What Developers And Investors Often Miss In Canadian Real Estate Joint Ventures

Introduction

Whether you are a real estate developer, owner, asset manager, financier, or investor, the way you structure a Canadian real estate joint venture ("JV") at the beginning will determine how you share profits, manage risk, and, in some cases, how much tax you ultimately pay. In practice, many JV disputes and disappointing returns trace back to avoidable structuring decisions made before the parties ever signed their deal. This article provides a structuring overview that should be carefully considered when establishing a Canadian real estate joint venture, so you can align interests, satisfy lenders and protect your investment over the life of a project.

Understanding Canadian real estate JV structures

In Canada, real estate JVs are typically structured in one of four ways:

• Limited partnership (an "LP") – the most common structure;
• JV partnership – a general partnership among the JV parties;
• Co-ownership – partners hold direct interests in the assets; or
• JV corporations ("JV Corps") – less commonly used.

Collectively, LP units, JV partnership interests, and JV Corp shares are called JV interests. While the term JV is used broadly in commercial contexts, Canadian tax rules are narrower. For tax purposes, a true JV is typically a co-ownership, where participants account for taxes individually rather than through a separate entity.

1. Limited partnerships (LPs): The most common structure for Canadian real estate JVs

LPs are the most common structure for Canadian real estate JVs as they provide flexibility and tax efficiencies. They are governed by a limited partnership agreement (the "LPA"). Key features include:

The parties

• The limited partners are investors with a right to participate in LP economics but are prohibited from managing LP operations (in doing so, a limited partner may become liable for the LP).
• The general partner (GP) is typically a corporation, the shares of which are controlled directly or indirectly by the JV parties.

Legal framework

• The LP and its activities are governed by the Limited Partnerships Act (Ontario) (the "Act").
• The GP and its activities are governed by, if an Ontario corporation, the Business Corporations Act (Ontario) (the "OBCA") and the Act or comparable legislations in other Canadian provinces or territories. When the GP has more than one shareholder, the GP shares are typically subject to a unanimous shareholders agreement (the "USA") among GP shareholders allocating decision making authority as well as other shareholder rights and responsibilities.
• LP units: LPs may issue multiple classes of LP units to limited partners, each with tailored rights and obligations bespoke to each JV, such as:
  • at minimum, the obligation to contribute capital or property to the LP and to covenant to refrain from actions that would jeopardize the tax status of the LP;
  • the right to receive distributions on LP units if and when declared by the GP;
  • the right to vote on specified fundamental matters;
  • the right to a return of capital contributions to limited partners in certain circumstances;
  • the right to approve amendments to the LPA on fundamental matters; and
  • the right to remove and replace the GP in narrow circumstances; typically bankruptcy, fraud or negligence.

Liability

Generally, the GP has unlimited liability for LP activities whereas limited partners of an LP have liability limited to their capital contributions they made or agreed to make to the LP.

Management agreements

LPs may enter agreements with development and/or construction managers as well as asset managers and/or property managers that may or may not be affiliates of the LP limited partners or GP shareholders.

Tax treatment of limited partnerships in Canadian real estate JVs

For Canadian tax purposes, the benefit of using an LP as a JV vehicle is the LP's income or losses potentially flow through to the partners. The income received by the partners generally retains the character it has at the partnership level. For example: a capital gain arising at the partnership level, is a capital gain of the partners.

An LP must compute income as if it were a taxpayer. However, it is not subject to income tax itself. In the computation of partnership income, with some exceptions, discretionary tax deductions, such as:

• capital cost allowance ("CCA"), and
• tax reserves,

are determined at the partnership level.

If an LP has net losses for a taxation year, those losses are allocated to the partners, who can use losses up to the partner's "at-risk amount" to offset other income.

Despite this general flow-through treatment, certain partnerships known as Specified Investment Flow-Through ("SIFT") partnerships are subject to entity-level tax. Typically, real estate investments formed as partnerships are intentionally structured to mitigate the risk of being a SIFT partnership. For example: by including in the LPA covenants prohibiting partners from taking actions that could cause the LP (or JV partnership) to become a SIFT partnership.

