As discussed when when we first wrote about this topic in 2015, our firm has long believed that accountants and lawyers should work together in the delivery of tax services. Both professions bring different skill sets and perspectives to the table when crafting client solutions. To that end, we purposely employ both professions in our tax law firm. It is common when dealing with tax matters that an issue will arise that requires input from both accountants and lawyers, and the subject of this article is a great example.
In October 2014, the Accounting Standards Board ("AcSB") released an Exposure Draft that, when fully implemented, we warned would have great consequences for many private enterprises when reporting certain common tax planning arrangements. In short, the changes were aimed at reclassifying certain types of equity issued by private enterprises - like preferred shares – as debt.
After receiving comments on the Exposure Draft (including our firm's submission), in December 2018 amendments were issued in Part II of the CPA Canada Handbook- Accounting ("Handbook"), specifically relating to the classification of "retractable or mandatorily redeemable shares issued in a tax planning arrangement" ("ROMRS"). This term is not defined in the Handbook, but in its briefing document ("Briefing Document") on this topic released in March 2019, CPA Canada stated that this generally captures shares issued in a tax planning arrangement with the following characteristics:
- The holder of the shares has the right to require their redemption on demand at a redemption price equal to the fair market value of the common shares exchanged;
- The shares have, at least, voting rights on any matter involving a modification to the attributes attached to them;
- There are no restrictions on the transfer;
- The shares have priority on distribution and liquidation over any other type of share; and
- The shares are issued as part of a tax planning arrangement.
The changes - as previously mentioned – are aimed at reclassifying ROMRS as debt instead of equity, and were supposed to take effect for years beginning on or after January 1, 2020, but as a result of COVID-19, the effective date of the amendments was revised to be for years beginning on or after January 1, 2021. As a result, if a fiscal period for a private enterprise began on January 1, 2021, and it has ROMRS issued and outstanding at the year end, an analysis would need to be completed to determine if the issued and outstanding ROMRS may be classified as equity, or if they will need to be reclassified as a liability. This change could have massive reporting consequences to private companies and its shareholders, which we will discuss below.
Historically, ROMRS met the definition of a liability pursuant to Section 1000 of the Handbook (Financial Statements Concepts). However, under the ASPE rules, Section 3856 provided an exception for ROMRS that were issued under certain provisions under the Income Tax Act (such as section 51, 85, 86), resulting in these ROMRS being classified as equity for ASPE purposes.
Having preferred shares issued and outstanding of a private corporation has become increasingly common in the context of tax and estate planning. The ability to "freeze" a company's value and transfer future growth to other family members without triggering any immediate tax consequences is a powerful tool, allowing the intergenerational transfer of a business. (Our firm wrote about the history and benefits of estate freezes here). Furthermore, it is very common to have a person transfer assets to a corporation in exchange for preferred shares of that corporation.
As part of an estate freeze, the CRA has indicated the "essential attributes" that must be attached to estate freeze shares.1 The CRA has indicated the following criteria would show that the fair market value ("FMV") of the preferred shares issued on a freeze would be considered equal to the FMV of the shares exchanged:
- redeemable at the option of the holder at a redemption price equal to the FMV of the common shares exchanged, plus any declared and unpaid dividends;
- no dividend can be paid on other classes of shares for an amount that would reduce the FMV of the preferred shares below their redemption price, or that would result in the corporation not having the necessary net assets for the redemption of the preferred shares ;
- they must have, at least, voting rights on any matter involving a modification to the attributes attached to them (these voting rights can be provided by the relevant corporate law or the articles of incorporation);
- absolute priority on all other classes of shares in the event of the distribution of the assets of the corporation on a winding-up or a dissolution of the corporation or any other distribution of its assets, up to the redemption price, plus any declared and unpaid dividends;
- absolute priority on all the other classes of shares with respect to the redemption of the shares , and the corporation cannot acquire shares of others classes before the redemption of all the preferred shares ;
- no restriction with respect to the transfer of the preferred shares (other than the restrictions required, if applicable, by the relevant corporate law in order to qualify as a private corporation); and
- containing a price adjustment clause for the redemption price of the preferred shares which is applicable when the redemption price agreed to by the parties is not equal to the FMV of the common shares exchanged, and also containing other appropriate adjustments when the shares have already been redeemed at the time of an adjustment of the redemption price.
On an exchange involving an estate freeze, it is important that the freezor receive preferred shares as consideration equal to the FMV of the company, as this allows other family members to subscribe for the newly issued common shares – which carry the future growth – for a nominal amount.
Many of the above factors that the CRA looks at in order to be a proper "freeze" for tax purposes are the same factors that lead a share to be considered a ROMRS. As a result, if a person was trying to avoid ROMRS classification on a classic estate freeze, it may cause significant adverse tax consequences since the attributes of the preferred shares would likely need to be modified to the point where the FMV of the preferred shares would be negatively impacted.
