Joint Ventures And The Economic Downturn: Things To Consider
- Joint ventures are an efficient way of bringing new investors into an existing project, but only if carefully planned and documented.
In the current economic downturn a number of property developers are faced with having to either sell projects or bring on board a new participant to steady a project's finances and help fund completion of the project.
With billions of dollars of property currently on the market and prices falling, developers are of course reluctant to put their projects up for sale in this softening market.
Other developers may wish to share the risks associated with a project or link with a cashed-up investor who see opportunities in the current market.
These scenarios are leading to new joint ventures of existing property development projects. However, each joint venture should be structured to take account factors such as ownership of project assets, finance requirements, tax/stamp duty and pricing and profit share mechanisms.
Ownership of project assets
In a neat perfect world the developer would be able to transfer the agreed share of the project assets to the new participant in exchange for an agreed price, and the parties would agree to jointly develop the project going forward. In practice this is rarely feasible. In most case it would trigger income/capital gains tax (CGT) and stamp duty liabilities too soon, wasting much needed cashflow. It would also hand a degree of control to the new participant before the new participant has delivered on its side of the bargain.
Further, in many projects the developer does not yet own the relevant land, but has secured it by way of contract (option or conditional contract). Particular care must be taken in attempting to transfer such contractual rights. If the contract or contracts are well drafted a transfer can be straightforward, but if the contract does not readily allow the developer to transfer some or all of the developer's rights then a transfer may be impossible without the consent of the other party to the contract. Each contract needs to be carefully reviewed to ensure any transfer or it complies with the contract terms.
It is important to note that under the applicable State's stamp duty legislation an contract to buy land is generally treated as a land asset. This means contracts cannot be transferred without considering the stamp duty implications.
Establishing a new incorporated joint venture
For an incorporated joint venture the new participant will receive securities (most commonly shares) in either the existing project vehicle or a new corporate structure overlaid on the existing structure. Key issues in designing such an arrangement include establishing an appropriate management structure and designing the structure so that taxes are not unnecessarily incurred.
The company management structures under the Corporations Act 2001 generally do not provide each participant with the control mechanisms and protection the participant requires. A well drafted shareholders' agreement is the most common solution to this issue.
If an existing project vehicle holds assets then it might be difficult for the new participant to take shares in that project vehicle without triggering CGT, land rich/corporate trustee duty or both.
Essentially land rich duty is designed to impose stamp duty on corporate transactions where the corporate transaction (eg. transfer of shares) effectively transfers control of land assets to a new shareholder and the land assets are worth more than a certain threshold (for example in Queensland it is $1 million). The land rich duty regimes have important differences from State to State, but generally it applies where the land assets comprise a large portion of the company's assets (for example 60 percent in Queensland) and the new shareholder takes a major interest (for example in Queensland it is 50 percent or more) in the relevant company. There are similar rules relating to changing control of corporate trustees.
It is useful to note that the test for an interest for land rich purposes is that a person has an entitlement to a distribution on the winding up of the company. Subject to the general anti-avoidance provisions, this means that land rich duty is not triggered merely because a shareholders' agreement or development services agreement gives an economic interest in the company's land to a particular shareholder or joint venture party.
In many cases these issues are addressed by establishing a new joint venture company where the shareholding of the new company reflects the new joint venture holdings, and the new company has an agreement under which the existing project vehicle gives an economic interest in the project land to the new joint venture company. This can defer the triggering of taxes until such time as the project profits are realised and distributed.
Establishing a new unincorporated joint venture
When using an unincorporated joint venture to bring a new participant into a project, project control and tax issues are also relevant.
Transferring a share of the ownership of project assets to the new participant is often inefficient, because it may trigger income tax/CGT liabilities and payment of stamp duty. Generally the parties do not wish to incur these taxes until after the project profits have been realised and distributed.
A common solution is for the existing project vehicle to enter into a development management agreement with the new joint venture company under which the new joint venture company is engaged to complete the development. The appropriate clauses allocating profits and losses can be included in this agreement. However, a development management agreement must usually be accompanied by suitable financing arrangements (see below) and a mechanism which prevents the owner of the land from dealing with it contrary to the joint venture requirements. This mechanism may be for example a caveat, mortgage or lease registered over the title.
If a bank or other financier has or will fund the project, then the project land will almost certainly be used as security. Quite often there will already be prime and mezzanine lenders with mortgages over the project land and charges over the other project assets. If further funding is required then the issues relating to the bank's securities can be complex. This is particularly the case where the developer has questions regarding its solvency. The new participant will not want its investment in the joint venture taken by existing mortgagees, particularly to meet other debts of the developer not related to the project. The finance and security arrangements need to be carefully considered on a project by project basis.
Sometimes the relationship between joint venture parties may break down. In other cases one of the joint venturers may go broke. Every joint venture should be structured with mechanisms setting out the ways and means of ending the joint venture.
There are a number of mechanisms which can be used in these circumstances. A "roulette clause" is a common solution. A roulette clause enables a party (first party) to offer up its share to the other party (second party) at the price it is prepared to sell for. If the second party does not take up the offer then the first party can buy second party's interest using the price it was prepared to sell for. This type of clause may be inappropriate where one party does not have the resources to buy out the other party's interest. A right of first refusal or option to purchase can also be also useful, however the difficult part is valuing the share of the project being sold, particularly if the share sold is a minority stake. In that case a comprehensive methodology for the valuation needs to be included. For example, to avoid a minority stake being discounted, the valuer might be instructed to value the project as a whole, and then determine a party's interest as a proportion of that.
Joint ventures are an efficient way of bringing new investors into an existing project, but only if carefully planned and documented. Taxes and other costs can be minimised or deferred if the joint venture is structured properly. There are a number of critical elements which need to be weighed up to determine the best structure. These include the existing project structure, the risks the parties are each prepared to take on, the way in which the project will be controlled and managed going forward and the requirements of existing and incoming financiers.
When the joint venture is being established, in many cases there is a degree of urgency to sign up the deal. Also there is a lot of goodwill at the start of the joint venture. These factors can lead to a tendency to assume that the joint venture parties can work things out as they go along. This is a dangerous practice which more often than not exposes participants to unnecessary risks and additional expense. The key is to structure and document the joint venture the best way when the joint venture is first established.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.