ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

The following discussion and analysis of financial condition and results of operations relates to the operations and financial condition reported in the unaudited condensed consolidated financial statements of China HGS Real Estate, Inc. For the three and six months ended March 31, 2020 and 2019 and should be read in conjunction with such financial statements and related notes included in this report.

As used in this report, the terms “Company,” “we,” “our,” “us” and “HGS” refer to China HGS Real Estate, Inc. and its subsidiaries.

Preliminary Note Regarding Forward-Looking Statements.

We make forward-looking statements in Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this report based on the beliefs and assumptions of our management and on information currently available to us. Forward-looking statements include information about our possible or assumed future results of operations which follow under the headings “Business Overview,” “Liquidity and Capital Resources,” and other statements throughout this report preceded by, followed by or that include the words “believes,” “expects,” “anticipates,” “intends,” “plans,” “estimates” or similar expressions.

Forward-looking statements are subject to a number of risks and uncertainties that could cause actual results to differ materially from those expressed in these forward-looking statements, including the risks and uncertainties described below and other factors we describe from time to time in our periodic filings with the U.S. Securities and Exchange Commission (the “SEC”). We therefore caution you not to rely unduly on any forward-looking statements. The forward-looking statements in this report speak only as of the date of this report, and we undertake no obligation to update or revise any forward-looking statement, whether as a result of new information, future developments or otherwise. These forward-looking statements include, among other things, statements relating to:

Business Overview

We conduct substantially all of our business through Shaanxi Guangsha Investment and Development Group Co., Ltd, in Hanzhong, Shaanxi Province. Since the initiation of our business, we have been focused on expanding our business in certain Tier 3 and Tier 4 cities and counties in China.

For the first six months ended March 31, 2020, our sales, gross profit and net loss were $4,194,073, $955,799 and $881,402, respectively, representing an approximate 75.5%, 76.5% and 206.7% decrease in sales, gross profit and net income as compared to six months ended March 31, 2019, respectively. The decrease in sales, gross profit and net income was mainly resulted from less gross floor area (“GFA”) sold during six months ended March 31, 2020 as a result of recent Chinese government curbs designed to cool the Chinese real estate market, which includes but not limit to restriction on home purchase, increase the down-payment requirement against speculative buying, development of low-cost rental housing property to help low-income groups while reducing the demand in the commercial housing market, increase the real estate property tax to discourage speculation, and control of the land supply and slowdown the construction land auction process, etc. In addition, in December 2019, a novel strain of coronavirus (COVID-19) surfaced. COVID-19 has spread rapidly throughout China and worldwide, which has caused significant volatility in the PRC and international markets. There is significant uncertainty around the breadth and duration of business disruptions related to COVID-19, as well as its impact on the PRC and international economies. To reduce the spread of the COVID-19, the Chinese government has employed measures including city lockdowns, quarantines, travel restrictions, suspension of business activities and school closures. Due to difficulties resulting from the COVID-19 outbreak, including, but not limited to, the temporary closure of the Company’s facilities and operations beginning in early February through early March 2020, limited support from the Company’s employees, delayed access to construction raw material supplies, reduced customer visit to the Company’s sales office, and inability to promote the real estate property sales to customers on a timely basis. The COVID-19 outbreak and spread also negatively impacted our operation result for the six months ended March 31, 2020, to certain extent.

For the six months ended March 31, 2020, we did not recognized any revenue under the percentage of completion method because all the real estate project generating revenue has been completed by September 30, 2019 and our current under development projects have not met the criteria for revenue recognition under the percentage of completion method. As a result, we put our focus on selling previously completed commercial and residential units in order to reduce the inventory stockpile during current period and accordingly 100% of our current quarter revenue was recognized under the completed contract method.

Total revenue recognized under the percentage of completion method for the six months ended March 31, 2019 was $16.1 million representing 94.3% of total revenue for the period, with related costs of these real estate sales was $12.6 million, representing 93.3% of the real estate costs in the period. During six months ended March 31, 2019, the gross profit before sales tax from the percentage of completion method was $3.6 million, representing 97.6 of the total gross profit for the same period of last year.

For the six months ended March 31, 2020, the average selling price (“ASP”) for our real estate projects (excluding sales of parking spaces) located in Yang County was approximately $593 per square meter, an increase of 7.9% from the ASP of $549 per square meter for the six months ended March 31, 2019, which was mainly due to more commercial units with higher selling price were sold during the six months ended March 31, 2020. The ASP of our Hanzhong real estate projects (excluding sales of parking spaces) was approximately $544 per square meter for the six months ended March 31, 2020, increased from the ASP of $295 per square meter for the six months ended March 31, 2019, because the Company had few sales of real estate projects in Hangzhou during first half of last year with discounted price.

Market Outlook

The Chinese government is expect to continue implementing the tighten measurement to cool down the real estate market. These measures may include but not limit to restriction on home purchase, increase the down-payment requirement against speculative buying, development of low-cost rental housing property to help low-income groups while reducing the demand in the commercial housing market, increase the real estate property tax to discourage speculation, and control of the land supply and slowdown the construction land auction process, etc. The downward pressure on home sales and prices will be especially obvious in third- and fourth-tier cities, while the property market in the first- and second-tier cities is expected to be resilient.

The Company expects to start the construction of Liangzhou Road related project after the approval by the local government of the road. These projects will comprise of residential for end-users and upgraders, shopping malls as well as serviced apartments and offices to satisfy different market demands.