Non-resident investors and Canadian real estate LPs

For an LP to qualify as a Canadian partnership, all partners must be Canadian residents. A single non-resident partner will disqualify an LP from being a Canadian partnership, which in turn places limitations on the LP.

• Non-resident partners also face tax complexities under the compliance and withholding regime in section 116 of the Income Tax Act ("ITA"). If an LP has partners that are non-resident, a disposition of Canadian real property by the LP can trigger section 116 obligations.
• In addition, if an LP holds real property, the LP units themselves could qualify as "taxable Canadian property" such that a disposition of LP units by a non-resident partner would result in section 116 obligations.

To navigate complexities and limitations created by having non-resident investors, a "blocker" can be interposed between the non-residents and the LP. Here, non-residents acquire an interest in a Canadian corporation, which in turn would invest in the LP. Alternatively, non-resident investors can be siloed in a parallel LP, then both the Canadian LP and non-resident LP would separately invest in the real estate.

The GP, or a separate vehicle established by GP shareholders, is typically entitled to receive a "promote" or "carried interest" at completion of the JV (see "Fees" below). GST/HST may apply to the carried interest, though planning opportunities may be available.

Tiered structures in Canadian real estate JVs

Often, JVs may have multiple "tiers" or "levels". The LP holding the property is often referred to as the "project level", where primary JV activities occur. When JV partners syndicate investment from separate investor groups, they may create an upper-level investment vehicle, often another LP that is then a limited partner to the "project level" LP.

Multiple assets

Most JVs have one asset. If an LP has more than one asset, the LP will have separate subsidiary LPs, each controlling a distinct asset. This is to compartmentalize liability among assets and provide flexibility to facilitate potential direct investment in one asset by one or more parties as opposed to investing in all assets through the project level JV.

Nominee corporations

JV subject property may be held through a nominee corporation, a subsidiary of the LP. Often, use of a nominee corporation to hold registered title to the real property (particularly in Ontario) is done for, among other things:

• Confidentiality and privacy, as the beneficial owner remains outside of the public record.
• Efficiency for lending and transacting, particularly in co-ownerships where multiple persons hold their beneficial interest directly rather than through an LP. Having one nominee registered on title can have efficiencies when transacting with the property (i.e., financings, development agreements, etc.).
• Liability protection, as third parties only transact with the nominee. Accordingly, there may be limited liability shielding, although this does not provide as much protection as many assume, and so is much less of a factor for sophisticated owner/investors who typically assume the nominee/beneficial owner structure provides no actual liability protection and tax advantages in certain jurisdictions (e.g., British Columbia), where the nominee structure can provide various tax advantages.

2. JV partnerships

The parties and legal framework

• JVs may be structured as a JV partnership by parties entering a partnership agreement.
• A JV partnership is governed by the Partnerships Act (Ontario) or other comparable provincial or territorial legislation.
• JV partnerships are more flexible than JV Corps due to the less prescriptive nature of the Partnership Act (Ontario) or other comparable provincial or territorial legislation, compared to the OBCA or comparable legislations in other Canadian provinces or territories. JV partnerships may enter agreements with development and/or construction managers as well as asset managers and/or property managers that may or may not be affiliates of the partners of the JV partnership.

Liability

• Unlike LP limited partners, parties to a JV partnership do not have limited liability.
• They are subject to joint and several liability (subject to otherwise apportioning liability in the partnership agreement) with respect to JV partnership activities.

Tax treatment

• A JV partnership is similar to an LP, as both provide a flow through of income (and losses) to partners.
• Key difference: LPs are subject to "at-risk" rules, which can restrict a limited partner's ability to claim certain losses, resource expenses and investment tax credits. While the at-risk rules primarily apply to LPs, in some circumstances, the rules may apply to a JV partnership structure.

