Multiplying business units: statutory requirement or initiative of large construction companies

Today, in the domestic market of construction, there are many smaller enterprises around large construction companies, sometimes affiliated with the developer, most often in the form of limited liability partnerships (LLP). We will try to understand why this is happening and for what purpose it is necessary to establish additional business units in this research.

Several factors are influencing the establishment of such market entities:

Administrative factors - when business units are created in accordance with the requirements of legislation and/or other regulatory documents;

Economic factors - when business units are designed to structure business processes, hedge risks, for the efficiency of accounting, as well as for compliance with a certain financing scheme, market trends, and others.

1. Influence of administrative factors

1.1 Legislation on architectural, urban planning and construction activities

With the amendments made to the Law of the Republic of Kazakhstan "On Architectural, Urban Planning and Construction Activities", which entered into force on January 1, 2016, the process of accepting newly built objects into operation has been optimized by eliminating the stage of commissioning a facility into operation by a working commission, and the composition of the state acceptance commission was minimized to the main four participants in the construction process: customer, contractor, architectural/design supervision, he is also the general designer (unless, of course, he transferred such a right to another specialized company, as is often the case) and technical supervisor. The listed entities are expressed in the form of registered JSCs, LLPs, and sometimes even individual entrepreneurs. Other participants actors  are also involved in the construction process: concerned government authorities, private expertise and state out of a departmental examination of projects, laboratories, geologists, surveyors, engineering companies managing the projects, and others, which we will dwell on a little later.

The main four construction participants perform the following functions:

Customer – is an individual or a legal entity performing activities according to the Republic of Kazakhstan’s legislation on architectural, urban planning and construction activities. Depending on the objectives of the activity, the customer can be the customer-investor of the project (program), the customer (owner), the developer or their authorized persons. Often, a customer is an entity that owns or leases a land plot on which it is planned to build an object. However with the development and improvement of public-private partnership transactions, rights to a land plot can be formalized in a different order. In the often-used classical schemes, the construction customer is the holder of the land plot, permits, design and estimate documentation. During the construction process, he is the copyright holder of the unfinished construction in the amount of the accepted interim acts of the work performed, upon the acceptance of the object – the copyright holder for the entire constructed object.

The general contractor is the performer of construction and installation works in accordance with the working project approved by the Customer and developed by the designer. The general designer is the developer of design estimate documentation. The general contractor is the contractor who performs the work on his own and by the forces of involved subcontractors, for which he solely bears full responsibility to the customer and other owners in the event of a change of ownership during the warranty period. He performs construction and installation work, ensuring the achievement of the project commissioning, thereby forming a new object on the customer's balance sheet.

Architectural supervision is the author's power to control the implementation of a construction project carried out by its developers, including the author(s) of architectural or urban planning work.

Technical supervision - supervision of construction at all stages of the project, including quality, timing, cost, acceptance of work performed, and commissioning of facilities.

1.2 Legislation on shared-equity construction

The construction market covers various spheres of life: construction of social facilities, construction of industrial facilities, housing construction, etc.

Using the housing construction market as an example, one can understand the nature and necessity of new business units’ establishment. At the initial stage in Kazakhstan, housing was built at the expense of budgetary funds by state operators, at the cost of the employer for their employees, then through mixed financing under the terms of a public-private partnership, at the expense of private and borrowed funds of private developers, as well as by attracting money from equity holders (the most common method today).

In cases of the state housing construction, the construction customer is often a regional state institution subordinate to the local administration. Such a subordinate entity transfers housing to the regional housing operator for distribution or financial management after putting the facility into operation.   In general, this set-up does not require creating additional business units for each apartment building under construction.

During the construction of housing under the public-private partnership scheme, the program operators from the state in different years were Samruk-Nedvizhimost JSC, Baiterek Development JSC and Kazakhstan Mortgage Company JSC, and they did not impose any requirements regarding the creation of new business structures. However, the partners-developers could always create separate business units for each project for the construction of a residential complex to structure their activities, to effectively account for and differentiate risks between the company's internal projects. This practice could be applied during construction by the employer for his employees, as well as by private developers who implement projects using their own and attracted funds.