We intend to remain focused on our existing construction projects in Hanzhong City and Yang County, deepening our institutional sales network, enhancing our cost and operational synergies and improving cash flows and strengthening our balance sheet. In this respect, we began the construction of the following large high rise residential projects in Hanzhong City and Yang County:

In December 2019, a novel strain of coronavirus (COVID-19) surfaced. COVID-19 has spread rapidly to many parts of the PRC and other parts of the world in the first quarter of 2020, which has caused significant volatility in the PRC and international markets. There is significant uncertainty around the breadth and duration of business disruptions related to COVID-19, as well as its impact on the PRC and international economies and, as such, the Company is unable to determine if it will have a material impact to its operations.

Based on current economic environment, customer demand and sales trend, and the negative impact from COVID-19 outbreak and spread, we believe that the real estate market downturn will continue to be uncertain in the coming months.

Liangzhou road and related projects

In September 2013, the Company entered into an agreement ("Liangzhou Agreement") with the Hanzhong local government on the Liangzhou Road reformation and expansion project (Liangzhou Road Project"). Pursuant to the agreement, the Company is contracted to reform and expand the Liangzhou Road, a commercial street in downtown Hanzhong City, with a total length of 2,080 meters and width of 30 meters and to resettle the existing residences in the Liangzhou road area. The government's original road construction budget was approximately $33 million in accordance with the Liangzhou Agreement. The Company, in return, is being compensated by the local government to have an exclusive right on acquiring at least 394.5 Mu land use rights in a specified location of Hanzhong City. The Liangzhou Road Project's road construction started at the end of 2013. In 2014, the original scope and budget on the Liangzhou road reformation and expansion project was extended, because the local government included more area and resettlement residences into the project, which resulted in additional investments from the Company. In return, the Company is authorized by the local government to develop and manage the commercial and residential properties surrounding the Liangzhou Road project. As of March 31, 2020, the main Liangzhou road construction is substantially completed, due to the complicated multiple level of government review process, the Company expected to the government's acceptance to be completed before the end of fiscal 2020. Due to historical delays in government approval and acceptance, the Company included such balance in real estate property under development as non-current assets.

As of March 31, 2020, the actual costs incurred by the Company was $151,261,464 (September 30, 2019 - $146,958,903) and the incremental cost related to residence resettlement was approved by the local government. The Company determined that the Company’s Investment in Liangzhou Road Project in exchange for interests in future land use rights is a barter transaction with commercial substance.

The Liangzhou Road related projects mainly consists Oriental Garden Phase II, Liangzhou Mansion and Pearl Commercial Plaza surrounding the Liangzhou road area:

Oriental Pearl Garden Phase II

Oriental Garden Phase II project is planned to consist of 8 high-rise residential buildings and 6 commercial buildings with total planned GFA of 370,298 square meters. The project will also include a farmer’s market.

Liangzhou Mansion

Liangzhou Mansion project is planned to consist of 7 high-rise building and commercial shops on the first floor with total planned GFA of 160,000 square meters.

Pearl Commercial Plaza

Pearl Commercial Plaza is planned to consist one office building, one service apartment (or hotel), classical architecture style of Chinese traditional houses and shopping malls with total planned GFA of 124,191 square meters.

The Company plans to start the construction of these three real estate projects in 2020 after the road construction is fully completed and passes local government’s inspection and approval. These related projects may take 2-3 years to fully complete.

Road Construction

Other road construction projects mainly included a Yang County East 2nd Ring Road construction project. The Company was engaged by the Yang County local government to construct the East 2nd Ring Road with a total length of 2.15 km and a budgeted price of approximately $23.7 million (or RMB 168 million), which was approved by the local Yang County government in March 2014. The local government is required to repay the Company’s project investment costs within 3 years with interest at the interest rate based on the commercial borrowing rate with the similar term published by China construction bank (March 31, 2020 and September 30, 2019 - 4.75%). The local government has approved a refund to the Company by reducing local surcharges or taxes otherwise required in the real estate development. The road construction was substantially completed as of March 31, 2020 and in process of government review and approval.

In September 2012, the Company was approved by the Hanzhong local government to construct four municipal roads with a total length of approximately 1,192 meters. The project was deferred and then restarted during the quarter ended March 31, 2014. As of March 31, 2020, the local government was still in the process of assessing the budget for these projects.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires us to make estimates and judgments that affect our reported assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate our estimates on an on-going basis and use them on historical experience and various other assumptions that are believed to be reasonable under the circumstances as the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates because of different assumptions or conditions.

We believe the following critical accounting policies affect our significant estimates and judgments used in the preparation of our condensed consolidated financial statements. These policies should be read in conjunction with Note 2 of the notes to unaudited condensed consolidated financial statements.

Revenue recognition

Most of the Company’s revenue is derived from real estate sales of condominiums and commercial property in the PRC. The majority of the Company’s contracts contain a single performance obligations involving significant real estate development activities that are performed together to deliver a real estate property to customers. Revenues arising from real estate sales are recognized when or as the control of the asset is transferred to the customer. The control of the asset may transfer over time or at a point in time. For the sales of individual condominium units in a real estate development project, the Company has an enforceable right to payment for performance completed to date, revenue is recognized over time by measuring the progress towards complete satisfaction of that performance obligation. Otherwise, revenue is recognized at a point in time when the customer obtains control of the asset.

Under percentage completion method, revenue and profit from the sales of long term real estate development properties is recognized by the percentage of completion method on the sale of individual units when all the following criteria are met:

If any of the above criteria is not met, proceeds shall be accounted for as deposits until the criteria are met.

