Re: Retractable or Mandatorily Redeemable Shares Issued in a Tax Planning Arrangement Exposure Draft (ED)

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1 January 15, 2018 Rebecca Villmann, CPA, CA, CPA (Illinois) Director, Accounting Standards Accounting Standards Board 277 Wellington Street West Toronto, ON M5V 3H2 Dear Ms. Villmann: Re: Retractable or Mandatorily Redeemable Shares Issued in a Tax Planning Arrangement Exposure Draft (ED) Thank you for the opportunity to comment on the above-noted document. MNP LLP (MNP) is one of Canada s largest chartered accountancy and business advisory firms, with a significant focus on clients in private enterprises. We believe that we are positioned well to provide feedback on this important issue, on which many of our clients have expressed concern. We have reviewed the document and have provided our comments below. Overall, we are pleased to see that the Board has reconsidered some of the changes proposed under the exposure draft in However, we still have several concerns. We have also identified some areas where we believe additional guidance may be needed to assist in the consistent application of the finalized standards. The origins of the Accounting Standards for Private Enterprises (ASPE) were to accommodate Canadian private enterprises different needs, including providing for less onerous reporting than that required by public companies and other publicly accountable entities. The accounting for tax planning shares is a major difference that was previously accepted on an exception basis prior to ASPE and then reaffirmed when transitioning to ASPE a few years ago. The Board has acknowledged the importance of the cost/benefit equation when developing standards, and we encourage the Board to consider all of the possible costs of implementing these proposed changes, for all of the stakeholders. The benefits to the users of the financial statements of these proposed changes are unclear. While it seems that some users have asked for clarity in the application of , in our experience, bankers and other lenders at the field level have not asked for the changes that are being proposed. Lenders and other users of the financial statements will likely continue to assess businesses creditworthiness using their own internal calculations and processes. Further, if the changes are implemented, no additional information is offered to the financial statement users as the existing standards require disclosure of the redemption value of tax planning shares. Comparability of financial statements is one of the presumed benefits of these changes. However, we are concerned that this may not be achieved because similar businesses will become less comparable to each other depending on the type of tax planning arrangement they have chosen. Their liabilities and equity positions will vary greatly even though they have undertaken similar tax planning arrangements for similar purposes. See the response to Question 3 below for specific examples. We are concerned that the presumed benefit of these changes will not exceed the costs to comply with the revised standards. A significant number of private entities may find themselves in breach of their financial covenants once their financial statements reflect the proposed changes in this standard. To resolve these breaches, owners and/or senior management personnel may need to invest a significant amount of time into renegotiating financial agreements with their lenders, which will divert time from the management of their businesses. Further, businesses may have to pay penalties and fees to the lenders for the renegotiated lending agreements. Businesses may also incur fees for professional advisors

2 regarding this matter. If all these expenses are going to be the responsibility of the private enterprises, the costs incurred by them could potentially be significant. Overall, while we agree that retractable or mandatorily redeemable shares issued in a tax planning arrangement should be presented as equity until a request for redemption has been made, we are concerned that the proposed criteria will lead to such shares being classified as liabilities more often than is intended by the Board. See our response to Question 3 for specific examples of how the criteria may be too restrictive. This issue has been discussed several times in the past and we do not believe that the understanding of the majority of users in regard to the nature of these shares has changed over time. Thus, education of the users and the time commitment required is still a significant cost if this amendment is implemented. We are also concerned that this change could negatively affect the individual entities financing opportunities, due to the lack of understanding of the users. Question 1: Do you agree that the shares issued in a tax planning arrangement with characteristics described in paragraphs 5-8, should be described as retractable or mandatorily redeemable shares? If not, what should these shares be called and why? We agree that the shares issued in a tax planning arrangement with characteristics described in paragraphs 5-8, should be described as retractable or mandatorily redeemable shares. Question 2: Do you agree that a definition of a tax planning arrangement is not necessary and that the use of judgment can be applied in practice? If not, why not? We agree that the definition of a tax planning arrangement is not necessary and that the use of judgment can be applied in practice. However, our clients and other users of the financial statements have indicated that asset rollover transactions are usually undertaken for the same reasons as an estate freeze, and it is not clear why asset rollover transactions are an excluded form of tax planning arrangement. If the intent is to only include estate freeze tax planning arrangements, then we believe it would be beneficial to define the scope as applying solely to retractable or mandatorily redeemable shares issued in estate freeze transactions. Our response to Question 3 provides some examples clarifying why we believe that shares issued in asset rollovers should be included in equity. Question 3: Do you agree an exception to liability classification for retractable or mandatorily redeemable shares issued in a tax planning arrangement based on retention of control of an enterprise and the further two conditions, as described in paragraphs of the Basis for Conclusions, reflects the notion that nothing of substance has changed? If not, why and what other conditions that reflect the notion that nothing of substance has changed should be considered for an exception to liability classification? We agree that if the three conditions are in place, then nothing of substance has changed. However, we believe that the conditions laid out in paragraphs may be too restrictive and have concerns that there will be unintended consequences. Control: We believe that the definition of control in the proposed changes may be too narrow. Consideration should be given to broadening the definition to include control within an immediate family group (i.e. parents and children, spouses) for the purposes of retractable and mandatorily redeemable shares issued in a tax planning arrangement. The

