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Using joint ventures to develop property (3) – Structuring alternative: ‘Profit-sharing’ arrangements (1)

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Where one or more of the JV participants are carrying on a business of property development, one of the problems with a JV arrangement is that those parties may need to account for their share of the land as trading stock once they have ‘dispositive power’ over the land.  

This can affect the timing of deductions for expenditure incurred in the course of the development, and possibly crystallise a gain in the hands of the original owner prior to the actual sale of the land.

Therefore, it may be in the interests of one of the parties (or all of them) to ensure that dispositive power over the land is never transferred from the landowner to the other parties. This result may be achieved if the landowner simply engages the builder to construct the units, and contracts to pay for those building services. In such a case, the land never becomes the trading stock of the builder (as they never have ‘dispositive power’ over the land). This also ensures that the builder can claim deductions as and when they are incurred (e.g., for payments to subcontractors).

Initial problems with such an arrangement include the fact the builder may not be able to benefit from the profits made on the sale of the units, and that the landowner may need to make progress payments to the builder (i.e., before the landowner has received any amounts from the sale of the property). In this instance, the vast majority of the commercial risk will be borne by the landowner.

In such a case, the landowner may be reluctant to pay the builder (possibly funding such payments from borrowings) without the certainty of knowing whether the sale proceeds will be sufficient. To accommodate the needs of both the builder and the landowner, they may instead enter into a contractual arrangement whereby:

  • the builder agrees to fund the development and will not be paid until the units are sold; and
  • the landowner agrees to pay the builder an amount that factors in a proportionate share of any profits made on the ultimate sale of the units.

In structuring such an agreement, it is important to ensure the parties do not inadvertently form a partnership and that any payments to the builder are not payments out of profits (which may not be deductible to the landowner). Despite the fact that such an arrangement may appear to be ‘profit sharing’ (which is a typical feature of a partnership), it must be made clear that the form and substance of the arrangement is that the builder has agreed to carry out the construction services for a variable fee. That is, the landowner is not sharing profits with the builder, but rather is paying a fee for a service that cannot be calculated until the units are sold.  

Nonetheless, the formula for calculating the payment must be clear in the agreement, or else there is a real risk that the arrangement may be seen as a sharing of profits.

 

  • Should you have any queries, please contact Tax Ideas Accountants & Advisers on +61 2 83181545
  • Alternatively, you can book an appointment in our live calendar.

Written by Panbo Ye

I help people discover POWERFUL unknowns in Tax Ideas | Wealth Strategies | Retirement Planning | Finance Solutions!

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