China Special Situations Insight (Volume 2, Issue 11)
Investment in Distressed Real Estate in China: Key Issues for Legal Due Diligence (I) – Outstanding Land Premiums and Taxes
The rapid growth of China’s economy has brought about a dramatic increase in the value of real estate and, at the same time, caused actual or contingent problems for the real estate industry. Some developers acquired lands in prime locations in early years, but the projects have become bogged down because the developers or the properties became distressed due to a variety of reasons, which have made the projects impossible to reach profitability. Many international and domestic investors have realized opportunities in this distressed real estate market and have set up funds to specifically bail out the distressed properties, so that they could make huge profits from the development and sales thereafter.
We have prepared a series of articles to highlight the major transaction structures and legal due diligence issues for investment in distressed real estate in China. The first part outlines the important issues that NPL investors need to be aware of during legal due diligence, and the second part outlines the major transaction structures that most NPL investors would deploy. We will continue this series and cover other investment structures and key issues when appropriate. In this article, we raise the importance of examining the full payment of land premiums and taxes regarding land use rights and set out the consequences if such fees remain outstanding.
When a real estate developer (or other enterprise) intends to acquire land use rights from the land authority, the buyer must participate in an auction and become the winning bidder; the buyer then qualifies to enter into a contract for the granting of land use rights with the local land bureau. The buyer shall pay all the land premiums and all relevant taxes to secure the title of the land use rights and complete the registration. Usually, the title transfer registration will not be completed if any land premiums or taxes remain outstanding, but a local government may grant special approval to allow the buyer to complete the title transfer registrations before paying the land premiums or taxes in full. According to our experience, it is not unusual across the country for a local government to make such an exception, and investors should not assume that all land premiums and taxes have been paid simply because the buyer has a title certificate for land use rights.
To invest in distressed real estate, generally investors will acquire either (i) the distressed real property or the equity in the company holding the distressed real property (collectively, the “Distressed Assets”) or (ii) the non-performing loans secured by distressed real property (the “Distressed Loans”). However, if any land premiums or taxes are outstanding, the investment will be adversely and materially affected whether the investors have acquired Distressed Assets or Distressed Loans.
If the buyer fails to pay all the land premiums or taxes pursuant to the contract for the granting of land use rights, the consequences will be as follows:
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(1) Where the investor acquired the Distressed Assets, (i) the project company may need to assume the liabilities for the violation of the contract or the tax laws, including but not limited to paying a penalty in a large amount and losing part or all the land use rights; and (ii) even if all the buildings are well constructed and pass the acceptance examination, the project company may not be able to complete building ownership registrations and sell the properties.
(2) Where the investor acquired the Distressed Loans, in practice, the outstanding land premiums, taxes and penalty accrued thereon will rank ahead of the mortgages over the land use rights; this means the investor will not be entitled to all the proceeds from the disposal of the land use rights because certain proceeds shall be applied to pay the land premiums, taxes and penalties.
According to our experience, there is another circumstance that investors need to be aware of. If the local land bureau has not organized an auction for the transfer of land use rights, which violates the relevant regulations, and has transferred the land use rights to a buyer at a premium lower than the local base price for the land use rights, the buyer shall pay the difference between the agreed price and the local base price, otherwise the consequences set out above may still apply.
It is very important for investors to investigate the payment of land premiums and taxes during legal due diligence, although in some distressed loans transactions, the investor may not be able to verify the payment due to a lack of authorization from the underlying obligors. We suggest that our clients require the seller to make representations and warranties in the transaction documents that all land premiums, taxes and other relevant fees with respect to the project have been paid in full, otherwise all outstanding fees shall be borne by the seller.
However, if it is confirmed that there are outstanding large land premiums, taxes or penalties and such outstanding fees will materially affect the profitability of the transaction, investors should think carefully whether it is time to walk away.
For further information, please contact Catherine Miao, Head of Special Situations and Alternative Investment at JunHe LLP: [email protected] or +86-21-22086350.