Special attention should be paid to the financing housing construction by attracting money from equity holders method, which is very popular today. The exclusive benefit of this scheme is guaranteed sales during the construction phase. For example, in many Western countries, the developer does not have access to the money received from equity holders before the facility is put into operation. Then in our country, the disposal of these funds is allowed at the construction stage, and therefore, the benefit from this construction method is attracting money as financing.

The development of the domestic market for the construction of shared housing can be conditionally divided into two stages: before the adoption of the new Law “On equity participation in housing construction” dated April 7, 2016 (hereinafter referred to as the Law), and after the entry into force of this Law. So, if, before the law adoption, transactions were not guaranteed by the state, the creation of separate business units for each project was solely the privilege of the developer himself. Where the risks of equity holders were more often regulated by the Civil Code, following the example of risks covered by signing joint operating agreements. Later preliminary sales and purchase agreements were concluded (it should be noted that there are still a number of construction companies that work "the old-fashioned way", despite the criminal and administrative liability for attracting money from equity holders without a permit).

Under Article 7 of the Law, equity participation in housing construction is organized in one of the following ways:

- obtaining a guarantee of a Single Operator;

- participation in a second-tier bank project;

- raising money from equity holders after the construction of the frame of an apartment building.

In all three cases, the Law requires the establishment of a separate business unit in the form of an authorized company: the developer creates an authorized company or acquires one hundred percent of voting shares (participatory interest in the authorized capital) of another legal entity to carry out activities under no more than one project for the construction of an apartment building. In practice, most frequently, the new limited liability partnerships are created, which is surprising and creates some kind of uncertainty for consumers and customers.

That is why many do not understand why the name of a well-known construction company appears in a new housing complex advertisement, and when it comes to signing an agreement, it turns out that the deal is with a completely different, unknown company, most often registered quite recently.

In fact, the risks for equity holders are minimal, since in this case, the authorized company and the general contractor open no more than one bank account and only in one bank, advance payments are strictly regulated, and the withdrawal of funds from the bank account of the authorized company in favor of the general contractor is strictly according to the acts of work performed and is audited by specialized engineering companies. Also, the parent developer bears subsidiary liability in accordance with paragraph 10 of Article 19 of the Law.

There are other examples of the influence of administrative factors on the creation of new business units. Thus, the market also has the requirements of international banks, which regulate their own procedure and structure for the implementation of joint construction projects (for example, the presence of security firms that should operate as a separate business unit). Such conditions are negotiated at the stage of agreeing on the terms of financing the future project.

2. Influence of economic factors

Economic factors can influence the establishment of new business units both in the contractor’s structure, and  in the structure of the customer or developer, as  the key participants in the construction process.

2.1 Structuring business processes.

Today, many developers and builders build a structure for their business area, in order to effectively manage and minimize risks. For example, developers allocate their architectural workshop in the form of a design institute to a separate business structure, with its separate state license. Due to the demand in the market for finished apartments, the creation of design studios and furniture and accessories showrooms has recently become popular. When a company has a large number of facilities, it is also useful to set-up separate security companies. To sell apartments, companies have recently started setting-up thier own or affiliated real estate agencies.  It should be noted that such agencies, operating in the secondary real estate market, often lure away a solvent client in favor of apartments in a certain residential complex. Some companies create new business units in the form of advertising agencies.

During the construction process, different types of risks arise and they are different for each entity, therefore, in order to hedge such risks, the participants in the process create certain business units.

To separate the activities, some construction companies allocate a concrete plant into a separate structure, others - transport and mechanization, some large construction companies also have their own service companies serving already erected residential complexes. To reduce construction costs, some companies attract cheaper foreign labor resources - even through separately created companies, thereby minimizing possible reputational risks and risks associated with fines for violation of migration laws for the parent company.

Large construction companies are split into subordinate companies according to various criteria, it can also be geographic characteristics, that is, the distribution of construction volumes by regions, and the ranking of subordinate companies depending on customers, are often divided by areas of activity, some are divided in connection with business partners.

