fund Law), a regulation issued by the CSRC,7 and a regulatory document.8
In terms of the practice of REITs in China, the current legal system is not clear and systematic regulations are still absent. In the field of trust law, in the background of separate management for different sectors of financial industry in China, the regulatory documents issued by the CBRC can only regulate private issuance; public issuance is subject to laws and regulations in other fields. However, REITs in other countries are typical public securities exchanged in the public capital market, which are not included in the regulatory scope of the CBRC.
In the field of security law, Article 58 of the Securities Investment Fund Law provides that fund assets can be used for the following investments: first, investment in stocks and bonds listed and traded on a stock exchange; and second, investment in other securities and their derivatives prescribed by the securities regulatory authority of the State Council. However, considering that the majority of REITs’ investment flows into the field of immoveable property, it is ambiguous whether REITs fall within the scope of security investment funds prescribed by the Chinese law.
Therefore, the primary obstacle to the development of REITs in China is the lack of systematic and unified regulations. Compared with the practice experience in the field of real estate finance, in order to establish a comprehensive statutory system, REITs would likely be examined from the perspectives of legal structure, regulatory authority, exchange market, ownership structure, limitation on minimal holding, limitation on development, the lowest percentage of real estate investment, and the lowest and highest proportion of profit allocation.
ii Unclear tax policies
Historically, tax preferences have played an important role in the development of REITs. In 1960, President Eisenhower signed a special tax regulation in which REITs were regarded as profit pass-through and double taxation could be avoided. This regulation remains unchanged except for some small modifications, and is regarded as the driving force behind the development of REITs in the United States. REITs in the United States further developed as a result of a series of reforms in relation to housing tax. Tax reform in 1986 allowed REITs to manage and operate real properties directly. In 1993, the restrictions on the investment of pension funds in REITs were removed. These reforms encouraged investors to invest in REITs, which led to a boom in REITs in the 1980s.
In China, in 2002, the Ministry of Finance and the State Taxation Administration jointly issued the a circular9 in which the tax preference policy of funds was clarified. First, the price differential income of the fund managers obtained from buying or selling stocks and bonds with funds was temporarily exempted from business tax and enterprise income tax before the end of 2003; second, no individual income tax was to be levied on the price differential income obtained by individual investors serving as fund subscribing and redeeming entities before the levy of individual income tax upon the price differential income from their buying and selling stocks was recovered; third, with respect to the income obtained by the fund from stock dividends and bonuses, the income from the interest of bonds, and the income from the interest of savings deposits, 20 per cent of the individual income tax was to be withheld and remitted by the listed company, enterprise or bank that issued the bonds when it was paying the above income to the fund. As for the income obtained by the investors (including individuals and institutional investors) from funds, individual income tax and enterprise income tax were not to be levied for the time being. Fourth, for investors serving as fund-subscribing and redeeming entities, no stamp duty was to be levied for the time being.
At the end of 2003, the Ministry of Finance and the State Taxation Administration prescribed that from 1 January 2014, the price difference of the incomes of the fund managers obtained from buying or selling stocks and bonds with funds was to be continuously exempted from business tax and enterprise income tax. However, this document applies to securities funds but not explicitly to REITs. In addition, the tax management of the Chinese government over funds and securities largely relies on the issuance of temporary documents, which also leads to an unstable tax policy.
Because Chinese tax collection has not been reformed or modernised, it is impossible to implement the levy based on the system of actual income and net income. The operation of REITs is related to a variety of transaction processes that result in a heavier tax burden. In this respect, although REITs may reduce the income tax levied on the fund, the company incorporated by trust that owns multiple properties would be liable for corporation income tax. Moreover, a transaction tax may arise from the property transactions during the process of REITs restructuring. In addition, housing tax is inevitable once rents from the property are taken during the operation of REITs.
