Consumer Behaviour,Corporate Governance

Exposing real estate agent’s role in tax evasion

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New study sheds light on the involvement of real estate agents in tax evasion practices in China’s housing market, calling for regulatory measures and increased transparency

By Pan Jingyi, Principal Writer, China Business Knowledge @ CUHK

In a highly anticipated move, China’s top judicial authorities have recently declared that twin contracts or “yin-yang contracts”, which refer to two documents being produced for the same agreement, as a form of tax evasion. While the country steps up its efforts to combat fraud, the new decision will help prosecutors and judges solve tax-related cases more effectively.

Yin-yang contracts are fairly common in real estate transactions in mainland China. The yin contract contains the actual price of a property that is kept secret from authorities, while the yang contract with a significantly lower price is submitted to local authorities. This practice has faced criticism for distorting property prices and causing conflicts between sellers and buyers, as the official record no longer offers a dependable and precise measure of a property’s value.

“Yin-yang contracts often facilitate tax evasion by allowing for a lower recorded transaction price, which benefits both buyers and sellers financially in the short term.”

Professor Yang Yang

“Yin-yang contracts often facilitate tax evasion by allowing for a lower recorded transaction price, which benefits both buyers and sellers financially in the short term,” says Yang Yang, Assistant Professor at the School of Hotel and Tourism Management at The Chinese University of Hong Kong (CUHK) Business School. “Sellers can avoid higher taxes on capital gains, while buyers can reduce their property taxes and registration fees.”

It is worth noting that yin-yang contracts mostly occur in the resale housing market. Professor Yang observes that such practice is not applicable in new home transactions that involve direct dealings between buyers and developers with no involvement of real estate agencies. “The sales prices of new homes are required to be officially recorded or registered, leaving no room for the existence of dual contracts with discrepant prices, as characteristic of yin-yang contracts,” she says.

Looking through yin and yang

Given the significance of real estate agents in determining the reported price to local registration offices, examining their role in yin-yang contracts and tax evasion is crucial. To address this issue, Professor Yang conducted a study titled The role of agents in fraudulent activities: Evidence from the housing market in Beijing, in collaboration with Professor Sumit Agarwal of the National University of Singapore, Professor Kuang Weida of the Renmin University of China and Professor Wang Long of Fudan University.

The team collected relevant data from the largest real estate brokerage firm in mainland China, including the sales records in the secondary housing market of Beijing from 1 January 2014 to 1 June 2017, along with information on the agents involved in each transaction. Although the primary analysis relies on data from the capital city, the researchers found it reasonable to assume similar prevalence in other major cities in China.

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Closing deals and earning commissions are the main drivers for real estate agents.

The data confirms a widespread practice of yin-yang contracts. More specifically, around 97 per cent of transactions involve such contracts, with the registered price averaging 32 per cent below the actual price. Real estate agents are found to play a significant role in this practice.

So, what motivates agents to create such contracts? Closing deals and earning commissions are the main drivers for real estate agents, making dual contracts quick solutions that benefit buyers and sellers. “There may be a prevailing cultural or societal acceptance of such practices, leading individuals to prioritise immediate gains over potential long-term legal consequences,” says Professor Yang. “Also, the complexities of the real estate market and the limited enforcement of regulations may embolden individuals to take risks.”

The researchers further explored how real estate agents influence the creation of yin-yang contracts and the extent of tax evasion. They first studied whether an agent’s past experience made a difference. As expected, agents with more experience tend to facilitate contracts with a higher level of tax evasion than their inexperienced peers. “Experienced agents could learn from their experience to appraise each district’s guideline price and assist clients in registering relatively lower prices,” Professor Yang explains.

In China, local tax authorities have established minimum price guidelines for second-hand housing transactions in each neighbourhood. Reporting a price slightly higher than the internal guideline helps buyers minimise their tax payments.

The team also explored the role of “peer effects”, which refers to the influences from fellow agents’ behaviours and characteristics. The results confirmed that real estate agents learned from their peers in tax evasion practices.

Different responses to policy adjustments

The involvement of real estate agents in tax evasion then raises a question about its impact on the real estate market. To get an answer, the researchers examined how agents responded to two housing policies that affected the minimum down payment.

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In China, local tax authorities have established minimum price guidelines for second-hand housing transactions in each neighbourhood.

The first policy, introduced by the People’s Bank of China and the Ministry of Finance in March 2015, combined a 30 per cent reduction in minimum down payment for mortgage buyers with a 5.5 per cent decrease in the tax rate for properties held for more than two years. Lower down-payment requirements would shift cash buyers to mortgage, increasing registered prices and reducing tax evasion. On the other hand, mortgage buyers could register their homes at a lower price with yin-yang contracts while still receiving the same loan amount as before, leading to increased tax evasion.

Professor Yang attributes this complex outcome to the dilemma of mortgage buyers. “Cash buyers usually aim to evade taxes by registering the property at a lower price,” she says. “However, mortgage buyers find themselves torn between registering higher prices to secure larger loans from banks and desiring to register lower prices to evade taxes.”

When the minimum down-payment requirement was increased from 30–40 per cent to 35–70 per cent through a policy issued in September 2016, some mortgage buyers could opt to purchase properties with cash instead, which would result in lower registered prices and increased tax evasion. However, among those who still chose to obtain a mortgage, the higher down-payment requirement would compel them to report higher prices for the same loan amount, acting as a deterrent to tax evasion.

The analyses found that experienced real estate agents exacerbated the magnitude of tax evasion during periods of the above policy adjustments. More specifically, agents’ expertise contributed to more tax evasion when minimum down payments were reduced, and the opposite occurred when minimum down payments were increased.

Imposing penalties can help

While the role of agents in fraudulent practices remains poorly understood in existing literature, this research addresses the gap and provides solid empirical evidence. Moreover, the findings can be generalised to other illegal activities involving intermediaries and offer insights into potential solutions.

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“By understanding how intermediaries manipulate transactions to evade regulations and taxes in the real estate market, other industries can learn to identify similar patterns and regulate the behaviour,” Professor Yang says. For instance, regulators in underground banking can search for discrepancies between recorded and actual transactions, similar to those observed in yin-yang contracts.

To effectively deter such illegal activities, Professor Yang suggests imposing penalties on intermediaries, which includes enforcing stricter licensing requirements, implementing financial penalties like fines, and establishing robust monitoring systems. Additionally, enhancing transparency and accountability through mandatory transaction and audits reporting can also contribute.

“Our research underscores the importance of vigilance and regulatory oversight in combating illegal activities facilitated by intermediaries across various industries,” Professor Yang concludes.