Under the percentage of completion method, revenues from individual real estate condominium units sold and related costs are recognized over the course of the construction period, based on the completion progress of a project. The progress towards complete satisfaction of the performance obligation is measured based on the Company’s efforts or inputs to the satisfaction of the performance obligation, by reference to the contract costs incurred up to the end of reporting period as a percentage of total estimated costs for each contract. In relation to any project, revenue is determined by calculating the ratio of incurred costs, including land use rights costs and construction costs, to total estimated costs and applying that ratio to the contracted sales amounts. Cost of sales is recognized by determining the ratio of contracted sales during the period to total estimated sales value, and applying that ratio to the incurred costs. Current period amounts are calculated based on the difference between the life-to-date project totals and the previously recognized amounts.

Any changes in significant judgments and/or estimates used in determining construction and development revenue could significantly change the timing or amount of construction and development revenue recognized. Changes in total estimated project costs or losses, if any, are recognized in the period in which they are determined.

Revenue from the sales of completed real estate condominium units is recognized at the time of the closing of an individual unit sale. This occurs when the customer obtains the physical possession, the legal title, or the significant risks and rewards of ownership of the assets and the Company has present right to payment and the collection of the consideration is probable. For municipal road construction projects, fees are generally recognized at the time of the projects are completed.

Contract balances

Timing of revenue recognition may differ from the timing of billing and cash receipts from customers. The Company records a contract asset when revenue is recognized prior to invoicing, or a contract liability when cash is received in advance of recognizing revenue. A contract asset is a right to consideration that is conditional upon factors other than the passage of time. Contract assets include billed and billable receivables, which are the Company’s unconditional rights to consideration other than to the passage of time. Contract liabilities include cash collected in excess of revenues. Customer deposit are excluded from contract liabilities.

The Company has elected to apply the optional practical expedient for costs to obtain a contract which allows the Company to immediately expense sales commissions (included under selling expenses) because the amortization period of the asset that the Company otherwise would have used is one year or less. Contract assets and liabilities are generally classified as current based on our contract operating cycle.

The Company provides “mortgage loan guarantees” only with respect to buyers who make down-payments of 20%-50% of the total purchase price of the property. The period of the mortgage loan guarantee begins on the date the bank approves the buyer’s mortgage and we receive the loan proceeds in our bank account and ends on the date the “Certificate of Ownership” evidencing that title to the property has been transferred to the buyer. The procedures to obtain the Certificate of Ownership take six to twelve months (the “Mortgage Loan Guarantee Period”). If, after investigation of the buyer’s income and other relevant factors, the bank decides not to grant the mortgage loan, our mortgage-loan based sales contract terminates and there will be no guarantee obligation. If, during the Mortgage Loan Guarantee Period, the buyer defaults on his or her monthly mortgage payment for three consecutive months, we are required to return the loan proceeds back to the bank, although we have the right to keep the customer's deposit and resell the property to a third party. Once the Certificate of Property has been issued by the relevant government authority, our loan guarantee terminates. If the buyer then defaults on his or her mortgage loan, the bank has the right to take the property back and sell it and use the proceeds to pay off the loan. The Company is not liable for any shortfall that the bank may incur in this event. To date, no buyer has defaulted on his or her mortgage payments during the Mortgage Loan Guarantee Period and the Company has not returned any loan proceeds pursuant to its mortgage loan guarantees.

Use of estimates

 The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes, and disclosure of contingent liabilities at the date of the consolidated financial statements. Estimates are used for, but not limited to, the assumptions and estimates used by management in recognizing development revenue under the percentage of completion method, the selection of the useful lives of property and equipment, provision necessary for contingent liabilities, revenue recognition, taxes and budgeted costs. Management believes that the estimates utilized in preparing its consolidated financial statements are reasonable and prudent. Actual results could differ from these estimates.

Real estate property development completed and under development

Real estate property consists of finished residential unit sites, commercial offices and residential unit sites under development. The Company leases the land for the residential unit sites under land use right leases with various terms from the PRC government. The cost of land use rights is included in the development cost and allocated to each project. Real estate property development completed and real estate property under development are stated at the lower of cost or fair value.

Expenditures for land development, including cost of land use rights, deed tax, pre-development costs, and engineering costs, exclusive of depreciation, are capitalized and allocated to development projects by the specific identification method. Costs are allocated to specific units within a project based on the ratio of the sales area of units to the estimated total sales area of the project (or phase of the project) multiplied by the total cost of the project (or phase of the project).

Cost of amenities transferred to buyers is allocated to specific units as a component of total construction cost. The amenity cost includes landscaping, road paving, etc. Once the projects are completed, the amenities are under control of the property management companies.

Real estate property development completed and real estate property under development are reclassified on the balance sheet into current and non-current portions based on the estimated date of construction completion and sales. The real estate property development completed classification is based on the estimated date that each property is expected to be sold within the Company’s normal operating cycle of the business and the Company’s sales plan. Real estate property development completed is classified as a current asset if the property is expected to be sold within the normal operating cycle of the business. Otherwise, it is classified as a non-current asset. The majority of real estate projects the Company has completed in the past were multi-layer or sub-high-rise real estate projects. The Company considers its normal operating cycle is 12 months.

