15 Mar FAQ – New Accounting Rules for Redeemable Shares
The accounting rules in Canada are changing for shares that are mandatorily redeemable and retractable. If applicable, the impact of this change on your company’s financial statements could be significant.
In this piece we have addressed the most common questions with respect to these changes and how they may impact you. If you think you have any of these shares issued, then you should read this piece.
1. What are mandatorily redeemable and retractable shares?
Mandatorily redeemable and retractable shares are shares issued by a company that can be exchanged by the shareholder for a fixed amount of cash. This means the shareholder can demand the cash from the company at any time, making them mandatorily redeemable. So although they are legally considered shares, they actually behave more like a loan that is due on demand.
2. What are mandatorily redeemable and retractable shares used for?
For private businesses in Canada, the most common use of mandatorily redeemable and retractable shares is in a tax transaction. There are two main kinds of tax transactions that are common in private businesses. These transactions are conducted in accordance with the Canadian income tax act and are legal and legitimate ways to defer taxes.
The first tax transaction is called a ‘freeze,’ where a shareholder that owns common shares exchanges them for mandatorily redeemable and retractable shares. This can be done for a variety of reasons including the establishment of a family trust, when parents transfer ownership of a business to their children, or when a key employee is brought in as minority owner. The freeze enables the transactions to be performed without triggering capital gains tax on the common shares.
The second tax transaction is called an ‘asset rollover,’ where an individual or company transfers assets, such as property or equipment, to another related company. This is often performed when sole proprietors incorporate their existing business or when a corporate reorganization is performed to move the assets out of one company to another. Similar to the freeze, the rollover enables the transactions to be performed without triggering capital gains tax on the transferred assets.
3. How do I know if my company has issued mandatorily redeemable and retractable shares?
Most mandatorily redeemable and retractable shares are preferred shares. If your private company has issued preferred shares, it was most likely due to a freeze or a rollover and these would be mandatorily redeemable and retractable shares.
If your financial statements are audited or reviewed, then the redeemable shares will be clearly identified in the share capital note to your financial statements.
If you don’t get a review or an audit, then the compiled financial statements may not disclose enough information for you to determine if you have any of these shares. However, the new accounting rules don’t apply to compiled financial statements so this less of an issue.
If you are unsure, you can always ask your primary contact at Clearline and they will let you know.
4. What is the impact of the new accounting rules?
In the past, mandatorily redeemable and retractable shares issued in a tax planning arrangement were shown in financial statements in the equity section of the balance sheet at their cost basis, which was often a relatively small amount. Under the new rules, most of the shares will now be required to be shown as a liability at their redemption value. The impact of this change could be very significant in that it will increase the liabilities on the balance sheet and reduce equity. This could have a negative impact on some financial covenants that banks and other lenders place on loan agreements.
There are some scenarios under the new rules that may permit a company to continue to show the mandatorily redeemable and retractable shares as equity, but they are limited. The exception rules are complex and are best to be discussed with your primary contact at Clearline.
It is important to note that the existence of these shares is common in private companies and Canada. The tax transactions that created these shares were probably recommended by your accountant to legally defer capital gains taxes. There is nothing wrong or bad about having issued these shares. The issue is that the way they were shown in financial statements in Canada was very favorable and that favorable accounting treatment is now coming to an end.
5. What might my balance sheet look like after these changes are applied?
If you are required to show the mandatorily redeemable and retractable shares as a liability, this will impact your balance sheet. There are a few ways this can be done but regardless of the specific approach taken, the total liabilities on your balance sheet will increase and the equity will decrease. If you would like to see how the changes specifically apply to your balance sheet, reach out to your Clearline contact and we can draft a balance sheet for you that will show the impact.
6. When does the change in the accounting rules take place?
The changes are effective for companies with fiscal years beginning on or after January 1, 2021. So if you have a December year end, this will apply to your December 31, 2021 financial statements. If you have a year end that is any other month of the year, the changes will apply to your 2022 financial statements.
7. If my company has issued these shares, what should I do?
Once you determine that you have mandatorily redeemable and retractable shares, you should discuss this with your primary contact at Clearline and get a better idea of how it will impact your financial statements. Then you should consider who uses your financial statements, such as your bank, other lender, a bonding company, or some other entity and discuss the impact with them ahead of time so there are no surprises when you provide them your financial statements.