Adjusted cost basis (ACB)

• For both LPs and JV partnerships, interest in the partnership is capital property to the partner and will have an adjusted cost basis ("ACB").
• The ACB of a partnership interest is relevant when:
  • disposing of the partnership interest (sale to a third party or withdrawal from the partnership);
  • dissolving the partnership; and
  • applying at-risk rules, in the case of LPs.
• A partner's share of partnership income is added to a partner's ACB in the partnership's interest after the fiscal year-end.
• Distributions reduce the ACB of the partnership interest immediately.

3. Co-ownerships

In co-ownerships, JV parties hold direct interests in underlying JV asset(s), with each JV co-owner holding an undivided interest in the JV assets, as opposed to each holding a distinct and separate indirect interest in the asset(s). Unlike some other JV structures, a co-ownership is not itself a distinct legal entity but is a contractual relationship between two or more owners' direct interests in real property.

The parties and legal framework

• In Ontario, co-owners are typically "tenants in common", meaning each holds an undivided interest in the JV property that may be in any proportion.
• The rights and obligations of the co-owners are governed by a co-ownership agreement.
• Co-owners can deal with their respective interests in the JV separately (e.g., registering separate mortgages).
• One or more nominee entity will typically hold registered title to the property as a bare trustee and nominee for and on behalf of the co-owners (as to their proportionate interest in the JV asset).
• If co-owners are corporations, they will be subject to limited liability with respect to the co-ownership through their respective vehicle.
• Careful structuring is needed to avoid accidently creating a general partnership, which could triggerjoint and several liability between the co-owners.

Management agreements

Co-owners may enter agreements with development and/or construction managers as well as asset managers and/or property managers that may or may not be affiliates of the co-owners.

Tax treatment

• Co-ownerships are not themselves subject to tax.
• Unlike partnerships, co-ownerships do not need to file annual partnership information returns.
• Each co-owner determines their income or loss individually, which allows:
  • deducting expenses directly from gross income; and
  • optimizing deductions such as capital cost allowance (CCA) for tax planning.
• Co-ownerships do not have their own fiscal period for tax purposes.

Small business deduction (CCPCs)

• A party to a co-ownership that is a private corporation operating in Ontario controlled by Canadian residents (a Canadian-controlled private corporation, or "CCPC") can claim the small business deduction in respect of all of the party's share of the co-ownership's active business income.
• In contrast, for partnerships, the "specified partnership income" rules limit a CCPC partner's ability to use the small business deduction in respect of active business income allocated to it by the partnership.

Contributions of property

• An investor can contribute property on a tax-deferred basis to a JV Corp, an LP, or a JV partnership.
• A JV investor can transfer real property inventory to an LP or a JV partnership on a tax deferred basis.
• In contrast, it is not possible to transfer any type of property to a co-ownership on a tax deferred basis. A party to a co-ownership seeking to contribute property may trigger a disposition for tax purposes. For example, if an investor held real property with an accrued gain, the investor could face a tax liability upon transferring the real property to a co-ownership.

4. JV Corps

JV Corps are corporations that control the JV asset(s) and issue shares to capitalize the corporation. Shareholders' liability in a JV Corp is generally limited to their equity contributions to the JV Corp.

The parties and legal framework

To organize contractual relations among JV partners:

• JV Corps are typically governed by a USA that organizes contractual relations among shareholders.
• JV Corps are subject to the OBCA or comparable provincial or territorial legislation. The OBCA is more prescriptive than the Act and accordingly offers less flexibility for JV structuring.
• JV Corps may enter agreements with development and/or construction managers as well as asset managers and/or property managers that may or may not be affiliates of the shareholders of the JV Corps.

Use and flexibility

• JVs are not typically structured as JV Corps due to other structures providing more flexibility and tax efficiencies.
• A JV Corp may be used in a limited capacity as a nominee, agent or bare trustee of a JV. For example, to hold legal title to land.

Tax treatment

• A JV Corp is itself a taxpayer and is required to file its own tax return and pay its own corporate level tax.
• Distributions from a corporation are generally paid to shareholders as dividends, which are not deductible by the corporation (unless the corporation is a mortgage investment corporation).
• For development phase assets, a disadvantage is that any development expenses (which can include interest expenses) or losses can only be used to reduce JV Corp revenue, not investor income. Subject to certain limitations, non-capital losses of a JV Corp can be carried forward 20 years or carried back 3 years.

