Jan 29, 2022, the Treasury Department and the State Administration of Taxation issued the Notice No. 3 of 2022, the Pilot Tax Policy of Real Estate Investment Trust (REITs) in the field of Infrastructure (hereinafter referred to as “Notice 3”), which is the first time for Chinese government to publicly support the development of REITs. This article will analyze the application and implication of the Notice 3.
A. Favorable Tax Policies Encourages The Initial Growth of REITs
Real Estate Investment Trust (REITs) is a trust fund that collects the funds of specific investors by issuing trust income certificates, operates and manages real estate investment by special investment institutions, and distributes the comprehensive investment income to investors in proportion.
Since the public offering REITs was launched in the United States in the 1960s, more than 40 countries (regions) have issued such products and established a relatively mature REITs operation mechanism, legal system and tax policies. The investment fields of REITs expanded from real estate to hotels, shopping malls, industrial properties, infrastructure, etc. Since Yuexiu REITs was listed on the Hong Kong Stock Exchange in December 2005, REITs started to emerge as a new rising area and required more policies to regulate. Below is a list of notices issued by the government.
The above policies mainly focused on regulating the scope, establishment, and operation of public offering REITs, but none of them offered any solution to related tax issues. In the absence of related tax policies, REITs will trigger few number of taxes in the establishment, holding, operation, and exit process, such as value-added tax, corporate income tax, personal income tax, land value-added tax, deed tax, etc. For example, it is common practice to set up REITs by acquiring real estate assets through asset transaction or equity acquisition; however, the high tax costs in the process greatly hindered investors’ desire to set up REITs.
On Jan 29, 2022, the issuance of Notice 3 states that REITs can defer the recognition of corporate income tax for relevant asset transactions or equity acquisitions before and during the establishment stage of REITs. The issuance of Notice 3 is the first time Chinese authorities explicitly support the development of REITs in terms of tax policies. It can be said to be a milestone document for the development of REITs in China.
B. The Tax Burden of the Infrastructural REITs Calls for Imminent Reform
Before interpreting the Notice 3, we need to briefly introduce the structure of infrastructural REITs, the common transaction before and during the establishment stage, and the corresponding tax issues.
According to the provisions of Document 54, infrastructural REITs have to adopt the "public fund + infrastructural asset-backed securities" structure. In addition, underlying REITs assets need to meet the following requirements:
(1) More than 80% of the REITs assets are invested in infrastructural asset-backed securities, and REITs holds all shares of the infrastructure project company through infrastructure asset-backed securities;
(2) The REITs obtains the full ownership or operating right of infrastructure projects through asset-backed securities, project companies, and other carriers;
(3) The fund manager actively operates and manages infrastructure projects with the main purpose of obtaining stable cash flow such as rents and charges of infrastructure projects;
(4) The REITs is under closed-end operation, and the distributed income shall not be less than 90% of the annual distributive amount of the combined fund.
The original asset holders need to complete a two-step transactions to meet the structural requirements provided in the Document 54, but each step will trigger severe tax consequences:
Transfer the assets to the project company in exchange for equity of the project company.
Since infrastructural REITs assets are real estate, the transfer process will trigger high tax costs, such as value-added tax, corporate income tax, land value-added tax, deed tax, and stamp tax. It became unreasonable for original asset holders to set up REITs because of the tax costs and the risk of unsuccessful fund-raising.
Transfer the equity of the project company to the SPV company (i.e. special asset support plan and project company) established by REITs.
Required by Document 54, the original asset holders must hold more than 20% of the infrastructural REITs, and there is a lock-in period. In other words, even after a successful fund-raising in step (1), the 20% threshold and lock-in period will cause the realized amount lower than the amount of asset transfer. On top of that, the original asset holder also needs to pay corporate income tax when transferring equity into the SPV company and when selling the REITs share in exit phase. Overall, The mandate requirements and heavy tax burden is not good for the REITs industry.
C. The Notice 3 Marks the Beginning of a New Era for REITs
The Notice 3 aimed to relief the tax burdens in the two-step transactions in three ways.
1. The establishment process of REITs can apply special tax treatments.
As required by the Ministry of finance, State Administration of Taxation, only certain entity restructure plans can apply special tax treatments. There are strict requirements regarding the proportion of specific assets or equity transfer, the proportion of equity payment, the non-transferable requirements within 12 consecutive months after the reorganization and so on. Since the original owner needs to transfer equity in step (2), the establishment process of REITs cannot meet the requirements to apply special tax treatments. However, the issuance of the Notice 3 provided an exception to the previous tax rules. It allows the original asset holders to apply special tax treatments, defer recognizing corporate income, when transferring the asset to project company in exchange for project company’s equity.
While being the milestone to the REITs field, The Notice 3 still has its flaws. First, The Notice 3 only allowed corporate owners to defer recognizing corporate income; it was unclear if individuals or partnerships can analogically apply the rules. Secondly, the Notice 3 did not consider the possibility that the assets may not be fully owned by the original asset owners. Under current tax rules, in order to apply special tax treatments, the transfers of assets can only happen between the entities that are fully owned by the same one or more owners. Therefore, if the original asset owners does not own 100% of the asset, it is unclear whether it can be viewed as applicable situation under special tax treatment rules.
2. Deferred corporate income tax on equity transfer in establishment stage of REITs.
Because of the structural requirements of infrastructural REITs, the original asset owner needs to transfer the project company’s shares to REITs and pay income tax on any increase of value. The Notice 3 allows the owners to defer tax payments until the fund-raising complete. As of the portion of REITs (more than 20%) required to be held by the original asset owners, the income tax payments can be deferred until the owners realized income from selling that part of assets. However, in practice, that portion of REITs can not only be held by the original asset owners but the owners’ related parties. The Notice 3 only indicates the original owner can enjoy deferred tax benefits, but it does not clarify if related parties can claim the benefit as well.
3. The Notice 3 can apply retroactively.
Before the release of the Notice 3, there were cases of infrastructure REITs already up and running in practice. This provision allows the tax preferential treatments to be retroactively applied to the established infrastructure REITs, which is a great news for the REITs industry. However, there are still some ambiguity in the Notice 3 regarding treatments of related parties awaiting for further details.
The issuance of the Notice 3 provides great tax benefits in corporate income tax when setting up infrastructure REITs. Nevertheless, it remains to be seen if there will be any preferential treatments for other taxes, such as value-added tax, land value-added tax, etc. Also, project companies can utilize “equity+debt” module to lower tax burden during the operation of REITs. Considering the effective tax rate is already low for project companies, there is unlikely to be any tax preferential treatments announced recently.
It should be reminded that the Notice 3 is only applicable to infrastructural REITs. As for the financing demand of real estate companies through commercial real estate, property, housing and other assets, it can only be achieved by setting up a type of fund that is similar to REITs. In the transaction structure similar to REITs, right of use is transferred mainly by means of transfer guarantee, rather than ownership. The premium value-added part arising from the transfer of such basic assets still needs to pay corresponding income tax. However, since the transfer phase does not involve high land value-added tax, we suggest that entities should choose the transaction scheme according to the specific situation in practice.