Top 10 tips for developers dealing with retentions and escrow agreements
Retentions and escrow agreements can be useful mechanisms in a sale or purchase of a development site to cover the risk of payments or works which need to be carried out by the other party. This article focuses on retentions and escrows used by purchasers/developers in the course of land transactions, but they are also used in a corporate and construction context.
1. What is the difference between a retention and an escrow?
A retention is a sum which is “retained” from the purchase price, usually by the purchaser. It will not be released to the seller until a trigger has occurred under the contract. But it will still form part of the purchase price paid at completion. An escrow is an agreement under which funds are held.
2. Why do you need a retention? (1) Works and payments
They are mostly used on purchases of a parcel which forms part of a wider scheme, where the purchaser is relying on the seller to carry out works for the benefit of that parcel, or make payments that affect the development of that parcel. The money held as a retention can then be used where those works are not carried out within the timescales required and a developer has to “step-in” see below). Can also be used to cover off a risk of e.g. an unanticipated s106 payment or CIL.
3. Why do you need a retention? (2) Covenant strength of seller
Where the seller is e.g. an SPV with limited assets, or the value of works, or the amount of payments, are high, there will be limited recourse for recovering expenditure from them. A retention offers certainly for recovery of costs.
4. How much should a retention be?
The retention must be sufficient to cover off costs of any works or payment. This requires considerable input up front to scope the cost of works and ensure that the retention is sufficient. The contract should also provide that where costs more than the retention then the seller has to repay the “shortfall” to the purchaser.
5. Step in rights
It is all well and good having a pot of money out of which you can deduct your costs but a developer needs to ensure that if they are carrying out works to third party land they have sufficient step-in rights to by way of licence or easements. To avoid occupation restrictions or the site being ransomed by non-completion of access or servicing works.
6. Triggers for deduction from the retention
The parties need to be clear what the trigger for the deduction from the retention is and return of the balance (if any). E.G. Practical completion of works or evidence of payments.
7. SDLT considerations in respect of a retention
As above, the retention forms part of the purchase price and will attract stamp duty land tax. You may apply to HMRC to defer the SDLT on the retention (on the basis that it is a contingent amount). Or if SDLT was paid on the entirety of the purchase price including the retention, the purchaser might be able to apply to HMRC to recover the SDLT paid on the retention by amending its SDLT return in the 12 month window. Once this has passed, the purchaser cannot recover the SDLT paid on the amount of any retained payment.
8. VAT considerations in respect of a retention
If the seller has opted to tax then VAT will also be payable on this retention. As the VAT is usually paid on completion SDLT will need to be paid on the whole amount of the VAT, and deferred as above if possible. But ensure your cash flow accounts for VAT.
9. What are the terms of the escrow agreement?
Consider whether or not (1) you will hold the retention – this is better for cash flow (2) it will be held by your solicitors (and whether this can be achieved under the Solicitors Accounts Rules) or (3) if it will be held by a third party escrow agent (if so, who covers the costs?).
10. Control of release of release of the retention from the escrow
The parties will need to consider who controls the release of funds e.g. does evidence need to be provided to, or from, an independent third party? Or do both parties just have to agree it is released? How soon the funds need to be made available will be a key consideration for this point. If there is a disagreement as to release of funds the parties need to consider how this will be resolved i.e. will it be referred for expert determination?