Real estate property development completed and under development are subject to valuation adjustments when the carrying amount exceeds fair value. An impairment loss is recognized only if the carrying amount of the assets is not recoverable and exceeds fair value. The carrying amount is not recoverable if it exceeds the sum of the undiscounted cash flows expected to be generated by the assets. The Company reviewed all of its real estate projects for future losses and impairment by comparing the estimated future undiscounted cash flows for each project to the carrying value of such project.

RESULTS OF OPERATIONS

Three Months Ended March 31, 2020 compared to Three Months Ended March 31, 2019

Revenue recognized for completed condominium real estate projects 

The following table summarizes our revenue generated by different projects:

Our revenues are derived from the sale of residential buildings, commercial store-fronts and parking spaces in projects that we have developed. Comparing to the same period of last year, revenues before sales tax increased by 733.5% to approximately $1.9 million for the three months ended March 31, 2020 from approximately $0.2 million. The total GFA sold during three months ended March 31, 2020 was merely 3,266 square meters, representing a significant increase from the 611 square meters completed and sold during the same period of last year. In addition, our Mingzhu Garden Phase I and Phase II, Yangzhou Pearl Garden Phase I and Phase II and Oriental Garden Phase I have all been completed in prior years, only limited models are available for customer selection, which resulted in limited sales. The sales tax for the three months ended March 31, 2020 was approximately $0.03 million, decreased by 41% from the same period of 2019, due less surcharge tax charged for the completed real estate properties during the three months ended March 31, 2020.

Revenue recognized for condominium real estate projects under development

We started to recognize revenue under the percentage of completion method for Yangzhou Palace real estate project since second quarter of fiscal 2017. For the three months ended March 31, 2020, there was no revenue recognized under the percentage of completion method, because Yangzhou Palace real estate project was completed by September 30, 2019 and our other projects under development as of March 31, 2020 have not met the criteria for revenue recognition under the percentage of completion method.

For the three months ended March 31, 2019, the Company recognized $9,140,425 revenue from Yangzhou Palace real estate project.

Our cost of sales consists primarily of costs associated with land use rights and construction costs. Cost of sales are capitalized and allocated to development projects using a specific identification method. Costs are allocated to specific units within a project based on the ratio of the sales area of units to the estimated total sales area of the project or phase of the project times the total cost of the project or phase of the project.

Cost of sales was approximately $1.5 million for the three months ended March 31, 2020 compared to $7.6 million for the same period of last year. The $6.1 million decrease in cost of sales was mainly attributable to less GFA sold during the three months ended March 31, 2020 which led to less cost of sales.

Land use rights cost: The cost of land use rights includes the land premium we pay to acquire land use rights for our property development sites, plus taxes. Our land use rights cost varies for different projects according to the size and location of the site and the minimum land premium set for the site, all of which are influenced by government policies, as well as prevailing market conditions. Costs for land use rights for the three months ended March 31, 2020 were approximately $0.13 million, as compared to approximately $0.7 million for the three months ended March 31, 2019, representing a decrease of approximately $0.6 million from the same quarter last year. The decrease was consistent with the fact that total GFA sold in this quarter was significantly less than the same period of last year. 

Construction cost: We outsource the construction of all of our projects to third party contractors, whom we select through a competitive tender process. Our construction contracts provide a fixed payment which covers substantially all labor, materials and equipment costs, subject to adjustments for some types of excess, such as design changes during construction or changes in government-suggested steel prices. Our construction costs consist primarily of the payments to our third-party contractors, which are paid over the construction period based on specified milestones. In addition, we purchase and supply a limited range of fittings and equipment, including elevators, window frames and door frames. Our construction costs for the three months ending March 31, 2020 were approximately $1.3 million as compared to approximately $6.8 million for the same period of last year, representing a decrease of approximately $5.5 million. The decrease in construction cost was due to decrease in units sold during the quarter ended March 31, 2020.

Gross Profit

Gross profit was approximately $0.4 million for the three months ended March 31, 2020 as compared to approximately $1.4 million for the three months ended March 31, 2019, representing a decrease of $1.0 million, which was mainly attributable to less GFA sold during the current quarter of fiscal 2020. The gross margin increased from 15.5% in the second quarter of fiscal 2019 to 21.0% in second quarter of fiscal 2020. It was mainly due to growing real estate price in the Hanzhong city and Yang County during the first half of fiscal 2020. For the first half of fiscal 2020, the ASP for our real estate projects (excluding sales of parking spaces) located in Yang County was approximately $593 per square meter, an increase of 7.9% from the ASP of $549 per square meter for the same period of fiscal 2019, which was mainly due to more commercial units with higher selling price were sold during the first half of fiscal 2020. The ASP of our Hanzhong real estate projects (excluding sales of parking spaces) was approximately $544 per square meter, increased from the ASP of $295 per square meter for the same period of last year, because the Company had few sales of real estate projects in Hangzhou during first half of last year with discounted price.

Operating Expenses

Total operating expenses increased by 14.8% to approximately $1.0 million for the three months ended March 31, 2020 from $0.9 million for the three months ended March 31, 2019, primarily as a result of an increase in selling expense of $0.1 million due to more marketing activities for the three months ended March 31, 2020. Our general and administrative expense was approximately $0.8 million for the three months ended March 31, 2020, increased by $0.04 million from the three months ended March 31, 2019 due to more office expenses and professional fee expenses. Our total operating expenses accounted for 54.0% and 9.5% of our real estate sales before sales taxes for the three months ended March 31, 2020 and 2019, respectively.

