Determining the right type of financing and obtaining loan approval is the easy part of a transaction. The real work begins as part of the closing process which can range from very simple to very complex depending on the ownership structure of the borrowing entity.
Many borrowers and owners of a property can have a different understanding of what their ownership structure entails.
This is one of the most common and challenging aspects of the closing process, because when the ownership structure as originally conceived in the underwriting process changes at the last minute or is not reflective of what was initially disclosed, it can result in the closing being delayed and an increase in legal fees.
Many professionals have different perspectives on ownership structure depending on the professional’s field. The tax accountant, the lawyer and the lender all look differently at an ownership structure.
The tax accountant, for example, looks to minimize taxes paid and to set up an ownership structure that achieves this. The lawyer, on the other hand, may advise clients to set up an ownership structure that minimizes the risk to the individual and shelters the personal covenant away from a lender.
The lender has to understand the ownership structure in order to comply with the Federal Government’s Know Your Client (KYC) Rules. A lender has to identify who the actual client is. When I say who the client is, I am referring to the ultimate individual or individuals who benefit from the asset.
This is where determining the true ownership structure can become complicated.
Let’s look at some examples:
The simplest ownership structure is to buy and hold an asset in the owner’s personal name. This is generally the structure used by individuals owning single family homes.
Although not necessarily common, occasionally this does get used in commercial transactions. It can be simple, since a lender can run a title search and identify that the individual applying for the loan is the one who holds title to the asset. The closing process is simple because it’s clear who the client is and the benefactor of the asset is.
Things can get more complicated when a company is incorporated to hold title to the asset. This is very common in commercial transactions and involves another “layer” that the lender has to identify during the application and closing process.
For example, the company may be identified as a numbered Canadian Company with an individual being the owner of the company. In this example, there are two different forms of ownership.
The first would be to have the company be both the title holder and beneficial owner of the property. From the accountant’s perspective, financial statements and tax returns for the company are generated, as the company is the true owner of the asset.
From the lawyer’s perspective, the company is the legal and beneficial owner of the asset. From the lender’s perspective, I know that the company holds title to the asset and the individual owns the shares of the company.
Second form of ownership
The second form of ownership occurs when the company holds title to the asset in trust, for a beneficial owner. This now creates some additional layers to the transaction, since the beneficial owner can take the form of an individual or another company or even a family trust.
Let’s, however, look at the individual being the beneficial owner of the property. In this scenario, the company holding title does not produce financial statements and the individual receives the benefit of the cash flows from the property through their personal tax return.
This ownership structure involves the individual as beneficial owner of the property and not the company holding title which is almost identical to holding title to the asset in your personal name.
The variance is the difference between the corporate tax rate and personal tax rate. I now understand that the individual is the beneficial owner and not the company.
Trust arrangements such as this can be complicated, and the more layers that are introduced, the more both a borrower and a lender can become confused. When multiple layers exist, the lender is required under federal regulations to “drill down” in order to determine the individual(s) involved in the ownership of the asset and truly understand the ownership structure.
Many borrowers do not clearly understand
In countless scenarios, many borrowers do not clearly understand the legal and beneficial ownership concepts of the property. In this situation, when a borrower does not truly understand their ownership structure and the closing documentation confirms a different structure than initially anticipated, this can lead to last-minute changes and delays in the closing process.
Many times a lender will ask a borrower who and what type of company holds title to the asset and the answer is “I do.”
However, once the drill down starts at the closing process and the lawyers identify a different ownership, the lender has to reevaluate the transaction and the parties involved. Ultimately, it may not be the individual who owns the asset but another company or individual or a family trust.
The additional parties involved now require the lender to obtain further information to safely say they “know their client”. This can create unnecessary stress and increases in legal costs to the transaction beyond what should have been.
By understanding your ownership structure when applying for a new loan, it will not only save you time and money but most importantly unnecessary stress.
Darryl Bellwood is a Director of Commercial Lending with First National Financial, Canada’s largest non-bank lender. He is active in most markets in the country with a focus on investment real estate. All feedback is welcome and he can be reached at [email protected].