Copyright 2010, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Real Estate Joint Ventures, October 2010
Joint ventures may take one or more of the following legal structures:
- joint venture corporation;
- general partnership;
- limited partnership; and
Joint Venture Corporation
A corporation is a commonly used and well-understood vehicle for carrying on business which, furthermore, offers limited liability protection to its shareholders. It would certainly be possible for joint venture participants to incorporate a corporation to own the intended joint venture project, and for the participants to hold shares in the corporation.
Why is a corporate structure not more widely used?
The use of a corporation as a joint venture vehicle is generally not a good idea for a number of reasons, the most important of which is that a corporation is a separate entity for tax purposes. This means that:
1. The profits of the corporation are separately taxed at the level of the corporation. This leads to a certain amount of tax leakage. For Canadian pension funds, which are tax-exempt, it makes little sense to participate in a venture whose profits are taxable. Although it is possible for Canadian pension funds to participate together as shareholders in a tax-exempt corporation pursuant to paragraph 149(1)(o.2) of the Income Tax Act (Canada), all of the shareholders of such a corporation must be pension funds or other similar tax-exempt entities, which precludes the participation of taxable entities such as real estate developers or managers.
2. Because the profits (or losses) of the corporation are determined and separately taxed at the corporation level, discretionary deductions under the Income Tax Act (Canada), such as capital cost allowance deductions, must be claimed at the corporation level, rather than directly by the individual participants.
3. An individual participant in a joint venture corporation holds shares of a corporation rather than a direct interest in real or immovable property. If the individual participant wishes to finance or sell its interest independently of its joint venture co-shareholders, its interest is not nearly as financeable or saleable as a direct interest in real or immovable property would be.
Another possible vehicle is a trust. However, trusts are rarely used for structuring real estate joint ventures, other than mutual fund trusts or REITS designed for multiple investors. A trust is created by a declaration of trust or trust deed. In Ontario, the trust property is vested in the trustee who holds legal title to the property on behalf of the beneficiaries, whereas in Quebec, it is the trust itself which holds legal title to the property and acts through its trustee. The trustee's powers are set out in the trust deed and it is the trustee who enters into contracts to buy, sell, lease, mortgage or hypothecate the trust property. In Ontario, beneficiaries do not have limited liability protection except in circumstances where the trust or REIT is a reporting issuer under the Securities Act (Ontario) or by contract, whereas, in Quebec, the patrimony of the trust is distinct from that of its beneficiaries and consequently beneficiaries do benefit from limited liability protection.
For tax purposes, the trust is a separate entity, like a corporation, and profits (or losses) of the trust are determined and taxed at the trust level. However, special rules under the Income Tax Act (Canada) apply to trusts in most circumstances to allow for the effective flow-through of the trust's income to the beneficiaries.
A general partnership is also rarely used for structuring real estate joint ventures. A partnership is an arrangement where two or more parties agree to carry on a business by combining property, knowledge or activities with a view to making a profit. For tax purposes, although the profits (or losses) of a general partnership are determined at the partnership level, they are not taxed at the partnership level but instead flowthrough directly to the partners, thereby avoiding the entity-level taxation of a corporate structure.
However, a general partnership is not a legal entity separate from its partners and there is no limited liability protection. Furthermore, in a general partnership, each of the partners is an agent for all of the other partners with respect to activities falling within the scope of the partnership and all of the partners are jointly and severally (or, in Quebec, solidarily) liable for the obligations of the partnership. These are not characteristics that are desirable for most participants in commercial real estate joint ventures, particularly for pension funds or other institutional investors.
Limited partnerships were invented to solve many of the problems described above in connection with general partnerships. A limited partnership is a partnership under which certain partners, termed the limited or special partners, enjoy limited liability protection, except to the extent of their contributions to the partnership. Otherwise, like a general partnership, the profits (or losses) of the limited partnership are determined at the partnership level but flow-through directly to the limited partners. This makes it a very attractive vehicle through which real estate assets may be held, offering the limited liability protection of a joint venture corporation coupled with the benefit of being a flow-through entity for tax purposes.
A limited partnership is formed by complying with the relevant provisions of the applicable legislation (such as the Limited Partnerships Act (Ontario) or the Civil Code of Québec) and, almost always, by entering into a limited partnership agreement. The limited partnership must consist of at least one general partner and at least one limited or special partner. The general partner is responsible for carrying on the business of the limited partnership and, in Ontario, often holds registered title to the real estate project on behalf of the limited partnership (although there is sometimes a separate nominee company holding registered title). The general partner is liable for all of the obligations of the limited partnership. Limited partners are essentially passive investors in the joint venture and cannot take an active role in decision-making and operations without the risk of losing their limited liability.
