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

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1 Retractable or Mandatorily Redeemable Shares Issued in a Tax Planning Arrangement (Exposure Draft) February 2018 Flash Flash bulletins provide a summary of the most recent news and publications from standard setters on accounting standards for private enterprises (ASPE), not-for-profit organizations (NFPO) and pension plans. This edition of Flash addresses the Exposure Draft issued by the Canadian Accounting Standards Board (AcSB) in September 2017 entitled Retractable or Mandatorily Redeemable Shares Issued in a Tax Planning Arrangement (Proposed amendments to Sections 1591, 3251 and 3856) which is relevant to private enterprises who report under Part II of the CPA Canada Handbook Accounting and apply ASPE. This publication is intended to inform readers about recent changes in accounting; however, it cannot deal with all aspects of the Exposure Draft. Readers are always encouraged to refer to the original publications mentioned in the articles before making any decisions. Overview In October 2014, the AcSB issued an Exposure Draft pertaining to ASPE which proposed significant revisions to the accounting for redeemable preferred shares issued in a tax planning arrangement under specific sections of the Canadian Income Tax Act (ITA). Had these amendments been issued as proposed, it would have resulted in the presentation of all preferred shares redeemable at the option of the holder as financial liabilities. Because of the significant concerns raised in response to the 2014 Exposure Draft, the AcSB reconsidered its 2014 proposals and proceeded to develop alternative guidance regarding the reporting of redeemable preferred shares issued in a tax planning arrangement. The new proposals are contained in the AcSB s September 2017 Exposure

2 Draft entitled Retractable or Mandatorily Redeemable Shares Issued in a Tax Planning Arrangement (Proposed amendments to Sections 1591, 3251 and 3856). The proposed amendments will result in significant changes in the accounting for redeemable preferred shares issued in a tax planning arrangement. Under the proposals, some of the preferred shares now classified as equity under the liability classification exception in Section 3856, Financial Instruments, would remain classified as equity if they meet certain conditions, while we expect many preferred shares will be reclassified as liabilities and recorded at their redemption value. Why the change? The AcSB is of the view that shares redeemable at the option of the holder are contractual obligations that will generally be repaid in the future with cash or other financial assets; therefore, these shares meet the definition of a financial liability under ASPE and as such, they would normally be reported as liabilities on the balance sheet at their redemption amount. However, Section 3856 currently provides a classification exception that requires retractable preferred shares issued in a tax planning arrangement under specific sections of the ITA to be presented as equity (hereafter the classification exception ) and measured at their par, stated or assigned value. There are application issues in practice today that caused the AcSB to re-examine the classification exception in Section 3856: There are transactions for which the classification exception was not intended, but is being applied. These transactions include commercial financing arrangements, transfers of individual assets, employee compensation plans and management buyouts. The AcSB wanted the exception to apply only to on estate freezes (which are generally when the value in the enterprise is frozen for the benefit of the owner while the future growth will accrue to the next generation). Some retractable or mandatorily redeemable shares issued in a tax planning arrangement are excluded from the scope of the classification exception because they are not issued under any of the specified sections of the ITA listed in Section However, these shares have the same characteristics as shares that currently meet the classification exception, which is inconsistent. There is confusion as to when retractable or mandatorily redeemable shares issued in a tax planning arrangement should be reclassified as liabilities. In creating the new proposed amendments, the AcSB analyzed their benefits and the costs to stakeholders and considered feedback received from users of financial statements and other stakeholders in roundtables and outreach activities throughout Canada. The AcSB acknowledges that the proposals will result in a change in practice; however, in their view, the AcSB concluded that the decision to retain a classification exception for a limited set of circumstances would be better than removing the classification exception entirely. 2