3 examples below illustrate how the narrow definition of control would lead to liability classification of the shares, when nothing of substance has in fact changed. Retention of control by the same individual should not be a condition of equity treatment if these transactions take place within a family group. In privately owned and operated enterprises, it is commonplace to execute a reorganization to transfer some or all of the future growth to the next generation. The resulting shares are typically bought out over time, if, as and when the Company can afford to pay for them. We have never seen a retraction of these shares when the Company cannot afford to do so. Due to the nature of the shares, they do not represent the typical characteristics of redeemable shares that would be considered a liability. That is, they are closely held within a family and do not represent an arm s length transaction. Their main purpose is to achieve tax planning objectives and their retraction feature is put in place for this reason; therefore, participants understand that they will not be called when detrimental to the Company. To force Companies to book the full retraction amount as a liability when control is transferring only within members of a family group misrepresents the intended substance of the transaction. Similarly, many of our clients have a share structure where a company is jointly controlled by two or more parties, such as a husband and wife. Retractable or mandatorily redeemable shares issued in a tax planning arrangement for these companies would always be excluded from equity presentation under these proposed changes. It is unclear why situations where joint control is held by the same parties before and after the tax planning arrangement result in a substantive change simply due to the fact that more than one owner controls the business. These changes would unfairly exclude family run businesses where both spouses own the business, equally, from equity presentation of shares issued in tax planning arrangements. Further, there are estate plans where control is slowly transferred to the child or children within a family group. In some of these plans, the children are issued redeemable preferred shares before they have control of the Company. Under the criteria laid out in the proposed standard, the children s shares would never be considered equity, since they would have to be initially recorded as a liability, even where it was intended that they never be redeemed. This case would create a mismatch between the accounting treatment of the shares and the reality of what they represent to the Company. Consideration exchanged: The proposed wording for Section (b) would exclude some estate freeze transactions from equity presentation and should be revised. By specifying that the shares exchanged must be shares of the enterprise that is issuing the shares, some estate freeze transactions where new corporations are created to issue the retractable or mandatorily redeemable preferred shares within the re-organized group will be excluded from equity presentation, even though the substance of the transaction is the same as a simple estate freeze. As the proposed standard is currently written, only retractable or mandatorily redeemable shares issued in simple estate freeze involving one corporation will qualify for equity treatment. When there are many corporations re-organized in an estate freeze (i.e., holdco and opco), some of the retractable or mandatorily redeemable shares will be classified as liabilities, even though they are in substance the same as the other shares issued in estate freeze transactions because the shares being exchanged are preferred shares of one company (e.g. a new company created) being exchanged for common shares of another (e.g. the operating companies). This is especially applicable for estate freezes that take place for the 3 rd, 4 th, etc. generations. We believe the wording of Section (b) should be revised to say, the only consideration exchanged in the arrangement is shares.