Since it is necessary for the restructuring of REITs to go through the procedures of assets transfers, if multiple taxes cannot be avoided, the profits of REITs products and other derivative asset securitisation products cannot be guaranteed to a desirable extent. As a consequence, REITs cannot be successfully popularised in China.
iii Uncertainties of legal subject status
Another obstacle that lies in the development of REITs is that REITs are not regarded as a legal entity. At present, the investment fund is not a corporation, or even a legal entity, and an investment collection is not regarded as a legal entity in the Chinese law system. No legal document has touched upon this issue so far.
There is no clear definition of a fund in the Securities Investment Fund Law, which is the only law related to funds. On the contrary, the legal system tends to define a fund as a collection of contracts. In these circumstance, it is difficult for REITs to have legal title over real estate considering that they are not legal entities. The relationship between the trustee and fund is contractual and the ownership of real estate is proprietary. It is against the theory of civil law that a proprietary right prevails over a contractual right and may result in legal conflict in practice.
The common solution is to establish a special purpose vehicle (SPV) to hold the ownership of the real estate. At present, in terms of China’s Company Law, there is no provision with respect to SPVs. Articles 5, 7 and 12 of the Company Law, effected on 1 January 2006, prescribe that the object of the company is operation of the company and the company must have the business scope that is stated in the business licence. In other words, one of the conceptual differences between Chinese and foreign legal systems is that the company is an operational entity rather than an SPV. The obstacles to legal subject status may only be removed once further improvements to the Chinese legal system are implemented.
v Milestone cases of REITs Practice in China
i Zhongxin Qihang
Zhongxin Qihang is a standardised product with a specific asset management plan, which is relatively similar to foreign REITs. It was established on 16 January 2014 upon the approval of the CSRC. Under the legal structure of this asset management plan, the CITIC Securities Company established an asset management plan to invest in a PE fund platform. The PE fund holds the equity of two project companies, which separately owns two properties. This plan adopts the traditional model of ‘product plus partnership fund’ under which the investors will exit through the standardised IPO of REITs or equity transfer to any other third party at the market price when the plan expires.
The highlight of Zhongxin Qihang is the increased fluidity in the way that it fills the gap between non-standardised products and standardised products, which provides an investment channel for institutional investors, including insurance funds. This also overcomes the restrictions imposed on non-standardised products by the authorities.
However, there are a number of limitations on Zhongxin Qihang. First, Zhongxin Qihang fails to meet the requirements for proceed allocation as return on investment of Zhongxin Qihang is substantially lower than that of standardised REITs, in which the majority of the annual taxable income is allocated to the investor. Second, although Zhongxin Qihang can be listed on the Shenzhen Stock Exchange, the prospectus states that in order to ensure that the number of investors is limited to no more than 200 after each transaction, each transfer of priority beneficiary certificate will no be less than 500,000 shares and each transfer of secondary beneficiary certificate will no be less than 300,000 shares. The par value of every beneficiary certificate is 100 yuan. In other words, the amount of transfer for the primary and secondary beneficiary certificate will not be less than 50 million yuan and 30 million yuan, respectively. These strict thresholds for transfer may substantially impair the fluidity of Zhongxin Qihang. In contrast, foreign standardised REITs provide lower thresholds that function as an important property disposition for the ordinary investor. It is the excellent investment channel for minority investors that brings the opportunities for ordinary investors to share the benefit that arises in the process of urbanisation.
ii Penghua Wanke
Penghua Wanke is the first public REIT in China with the basic structure of a contractual close-end securities fund. It has been listed on the Shenzhen Stock Exchange. During the closed period, Penghua Wanke invested in the equity of a specific single target company. The fund manager signed the agreement with the target company and original shareholders and holds the equity on behalf of the fund.
Compared with a Zhongxin Qihang structure, Penghua Wanke has a lower threshold of subscription and has greater fluidity. The prospectus states the minimal amount of each subscription for each fund account sold by the sales agent of the fund to be no less than 100,000 yuan. The minimal amount of each initial subscription is no less than 100,000 yuan and additional subscription will be no less than 1,000 yuan in direct sales centre. During the fund-raising period, there is no limitation on the accumulated subscription amount for the single fund holder.