Income Taxes

U.S. Taxes

China HGS is a Florida corporation. However, all of our operations are conducted solely by our subsidiaries in the PRC. No income is earned in the United States and we do not repatriate any earnings outside the PRC. As a result, we did not generate any U.S. taxable income for the three months ended March 31, 2020 and 2019.

Recent U.S. federal tax legislation, commonly referred to as the Tax Cuts and Jobs Act (the “U.S. Tax Reform”), was signed into law on December 22, 2017. The U.S. Tax Reform significantly modified the U.S. Internal Revenue Code by, among other things, reducing the statutory U.S. federal corporate income tax rate from 35% to 21% for taxable years beginning after December 31, 2017; limiting and/or eliminating many business deductions; migrating the U.S. to a territorial tax system with a one-time transition tax on a mandatory deemed repatriation of previously deferred foreign earnings of certain foreign subsidiaries; subject to certain limitations, generally eliminating U.S. corporate income tax on dividends from foreign subsidiaries; and providing for new taxes on certain foreign earnings. Taxpayers may elect to pay the one-time transition tax over eight years or in a single lump sum. The U.S. Tax Reform also includes provisions for a new tax on GILTI effective for tax years of foreign corporations beginning after December 31, 2017. The GILTI provisions impose a tax on foreign income in excess of a deemed return on tangible assets of controlled foreign corporations (“CFCs”), subject to the possible use of foreign tax credits and a deduction equal to 50 percent to offset the income tax liability, subject to some limitations.

As of March 31, 2020 and September 30, 2019 the Company accrued a one-time transition toll tax of approximately $2.3 million that represented management’s estimate of the amount of U.S. corporate income tax based on the deemed repatriation to the United States of the Company’s share of previously deferred earnings of certain non-U.S. subsidiaries and VIE of the Company mandated by the U.S. Tax Reform. The Company’s estimate of the onetime transition toll Tax is subject to the finalization of management’s analysis related to certain matters, such as developing interpretations of the provisions of the Tax Act and amounts related to the earnings and profits of certain foreign VIEs and the filing of our tax returns. U.S. Treasury regulations, administrative interpretations or court decisions interpreting the Tax Act may require further adjustments and changes in our estimates. The Company provided an additional $0.9 million tax provision due to delinquent U.S. tax return fillings.

PRC Taxes

Our Company is governed by the Enterprise Income Tax Law of the People’s Republic of China concerning private-run enterprises, which are generally subject to tax at a statutory rate of 25% on income reported in the statutory financial statements after appropriate tax adjustments.

However, the local taxing authority of Hanzhong City has the power to assess corporate taxes annually on local enterprises at a pre-determined fixed rate as an incentive to stimulate the local economy and encourage entrepreneurship. In the fiscal year 2017, the taxing authority assessed us for income taxes at the rate of 1.25% on revenue in Yang County and 2.5% on our revenue in Hanzhong, instead of the statutory rate of 25% of net income. Starting from fiscal 2019, the Company is subject to income tax rate of 25% on taxable income. The change in the income tax policy could negatively affect the Company’s net income in future years. Although the possibility exists for reinterpretation of the application of the tax regulations by higher tax authorities in the PRC, potentially overturning the decision made by the local tax authority, the Company has not experienced any reevaluation of the income taxes for prior years. The PRC tax rules are different from the local tax rules and the Company is required to comply with local tax rules. The difference between the two tax rules will not be a liability of the Company. There will be no further tax payments for the difference.

Net Loss

We reported net loss of approximately $0.6 million for the three months ended March 31, 2020, as compared to net income of approximately $0.3 for the three months ended March 31, 2019. The decrease of approximately $1.0 million in our net income was primarily due to lower amount of revenue for the three months ended March 31, 2020 as discussed above under Revenues and Gross Profit.

Other Comprehensive Income (loss)

We operate primarily in the PRC and the functional currency of our operating subsidiary is the Chinese Renminbi (”RMB”).   RMB is not freely convertible into foreign currency and all foreign exchange transactions must take place through authorized institutions. No representation is made that RMB amounts could have been, or could be, converted into USD at the rates used in translation.

Translation adjustments resulting from this process amounted to loss of $2.8 million and gain of $4.1 million for the three months ended March 31, 2020 and 2019, respectively, due to the significant fluctuation of RMB during the period. The balance sheet amounts with the exception of equity at March 31, 2020 were translated at 7.0808 RMB to 1.00 USD as compared to 7.1477 RMB to 1.00 USD at September 30, 2019. The equity accounts were stated at their historical rate. The average translation rates applied to the income statements accounts for the periods ended March 31, 2020 and 2019 were 7.0117 RMB and 6.8302 RMB, respectively.

 Six Months Ended March 31, 2020 compared to Six Months Ended March 31, 2019

Revenue recognized for completed condominium real estate projects 

The following table summarizes our revenue generated by different projects:

Our revenues are derived from the sale of residential buildings, commercial store-fronts and parking spaces in projects that we have developed. Comparing to the same period of last year, revenues before sales tax increased by 329.5% to approximately $4.2 million for the six months ended March 31, 2020 from approximately $1.0 million in the same period of last year. The total GFA sold during six months ended March 31, 2020 was merely 7,173 square meters, representing a significant increase from the 3,342 square meters completed and sold during the same period of last year. As of March 31, 2020, our Mingzhu Garden Phase I and Phase II, Yangzhou Pearl Garden Phase I and Phase II and Oriental Garden Phase I have all been completed in prior years, only limited models are available for customer selection, which resulted in lower sales for current period. The sales tax for the six months ended March 31, 2020 was approximately $0.07 million, decreased by 46.4% from the same period of 2019, due less surcharge tax charged for the completed real estate properties during the six months ended March 31, 2020.