3 Proposed amendm ents to Sections 3856 and 3251 Equity The classification exception proposed by the AcSB is based on the principle that nothing of substance has changed in the management and operations of the enterprise as a result of the tax planning arrangements in which redeemable shares are issued. They are of the view that if nothing of substance has changed, such as the retention of control by the shareholder holding the redeemable shares, an exception from liability classification would be warranted. As a result, it proposes the following significant amendments to Section 3856: The current classification exception in Section 3856 would be replaced with a new classification exception. Retractable or mandatorily redeemable shares issued in a tax planning arrangement (which is not defined in the guidance) that meet the all three of the following conditions would be classified as equity and measured at their par, stated or assigned value: 1. Control test: Control of the enterprise issuing the retractable or mandatorily redeemable shares in a tax planning arrangement is retained by the shareholder receiving the shares in the arrangement; 2. Share exchange test: The only consideration exchanged in the arrangement is one class of shares for another class of shares of the enterprise issuing the shares; and 3. Redemption schedule test: No other explicit or implicit arrangement exists, such as a redemption schedule, that gives the holder of the shares the contractual right to require the enterprise to redeem the shares on a fixed or determinable date or within a fixed or determinable period. All other retractable or mandatorily redeemable shares issued in a tax planning arrangement would be accounted for as financial liabilities at their redemption amount. Any resulting difference between the redemption amount of the shares and the carrying amount of the shares or assets exchanged would be recorded in a separate component of equity. For the first test, control would be assessed based on guidance in Section 1591 Subsidiaries. Any tax planning arrangement transactions involving shareholders with joint control or significant influence would lead to the classification of any retractable or mandatorily redeemable shares as liabilities. The second test aims to limit the classification exception to estate freezes that meet the required conditions. This means that retractable or mandatorily redeemable shares issued in asset rollover transactions would not be classified as equity. In the third test, the AcSB decided that the existence of a redemption schedule specifying the timing of redemption of the shares by the issuer would require liability classification of those shares. 3

4 In the following table, we provide examples of transactions that would or would not qualify for equity classification under the proposals, assuming there is no redemption schedule in place: Classification as equity Estate freeze where the controlling shareholder continues to control the enterprise afterwards Classification as liabilities Asset rollovers i.e., the transfer of assets between related parties (no matter the nature of the relationship) Transfers of businesses under common control Estate freezes for shareholders who do not have control (e.g. significant influence or joint control) Business combinations A series of transactions where the substance of the overall transaction is to transfer assets in exchange for retractable shares UNCLEAR - Dividends of retractable or mandatorily redeemable shares paid to the controlling shareholder Reassessment of classification An enterprise would be required to reassess the classification of the retractable or mandatorily redeemable shares classified as equity only when a subsequent event or transaction occurs that indicates one or more of the conditions for equity classification may no longer be met. When no longer met, the shares would be reclassified as liabilities at the reassessment date, measured at their redemption amount, and any resulting adjustment would be recorded in a separate component of equity. Once retractable or mandatorily redeemable shares issued in a tax planning arrangement are classified as financial liabilities, they would never be reclassified in equity. Presentation and Disclosure The AcSB recognizes that classification of retractable or mandatorily redeemable shares issued in a tax planning arrangement as financial liabilities will affect the net assets, net income and equity of the enterprise. To mitigate the effects of the change and to ensure that financial statement users have the information that they need, the following amendments to Section 3856 and Section 3251 are proposed: The shares classified as liabilities would be presented separately on the balance sheet, either as current or noncurrent depending on the agreement with the shareholder(s); The effect of recognizing the liability (i.e., the debit side of the entry) would be presented as a new separate component of equity; Shares classified as equity would continue to be presented on a separate line item on the balance sheet with disclosure of the redemption amount; 4

5 Enterprises would provide a description of the arrangement that gave rise to the shares, whether classified in equity or as liabilities and indicate that the balance of the separate component of equity will be charged to retained earnings as the shares are called for redemption; and Section 3251 would include guidance on the presentation of the separate equity component and its reclassification to retained earnings. An example Mr. Smith, the sole shareholder of Company A, enters into an estate freeze transaction under Section 86 of the ITA. As part of the tax planning arrangement, Mr. Smith exchanges all his common shares in Company A for 800 voting preferred shares redeemable at the option of the holder and have a legally stated capital amount of $100 and a redemption amount equal to the fair value of Company A at the time of the estate freeze transaction ($800,000 which is supported by a valuation report). Mr. Smith s adult daughter, Margaret Smith then subscribes for one common share of Company A for $100. Assume that there is no redemption schedule in place. Previously, Company A had acquired assets from a related party on a rollover basis, under Section 85 of the ITA in exchange for preferred shares redeemable at the option of the holder and have a redemption amount of $250,000 and a legally stated capital amount of $100. The effects of the proposed requirements on Company A s balance sheet from the estate freeze transaction and the previous asset rollover would be as follows under the current and proposed requirements: Under the current guidance, the redeemable preferred shares issued to Mr. Smith and a related party are within the scope of the classification exception, so they are presented as equity at their stated value ($200); If the amendments proposed in the Exposure Draft are approved: the preferred shares issued to Mr. Smith as part of the estate freeze would be measured at $100 and presented as equity. the preferred shares issued to a related party as part of an asset rollover would be measured at $250,000 and presented as a liability. This change would result in an increase in liabilities by $250,000, decrease in preferred share equity of $100, with the effect of the adjustment of $249,900 presented as a separate negative component of equity. 5