In addition, the progress of Penghua Wankes also includes an increase of the proceeding allocation ratio so that 90 per cent of annual allocable profits are allocated to the investors. However, similarly to Zhongxin Qihang, Penghua Wanke has not disclosed that it is entitled to any tax preference outside of the current regulatory scheme.
However, Penghua Wanke has a long way to go to achieve the requirements of international standardised REITs. First, Penghua Wanke is a securities fund rather than an investment trust. Second, the trust deed that is required to establish a REIT is not involved, so no trust legal relationship has been established. As there is no establishment of a trust legal relationship, there is no trust asset. Third, the concepts of custodian and custodian bank are different from the meaning of trustee in the relationship of trust and the powers of which are different. The aforementioned three aspects indicate that due to the lack of the required legal environment and the failure to adopt a complete trust structure, typical REITs in China are currently still remote from the standardised REITs in the international market.
VI Trends of REITs in China
Despite the advantages of REITs and the need for their implementation, so far no REITs that comply with international standards have been issued because of the legal environment. After reviewing the history and current situation of REITs across the world, it is clear that the development of REITs depends on the establishment of an appropriate legal scheme. REITS in the United States began with legislative activities in the 1960s, as was the case also in Hong Kong, Singapore and Japan. The absence of relevant regulations has resulted in the slow development of REITs in China. Therefore, the promotion of REITs depends on the following improvements in legislation and regulation.
First, the regulatory authority should be determined. Although China has put forward the promotion of REITs for nearly 10 years, it has made little headway. One important reason is that the regulatory authority is not clear. The Central Bank, the CSRC, the CBRC and the Ministry of Construction all intend to be the regulator of REITs. REITs were first promoted by the Central Bank because it intended investors of REITs to be institutional investors; ordinary investors have difficulties investing in REITs and the exchange platform will be the interbank bond market, the fluidity of which is limited. The CBRC and the Ministry of Construction also desire to be the regulator for REITs but they have similar problems as the Central Bank. The CSRC has the comprehensive system for the regulation of securities and funds in Shanghai and Shenzhen Stock Exchange, and this makes the CSRC the most suitable candidate. The issued REITs, such as Zhongxin Qihang, are listed on the Shenzhen Stock Exchange with the approval of the CSRC. In the special structure of the market economy in China, the ambiguity of the regulator always leads to inefficiencies in the promotion of the regulation system. Therefore, determining the regulator and establishing a corresponding legal system as soon as possible are priorities.
Second, the issue of tax preference should be resolved. REITs are entitled to tax exemption in foreign REIT structures for the purpose of maximising the benefits to investors. At present, REITs in China are not regarded as a securities fund and subsequently are not subject to the Securities Investment Fund Law under which tax related to the contractual fund is exempted. Pursuant to the tax system in China, the revenue from the real estate operation will be subject to business tax at 5.5 per cent, housing tax at 12 per cent and business income tax at 25 per cent. If REITs pay tax in accordance with the current tax system, the profit margin will be narrowed, which is not helpful in the cultivation and development of the REITs market. Therefore, the tax exemption or tax preference policy must be achieved through special statutory issuance.
Third, a real estate property registration system should also be established. All the investors have common ownership over the real estate property via REITs in the manner of securities issuance, which means ownership registration will be the issue to be resolved. No restrictions on the ownership registration will exist if the REIT is incorporated as a company. However, in terms of the current legal system, the Chinese government tends to develop contractual REITs, which results in difficulties of ownership registration. For the purpose of ensuring independence of ownership and achieving the effect of judicial separation, a legal system that facilitates ownership registration under the name of REITs should be established. It will answer the concerns of investors regarding the independence of property ownership and avoid the high tax (especially VAT and deed tax) that arises during the process of property transfer, which will reduce the cost of establishment and operation of REITs and subsequently facilitate the issuance and operation of REITs and mortgage financing.
