By Nicolas Beaulieu, Lawyer and Partner at Gascon & Associés SENCRL.

For several years now, owing to the substantial and steadily increasing costs associated with carrying out real estate projects, such projects have increasingly been undertaken in partnership by various stakeholders, including real estate developers and institutional or private investors.

In Québec, for various reasons, these partnerships are rarely structured through a corporation. They instead take the form of either a limited partnership or a joint venture. While the limited partnership is a well-known vehicle widely used in the real estate sector, the joint venture remains poorly understood, including by many lawyers practising real estate law.

In practice, a joint venture is frequently confused with mere ownership of immovable property in indivision. It is not uncommon for indivision and joint venture agreements to be prepared on the mistaken assumption that they are sufficient, in and of themselves, to confer joint venture status on the parties, without regard to the specific criteria required to establish the existence of a joint venture for tax purposes. This confusion may, however, give rise to significant, even disastrous, tax consequences.

Indeed, if the tax authorities do not recognize the existence of a joint venture, all taxable transactions carried out by the participants may be reassessed, in particular with respect to the collection and remittance of GST and QST, as well as input tax credits and input tax refunds (ITCs and ITRs). Yet a large-scale real estate project generates a considerable volume of contracts, invoices, and financial flows in which sales taxes play a central role. It is therefore essential to have a sound grasp of the legal and tax parameters of a joint venture, rather than simply reproducing or drawing heavily on agreements used in other projects.

Against that backdrop, and since the limited partnership is generally well understood by participants in the real estate industry, this article seeks to highlight certain fundamental similarities and distinctions between the limited partnership and the joint venture.

Similarities Between the Limited Partnership and the Joint Venture

One initial similarity is that both arrangements involve at least two persons.

Among other main similarities, it should be noted that, on a day-to-day basis, both the limited partnership and the joint venture are managed by a single person, namely the designated participant in the case of a joint venture and the general partner in the case of the limited partnership.

In the context of large-scale real estate projects, both structures are generally established for a specific and limited purpose, namely the completion of a defined project. In both cases, it is therefore important to define that purpose clearly, as well as the nature of the permitted activities. Although a limited partnership is not required to impose such limits on its activities, it is common in practice to do so in order better to protect the limited partners. It is nevertheless important to note that the tax authorities do not, in theory, treat this as a similarity between the two structures and will, on the contrary, distinguish the joint venture from the limited partnership on the basis that the latter is not, in principle, subject to limits on its activities.

Lastly, both the limited partnership and the joint venture rest on a written agreement establishing their existence and setting out their parameters. In the absence of such an agreement, neither structure will be recognized by the tax authorities.

Fundamental Distinction: The Limited Partnership and the Joint Venture

Unlike a limited partnership, a joint venture must imperatively demonstrate collaboration among the participants. For that reason, it appears advisable to us to set out in the joint venture agreement a certain level of detail regarding that collaboration. Such collaboration may take the form, in particular, of a pooling of assets, financial resources, skills, or knowledge.

In that regard, it is important to emphasize that ownership in indivision, although it is a common feature in the context of a real estate joint venture, is not in itself sufficient to establish the existence of a joint venture. In Québec, indivision is merely a mode of holding ownership, governed by the indivision agreement and, where applicable, by the Civil Code of Québec, whereas the joint venture rests on criteria developed by the tax authorities and Canadian jurisprudence.

In this sense, indivision and the limited partnership are legal concepts, whereas the joint venture is above all a tax concept, even though it is not defined in tax legislation. A joint venture is neither a partnership, nor a trust, nor a corporation. Nor is it regarded as a “person” for GST and QST purposes and, as such, it cannot register for those taxes.

The Tax Criteria of the Joint Venture

According to CRA Policy Statement P-171R, the principal criteria for identifying the existence of a joint venture may be summarized as follows:

• The arrangement is set out in a written agreement;
• The participants’ intention, as evidenced by their conduct, the nature of their undertaking, and the other circumstances of their arrangement, is that of a joint venture;
• The collaboration is limited to a specific project or undertaking;
• Each participant contributes to the enterprise (funds, property, skills, services);
• Important decisions generally require the consent of all participants, thereby ensuring mutual control.