Revenue recognized for condominium real estate projects under development

We started to recognize revenue under the percentage of completion method for Yangzhou Palace real estate project since second quarter of fiscal 2017. For the six months ended March 31, 2020, there was no revenue recognized under the percentage of completion method, because Yangzhou Palace real estate project was completed by September 30, 2019 and our other projects under development as of March 31, 2020 have not met the criteria for revenue recognition under the percentage of completion method.

For the six months ended March 31, 2019, the Company recognized $16,127,788 revenue from Yangzhou Palace real estate project.

Revenue recognized for condominium real estate projects under development

Our cost of sales consists primarily of costs associated with land use rights and construction costs. Cost of sales are capitalized and allocated to development projects using a specific identification method. Costs are allocated to specific units within a project based on the ratio of the sales area of units to the estimated total sales area of the project or phase of the project times the total cost of the project or phase of the project.

Cost of sales was approximately $3.2 million for the six months ended March 31, 2020 compared to $13.5 million for the same period of last year. The $10.3 million decrease in cost of sales was mainly attributable to less GFA sold during the six months ended March 31, 2020 which led to less cost of sales.

Land use rights cost: The cost of land use rights includes the land premium we pay to acquire land use rights for our property development sites, plus taxes. Our land use rights cost varies for different projects according to the size and location of the site and the minimum land premium set for the site, all of which are influenced by government policies, as well as prevailing market conditions. Costs for land use rights for the six months ended March 31, 2020 were approximately $0.3 million, as compared to approximately $1.3 million for the six months ended March 31, 2019, representing a decrease of approximately $1.0 million from the same period of last year. The decrease was consistent with the fact that total GFA sold in the first six months 2020 was significantly less than the same period of last year. 

Construction cost: We outsource the construction of all of our projects to third party contractors, whom we select through a competitive tender process. Our construction contracts provide a fixed payment which covers substantially all labor, materials and equipment costs, subject to adjustments for some types of excess, such as design changes during construction or changes in government-suggested steel prices. Our construction costs consist primarily of the payments to our third-party contractors, which are paid over the construction period based on specified milestones. In addition, we purchase and supply a limited range of fittings and equipment, including elevators, window frames and door frames. Our construction costs for the six months ending March 31, 2020 were approximately $2.9 million as compared to approximately $12.1 million for the same period of last year, representing a decrease of approximately $9.3 million. The decrease in construction cost was due to decrease in units sold during the first half of fiscal 2020.

Gross Profit

Gross profit was approximately $1.0 million for the six months ended March 31, 2020 as compared to approximately $3.1 million for the six months ended March 31, 2019, representing a decrease of $2.2 million, which was mainly attributable to less GFA sold during the first half of fiscal 2020. The gross margin increased from 18.2% in the first half of fiscal 2019 to 22.8% in first half of fiscal 2020. It was mainly due to growing real estate price in the Hanzhong city and Yang County during the first half of fiscal 2020. For the first half of fiscal 2020, the ASP for our real estate projects (excluding sales of parking spaces) located in Yang County was approximately $593 per square meter, an increase of 7.9% from the ASP of $549 per square meter for the same period of fiscal 2019, which was mainly due to more commercial units with higher selling price were sold during the first half of fiscal 2020. The ASP of our Hanzhong real estate projects (excluding sales of parking spaces) was approximately $544 per square meter, increased from the ASP of $295 per square meter for the same period of last year, because the Company had few sales of real estate projects in Hangzhou during first half of last year with discounted price.

The following table sets forth the gross margin of each of our projects:

Operating Expenses

Total operating expenses were approximately $1.8 million and $1.5 million for both the six months ended March 31, 2020 and 2019, respectively. The increase in selling expenses of $0.1 million for six months ended March 31, 2020 was primarily attributed to higher marketing activities costs. The increase in general administration expense of $0.2 million for the six months ended March 31, 2020 was primarily attributed to more office expenses and professional fee expenses incurred. Our total operating expenses accounted for 43.1% and 8.9% of our real estate sales before sales taxes for the six months ended March 31, 2020 and 2019, respectively.

Income Taxes

U.S. Taxes

China HGS is a Florida corporation. However, all of our operations are conducted solely by our subsidiaries in the PRC. No income is earned in the United States and we do not repatriate any earnings outside the PRC. As a result, we did not generate any U.S. taxable income for the six months ended March 31, 2020 and 2019.

Recent U.S. federal tax legislation, commonly referred to as the Tax Cuts and Jobs Act (the “U.S. Tax Reform”), was signed into law on December 22, 2017. The U.S. Tax Reform significantly modified the U.S. Internal Revenue Code by, among other things, reducing the statutory U.S. federal corporate income tax rate from 35% to 21% for taxable years beginning after December 31, 2017; limiting and/or eliminating many business deductions; migrating the U.S. to a territorial tax system with a one-time transition tax on a mandatory deemed repatriation of previously deferred foreign earnings of certain foreign subsidiaries; subject to certain limitations, generally eliminating U.S. corporate income tax on dividends from foreign subsidiaries; and providing for new taxes on certain foreign earnings. Taxpayers may elect to pay the one-time transition tax over eight years or in a single lump sum. The U.S. Tax Reform also includes provisions for a new tax on GILTI effective for tax years of foreign corporations beginning after December 31, 2017. The GILTI provisions impose a tax on foreign income in excess of a deemed return on tangible assets of controlled foreign corporations (“CFCs”), subject to the possible use of foreign tax credits and a deduction equal to 50 percent to offset the income tax liability, subject to some limitations.

