Transaction volume in the Shanghai residential real estate market plummeted over 80% between January and February 2011. Some point to a historical drop-off near the Chinese New Year holidays, while others credit the spate of initiatives unveiled by the Shanghai municipal government in late January, which appear to be aimed at the heart of Shanghai’s thriving residential property market. The three pronged initiative, comprised of property taxes, restrictive purchase quotas and an expanded sales tax, was introduced after months of speculation regarding possible actions that the government would take to reign in Shanghai’s skyrocketing residential real estate prices. Market experts predict that it will not be long before large cities across China adopt similar measures.

Expanded Sales Tax

On January 27, 2011, the Ministry of Finance and the State Administration of Taxation jointly issued the "Notice on Adjusting the Polices of Business Tax in the Transfer of Individual Homes," which provides that residential property sold within five years of the purchase date is subject to business tax at a rate of 5.55% on the full amount of the most current purchase price. Prior to this regulation, business tax was only levied on the profit generated on a residential property that was sold within five years of the purchase date.

Although the increased scope of the business tax is significant, it is unclear whether the regulation itself will have a material impact on reducing transaction volume or the relative pricing of residential assets, given that many homes in Shanghai are often sold after the five year holding period and that typical practice is for the seller to be paid a purchase price net of all transaction expenses. Provided that buyers and sellers believe that housing prices will continue to appreciate, it does not appear that the expanded sales tax will deter market participants from their current pricing expectations.

Property Tax

One day after the new business tax was introduced, Shanghai’s municipal government officially announced that property tax will be assessed on the following types of residences: (i) non-primary residences purchased after January 28, 2011 (the "Effective Date") by Shanghai residents (i.e., individuals who have been registered as residents in the city’s household registration system, or hu-kou), and (ii) any home purchased by a non-Shanghai resident after the Effective Date. Residential homes in Shanghai purchased prior to the Effective Date by anyone, whether Shanghai residents or non-Shanghai residents, will not be subject to the new property tax (i.e., the property tax will not be levied on home owners who purchased two or more residential properties prior to the Effective Date).

Until the introduction of the property tax, residential property investors had the luxury of steady appreciation without any significant carrying costs. Now, with management fees averaging 4 to 6 RMB per square meter, variable mortgage rates over 6% and a property tax between 0.4% and 0.6%, it would appear that investors will need to think twice before buying a residential investment property. In practice, however, the additional costs to hold an investment will likely be passed on to renters, who have little choice but to pay up.

Calculation of Property Tax

Property Tax will be levied on the tax basis at the applicable tax rate, as described below. Based on discussions with local real estate bureaus, property taxes will be assessed in each calendar year and will be due no later than December 31 of each calendar year.

Tax Basis

The basis upon which property tax will be assessed is calculated as 70% of the taxable construction area (sqm) times the assessed property value (price per sqm).

Taxable Construction Area

The taxable construction area of each taxable property may be reduced using a formula that aggregates the total construction area of all residences in Shanghai owned by members of a registered household, and then deducting from that amount up to 60 square meters per household individual. For example, for a family of three that owns two homes – (i) the first with a construction area of 150 sqm purchased prior to the Effective Date and (ii) the second with a construction area of 100 sqm purchased AFTER the Effective Date – the taxable construction area will be 70 square meters (i.e., 250 (total construction area) minus 180 (60 sqm * 3 family members)).

Notwithstanding the paragraph above, if the first home purchased by a homeowner prior to the Effective Date has a construction area greater than the product of 60 sqm multiplied by the number of registered household members, the entire construction area of the second home would be subject to taxation. Thus, if a family of three purchased a home prior to the Effective Date with an area of 200 square meters and then purchases a second home after the Effective Date with an area of 100 square meters, the second home of 100 square meters would be fully taxed.

While the formula described above is relatively simple, the calculation of taxable construction area and any deduction applicable thereto raises certain complications depending on the number of homes owned by each member in a household and on how membership in a household is officially determined. In practice, application of the general taxation rules by each local real estate bureau may vary.

Assessed Property Value

The unit price of the property will be based on the then current market value of the property as determined by the taxing authority at the time of annual assessment. As such, the property tax payable with respect to a taxable property may vary each year depending on the valuation of the property. The methodology to be applied by the relevant governmental authority in determining property value is not clear at this stage, but for 2011, the purchase price will be deemed as the current market value.

Applicable Tax Rate

The applicable property tax rate is currently 0.6%. However, if the per square meter market price of a taxable property is less than twice the average per square meter market price of new residential properties in Shanghai which have entered the market in the preceding year, a concessionary rate of 0.4% will be applied. For example, if the average per square meter sales unit price in 2010 is RMB14,000, and the market price of a taxable property is less than RMB28,000 per square meter, then the applicable rate would be 0.4%.

Restrictive Quota on New Home Purchases

The third prong of the regulatory trident was forged on January 31, 2011, when the Shanghai government imposed a quota on new home purchases. The quota regulation provides that residential property in Shanghai may not be purchased by: (i) any Shanghai resident household that owns two or more homes prior to the Effective Date, (ii) any non-resident household that owns one or more homes prior to the Effective Date, and (iii) any non-resident household that does not have evidence of its payment of local tax and/or social insurance payment receipts.

The purchase quota is the stiffest measure introduced by the local government in recent history and would appear to have a recognizable impact on sales volume. It remains to be seen whether the quota will remain in place indefinitely or if, due to any number of political and/or economic reasons, the quota will be lifted in the not so distant future. After all, it was only a few years ago, during the 2008 economic crisis, that similar measures were repealed by the government almost overnight in an effort to stimulate what was then a sluggish market sector.

Conclusion

The introduction of the property tax, property purchase quota and the expansion of the business tax signal a clear effort by the government to control what many consider to be an overheated real estate market. It remains to be seen how local authorities will implement the property tax and other recently promulgated policies, and the precise impact they will have on Shanghai’s residential real estate market.