Among these criteria, mutual control is undoubtedly the least well known and the most problematic in the context of real estate projects structured as joint ventures.

Mutual Control: A Central and Often Overlooked Issue

In practice, participants in a joint venture do not necessarily contribute equally, whether financially or operationally. It is also perfectly acceptable for profits and losses to be allocated unequally, provided that each participant retains a reasonable expectation of sharing in the profits.

Particular attention must, however, be paid to decision-making mechanisms. Unlike a limited partnership, in which decisions relating to the management of the partnership are vested in the general partner, a joint venture does not permit one participant, or a group of participants, to exercise unilateral control over decisions affecting the project’s “essential strategic and functional aspects.”

In that regard, the Canada Revenue Agency has expressed its position both in its policy statements and in certain advance rulings.

In its policy statement, the CRA states as follows:

“A joint venture is not an entity separate from its participants. Therefore, while one participant may carry out the day-to-day activities of the joint venture on behalf of, and at the direction of, the other joint venture participants, there is usually no delegation of ultimate authority or abandonment of final control over the joint venture operations by one participant to another. Instead, essential strategic and functional decisions (e.g. major decisions such as disposition of joint venture capital property, acquisition of new capital property, large expenditures, etc.) normally require the consent of all the participants and they cannot usually be made by one participant acting as agent for another. Where the consent of all the participants is not required to make a decision, the agreement between the participants should at least require the consent of the majority of the participants (where the majority is not based on the interests of the participants in the joint venture). Therefore, no single participant or group of participants exercises unilateral control.” (emphasis added)

In a ruling issued in 2003, the CRA examined the structure of a joint venture which included a management committee consisting of three members, two appointed by one participant and only one appointed by another participant. It reviewed the question of mutual control and found that important decisions were taken by the management committee, and those decisions were to be approved by a majority of the management committee members, dominated by one participant. The CRA concluded that the criteria of mutual control for decision taking on important decisions was not respected.

In principle, in a limited partnership, a limited partner will not be called upon to take decisions relating to the management of the limited partnership if it is not involved in the structure of the general partner. It is therefore possible to structure a limited partnership so as to limit decisions to be made by certain limited partners where they are not involved in the general partner of that partnership. This can prove very useful in certain projects, where it may be preferable to limit the decision-making role of certain, or even most, limited partners.

A joint venture does not offer that flexibility. In fact, it does not offer it with respect to major decisions, which must be taken by all the participants in the joint venture. Thus, a joint venture agreement that does not expressly provide that major decisions must be made with the consent of all participants could, for that reason alone, be reviewed and challenged by the tax authorities.

Practical Consequences for Real Estate Projects

In the context of a real estate project carried out through a joint venture, decisions such as the sale of the immovable, its financing, the acquisition of other immovables, or the establishment of the financial parameters applicable to the immovable’s projected revenues generally constitute major decisions requiring the consent of all participants.

Yet it is not uncommon to find that some agreements described as “joint ventures” instead provide for majority decision-making authority vested in a management committee or in certain participants, often for the purpose of ensuring greater control to one participant or group of participants or to avoid deadlock situations. Such an approach, although it may be justified from a business perspective, is difficult to reconcile with the conditions inherent in a joint venture.

Where the application of the joint venture agreement results in an imbalance of decision-making power with respect to major decisions, the participants expose themselves to a recharacterization of their structure and to potentially costly tax adjustments. It is therefore essential, when deciding on the appropriate structure to develop a project, to determine whether the desired tax advantages justify the constraints inherent in a joint venture, or whether another structure, notably a limited partnership, would be more appropriate.

Conclusion

A joint venture may constitute an attractive vehicle for real estate projects in Québec, but it imposes strict requirements, particularly with respect to mutual control. An imperfect understanding of those requirements, or a poor alignment between business objectives and the chosen legal structure, may result in significant financial consequences.

Early involvement by legal and tax advisers who genuinely understand the particular features of the various structures used in real estate is therefore essential. Once the joint venture has been put in place, it remains equally important to understand the rules applicable to the options available to participants with respect to the treatment of sales taxes and inputs, a topic that will be the subject of a future article.