As of March 31, 2020 and September 30, 2019 the Company accrued a one-time transition toll tax of approximately $2.3 million that represented management’s estimate of the amount of U.S. corporate income tax based on the deemed repatriation to the United States of the Company’s share of previously deferred earnings of certain non-U.S. subsidiaries and VIE of the Company mandated by the U.S. Tax Reform. The Company’s estimate of the onetime transition toll Tax is subject to the finalization of management’s analysis related to certain matters, such as developing interpretations of the provisions of the Tax Act and amounts related to the earnings and profits of certain foreign VIEs and the filing of our tax returns. U.S. Treasury regulations, administrative interpretations or court decisions interpreting the Tax Act may require further adjustments and changes in our estimates. The Company provided an additional $0.9 million tax provision due to delinquent U.S. tax return fillings.

PRC Taxes

Our Company is governed by the Enterprise Income Tax Law of the People’s Republic of China concerning private-run enterprises, which are generally subject to tax at a statutory rate of 25% on income reported in the statutory financial statements after appropriate tax adjustments.

However, the local taxing authority of Hanzhong City has the power to assess corporate taxes annually on local enterprises at a pre-determined fixed rate as an incentive to stimulate the local economy and encourage entrepreneurship. In the fiscal year 2017, the taxing authority assessed us for income taxes at the rate of 1.25% on revenue in Yang County and 2.5% on our revenue in Hanzhong, instead of the statutory rate of 25% of net income. Starting from fiscal 2019, the Company is subject to income tax rate of 25% on taxable income. The change in the income tax policy could negatively affect the Company’s net income in future years. Although the possibility exists for reinterpretation of the application of the tax regulations by higher tax authorities in the PRC, potentially overturning the decision made by the local tax authority, the Company has not experienced any reevaluation of the income taxes for prior years. The PRC tax rules are different from the local tax rules and the Company is required to comply with local tax rules. The difference between the two tax rules will not be a liability of the Company. There will be no further tax payments for the difference.

Net Income (Loss)

We reported net loss of approximately $0.9 million for the six months ended March 31, 2020, as compared to net income of approximately $0.8 million for the six months ended March 31, 2019. The decrease of $1.7 million in our net income was primarily due to lower amount of revenue for the six months ended March 31, 2020 as discussed above under Revenues and Gross Profit

Other Comprehensive Income (Loss)

We operate primarily in the PRC and the functional currency of our operating subsidiary is the Chinese Renminbi (”RMB”).   RMB is not freely convertible into foreign currency and all foreign exchange transactions must take place through authorized institutions. No representation is made that RMB amounts could have been, or could be, converted into USD at the rates used in translation.

Translation gain adjustments resulting from this process amounted to $1.6 million and $3.9 million for the six months ended March 31, 2020 and 2019, respectively, due to the significant fluctuation of RMB during the period. The balance sheet amounts with the exception of equity at March 31, 2020 were translated at 7.0808 RMB to 1.00 USD as compared to 7.1477 RMB to 1.00 USD at September 30, 2019. The equity accounts were stated at their historical rate. The average translation rates applied to the income statements accounts for the periods ended March 31, 2020 and 2019 were 7.0117 RMB and 6.8302 RMB, respectively.

Liquidity and Capital Resources

Our principal need for liquidity and capital resources is to maintain working capital sufficient to support our operations and to make capital expenditures to finance the growth of our business. Historically we mainly financed our operations primarily through cash flows from operations and borrowings from our principal shareholder.

For the recent years, the Chinese government has implemented measures to control overheating residential and commercial property prices including but not limited to restriction on home purchase, increase the down-payment requirement against speculative buying, development of low-cost rental housing property to help low-income groups while reducing the demand in the commercial housing market, increase the real estate property tax to discourage speculation, and control of the land supply and slowdown the construction land auction process, etc. In addition, in December 2019, a novel strain of coronavirus (COVID-19) surfaced. COVID-19 has spread rapidly throughout China and worldwide, which has caused significant volatility in the PRC and international markets. There is significant uncertainty around the breadth and duration of business disruptions related to COVID-19, as well as its impact on the PRC and international economies. To reduce the spread of the COVID-19, the Chinese government has employed measures including city lockdowns, quarantines, travel restrictions, suspension of business activities and school closures. Due to difficulties resulting from the COVID-19 outbreak, including, but not limited to, the temporary closure of the Company’s facilities and operations beginning in early February through early March 2020, limited support from the Company’s employees, delayed access to construction raw material supplies, reduced customer visit to the Company’s sales office, and inability to promote the real estate property sales to customers on a timely basis, and our revenue decreased by approximately $12.9 million during the first half of fiscal 2020 as compared to the same period of 2019 due to decreased sales volume of both residential and commercial properties developed by us, as a result, we reported a net loss of approximately $0.9 million for the six months ended March 31, 2020. In addition, as of March 31, 2020, we had an approximately $139.9 million working capital deficit. The deficit increased by $110.2 million as compared to a deficit of $29.7 million as of September 30, 2019. Based on assessment of current economic environment, customer demand and sales trend, and the negative impact from COVID-19 outbreak and spread, we believe that the real estate market downturn will continue to be uncertain in the coming months and we may not be able to liquidate our large balance of completed real estate property within the next 12 months as we originally expected. Therefore, approximately $96.9 million completed real estate property originally sitting under our current assets as of September 30, 2019 has been reclassified as non-current assets as of March 31, 2020. In addition, as of March 31, 2020, we had large construction loans payable balance of approximately $88.3 million with maturity less than one year and large accounts payable balance of approximately $27.7 million to be paid to subcontractors within one year. These factors led to our working capital deficit of approximately $139.9 million as of March 31, 2020. The above mentioned facts raised substantial doubt about the Company's ability to continue as a going concern for the next 12 months from the date of this filing.

