Which Structures Suit Property Acquisitions For Development?

Introduction

Property developments can be held under various structures, each offering distinct benefits and drawbacks. Choosing the appropriate structure requires a thorough examination beyond just income tax and Capital Gains Tax (CGT). Key factors to consider include:

• Goods and Services Tax (GST)
• Stamp duty
• Financing
• Access to cash
• Asset protection
• Simplicity in understanding and explaining the structure
• Other commercial considerations

While analysing tax issues is essential, it’s often not enough to determine the best structure. The most tax-efficient structure might not be the most appropriate once all factors are considered.

What Are Your Options?

If there’s more than one equity holder in the project, the primary structures to consider are:

1. Entity Structures: Typically, a company or unit trust.
2. Contractual Structures: Typically, a partnership or a joint venture.

Companies vs. Unit Trusts

Companies and unit trusts are often compared directly. While they may operate similarly, key differences set them apart, as outlined in the table below:

Let’s delve a little deeper into each of these factors.

Incidence of Tax

A crucial difference is that a company pays tax at the entity level, while a unit trust does not. This difference affects the entity’s ability to access finance and the priority of unsecured creditors. In a unit trust, income tax falls at the unitholder level, potentially placing unsecured creditors ahead of the ATO. Additionally, the timing of tax liabilities can differ, impacting cash flow and financing options.

Rate of Tax

A company’s tax rate is 25% for base rate entities, whereas in a unit trust, tax is borne at the unitholders’ rates. The 25% tax rate in a company allows profits to be retained within the entity, aiding further development without Division 7A issues. In a trust, income needs to be distributed each year, which may require reinvestment through subscription for additional units or loans to the trust.

The franking rules allow tax paid by a company to be credited against the shareholders’ tax on dividends. If individual shareholders’ tax rates are lower than 25%, they can receive a refund of the difference, meaning both structures ultimately see tax paid at the equity holders’ individual rates.

Asset Protection

A company provides asset protection through its limited liability, with shareholders generally protected from the company’s liabilities, provided their shares are fully paid. However, directors may still face liabilities under the Corporations Act for certain actions like insolvent trading. In a unit trust, directors of a trustee company might also be personally liable for debts if the trust lacks indemnity from its assets. The choice between these structures may depend on the specific risks associated with the property development project and the level of asset protection required by equity holders.

Ability to Enter/Exit

Both structures offer ease in entering and exiting. However, unit trusts may have a slight advantage as capital reduction through unit redemption can be done without ASIC notification, unlike with companies. Care is needed when redeeming units or shares in property development projects due to CGT implications. The ability to manage entry and exit efficiently can be critical in complex property developments where the composition of equity holders may change over time.

Consolidation

Both companies and unit trusts can be consolidated, but unit trusts cannot act as the head entity of a consolidated group. Typically, equity holders use special purpose entities to hold their shares or units. However, if tax benefits like discount CGT or tax-deferred distributions are priorities, having a company as a unitholder might negate the advantages of using a unit trust. The choice of structure should consider the long-term plans for the development and any future transactions that may affect the group’s tax position.

Discount CGT

One significant advantage of unit trusts is the ability to access discount CGT, which companies cannot. If a property is sold, a unit trust can access the discount CGT regime, provided the property is held on capital account for more than 12 months. In contrast, a company would pay tax at 25% and potentially face further tax when profits are distributed. The ability to access discount CGT can be a significant consideration in long-term property investments where capital growth is expected.

Flow-Through Tax Characterisation

Unit trusts offer a benefit in tax characterisation. For instance, if a property is held on capital account, the tax depreciation deduction will likely be greater than the accounting depreciation expense, resulting in untaxed cash flow that can be distributed to unitholders. In a company, such distributions are treated as unfranked dividends and taxed, while in a trust, they may only trigger a CGT Event, which could result in a more favourable tax outcome. This distinction can impact the overall tax efficiency of the development and the after-tax returns to equity holders.

Losses

Companies generally offer clearer loss rules, while unit trusts may face more complex issues. Non-fixed trust loss rules apply to unit trusts, potentially complicating loss utilisation. Companies, on the other hand, have well-established loss rules. The ability to utilise losses effectively can be critical in the early stages of property development when upfront costs may result in tax losses.

Stamp Duty

Stamp duty considerations emphasize the importance of selecting the right structure initially. Moving assets or significant equity post-acquisition can trigger duty, with different thresholds for companies and trusts. In Victoria, the thresholds for triggering landholder duty differ between companies and trusts, potentially affecting the choice of structure. The impact of stamp duty on the overall cost of the development and the timing of transactions should be carefully considered.

Now for contractual structures

Partnerships vs. Unincorporated Joint Ventures

A common law partnership involves two or more people in business together for profit. In contrast, a joint venture typically involves participants contributing different assets or services to a project, with each taking the product of the development. The key difference is liability. Partners in a partnership are jointly and severally liable for the partnership’s liabilities, whereas joint venturers are not. In a tax context, this difference is less significant as income tax is not paid by the partnership but by the individual partners.

However, in a partnership or joint venture, losses flow through to the participants in the current year, unlike in a company or unit trust where they are quarantined. This can be significant in property projects where deductions are available upfront, and revenue comes later. The use of development agreements or construction contracts can help manage these deductions.

Development Agreements

Development agreements are another structure where no jointly owned vehicle is used. Instead, the developer receives a fee based on the project’s success. Originally designed to minimize stamp duty, these agreements can now trigger economic entitlement provisions, especially in Victoria, potentially making them subject to duty. The complexity of these agreements requires careful drafting and consideration of all legal and tax implications.

Superannuation Funds

Superannuation funds can participate in property development projects, but must meet stringent regulatory requirements, such as the sole purpose test and arm’s length dealings with associates. Investments must align with the fund’s trust deed and investment plan. While these hurdles are significant, they can be managed with the right project and structure. The involvement of superannuation funds can provide a source of stable long-term capital, but the regulatory requirements must be carefully navigated to avoid penalties.

Conclusion

Unfortunately, there is no one specific structure for use in all property development situations. It will depend on the profile of the parties, whether the property is held on capital or revenue account, how long it will take to recognise a profit and the appetite of the parties for complexity.

Clearly there are some factors which, if they are present, will lead to a more obvious choice of structure than others. They include:

• if the property will be held on capital account, a unit trust is preferable to a company;
• if the project is likely to generate years of losses before turning a profit, then partnerships, joint ventures and development agreements may take advantage of those losses on a current year basis; and
• where the equity holders have different objectives for the use of the developed properties then a joint venture is appropriate.

You have various choices from which you need to determine the most suitable to you and your circumstances including your intentions with the specific property acquisition/development.

It is always wise to get professional help to ensure the best possible outcome.