By Phoebe Elliot, CPA, CA – Kingston Ross Pasnak LLP

Many business owners undertake transactions commonly referred to as “estate freezes”, converting the existing value in their corporations to fixed-value redeemable preferred shares, and allowing new common shares to be issued to other owners, such as spouses, children or other family members, or trusts for such persons.  To the business owner, this simply converts their shares from one form to another.  Recent changes to accounting requirements for these freeze shares – or ROMRS – which will apply for fiscal years ended December 31, 2021, may require a substantial change to the corporate financial statements.

Why is this important?

Soon, many freeze shares that were originally reported on an entity’s financial statements as equity at a nominal amount must be reported as a liability at their redemption value.  This will result in significant increases to the liabilities reported on the balance sheet.  This could have serious implications for lenders who will have to determine if the entity is meeting its loan covenants, and for other external financial statement users.

How will this change your company’s balance sheet?

These changes, issued in December 2018 by the Accounting Standards Board (‘AcSB’), amend key provisions of Section 3856, Financial Instruments, in Part II of the CPA Canada Handbook – Accounting. The new ‘ROMRS rules’ were intended to apply to fiscal years beginning on or after January 1, 2020, but due to the COVID-19 pandemic, the mandatory application date was moved forward by one year.

Generally, it is mandatory to classify ROMRS as liabilities, not equity. In a notable exception, the accounting standards prior to the amendments required that redeemable preferred shares issued under specified sections of the Income Tax Act be classified equity; this covered most estate freeze shares.  The new ROMRS rules replaced this exception with three conditions for equity classification and added an option to classify any ROMRS as a liability without further analysis.

Are there any exceptions to keep ROMRS in equity?

The AcSB designed the following three conditions to allow equity classification only when the issuance of the shares resulted in no substantive changes to the issuing enterprise:

  1. The recipient of the ROMRS must retain control of the enterprise issuing the ROMRS;
  2. No consideration can be exchanged other than shares of the enterprise issuing the ROMRS; and
  3. No written or oral redemption arrangement that requires redemption of the ROMRS within a fixed or determinable period may exist.

Each class of ROMRS should be assessed separately as some may qualify for equity classification while others do not.  Section 3856 explicitly states that, if two or more parties have joint control over the enterprise, then the first condition above cannot be met.  As a result, when a group of shareholders, even a related group such as a husband and wife, control the enterprise both before and after an estate freeze, the resulting shares will not qualify for equity classification.  This will likely result in many ROMRS being reclassified from equity to liabilities.

Where ROMRS are classified as equity, they remain equity unless a future event or transaction results in one of the three conditions above no longer being met. Once ROMRS have been classified as a liability, they cannot be reclassified to equity even if they meet the three conditions.

The AcSB has clarified that nominal non-share consideration, including small dollar amounts exchanged for tax purposes, would not automatically contravene condition two above, and that shares redeemable upon demand by the holder (a right required by CRA to accept that an estate freeze is effective) are not automatically disqualified from equity classification as condition three above may still be met, provided there are no scheduled redemption dates.

If ROMRS are classified as equity, they are measured at their par, stated or assigned value (typically a small amount for most private corporations) and any dividends paid do not impact the enterprise’s net income.  If ROMRS are classified as liabilities, they are measured at their redemption amount and any dividends paid are shown as interest expense in the enterprise’s financial statements (but remain non-deductible for income tax purposes).  The difference between the carrying value of the shares as equity and their redemption amount is recorded in the enterprise’s financial statements as either a separate component of equity, or a direct charge to retained earnings.  In the latter case, the amount charged to retained earnings must be disclosed on the face of the Balance Sheet.

Section 3856 contains transitional provisions for the adoption of the ROMRS rules.  Management can choose whether or not to restate comparative figures for the impact of the new ROMRS rules and, for the purposes of condition 1 above, control can be assessed at the date that the enterprise first applies the amendments.  Additionally, ROMRS issued prior to January 1, 2018 may continue to be classified as equity as long as conditions 1 and 3 above are met.

An enterprise with ROMRS classified as liabilities must include specific disclosures in its financial statements to allow users to understand the nature of the arrangement that gave rise to the shares and the impact of classifying the shares as liabilities.

A common example where the balance sheet will change

Consider Opco, which issued 50 voting common shares to each of Mr. and Mrs. X for $1 per share when it was incorporated many years ago.  Last year, Opco had retained earnings of $1.5 million and a value of $5 million.  Mr. and Mrs. X exchanged their shares for ROMRS redeemable for $5 million as part of an estate freeze.  This would require that the ROMRS be reflected at a value equal to their $5 million redemption price, turning that healthy equity into a daunting $3.5 million deficit.  Even if the estate freeze was undertaken several years ago, this reclassification will still be required.

What steps should be taken now?

Given the potentially significant implications of these new ROMRS rules on an enterprise’s financial statements, ratios and debt covenants, timely communication of these changes to management and to others who receive copies of the financial statements, including lenders, is highly recommended.  When the lender opens up this year’s financial statements expecting to see equity rising a bit higher than last year, and instead they see a substantial deficit, the banking relationship could become strained.  Talk to your DFK advisor today about educating your banker or other financial statement recipients in advance, and avoiding a surprise when they get the new financial statements.