In a year where many private companies' balance sheets have been negatively impacted due to COVID-19, these changes may require these enterprises to recharacterize equity - their issued preferred shares – into a liability of the company, further impacting their debt to equity ratios, and potentially, their ability to obtain or maintain financing. Such a reclassification of preferred shares from equity to debt may also reduce a company's attraction to potential buyers with such buyers being concerned about the amount of debt on its balance sheet.
Maintaining an Equity Characterization
ASPE section 3856 provides guidelines on what shares may maintain its equity status on a company's financial statements, i.e., it would not be subject to the reclassification to a liability. However, in many cases, it may be difficult to achieve the entirety of the three below criteria:
- The shareholder receiving the ROMRS retains "control" of the enterprise;
- No consideration other than shares is received (or contributed); and
- No redemption arrangement exists with respect to the ROMRS.
If a shareholder previously had "control" of a private company (in accordance with Section 1591 of the Handbook), and that shareholder will retain control after receiving ROMRS, they should meet the control criteria. However, for example, if a company is controlled 50/50 by a husband and wife, and neither "controls" the company, the exception will not be available. If multiple shareholders are part of freeze, for example, only one shareholder would be able to claim the control exception (provided they had control before and after the tax planning). If control is not retained after a transaction, the shares will automatically be classified as a liability on the financial statements. This control criteria does not, at face value, appear to make sense.
No Consideration Other Than Shares
According to the revised rules, the second condition to be classified as equity is that the only consideration exchanged in the transaction should be shares. This appears to be both for the amount transferred and consideration received. Accordingly, assuming such an interpretation is correct, a transfer of assets from one corporation to another in consideration for preferred shares would violate this criteria. CPA Canada in its March 2019 Briefing Document states that ROMRS issued as part of an asset rollover transaction cannot be classified as equity. Again, this does not appear to make sense.
No Redemption Arrangement
Lastly, in order to maintain classification as equity, the ROMRS must not have any arrangement requiring redemption within a fixed or determinable period (including both written and oral arrangements). Again, why not? This does not appear to make sense.
Consequences of Not Meeting the Equity Exception
If a ROMRS does not satisfy all of the above three criteria for equity treatment, and the shares are outstanding when its financial statements are prepared, they must be classified as debt instruments and recorded as a liability on the financial statements. If at the time of the reporting, the ROMRS does meet the three criteria, it may be recorded as equity, but if a future event or transaction causes one of the three criteria to not be met, it must be reclassified on the financial statements. Once a ROMRS is classified as a liability, it must always be recognized that way.
The classification of these preferred shares as a liability instrument brings forth several areas of concern. Under corporate law statutes, for example, within the Alberta Business Corporations Act, a corporation is generally prohibited from declaring a dividend if there are "reasonable grounds for believing that a) the corporation is, or would after the payment be, unable to pay its liabilities as they become due, or b) the realizable value of the corporation's assets would thereby be less than the aggregate of its liabilities and stated capital of all classes". Generally, such a prohibition also exists in the context of a redemption. When looking at the amount of the liability, the redemption amount of such shares would be the amount of the liability and as a result, in a typical estate freeze, what may be a very successful business with an extremely clean balance sheet would now disclose a massive liability as a result of certain important tax planning thus calling into question whether or not a corporation could legally declare a dividend without violating corporate law.
In addition, when a company pays a dividend on its ROMRS, the dividend would be reported as an interest expense, rather than a dividend, thereby affecting any interest based ratios.
As a result of its issued preferred shares being classified as debt, these successful businesses may now have violated their debt covenants, and on an initial review of the companies' financial statements, would look like highly leveraged companies, which may prohibit future loans from being obtained. These changes could also affect other performance measures or ratios such as current ratios, working capital amounts, ratios of assets or operations to equity, etc. Every company subject to these rule changes will need to revisit their agreements (particularly banking agreements) to determine how the changes to the financial statements will affect their business and corporate matters.
What Can Advisors Do?
It is important to analyze the capital structure of the company, determine who is affected, and whether or not a "thaw" or "refreeze" can be done in a manner to qualify any outstanding ROMRS as equity, or to determine if there are other alternatives that could be completed. It is critical to review any contracts, covenants or other related documents where financial ratios are relevant, as these may have an immediate financial impact on a company. It is entirely possible that ROMRS classification is currently irrelevant for some businesses, for example, if they do not need financing, but the presentation of an additional liability may cause issues in the future. The changes take affect on fiscal periods starting on or after January 1, 2021, and adjustments need to be made as of the opening date. For these companies, it may be only possible to fix the year-end liabilities on the financial statements. However, for companies whose 2021 fiscal year has not yet begun, there is still time to re-visit the capital structure to determine if changes need to be made.
Why We Don't Think This ASPE Change Is Appropriate
In our firm's original 2015 blog and submission to the AcSB, we documented reasons why we thought the proposals were misguided. We will not repeat such reasons here but suffice it to say that 6 years later, we firmly believe that our original reasons for opposition to these misguided changes are sound. In its March 2019 Briefing Document, the AcSB stated the following for the reasons why the changes were being made:
The AcSB noted the following concerns with the existing accounting requirements in Section 3856:
- Liability accounting was being applied to transactions such as commercial financing agreements, employee compensation plans and management buyouts. This was not the intent of Section 3856.