4 Also, we are concerned that asset rollover transactions have been excluded from equity treatment. Our clients, especially family groups, use asset rollover transactions in the same manner and for the same reasons as other estate freeze plans. The redeemable shares issued in an asset rollover are treated in the same manner by businesses and owners as redeemable shares issued in an estate freeze. The shares are often not redeemed for many years. Depending on which type of tax planning transaction the Company has chosen, its debt-to-equity ratio may not be comparable to other companies. The type of tax planning transaction should not result in the shares having significantly different presentation on the financial statements. This could negatively affect the Company s risk rating with lenders or bonding companies as these users tend to be very focused on the debt-to-equity ratio. It seems unfair to treat these transactions differently when they occur for the same reasons within a family group. With this in mind, we believe that asset rollover transactions should be eligible for equity treatment, and the criteria in Section (b) should be removed from the standard. Redemption schedule: Even if a redemption schedule exists, whether the redemptions take place according to the schedule is often still at the discretion of the holder of the retractable or mandatorily redeemable shares. We have never seen a retraction of these shares when the Company cannot afford to do so when the shares are held by an immediate family member. It is our view that the redeemable shares do not represent a liability until such time that redemption is formally requested. Treating the whole balance of shares as a liability because there is a plan to redeem them years into the future, is not consistent with what the shares represent to the Company now. We believe that the criteria in proposed Section (c) is too restrictive and should be removed. We believe that the amended control criteria, as we have suggested, is sufficient to determine if the shares should be classified as equity or a liability. The Basis for Conclusions section of the ED notes that there is confusion in practice when applying the current exception in paragraph as to when redemption is demanded. We don t believe that the proposed amendments to adequately address this confusion. In practice, users may not interpret the future plans of redemption or when redemption has been demanded consistently, limiting comparability of the financial statements. In summary, when these types of tax planning arrangements occur within a family group with the intent to transfer equity from one generation to the next, nothing in substance has changed and there should be no change in the accounting treatment of the equity. We believe the conditions in paragraphs are too restrictive and may result in an inappropriate reclassification of the Company s equity as a liability. The criteria in Section should be amended such that in (a) the definition of control is broadened to include control within an immediate family group, and (b) and (c) should be removed. Question 4: Do you think retractable or mandatorily redeemable shares issued in a tax planning arrangement classified as financial liabilities should be measured at the redemption amount? If not, why not? We agree that if these shares must be classified as a liability, then they should be measured at the redemption amount. Question 5: In order to provide sufficient guidance to stakeholders in assessing control, the Board proposes to provide additional guidance on substantive rights in SUBSIDIAIRES, Section Do you think this additional guidance could affect control assessments beyond the scope of this project? If so, should the Board consider providing transitional relief? Please provide examples of situations where a control assessment could change as a result of this additional guidance and how commonly these situations occur.

5 We do not think that the additional guidance on substantive rights in SUBSIDIARIES, Section 1591 will affect control assessments beyond the scope of this project. However, if effects are found beyond the scope of this project, the Board should provide transitional relief. Question 6: Do you agree that the effect of classifying and measuring the financial liability at its redemption amount should be presented in a separate component of equity? If not, how should the adjustment be presented and why? We agree that the effect of classifying and measuring the financial liability at its redemption amount should be presented in a separate component of equity. However, we have concerns that one significant user group, the lenders, will not fully understand the debit in equity and that this will negatively affect their evaluation of a company s credit worthiness. Our past experience would suggest there is a significant risk that some of the loans personnel that directly interact with private enterprises will not have the same understanding of this issue as the higher-level executives of lenders would. For this reason, we are concerned that there is a potential for a significant number of private enterprise owners to be negotiating their financing needs with individuals that do not have a sufficient level of understanding of the nature of these shares. These users would have to be educated to ensure private entities opportunities to obtain financing would not be diminished by the proposed standards change. We believe there is a risk that, although the financial institution personnel consulted have an intellectual understanding of why there would be a deficit on the financial statements, in practice this change may still affect the assessment of credit risk. Credit risk may be assessed much higher than previously, resulting in either the denial of financing or the imposition of restrictive terms and covenants, either of which could significantly impact a private enterprise s future operations. Another significant user group may be bonding and other similar companies. Our concern is that these critical users of private entity financial statements may also not understand the reason for the debit balance in the equity section. This may create a huge cost to the entity through increased bonding fees or result in them not being able to get bonding at all, if the bonding company perceives that the entity has a solvency issue. Also, our understanding is that there may be adverse tax consequences for private companies with business operations in Quebec. Under the Quebec Income Tax Act, a corporation must calculate its taxable capital. The amount of taxable capital is increased by the amount of paid-up capital and by any debt in existence for more than 6 months. The proposed standards change will result in an increase in the taxable capital amount, as the offsetting debit in equity would not reduce the taxable capital for the Company for Quebec purposes. Unlike the federal Income Tax Act, the Quebec Income Tax Act does not contain a specific provision to allow for the deduction of the amount that would be recognized in a separate component of equity. Question 7: Do you agree with the proposed disclosures in EQUITY, Section 3251, about the charge resulting from classifying and measuring the liability and presented as a separate component of equity? If not, why not and what disclosures, if any, should be provided? We agree with the proposed disclosures in EQUITY, Section Question 8: Do you agree that retractable or mandatorily redeemable shares issued in a tax planning arrangement classified as a financial liability should be separately presented on the balance sheet? If not, why not?

