FYI Article – Accounting for Redeemable Preferred Shares Issued in a Tax Planning Arrangement
The Accounting Standards Board (AcSB) has recently issued an Exposure Draft regarding accounting for redeemable preferred shares issued in a tax planning arrangement, specifically for shares issued in transactions commonly known as an “estate freeze”. The proposal would see these shares treated in the same manner as any other redeemable preferred shares – i.e., as a financial liability.
Accounting for these redeemable preferred shares is not a new issue. As the shares are redeemable by the holder, they meet the definition of a liability. Liability presentation, with initial measurement at fair value (generally equal to the redemption amount), would result in a large reduction in equity. This is due to the redemption amount of the preferred shares in an estate freeze being equal to the value of the enterprise at the time of the transaction. Historically, the concern has been that liability treatment will wipe out the entities’ equity making the entity appear to be in poor financial condition. For a number of years, the solution has been to make an exception and present these shares as equity and measure them at their par or stated amount – usually a nominal value. This provision is currently contained in Financial Instruments, paragraph 3856.23. A key argument in the creation of equity treatment was a concern that financial statement users would not understand the nature of the liability and resulting reduced equity in the company making it difficult for companies to access capital. Explaining the nature of the redeemable preferred shares to users could be a significant effort for companies and their accounting advisors.
The current proposals would eliminate equity classification (i.e., paragraph 3856.23).
Why is the AcSB proposing this change?
The current exception has become ineffective in several respects and an analysis of cost/benefit suggests that it is no longer needed. Paragraph 3856.23 was created to provide relief to redeemable preferred shares issued as part of a tax planning structure that passed a business from one generation to the next. Over time, the simplification has become ineffective. Some redeemable preferred shares that are issued as part of these tax planning arrangements are not eligible for equity treatment because they do not make use of the specific income tax act sections noted in the paragraph 3856.23. Also, the current wording of paragraph 3856.23 allows redeemable preferred shares that are issued in a number of other transactions to receive equity treatment (for example, commercial financing arrangements, business combinations, and key employee incentive programs). These issues resulted in the AcSB undertaking a re-examination of equity treatment of these shares.
In re-examining paragraph 3856.23, the AcSB performed a cost/benefit analysis. In evaluating the benefits, the AcSB consulted a number of creditors – the primary financial statement users of private enterprises. The unanimous view of the users consulted is that they understand the nature of redeemable preferred shares issued pursuant to a transfer of a business from one generation to the next. Consequently, users did not think that they would make different lending decisions than today if these redeemable preferred shares were presented as liabilities.
Many of the users agreed that these redeemable preferred shares should be shown as liabilities because:
- the shares are liabilities and there is value in consistent application of principles;
- doing so avoids financial statement users having to reclassify the shares from equity to liabilities; and
- it ensures the nature of the shares is identified.
Therefore, the AcSB thinks that there are significant benefits associated with liability classification. This analysis suggests that there are no benefits associated with equity classification – in fact there are some who argue that there are negative benefits to users in not presenting these shares in the same way as all other redeemable preferred shares.
Costs are assessed based on the costs of complying with an accounting requirement. Factors assessed include preparation costs, communication costs, specialized expertise costs and related assurance costs. The main cost argument supporting equity treatment was that, if financial statement users do not understand the nature of these redeemable preferred shares, there would be significant communications costs involved in educating users. As financial statement users currently state that they understand the nature of these redeemable preferred shares, the costs associated with explaining the results of liability classification should be minimal and non-recurring.
The change in the user perspective is the driver of the current proposal to remove paragraph 3856.23 and require redeemable preferred shares issued in tax planning arrangements to be presented as liabilities rather than equity. Liability presentation would reflect the economic nature of redeemable preferred share and would improve financial reporting.
Because the issuance of these redeemable preferred shares is not accompanied by an infusion of capital, liability classification with measurement of the shares at their redemption value will result in a substantial debit. Based on the existing requirements in Section 3251, Equity, the Exposure Draft proposes that this debit be recorded in a separate component of equity. The balance in this separate component of equity would be reclassified to retained earnings as the redeemable preferred shares are redeemed. The accompanying note disclosure would explain the nature of this component of equity, its relationship to the redeemable preferred shares, and the basis on which it will be reclassified to retained earnings. The advantage of this separate component of equity is that the effect on retained earnings is directly observable in future periods. Without this separate presentation, the effect of issuing these shares would be “folded” into equity in future periods.
The Exposure Draft proposes retrospective application of this change. Given the significant impact on the balance sheet, retrospective application would provide better information because the current and prior period would be comparable.
The proposed effective date is for periods beginning on or after January 1, 2016. The AcSB understands that removal of paragraph 3856.23 will have a significant effect on the balance sheet and may require amendment of loan agreements. The AcSB thinks that the proposed effective date will give private enterprises sufficient time to adopt the new requirements and make amendments to existing loan agreements.
The Exposure Draft is open for comment until January 15, 2015. The Exposure Draft includes an analysis of the arguments that the AcSB considered in drafting its proposals. The AcSB welcomes responses to the Exposure Draft. Responses are most helpful if they provide specific reasons for the support or objection to the proposals. The AcSB will redeliberate the proposals in light of comments received. Part of the redeliberation process includes consultations with the AcSB’s Private Enterprise Advisory Committee.
Further information about this project, including planned communications activities and updates about AcSB redeliberations, can be found on the supporting project page.
Kelly Khalilieh, CPA, CA
Principal, Accounting Standards Board
Phone: +1 (416) 204-3453