Corporate income tax rates (Ontario)

Taxation of corporate income depends on the nature of the corporation and the type of income earned. A CCPC will generally be subject to corporate level income tax at:

• A combined federal provincial rate of 12.2% for active business income under $500,000; and
• 26.5% for active business income more than $500,000.

Income of a corporation operating in Ontario that does not qualify as a CCPC will generally be subject to tax at a rate of 26.5%.

Passive income and investment businesses

• Active business income excludes "specified investment business", defined as a business whose principal purpose is to earn income from property (such as rent), but does not include a business that has more than five full-time employees.
• Passive income taxation in Ontario:
  • A CCPC earning passive income, such as rent, is subject to tax at a combined rate of 50.17%, of which 30.67% is refundable.
  • A non-CCPC in Ontario earning passive income is taxed at a combined rate of 26.5%.

JV capitalization structures in Canadian real estate

At the outset of the JV, in an LP, limited partners may capitalize the LP with capital contributions, real property or assets, or a combination thereof, in each instance receiving LP units in return for their contribution to the LP. The price per LP unit is typically "artificial", using simple figures such as one or a hundred dollar per LP unit. When LP units are later issued, the price is typically based off the then fair market or net asset value per LP unit (see "Valuation" below). These concepts similarly apply to other JV structures.

Capital may be contributed to the JV on contributed basis, committed basis or combination:

• Contributed capital is when JV partners contribute capital to the JV.
• Committed capital is when JV partners agree to contribute stated capital at specified times in the future or when "called".

Uncommitted capital

• If a JV does not include the concept of committed capital and the JV requires capital, limited partners may (but are not obligated to) contribute capital.
• Partners who opt not to contribute are typically diluted, while the economic interest of JV partners that contributed additional capital increases.

Committed capital

• If a JV structure includes a committed capital construct and a JV partner defaults on its obligation to contribute capital, typical penalties may include:
  • buyout of the defaulting partner's JV interests at a discount to fair market or net asset value;
  • dilution of the defaulting partner by other partners contributing the shortfall;
  • deemed loan from the JV to the defaulting partner at an above-market interest rate; or

Debt financing considerations

The JV documents may also require the JV in certain circumstances seek debt as a primary method of financing before requiring JV partners to contribute additional capital.

Asset classes in Canadian real estate JVs

A JV may be structured for development, redevelopment or fully stabilized assets, and for any asset class such as multifamily residential, condominiums, office, industrial, retail, self-storage, seniors housing, and student housing.

Investor liquidity and exit options in Canadian real estate JVs

JVs are most frequently "closed end", meaning contributed capital is required to be retained by the JV for its lifecycle, which can be a specified time, or until the occurrence of a specified event(s). In addition, JV interests are typically subject to additional restrictions including pledging or encumbering JV interests.

Notwithstanding a JV is closed-end, JV partners may have limited liquidity rights prior to the completion of the JV relationship. These rights can include:

• Selling JV interests to other JV partners or third parties. Sales to third parties typically require the selling partner to first offer their interests to the other JV partners.
• Acquiring JV interests of other partners in specific circumstances.
• Compelling the sale of all JV interests or the underlying JV asset(s) to third parties. Again, the selling partner must generally first offer their portion proposed to be sold to the other JV partners. The number of JV partners and the proportion of JV interests they control often determines whether and to what extent these rights can be exercised.

Less frequently, JVs may be "open ended", meaning contributed capital does not need to be committed for a specific period. In that case, JV partners may exit their investment by redeeming their JV interests, typically at a price equal to the fair market or net asset value. Given, however, the illiquid nature of the underlying asset(s), JV partners do not typically have redemption rights.

In contrast, real estate investment trust or "REIT" units are required under the ITA to be redeemable upon demand by unitholders. While REITs are a popular Canadian real estate investment vehicle, they are not typically used as JV vehicles and REIT units are held by a higher number of investors than a JV.

