There has been significant debate over the years regarding the financial statement presentation of redeemable or mandatorily retractable shares (RoMRS) as either a liability or equity.

First, a bit of background

When Accounting Standards for Private Enterprises (ASPE) were issued in 2011, it was determined that RoMRS should continue to be recorded at par, stated or assigned value in a separate component of equity.  An amendment to ASPE reporting of RoMRS has been implemented for fiscal years beginning on or after January 1, 2021, which may require classification as a liability instead of equity.

What are RoMRS?

RoMRS are shares issued in a tax planning arrangement that generally have 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 their transfer,
• the shares have priority on distribution and liquidation over any other type of shares, and
• the shares are issued as part of a tax planning arrangement. Not all shares issued in tax planning arrangements are preferred shares. That is why the standard refers to “retractable or mandatorily redeemable shares”.

Liability or equity?

For any shares that meet the criteria for RoMRS, the default classification for financial statement presentation under ASPE will be a liability. There is still an option to classify RoMRS as equity under ASPE, but the following three conditions must be met as part of the tax planning arrangement:

1. Control test – Control[i] of the enterprise issuing the shares is retained by the shareholder receiving the shares in the arrangement,
2. Consideration test – non-share consideration is not received as part of the arrangement, and
3. Redemption arrangement – there are no arrangements, either formal or informal, requiring redemption within a fixed or determinable period.

If any of these three conditions are not meet then RoMRS must be classified as a liability under ASPE, which can have a negative impact on the financial statements.

This is just accounting – who cares?

There is no actual change to the underlying business and the employees would continue to show up to work as if nothing happened.  The potential issue with recording RoMRS as debt is due to the fact that the shares have to be shown under ASPE at its redemption and retractable value.  A lot of times RoMRS are issued with the stated purpose of freezing all or a portion of the companies value into these shares. If the company has significant inherent untaxed value (i.e. goodwill), then these shares would reflect that inherent untaxed value in their redemption and retraction price of these shares.  In order to properly record RoMRS as a liability, a negative adjustment would have to be recorded to the equity section of the company’s balance sheet.  This negative equity adjustment may impact various financial ratios (such as: current ratio, debt-to-equity ratio and the debt coverage ratio), which could ultimately impact debt covenants with third-party lenders.

How does this affect estate planning?

Many estate plans result in the creation of preferred shares that will meet the RoMRS criteria. Therefore, it will be important to review financial statement reporting issues prior to executing an estate plan to avoid potential changes to financial ratios that could negatively impact debt covenants.

Keep in mind that this reporting amendment for RoMRS applies to companies reporting their financial statements under ASPE, so that is the first thing to look at when determining if the estate plan will have an impact on the financial statements.

[i] Control of an enterprise is the continuing power to determine its strategic operating, investing, and financing policies without cooperation of others.