6 The following is a summarized balance sheet demonstrating the differences between the current and proposed requirements: Summarized balance sheet Current requirements Proposed requirements Total assets $ 500,100 $ 500,100 Preferred shares liability 1-250,000 Other current liabilities 100, ,000 Total liabilities 100, ,000 Preferred shares, redeemable at $1,050,000 (currently) 200 Preferred shares, redeemable at $800,000 (as proposed) 100 Common shares Other (note X) (249,900) Retained earnings 399, ,800 Total equity 400, ,100 Total liabilities and equity $ 500,100 $ 500,100 Under the proposed requirements, since, some of the shares must be reclassified as liabilities, equity decreased by $250,000 and liabilities increased by the same which could have an effect on debt covenants. Effective date and transition The AcSB proposes an effective date for the amendments for annual financial statements relating to fiscal years beginning on or after January 1, 2020, with earlier application permitted. An enterprise would be able to choose to apply the amendments retrospectively at one of the following dates: The beginning of the earliest period presented (i.e. comparative restated); or The beginning of the fiscal year in which the amendments are first applied (comparatives are not restated). When first applying the amendments, the enterprise would present in equity, retractable or mandatorily redeemable shares issued in a tax planning arrangement that meet the following conditions: The party that owns the shares has control as at the date of initial application of the amendments (i.e., January 1, 2020 for enterprises with a December 31 year end). The entity would not need to assess if the party that owns the shares at the date of initial application has retained control since the date of the initial transaction; The shares must have arisen from a share exchange; 1 The preferred shares liability is presented as a current liability unless the shareholder has formally waived the right to redeem the shares for at more than one year from the balance sheet date. 6

7 There is no redemption schedule in place at the date of initial application. If the enterprise elects to apply the amendments to the comparative period, the enterprise does not have to make retrospective adjustments for shares issued in a tax planning arrangement that were extinguished prior to the beginning of the year in which the amendments were first applied. Revisions to other standards The only other significant amendments that would be made to other standards concerns Section Guidance on substantive rights would be added to help enterprises assess whether they have control over an investee. Essentially, substantive rights are rights that are exercisable when decisions about the direction of the strategic operating, investing or financing policies need to be made. Advice The AcSB expects to issue the final version of the proposed changes in the first quarter of The implementation date of the proposed changes for fiscal years beginning on or after January 1, 2020 will arrive faster than we think. Thus, the entities should begin preparing for their application as soon as possible, because the proposals could have a significant effect on covenants related to loans and other contractual agreements. We encourage entities to start discussions with their creditors and other stakeholders to review the contractual agreements. If you have any questions about the proposals, please reach out to your Raymond Chabot Grant Thornton advisor. About Raymond Chabot Grant Thornton Raymond Chabot Grant Thornton LLP is a leading accounting and advisory firm providing audit, tax and advisory services to private and public organizations. Together with Grant Thornton LLP in Canada, Raymond Chabot Grant Thornton LLP has more than 4,200 people in offices across Canada. Raymond Chabot Grant Thornton LLP is a member firm within Grant Thornton International Ltd (Grant Thornton International). Grant Thornton International and the member firms are not a worldwide partnership. Services are delivered independently by the member firms. We have made every effort to ensure information in this publication is accurate as of its issue date. Nevertheless, information or views expressed are neither official statements of position, nor should they be considered technical advice for you or your organization without consulting a professional business adviser. For more information about this publication, please contact your Raymond Chabot Grant Thornton adviser. 7