Despite well thought out exit mechanisms included in JV documents at the outset of the relationship, when one or more parties seek to later exit the JV and the departure is amicable, parties frequently disregard prescribed exit mechanics and negotiate a deal based on the commercial realities framing the exit. When, however, the parting ways is adversarial, the prescribed exit mechanics become important and helpfully dictate the process.

Decision-making and management in Canadian real estate JVs

• In an LP, the GP is responsible for JV management and decision-making unless decision making is delegated to a manager.
• In a JV partnership and co-ownership, decision making authority is typically specified in the co-ownership or joint venture agreement, as applicable, unless delegated to a manager pursuant to a management agreement.

Depending on the nature of the JV asset(s), the JV may enter a commercial agreement with other parties to provide necessary services and delegate decision making in certain circumstances. For example:

• If the JV controls a development asset, the JV may enter a development and/or construction management agreement.
• If the JV controls a fully stabilized asset, the JV may enter an asset and/or property management agreement depending on the nature of the management services required for the JV asset and the expertise of the JV parties.

The development manager and/or construction manager, asset manager and/or property manager may also be JV parties (or affiliates or related parties to the JV parties) or part of JV management or the role may be fulfilled by arms-length service providers.

These management agreements will outline, among other things:

• the scope of the services to be provided by the manager to the JV;
• fees payable by the JV to the applicable manager for the services provided;
• decision-making authority, liability and indemnity arrangements between the manager and the JV; and
• mechanics fortermination by the JV parties of the manager.

Less frequently, in more widely held JVs where capital is syndicated, the JV may provide observation, advisory and/or information rights to certain JV partners who are not members of management or on the board of directors (if applicable), increasing their access to decision making without formally participating in the process.

Roles, rights, and governance under Canadian JV shareholder agreements

In an LP, when the GP has more than one shareholder, the GP shares are typically subject to a USA among GP shareholders allocating decision making authority as well as other shareholder rights and responsibilities. The USA often provides that certain GP decisions are subject to different approval thresholds, such as:

• A simple majority (50% plus one vote);
• super majority (often 66% or 75% of votes);
• requiring unanimous approval of all GP shareholders; or
• certain GP matters may be subject to approval of only one GP shareholder.

The USA often includes a rule for GP shareholders who are also an LP. If such a GP shareholder ceases to be a limited partner, they are generally required to sell their GP shares to the other GP shareholders for nominal value. This prevents a situation where a limited partner exited its equity investment in the LP, but retains GP decision making authority, thereby participating in decision-making for a project in which it no longer invested. Similar terms are typically included in the agreement governing a JV partnership, co-ownership, or shareholders agreement governing a JV Corp.

How fees are structured in Canadian real estate JVs

Fees payable by the JV to various JV participants are typically payable on an ongoing basis, and upon achievement of certain milestones. Common ongoing fees payable by the JV during the JV lifecycle are:

• Fees payable to the development and/or construction manager, asset manager, and/or property manager are typically more substantial, whereas fees payable to JV management are less robust, or the JV management may not receive any ongoing fees, with management choosing to keep such capital invested in the project. Management is also typically entitled to be reimbursed by the JV for funds it expends on behalf of the JV such as JV creation, office, financial reporting, administrative, audit, and legal.
• Guarantee fees if one or more JV partners provides guarantees for JV financing. Guarantee fees vary but are often in the range of 0.5% to 1.5% of the amount guaranteed.
• Although less common, fees paid to a registered exempt market dealer (a "EMD") to raise capital for the JV. This is unusual as capital contributions to the JV are typically made by the JV partners and equity capital is not typically sourced from arms length investors, or, if it is, it is formally syndicated in an entity "one level up" from the JV party that capitalizes the JV. Fees payable to EMDs widely range depending largely on the established track record of comparable project success (or lack thereof) of JV management.