1 Sammuel (Xiyong) Zhao is a partner at JunHe LLP.
2 Zhirong Mao, ‘Analysis of the Development of REITs in China’, Shenzhen Stock Exchange Research Institute, 20 September 2004.
3 CBRC, ‘Notice of China Banking Regulatory Commission on the Specific Issues Concerning the Implementation of the Measures for the Administration of Trust Companies and the Measures for the Administration of Trust Companies’ Trust Plans of Assembled Funds’ (No. 18  of China Banking Regulatory Commission), 14 February 2007, ‘the CBRC encourages the trust and investment companies which have been approved to be reissued new financial licences to initiatively propose trial plans in terms of business innovation and organisational management and, in accordance with the procedure for examination and approval, gives priority to their such innovative business as personal equity investment trust, asset securitisation, overseas financing upon entrustment and real estate investment trust, etc. Any reform measure that promotes the innovation and development of trust and investment companies and institutional supervision will be tried out on them firstly.’
4 General Office of the State Council, Several Opinions of the General Office of the State Council on Promoting the Healthy Development of the Real Estate Market (No. 131  of the General Office of the State Council), 20 December 2008, ‘We shall also encourage real estate development enterprises with good credit records to issue corporate bonds upon approval, and launch pilot real estate investment trust funds to diversify the channels for direct financing’; Central Bank and CBRC, Guiding Opinions of the People’s Bank of China and China Banking Regulatory Commission on Further Adjusting the Credit Structure to Promote the Rapid yet Steady Development of the National Economy (No. 92  of the People’s Bank of China), 18 March 2009, ‘We need to provide more financing support and financial services for real estate development enterprises which have strength and good reputation to merge or reorganise the relevant enterprises or projects, encourage the real estate development enterprises with good credit record to issue corporate bonds and do the pilot operation of real estate investment trust funds, diversify the channels for real estate development enterprises to raise funds, provide more credit support to the purchase of houses and improved houses, and encourage the purchase of ordinary commercial residential houses.’
5 China Securities Regulatory Commission, Opinions of the China Securities Regulatory Commission on Further Promoting the Innovative Development of Securities Operation Institutions (No. 37  of the China Securities Regulatory Commission), 13 May 2014. ‘Promoting the development of asset management business. Securities operation institutions shall innovate and improve asset management business processes, and improve the professional level in product sale, product design, investment operation, post-sales service, and other aspects. Qualified securities operation institutions may develop cross-border or cross-market products, or products covering different asset categories, or adopting diversified investment strategies and differentiated charging structure and charging level. Research shall be conducted to establish the institutional system of real estate investment trusts (REITs) and corresponding product operation mode and program. The investment scope of collective asset management plan shall be broadened. Investment in equities, creditor’s rights, and other property rights that are not transferred through stock exchanges shall be allowed’; Central Bank and CBRC, Notice of the People’s Bank of China and the China Banking Regulatory Commission on Further Improving Housing Financial Services, 29 September 2014, ‘Banking financial institutions shall, under the premise of preventing risks, rationally allocate credit resources, provide support for the real estate enterprises which have good qualifications and operate in good faith to develop and construct ordinary commodity housing, and actively support the reasonable financial needs of the in-process and continuing projects with market prospect. Efforts shall be made to broaden the market-oriented financing channels, and qualified real estate enterprises shall be supported in issuing debt financing instruments in the interbank bond market. The pilot programME of real estate investment trusts shall be conducted in an active and prudential manner.’
6 Measures for the Administration of Trust Companies and Measures for the Administration of Trust Companies’ Trust Plans of Assembled Funds.
7 The Administrative Rules on Asset Securitisation by Security Company.
8 The Notice on Further Strengthening the Asset Management Services for Specific Clients Engaged by the Fund Management Companies and their Subsidiaries.
9 Ministry of Finance and State Taxation Administration, Circular of the Ministry of Finance and the State Taxation Administration on the Relevant Issues concerning the Taxation on the Open-end Securities Investment Funds ( No. 128), 22 August 2002.