6 We agree that retractable or mandatorily redeemable shares issued in a tax planning arrangement classified as a financial liability should be separately presented on the balance sheet. We believe that this separate presentation will help to limit confusion about the nature of the liability resulting from retractable or mandatorily redeemable shares versus operating liabilities. However, we are concerned that the standard does not make clear whether the liability should be treated as current or long-term and the basis for how this would be determined (i.e., based on the obligation or the expected repayment schedule). Without this guidance, the liabilities resulting from retractable or mandatorily redeemable shares may be classified inconsistently between entities. Question 9: Do you agree with the proposed disclosure requirements in FINANCIAL INSTRUMENTS, Section 3856, to require a description of the arrangement that gave rise to the retractable or mandatorily redeemable shares issued in a tax planning arrangement? If not, why not? We agree with the additional disclosure requirements proposed. Question 10: Do you agree that the proposals should be applied retrospectively in accordance with ACCOUNTING CHANGES, Section 1506, with simplified transitional provisions and an option to not restate comparative financial information? If not, why not? We agree that the proposals should be applied retrospectively in accordance with ACCOUNTING CHANGES, Section 1506, with simplified transitional provisions and an option to not restate comparative financial information. Question 11: Do you agree that the proposals should not require an enterprise that chooses to retrospectively apply the amendments, to restate retractable or mandatorily redeemable shares in a tax planning arrangement that were settled or otherwise extinguished in periods prior to the date the amendments are first applied? If not, why not? We agree that an enterprise that chooses to retrospectively apply the amendments should not be required to restate retractable or mandatorily redeemable shares in a tax planning arrangement that were settled or otherwise extinguished in periods prior to the date the amendments are first applied. Question 12: Do you agree that the transition options should be available on first-time adoption of accounting standards for private enterprises? If not, why not? We agree that the transition options should be available on first-time adoption of accounting standards for private enterprises. Question 13: Do you agree with the proposed effective date (i.e., fiscal years beginning on or after January 1, 2020)? If not, why not? We believe that an effective date of January 1, 2020 should provide sufficient time to implement these changes. Time is needed for practitioners to communicate these changes and discuss the impacts with clients. Clients will need to be educated on the expected effect on their financial statements and how the changes may impact their loan covenants, so they are prepared to discuss the changes to the financial statements with their lenders, when loans are being renegotiated. Once business owners are aware of the change and understand its implications, they will have to undertake the renegotiation of their loan agreements with their financial institutions.

7 Additional comments: We believe that the amendments to Section 3856.A29 should include the criteria set out in , in order to facilitate its application in practice. Also, Example 4 in Section 3840 as presented at the end of the ED, notes that the consideration given up is cash and shares in exchange for a building. Since there is consideration exchanged other than classes of shares, should the shares issued should be classified as a liability instead of equity, to be consistent with the changes proposed in the ED? We are pleased to offer our assistance to AcSB in further exploring issues raised in our response and in helping to find alternative solutions which meet the needs of financial statement users. Yours truly, MNP LLP Jody MacKenzie Jody MacKenzie, CA Director, Assurance Professional Standards