Understanding carried interest and promote for JV partners in Canada

In an LP, the GP or a separate carry vehicle established by GP shareholders typically receive a "promote" or "carried interest" from the LP when its assets are cash flow positive, or upon occurrence of a "liquidity event", often the sale of the underlying JV asset(s).

Carry economics vary, but the common approach is:

• limited partners first receive a return of contributed capital from the LP;
• a specified hurdle rate typically calculated annually (e.g., 7% to 10%); and
• any remaining profits are allocated 80% to limited partners and 20% to the GP.

Carry structures are often tiered based on LP performance. For example, assuming full return of capital to limited partners:

• 7%–10% return to limited partners, remainder split 80% LP / 20% GP;
• 10%–15% return, remainder split 70% LP / 30% GP; and
• above 15% return, remainder split 75% LP / 25% GP.

In some cases, if the carry is calculated and paid on an ongoing basis as opposed to solely at the time of a liquidity event, prior paid carry may be subject to claw back to ensure payments reflect aggregate JV performance. Similar terms may apply in agreements for JV partnerships, co-ownerships, or JV Corps. These figures are illustrative only, and the actual economics of the carry are specific to each JV.

Valuation

Valuation of JV assets and JV interests are distinct concepts, although JV management often use the concepts interchangeably.

• Valuation of JV interests is often described as the "fair market value" or "net asset value" per JV interest. At a high level, it is calculated as the value of the JV's assets (the subject property) net of liabilities and necessary reserves as determined by management.
• Valuation of JV assets refers to the aggregate value of all JV assets, rather than the value per JV interest.

Valuation of JV assets or JV interests is relevant at different stages of the JV life cycle:

• Investor exits: When partners seek to exit their investment, valuation determines the price per JV interest.
• Debt financing: Lenders may require an updated valuation of assets or JV interests.
• Additional capital contributions: If the JV raises more capital, the price per JV interest should reflect the current value. For example, if investors initially contributed capital to a JV during early development and the project later achieves key milestones, the asset value typically increases and the risk decreases, resulting in a higher price per JV interest.

Valuation methodology

JV documents should clearly outline the valuation mechanism. Ideally, this includes:

• a comprehensive valuation process;
• use of qualified appraiser(s) or specified selection criteria; and
• a dispute resolution mechanism.

Simplistic methods such as "value as agreed by the parties" are discouraged, as they can easily lead to disputes over a fundamental JV matter.

Dispute resolution mechanism

JV documents typically contain dispute resolution mechanisms that may compel negotiation, meditation, arbitration, or going to Court, as well as any number of exit mechanisms such as shotgun and buy sell provisions.

Registration matters

Although less relevant in closely held JVs with few parties, JV partners must nonetheless ensure that when undertaking capital raising activities, they are not engaging in activities such as being in the business of trading, which would require them to be registered under applicable Canadian securities laws as a securities dealer or EMD, or that they are properly registered to conduct these activities. These considerations are often more relevant "one level up" where a JV partner is syndicating capital to then contribute to the JV.

Select tax considerations

Land Transfer Tax (LTT) in Ontario

Under the Ontario Land Transfer Tax Act, a purchaser of land must pay land transfer tax based on the value of consideration received upon a conveyance of land.

Toronto-specific rule: If the property is in Toronto, an additional municipal land transfer tax applies.

Purchasing shares vs. partnership units

• If shares of a corporation are purchased, land transfer tax will not apply even if the corporation holds real property.
• In contrast, the acquisition of partnership units of a partnership that owns land in Ontario will be subject to LTT. The reason is for land transfer tax purposes, a partnership is not a legal entity and the partners, in proportion to their ownership interest in the partnership, are considered the directly beneficial owners of the land.

Co-ownerships

A similar result should apply for a co-ownership. For partnerships, there is a de minimis exemption, which applies if a partner does not increase its interest in a partnership by more than 5% in a fiscal year. This exemption does not however apply if the partner is itself a partnership or a trust.

Don't leave your Canadian real estate JV to chance. Reach out to our Commercial Real Estate, Corporate Law and Tax teams to get trusted guidance on structuring, taxation, and asset management, and spark the success of your next project.

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.