Updated: Retractable or Mandatorily Redeemable Shares Issued in a Tax Planning Agreement – Debt or Equity?
Under the current ASPE standards of Section 3856 Financial Instruments, preferred shares issued in a tax planning agreement (Income Tax Act Sections 51, 85, 85.1, 86, 87 or 88) are recorded at stated or assigned value. These shares are required to be presented on a separate line of the equity section on the balance sheet and disclose the aggregate redemption amount of the outstanding shares. These presentation rules are designed to allow users of the financial statements to re-evaluate all future cash liabilities of the company, above and beyond those recorded in the liabilities section of the balance sheet.
The Accounting Standards Board has amended Section 3856 Financial Instruments to restrict instances in which preferred shares, now referred to as retractable or mandatorily redeemable shares (ROMRS) issued in a tax planning agreement, are recorded at their assigned or stated value. Instead, these shares would now be presented as a liability (likely a current liability classification) and measured on initial recognition at the redemption amount. These amended rules were to come into effect for fiscal years beginning on or after January 1, 2020. However, in light of the recent COVID-19 pandemic, the effective date has been deferred by 1 year, to fiscal years beginning on or after January 1, 2021. Early adoption continues to be permitted.
This will result in material changes to many company’s balance sheets as a new (potentially significant) liability will be recognized, with a corresponding reduction to equity. The equity section would specifically identify this component of equity to enable users to isolate and evaluate the impact of the new rules. In addition, specific disclosures relating to the transaction that resulted in the reduction of equity and recognition of liability would also be required.
There are a few exceptions to these new rules which will allow your company to continue to classify these preferred (ROMRS) shares as equity. For shares issued on or after January 1, 2018, all three of the below criteria need to be met in order to maintain the current equity classification:
- Retention of Control – Control of the organization must be retained by the party receiving the ROMRS issued in a tax planning agreement. The shareholder receiving the ROMRS should have the ability to control the strategic operating, investing and financing policies of the company before and after the transaction. If control is maintained, the shares can continue to be classified as equity as long as the next exceptions are met as well
- No Redemption Schedule – If there is a written or oral arrangement surrounding a redemption schedule then the shares must be treated as a liability. Even if the redemption schedule is an informal agreement, the shares must be presented as a liability and measured at their redemption value. These liabilities will typically be reported as a current liability, unless there is an agreement with the holder of the shares that no redemption will be required in the next fiscal period.
- No Consideration Other Than Shares Exchanged – If there was any non-share consideration received by the shareholder on the transaction (other than nominal consideration) when the ROMRS were issued then the shares must be presented as a liability and measured at their redemption amount.
It is important to note that the exceptions noted above must be reviewed at each financial statement date. If conditions have changed from the prior year, it may be that the exception is no longer relevant thereby requiring reclassification from equity to liabilities. Shares originally recognized as liabilities cannot subsequently be classified as equity.
If these three conditions are not met, then you must classify the shares as a liability at the redemption amount. Any resulting adjustment is debited to retained earnings or a separate component of equity (i.e. separate account).
It is important to note that for shares issued prior to January 1, 2018, only two of the three conditions need to be met in order to maintain equity classification. The condition of only share-for-share exchange is excluded for ROMRS issued prior to January 1, 2018, meaning ROMRS issued in an asset rollover will qualify for equity classification provided the other two conditions are met.
Transitioning to the New Presentation Rules
Assuming you need to reclassify your ROMRS from equity to liabilities, the new standards allow for two alternative transitional provisions.
The cumulative effect of applying the amendments is recorded in opening retained earnings or in a separate component of equity of the earliest period presented. For example, for fiscal December 31, 2021, the cumulative adjustment is recorded as of January 1, 2020. Note, retrospective adjustment is not required for ROMRS that were extinguished prior to the beginning of the fiscal period in which amendments are first applied (i.e. January 1, 2021). For example, assume ROMRS classified as equity are redeemed in May 2020 and amendments adopted January 1, 2021. If those shares do not meet the classification exception, the entity will not be required to apply the new accounting to those redeemed shares in the 2020 financial statements.
Apply at the beginning of the fiscal year in which the amendments are first applied.
With this option, the cumulative effect of applying the amendments is recorded in opening retained earnings or separate component of equity as of January 1, 2021. This option was given to help with the challenges that some ROMRS may have been issued many years ago and we may not have all the details from way back when. These transitional provisions therefore consider control at the adoption date (e.g. January 1, 2021) rather than at the time of the original transaction.
Other Reporting Implications
If you are required to treat ROMRS as a liability, any dividend paid on those shares will be reported as an interest expense on the income statement. It is important to note this financial statement reporting requirement will not impact how the dividends will be reported for tax purposes.
What impact does this have on my company, my financial statements and my ability to borrow?
It is prudent to analyze your company’s balance sheet to determine if any issued ROMRS will require a reclassification to liabilities when the standards become effective for your company. If so, the sooner you determine the impact it will have on your balance sheet, the sooner you can start to have conversations with your financial statement users to ensure they are aware of the upcoming changes to your liabilities and equity sections. For example, preparing a pro forma balance sheet under the upcoming standards will allow you to have an open dialogue with your financing partners to ensure your banking covenant calculations are revisited to ensure the reclassification will not result in a covenant breach.
If you have questions about these new standards or require assistance in determining the impact it will have on your company’s financial statements, please contact your DJB advisor.