Common pitfalls of property developers

The world of a property developer is an ever moving landscape of choices and, for each opportunity, there are a myriad of potential directions the deal can go in. Because of the need for flexibility the paths which can be travelled are often littered with potential commercial and taxation pitfalls.

This article highlights some common issues and potential pitfalls which should be born in mind by developers. This doesn’t include purchases at auction, which carry their own set of issues.

A change of intention

Many developers looking at opportunities, such as the conversion of an industrial unit into a residential property, or possible green field developments will often start a project with the intention of buying the land in total, building out the development in full and then selling on all the properties to realise their profit. In taking initial advice, they will often plan and structure their affairs to follow such a route. However, market conditions and indeed commercial factors can influence this decision making part way through the project and therefore the intention changes.

Example 1

A developer whose original intention on a piece of bare land, following the grant of planning permission, was to build out a number of residential dwellings and for these to be sold in full to third parties on completion of the building project. From a VAT perspective all of the input VAT on the development would be fully recoverable with some notable exceptions (i.e. white goods in fitting out any houses).

However, market conditions change and, with them, the developer’s intention is forced to change. They now decide to hold some or all of those properties once built out and rent them out to third parties on a long term basis. This changes the nature of the initial supply from one of a zero rated supply on a sale of the new build property to an exempt supply of letting. The implication is that if VAT has been recovered on the building costs up to the point of the first supply because the original intention was to sell, then this VAT is now repayable to HMRC.

A planning solution around this potential loss of VAT could be actioned to avoid the clawback. Timing is key; planning after the event is generally ineffective.

Example 2

A one-off developer has had an opportunity to convert an existing industrial property into residential units. They then propose to hold all of the residential assets as a long term investment. The treatment of the building out of those properties would be that of creating an investment to produce future rental income.

The impact of legislative changes, such as the change in the tax deductibility of mortgage interest, may have a serious impact on a large scale, holding a residential property where the holding is highly geared with mortgage debt. The developer may decide that they have to dispose of some or all of the newly developed residential properties in order to reduce the tax impact of the change in deductibility of mortgage interest.

The interesting implication is that ‘has this change of legislation and resulting change in intention created a trading activity for the developer?’

We would argue that this is not the case, however, HM Revenue & Customs may be inclined to look at the sale of some of the properties as a trading activity and tax it accordingly as income, which would be disadvantageous to the developer. Therefore, to avoid such pitfalls, it is important that the audit trail surrounding intention is robust.

Again, VAT considerations could be significant here with early consideration offering significant potential savings.

Example 3

Some developers will purchase options over land rather than purchasing the land outright whilst they apply for planning permission. The intention at the outset may be for the option to be exercised and the land purchased wholly and then built out. However, once planning permission is received, offers may come in on the land unbuilt out, which the developer decides may be a lucrative opportunity for them to cash out the deal and use their capital and profits on the next deal. This would result in a VAT issue being created. VAT may have been recovered initially where the intention was to build out and have a zero rated supply at the end of the process. With the change of intention, the supply becomes that of a simple land transaction, which is an exempt transaction for VAT and all the recovered VAT on input can then be clawed back by HMRC. Even where the land has been opted to tax, this may not always prove effective.

In some circumstances whereby the change of intention is forced upon the developer there may be an argument for VAT clawback, only from the point of change of intention and not for the whole of the period.

Joint venture financing

We are often asked questions regarding developments funded by groups of investors. For example, the lead developer is holding the asset inside a limited company and receives loans from third party investors into the limited company. They will then partake in the profits of the development at a future date. How should such investments should be structured?

The options are as follows:

Shareholdings

The investors could take shares in the investing company and from an investor’s point of view, this would be fairly secure as they have some degree of control over the destiny of the business. However, from a cost perspective, drawing up complex shareholders’ agreements can be time consuming, as well as expensive, and may be too cumbersome for some investors.

Loan

Often where the investors know the developers, the financing can be in the form of a simple loan with a fixed coupon interest rate based on an agreed return for an unsecured loan. This is paid out as interest to the investor. If the loan is from an individual, the developer company would need to complete form CT61 when paying out the interest and pay over any tax deducted from the interest. Interest payable to corporate investors would not need to suffer any income tax deduction.

Loan with variable coupon rate depending on the profitability of the company

There may be a situation whereby a loan is made to a corporate vehicle, which has a non-defined coupon, calculated by reference to the property development profits after the properties have all been sold. A mechanism would need to be agreed up front between the investor and the developer and this could be complicated due to the need for loan agreements. However, a lawyer should be able to assist in the drawing up of these. Again, any payments to the investors can take the form of interest payable by the developer company.

Occasionally, the investing company may also be in the activity of development and, therefore, this may create opportunities for the investing company. Not only, could they lend capital at, potentially, a very low rate of interest, but, because they are adding some form of skill or added value to the development, they may be able to charge a fee, agreed or variable, to the developer based on the outcome of the profits. This may be a finder’s fee or for services rendered. This would be taxed as trading income in the recipient’s hands.

Some pitfalls of the above financing arrangements may be again related to VAT in that if there is some form of service being provided by the investor, is this a VATable supply and should the investor be VAT registered for this trading activity? Also, if the income is not interest and is deemed to be of a trading nature, how does this impact on the investor personally or, if through a company, the other activities carried on by that company?

As a final note, there is no doubt that property development will nearly always carry with it VAT and structural issues. Seeking advice in advance of carrying out a transaction is invariably the safest route to avoid VAT leakage, very expensive VAT problems or to be caught in a structure, which is not suitable to the developer.

Gaming possible scenarios at an early stage may well prove a valuable investment in today’s property market as early action to pre-empt risks may not be possible further down the line.

If you would like to discuss any property development issues, please call Mark Cassidy or your usual Mercer & Hole partner.