Limited partnerships are popular vehicles for real estate investments by pension funds. This has especially been the case since 2005 when foreign property restrictions affecting pension fund investments in limited partnerships were repealed. Under the former rules, all investments by pension funds in limited partnerships, regardless of location, were deemed to constitute "foreign property" (subject to a 30% restriction).
One of the major issues in the limited partnership structure is the degree of control over the enterprise by the limited partners. As previously noted, this is a delicate balance as limited partners may lose their limited liability protection if they take an active role in the business of the limited partnership. Different devices have been employed as a means for enabling limited partners to exert some degree of control while still retaining their limited liability status. It may be possible for limited partners to hold shares in the general partner corporation and to influence the decisions of the general partner through their appointees as directors of the general partner. Alternatively, an advisory committee made up of representatives of the limited partners and the general partner may be given a degree of oversight over the activities of the general partner. The limited partnership agreement may also contain provisions requiring the general partner to adhere to the investment policies of individual limited partners, to notify the limited partners and to obtain their consent for any transactions involving a conflict of interest and other contractual limitations.
Unlike all of the other structures, a co-ownership offers participants the ability to hold a direct interest in the underlying real or immovable property. Technically, a co-ownership is a tenancy-in-common, a centuriesold legal concept whereby participants enjoy "unity of possession" of the property. That is to say, they each hold an undivided interest in the entire property; they do not each hold a separately identifiable physical portion of the property.
As owners of separate real or immovable property interests, the participants receive and are taxed on their respective shares of the profits from the project directly; there is no determination or payment of tax at the joint venture level. Indeed, the joint venture does not exist as a separate entity at all, whether for legal or tax purposes. This means that joint venture participants have the added flexibility (not available in a general or limited partnership) of being able to determine their own discretionary deductions under the Income Tax Act (Canada), such as capital cost allowance deductions. As owners of direct real or immovable property interests (as opposed to units in a trust or limited partnership), the joint venture participants also have a considerably enhanced ability to mortgage, hypothecate or sell their interests to third parties, subject to the restrictions set out in the co-owners' agreement.
A co-ownership is formed whenever two or more persons hold undivided interests in the same parcel of real or immovable property and is almost always governed by a co-owners' agreement. The co-owners' agreement sets out rules with respect to decisionmaking among the co-owners, the distribution of revenues and payment of expenses and restrictions and rules governing transfers and mortgages or hypothecation of the co-owners' interests.
Limited liability protection is available for participants in a co-ownership provided that the participant itself is structured as a limited liability vehicle, such as a corporation (including a pension realty corporation) or a limited partnership. The only exception to this is if, notwithstanding the intention of the parties, the relationship among the co-owners is determined in fact to constitute a general partnership, in which case the partners would be jointly and severally (or, in Quebec, solidarily) liable for the obligations of the partnership. To avoid this highly undesirable result, co-owners' agreements typically include some or all of the following features:
1. A direct statement that the relationship is not a partnership, although such statement is not determinative in and of itself;
2. No restrictions on the co-owners' other businesses and activities, even if in competition with the co-owned project, which refutes the concept of partners owing a fiduciary responsibility to each other;
3. Liabilities are stated to be several and proportionate among the co-owners, in proportion to their respective ownership interests, and the co-owners are obliged to use their reasonable commercial efforts to cause all liabilities to third parties to be similarly several (or, in Quebec, joint) and proportionate. This is in contrast to the joint and several (or, in Quebec, solidary) liability which prevails in a general partnership; and
4. Day-to-day management of the project is commonly delegated to a property manager pursuant to a separate property management agreement so as to avoid the implication that the co-owners are "carrying on a business in common".
A co-ownership represents a structure that offers participants maximum flexibility. The co-ownership is not a separate entity for legal or tax purposes, so there is direct flow-through to the participants of profits and losses, plus the ability to claim discretionary deductions without the agreement of other parties. Limited liability can be maintained provided that characterization as a partnership can be avoided. Significantly, the participants own a direct interest in real or immovable property, so their investment is generally more freely capable of being mortgaged, hypothecated or sold than units of a partnership or trust or shares of a corporation.
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.