5.13_common_control_transactions_and_newco_formations_(insights_into_ifrs)

5.13 Common control transactions and Newco formations OVERVIEW OF CURRENTLY EFFECTIVE REQUIREMENTS CURRENTLY EFFECTIVE REQUIREMENTS This publication reflects IFRSs in issue at 1 August 2011. The currently effective requirements cover annual periods beginning on 1 January 2011. This chapter deals with business combinations amongst entities under common control. It does not deal with the wider issue of common control transactions, e.g. the transfer of a single item of property, plant and equipment between fellow subsidiaries. The issues dealt with in this chapter are not covered explicitly in any of the standards. However, the following standards are relevant in understanding the accounting for common control transactions and Newco formations: IFRS 3 Business Combinations, IAS 27 Consolidated and Separate Financial Statements and IFRIC 17 Distributions of Non-cash Assets to Owners. FORTHCOMING REQUIREMENTS AND FUTURE DEVELOPMENTS When a currently effective requirement will be changed by a new requirement that is issued but is not yet effective, it is marked with a # as a forthcoming requirement and the impact of the change is explained in the accompanying boxed text. The forthcoming requirements related to this topic are derived from IFRS 10 Consolidated Financial Statements, which is effective for annual periods beginning on or after 1 January 2013. A brief outline of the impact of IFRS 10 on this topic is given in 5.13.10.80. See 2.5A for a broader discussion of the forthcoming requirements relating to IFRS 10. Several paragraphs in this chapter refer to 'fair value' as the appropriate measurement basis. Guidance on fair value measurement is currently dispersed across various IFRSs. IFRS 13 Fair Value Measurement replaces most of the fair value measurement guidance contained in individual IFRSs with a single definition of fair value, provides fair value application guidance, and establishes a comprehensive disclosure framework for fair value measurements. The standard also changes some of the fair value terminology in other IFRSs. IFRS 13 is effective for annual periods beginning on or after 1 January 2013. See 1.2.57 for further details. The currently effective or forthcoming requirements may be subject to future developments and a brief outline of the relevant project(s) is given in 5.13.240 and Appendix III. When a significant change to the currently effective or forthcoming requirements is expected, it is marked with an *. 5.13.10 COMMON CONTROL TRANSACTIONS # 5.13.10.10 A business combination involving entities or businesses under common control is a business combination in which all of the combining entities or businesses ultimately are controlled by the same party or parties both before and after the combination, and that control is not transitory (see 5.13.30). [IFRS 3.B1] 5.13.10.20 A group of individuals is regarded as controlling an entity when, as a result of contractual arrangements, they collectively have the power to govern its financial and operating policies so as to obtain benefits from its activities. In our view, the requirement for there to be a contractual arrangement should be applied strictly and is not overcome by an established pattern of voting together. [IFRS 3.B2] 5.13.10.30 For example, Company X and Company Y are owned by shareholders B, C, D and E, each of whom hold 25 percent of the shares in each company. B, C and D have entered into a shareholders' agreement in terms of which they exercise their voting power jointly. Therefore, both X and Y are under the control of the same group of individuals (B, C and D), and are under common control. 5.13.10.40 In another example, Company Y and Company Z are owned by members and close relatives of a single family. The father owns 40 percent of the shares in each entity, each of his two brothers owns another 15 percent of the shares, and his son owns the remaining 30 percent of the shares. However, there are no agreements between the family members that they will exercise their voting power jointly. Therefore, even though the shares are held within a single family who may have an established pattern of voting together, this group of individuals does not have a contractual arrangement to exercise control collectively over either company, and Y and Z are not under common control. 5.13.10.50 Continuing the example in 5.13.10.40, a different conclusion might be reached if, for example, the son were a child. However, judgement would be required to assess the facts and circumstances of each case. 5.13.10.60 In determining whether the combination involves entities under common control, it is not necessary that an individual, or a group of individuals acting together under a contractual arrangement to control an entity, be subject to the financial reporting requirements of IFRSs. Also, the entities are not required to be part of the same consolidated financial statements. [IFRS 3.B3] 5.13.10.70 The extent of non-controlling interests in each of the combining entities before and after the business combination is not relevant in determining whether the combination involves entities under common control. However, transactions that affect the level of non-controlling interests are discussed in 5.13.60.60-90. [IFRS 3.B4] FORTHCOMING REQUIREMENTS 5.13.10.80 IFRS 10 changes the definition of control, and introduces a number of changes from the control model in IAS 27. Therefore, the new standard will change the assessment of whether a business combination involves entities under common control. See 2.5A for a discussion of IFRS 10. 