2.2 Trends in the construction market

There are two main stages in the life cycle of domestic construction companies. The first is when the company develops a name, and the second is when the company uses its name to generate revenue. Let's consider how these two stages relate to the number of created business structures around them.

Previously, many large construction companies tried to organize a full production cycle, thereby controlling all processes and achieving high construction quality Concrete plants, metal workshops, vehicle fleets, precast concrete factories, and others were organized in their subordinate companies.

Now, many construction companies have switched more to the construction management model, giving all processes to outsourcing, or, as they say, in construction slang - to subcontracting. This trend reduces the number of subsidiary business units in large corporations.  It gives impetus to the development of small and medium-sized businesses by stimulating new demanded private business units.

With all other factors, almost all developers have approximately equal conditions of accessibility to construction resources; the average quality of all companies is quite the same since the work is actually performed by the same people who move from one company to another depending on the construction volumes. Therefore, at this stage, the winner is the one who builds faster. People usually prefer buying apartments from such developers, since most of the real estate buyers are still skeptical about the so-called "long-delayed construction" (many still believe: if it takes them a long time to build, it is a suspicious and not reliable company).

The change in trends in the form of a transition from a full cycle of construction to project management that explains the emergence of new structures on the market for construction companies. Where previously affiliated companies are now moving into partner companies’ status.

2.3 Funding and partnerships as a reason for creating new business units

While in many Kazakhstan regions, including the capital, the land fund is not very limited, then in Almaty there are almost no free lands to implement the ideas of construction companies. Recently, developers have had to buy land at reasonably high prices at auction from second-tier banks or acquire and demolish existing facilities for building new ones. All these factors ultimately affect the final cost of apartments and make their own adjustments to the construction companies’ structures in terms of creating new business units.

For example, it has often been practiced to create new business units through cooperation between developers and landowners in recent years. Developers began to understand that it is unnecessary to buy out plots at high prices when it is possible reaching agreement on joint participation in the project. If earlier private companies and business people participated in such cooperatives, then recently second-tier banks with land plots they have on their balance sheets have also entered such schemes. In some cases, they even finance the developer with credit funds since the banks themselves are limited in entrepreneurial activity.

Such a partnership scheme requires  adequate control over the expenditure of funds. That is why, new limited liability partnerships  are most often created with predetermined shares of partners, while a large developer, becoming a member of a new business unit with a certain percentage of share, continues positioning itself in the market and conducting advertising campaign on behalf of its well-known brand. Often, such new business units also include suppliers of rolled metal products, concrete, and other building materials and structures.

2.4 Tax accounting

In accordance with tax legislation, the sale of apartments by developers is included in the total aggregate annual income, which is taxed, taking into account adjustments and deductions. At the same time, it is allowed to take into account adjustments and deductions only for the taxpayer’s expenses in connection with the implementation of activities explicitly aimed at generating income.

When several projects and activities are implemented in one business unit, then certain difficulties arise in proper tax administration. Of course, there are no special requirements for establishing a separate company for each project, however, for the purposes of practical tax accounting and administration, different companies are often created for each project.

It is also convenient in regards to obtaining the initial permits and approvals for the implementation of the newly created company’s project. Indeed, a land plot itself or a land plot with unfinished construction before commissioning is a clumsy, low-liquid asset. The allocation (cutting off) of which into a separate company gives maneuverability and flexibility, since it can be implemented by changing participants in the partnership for which the land plot is registered at any stage of the project implementation.

What happens after the completion of construction with business units created for a specific project?

In accordance with the Law of the Republic of Kazakhstan on equity participation in housing construction dated April 7, 2016, the Developer has the right to attract an authorized company that has fulfilled its obligations for the construction, commissioning and acceptance into the operation of the previous project for the construction of an apartment building, or another legal entity, the sole founder (participant) of which he is. Therefore, the created company can be used on the next project as an authorized company. Sometimes such companies remain service companies serving the constructed residential complex. In other cases they are liquidated.

Co-authored with Aset Sabituly, Assosiate