- Section 3856 only permitted equity accounting for ROMRS issued under specified sections of the Income Tax Act. ROMRS issued under other sections of the Income Tax Act did not qualify for equity treatment, even though they might be substantively similar.
- Section 3856 required ROMRS classified as equity to be reclassified as liabilities "when redemption is demanded." Given the broad range of redemption features occurring in practice, there was diversity in practice over when to reclassify ROMRS from equity to liabilities.
The above reasons do not appear convincing. For example, if liability accounting treatment was being applied to commercial financing agreements, employee compensation plans and management buy-outs, then prohibit treatment for those types of transactions. If other sections of the Income Tax Act did not qualify for equity treatment although they were substantively similar, then expand the list for qualified equity treatment. Don't simply require blanket liability treatment for ROMRS.
Overall, the primary reason for issuing financial statements is to tell the financial story of a business to stakeholders. This change adds substantial amount of confusion to this story. There is a real and meaningful legal difference between preferred shares (that are legally an equity instrument) and a liability. Equating the two on a financial statement does not improve the relevance and improve the comprehension of those instruments on a balance sheet. For example, to a lender whose objective is to ensure the business has sufficient assets or an income stream to cover their claim, the existence of ROMRS should not adversely impact this objective; a secured liability should always have priority claim over preferred shares. A lender examining a balance sheet that has ROMRS classified as liabilities will now have to understand this subtle but important difference to make their lending decision.
In the private business context, the liability classification of ROMRS is inconsistent with economic and business realities. In this context, ROMRS are generally held by owner-managers or founders of a business who is interested in the viability and continuing legacy of their business. In our experience, these ROMRS holders will never redeem shares to the extent the redemption will hurt the cash flow or viability of the business. In fact, they will typically avoid redeeming large amounts in order to efficiently manage the tax impact or to maximize income-tested benefits such as OAS. The long redemption or holding periods of ROMRS will result in a company disclosing large debts for longer periods of time thus distorting or providing a misleading picture of the real business.
Suffice it to say, again, that our firm wholly disagrees with the policy intent behind these changes. Notwithstanding, affected business owners will need to "own up" to the changes.
This saga reminds us of the classic 1986 movie - Ferris Bueller's Day Off. The font of all wisdom - Wikipedia - describes the plot of the movie as follows:
In suburban Chicago, near the end of the school year, high school senior Ferris Bueller fakes illness to stay at home.His parents believe he really is ill, though his sister Jeanie does not. Dean of Students Edward R. Rooney suspects Ferris is a repeat truant and commits to catching him. Ferris convinces his best friend Cameron Frye, who is legitimately absent due to illness (though a hypochondriac, which Ferris sees through), to help lure Ferris' girlfriend Sloane Peterson from school on the pretext of her grandmother's supposed demise. To further the ruse, Ferris borrows Cameron's father's prized 1961 Ferrari 250 GT California Spyder. Cameron is dismayed when Ferris takes them into downtown Chicago in the car, to spend the day. Ferris promises they will return it as it was.
The trio leave the car with parking attendants, who promptly take the car for a joyride. The trio explore the city, including the Art Institute of Chicago, Sears Tower, Chicago Mercantile Exchange, and attend a ball game at Wrigley Field, and their paths occasionally intersect with that of Ferris' father. Cameron remains worried, and Ferris attempts to cheer him up by joining a parade float during the Von Steuben Day parade and spontaneously lip-syncing Wayne Newton's cover of "Danke Schoen", followed by a rendition of the Beatles' "Twist and Shout" that excites the gathered crowds.
The friends collect the Ferrari from the parking lot and head home. Discovering many more miles on the odometer, Cameron becomes catatonic with shock. Back at Cameron's house, Ferris jacks up the car and runs it in reverse to "rewind" the odometer. This does not succeed and Cameron finally snaps, letting out his anger against his overbearing father. Repeatedly kicking the car causes the jack to fail and the car races in reverse through the wall and into the ravine below. Ferris offers to take the blame, but Cameron declines the offer and decides he will stand up against his father.
The AcSB in Ferris Bueller's Day off is Ferris – fun loving, well intentioned and always wanting to have a good time. Business owners affected by the new ROMRS changes are Cameron.always worried about doing the right thing and not wanting to cause any trouble. The lenders to business owners (such as banks) are Cameron's father. Cameron decides that he will stand up to his overbearing father at the end of the movie. Affected business owners as a result of this accounting change may have to stand-up / "own-up" to their lenders to explain why this accounting change doesn't affect anything despite lending ratios that say otherwise. We fear that the AcSB ("Ferris") may be jacking up the car and running the car in reverse in a few years in an attempt to reverse the odometer on this trip.
As Ferris says in the movie: "Life moves pretty fast. If you don't stop and look around once in a while, you could miss it."
We agree. Business owners will need to stop and look around their balance sheet to determine if they've missed an important reporting classification issue and, if so, what they will need to do.
Our firm is here to help.
1. CRA Views 2008-0285241C6F
Originally Published by Moodys Gartner, March 2021
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