The People's Republic of China has taken another step to curb the overheating property sector, issuing a circular to strengthen the tax oversight of on real estate developers.  The circular, Guo Shui Fa [2006] No.187 ("Circular 187"), issued by China's State Administration of Taxation ("SAT") on December 28, 2006 (released on its Web site on January 16, 2007), will come into effect on February 1, 2007.  Circular 187 requires local tax bureaus to strictly implement administration of land value-added tax ("LVAT") and provides detailed directives on the mandatory final settlement of LVAT and other compliance requirements.

LVAT is a tax on the gains realized from the transfer of land, buildings and associated structures and is charged progressively at a rate of 30% to 60%. The gain realized or the "value added" is the amount of income (in both cash and other considerations) derived through the assignment of real estate after the deduction of certain items.

Filing of LVAT generally involves two stages: provisional filing and of final settlement.  The provisional filing of LVAT should be made on advance sales and the final settlement is made on the completion of a development. Since LVAT was first introduced in 1993, enforcement has been weak due to a subsequent recession in the real estate market.  Currently, some regions in China are collecting the tax at a rate of 0.5% to 2% on the sales price during provisional filings and are not strictly imposing the requirement of final settlement.

The most critical requirement of Circular 187 is the introduction/reaffirmation of a mandatory final settlement, along with providing local tax bureaus with the discretion to require final settlement under certain circumstances.

Taxpayers are required to go through final settlement of their LVAT obligations in any of the following circumstances:

§         construction work of the real estate development project has been completed, and the underlying sale occurred;

§         the real estate development project is transferred as a whole, although construction has not been completed and final accounts are not available; or

§         land use rights are directly transferred without any construction work.

In addition, the competent tax authority may (at its discretion) demand final settlement of LVAT obligations in any of the following circumstances:

§         in the case of a completed and accepted real estate development project, the building area thereof which has been conveyed accounts for 85% or more of the total salable building area, or, although such 85% threshold is not surpassed, the remaining salable building area has been let, or used for its own account;

§         the sale is not completed upon elapse of a period of  three years after the issuance of the sales (pre-sale) permit;

§         the taxpayer files an application for tax deregistration without having first completed LVAT final settlement formalities; or

§         other circumstances identified by the provincial tax authority.

Circular 187 also reconfirms the tax treatment of deemed sales.  It prescribes that if a real estate developer applies the properties it has developed as welfare benefits or rewards for its own employees, contribution to external investment projects, distribution to its share/equity holders, for satisfaction of its obligations or in exchange for nonmonetary assets of other entities or individuals, a sale is deemed to have been made and income is deemed to be realized on the transfer of the title to the properties. The income of such a deemed sale should be determined in the following order: (1) average price of similar properties sold by the enterprise in question in the same region and in the same year; or (2) the fair market value assessed by the tax authorities based on similar properties in the same region and during the same year.

According to Circular 187, deductible items should be supported with valid and lawful vouchers and invoices. Otherwise, the tax authority will use its discretion to determine the deductible amount by referring to the market price of construction, installation and engineering work, while taking into consideration the structure, use, location and other factors of the buildings in question.

The new rule also covers the matching principles of sales income and deductible expenses, documentation requirements for final settlement and situations where LVAT can be collected on deemed basis.

It is apparent that the strict enforcement of LVAT will reduce the attractiveness of property investment in China. Since Circular 187 leaves some room for local tax bureaus to set detailed administrative measures, it will be crucial to see how the local tax authority will implement the new rule.

Foreign investors planning to invest in the Chinese real estate market should carefully examine their structuring options in light of these new developments. Additional tax administrative measures will require investors to identify new tax planning strategies to keep their bottom line unaffected.

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