In assessing its liquidity, management monitors and analyzes the Company’s cash on-hand, its ability to generate sufficient revenue sources in the future, and its operating and capital expenditure commitments. As of March 31, 2020, our total cash and restricted cash balance increased to approximately $4.5 million as compared to approximately $4.2 million as of September 30, 2019. With respect to capital funding requirements, the Company budgeted our capital spending based on ongoing assessments of needs to maintain adequate cash. As of March 31, 2020, we had approximately $111.9 million construction completed residential apartments and commercial units available for instant sales to potential buyers when needed (including approximately $13.9 million current portion and approximately $98.0 million non-current portion of real estate property development completed). For the current portion of $13.9 million completed residential apartments and commercial units, we estimate we will be able to substantially sell them within one year to generate cash to be used in our operations and funding our other real estate projects under development. Although we reported approximately $27.7 million accounts payable as of March 31, 2020, due to the long term relationship with our construction suppliers and subcontractors, we were able to effectively manage cash spending on construction and negotiate with them to adjust the payment schedule based on our cash on hand. In addition, most of our existing real estate development projects related to old town renovation which are supported by local government. As of March 31, 2020, we reported approximately $88.3 million short-term construction loans and approximately $17.4 million long-term construction loans borrowed from financial institutions controlled by local government and such loans can only be used on old town renovation related project development. We expect that we will be able to renew all of the existing construction loans upon their maturity and borrow additional new loans from local financial institutions when necessary, based on our past experience and the Company’s good credit history. Also, the Company’s cash flows from pre-sales and current sales should provide financial support for our current developments and operations. As of March 31, 2020, we had approximately $19.6 million customer deposits (including approximately $18.6 million short-term and approximately $1 million non-current customer deposits) representing cash advance from buyers for pre-sales of our residential units and we believe such cash advance can be used to fund our ongoing construction projects whenever necessary. As of March 31, 2020, we had five large ongoing construction projects which are currently under preliminary development stage due to delayed inspection and acceptance of the development plans by local government. We expect we will be able to obtain government’s approval of the development plans on these projects by before the end of fiscal year 2020, and start the pre-sale of the real estate property to generate cash when certain property development niches have been achieved. For the six months ended March 31, 2020 and 2019, the Company had positive cash flow from operating activities. In addition, our principal shareholder, Mr. Xiaojun Zhu has been providing and will continue to provide his personal funds to support the Company’s operation whenever necessary.

Amid the COVID-19 outbreak and spread, we have resumed our business activities in early March 2020 and we expect the negative impact of the COVID-19 coronavirus outbreak on our business to be temporary and our sales activities have started to run as normal, which will help us to increase our real estate proper sales in the upcoming months.

Due to the effects of the outbreak of COVID-19 discussed above, to the extent that we experience a more adverse operating environment, incur unanticipated capital expenditures, or if we decide to accelerate our growth, then additional financing may be required. Currently, we are working to improve our liquidity and capital sources primarily through financial support from our principal shareholder and debt or equity financing. In order to fully implement our business plan and sustain continued growth, we may also need to raise capital from outside investors. Our expectation, therefore, is that we will seek to access the capital markets in both the U.S. and China to obtain the funds as needed. At the present time, however, we do not have commitments of funds from any third party. No assurance can be given that additional financing, if required, would be available on favorable terms or at all.

Based on above reasons, there is a substantial doubt about the Company's ability to continue as a going concern for the next 12 months from the date of this filing.

Operating Activities

Net cash provided by operating activities during the six months ended March 31, 2020 was approximately $2.4 million, consisting of net loss of approximately $0.9 million and net changes in our operating assets and liabilities, which mainly included a decrease in real estate property completed by approximately $2.9 million due to sales of our Yangzhou Palace project, a collection of security deposit of $3.2 million and an increase in customer deposit received of $2.3 million, offset by additional spending in real estate under development of $2.8 million and payments of accrued expense and tax payable in aggregated of approximately $2.1 million.

Net cash provided by operating activities during the six months ended March 31, 2019 was approximately $7.5 million, consisting of net income of approximately $0.8 million, noncash adjustments of $0.4 million and net changes in our operating assets and liabilities, which mainly included a decrease in real estate property under development by approximately $8.6 million due to sales of our Yang County Palace project and a decrease of approximately $1.3 million in contract receivable due to collection, offset with a decrease in customer deposit of approximately $3.0 million and reduced tax payable by $1.2 million due to tax payments made.

Financing Activities

Net cash flows used in financing activities was approximately $2.1 million for six months ended March 31, 2020, which due to a repayment of construction loans of approximately $2.1 million during the six months ended March 31, 2020.

Net cash flows used in financing activities was approximately $9.2 million for six months ended March 31, 2019, which mainly included a repayment of construction loans of approximately $9.2 million during the six months ended March 31, 2019.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements.

Inflation

Inflation has not had a material impact on our business and we do not expect inflation to have a material impact on our business in the near future.