5.13.20 Scope of the common control exemption 5.13.20.10 In general IFRSs do not make specific provision for the accounting for common control transactions in the separate financial statements (see 2.1.70) when the entity elects to account for investments in subsidiaries at cost in accordance with IAS 27. The only exception is the establishment of a new parent in certain circumstances (see 5.13.150). In our view, an entity may apply the common control scope exclusion in IFRS 3 by analogy to the accounting for common control transactions in separate financial statements. When the entity elects to account for investments in subsidiaries in accordance with IAS 39, the common control exemption is not relevant and the requirements of IAS 39 apply (see 7.5 and 7.6). [IAS 27.38] 5.13.20.20 In our view, the common control exemption in accounting for business combinations also applies to the transfer of investments in associates and jointly controlled entities between investors under common control. Although neither IAS 28 nor IAS 31 includes an explicit exemption for common control transactions, both equity accounting and proportionate consolidation follow the methodology of acquisition accounting. Therefore, we believe that it is appropriate to extend the application of the common control exemption. [IAS 28.20, 31.33] 5.13.20.30 For example, in the following group structure the 30 percent investment in Associate C is transferred from Subsidiary S1 to Subsidiary S2, both of which are controlled by Company P. Accordingly, we believe that the transfer of C, compared with the acquisition of an associate from a third party, is outside the scope of the IFRS 3 methodology by virtue of the common control exemption in IFRS 3. 5.13.20.40 Questions have been raised about whether the view in 5.13.20.20 can continue to apply following comments made by the Board in amending the scope of IAS 39 in respect of forward contracts to enter into a business combination (see 7.1.120). The Board noted that the exemption in respect of forward contracts to enter into a business combination had not been extended to forward contracts in relation to associates and joint ventures, and therefore the scope exemption could not be inferred to extend to IAS 28. This was on the basis that the linkage between acquisition accounting and equity accounting is only in respect of accounting methodology and not the principles of the accounting. However, we believe that the extension of the common control exemption is a matter of accounting methodology and therefore that the common control exemption in IFRS 3 applies. [IAS 39.BC24D] 5.13.30 Transitory common control 5.13.30.10 The term 'transitory' is not defined under IFRSs. In our view, the notion of transitory is included in the common control definition as an anti-abuse measure to deal with so-called 'grooming' transactions, i.e. transactions structured to achieve a particular accounting treatment. Therefore, acquisition accounting should be applied to those transactions that look as though they are combinations involving entities under common control, but which in fact represent genuine substantive business combinations with unrelated parties. 5.13.30.20 In our view, the requirement that control not be transitory should be applied narrowly in order to give effect to its intention. We believe that transitory common control is relevant only when there is an intention to avoid applying acquisition accounting by sequencing an acquisition to place entities under common control before effecting the business combination. 5.13.30.30 For example, Company P has a subsidiary, Company B. P acquires all of the shares of Company C. Next P combines the activities of B and C by transferring the shares in C to B. The question arises as to how the transfer of C into B should be accounted for in the consolidated financial statements of B. 5.13.30.40 In this example, if the intermediate step had been omitted and instead B had been the P group's vehicle for the acquisition of C (i.e. going straight to the 'after' position), then B would have been identified as the acquirer. Since B and C are under common control, initially it appears that acquisition accounting would not be required because of the common control scope exemption. However, we believe that B should be identified as the acquirer and should account for its combination with C using acquisition accounting. This is because B would have applied acquisition accounting for C if B had acquired C directly rather than through P. Acquisition accounting cannot be avoided in the financial statements of B simply by placing B and C under the common control of P shortly before the transaction in what is a grooming transaction. 5.13.30.50 An assessment of whether control is transitory may require consideration of a wider series of transactions of which the business combination, which looks as though it involves entities under common control, is only one element. 5.13.30.60 Another issue with respect to common control transactions is whether an intention to dispose of a restructured or internally-created group means that post-combination control is transitory and therefore that common control accounting does not apply to a restructuring within a group in preparation for disposal. In our view, an intention to dispose of restructured or internally-created entities does not in itself result in control of the combined entities being transitory. 5.13.30.70 For example, Company P has two subsidiaries, Company M and Company V. Both subsidiaries have been part of the group for many years. P intends to combine the activities of M and V by transferring the shares in V to M, and then to sell the M sub-group. We believe that control by P over M and V is not transitory because M and V were part of the group for many years. Therefore, we believe that the common control exemption applies. 5.13.40 Consistency of accounting policies 5.13.40.10 As outlined in 5.13.50-150, we believe that there are a number of accounting policy options in accounting for common control transactions, depending on whether the financial statements are consolidated or separate. 5.13.40.20 IFRSs require the application of consistent accounting policies for similar transactions. Accordingly, common control business combinations are accounted for using the same accounting policy in the consolidated financial statements to the extent that the substance of the transaction is similar. [IAS 8.13, 27.34] 5.13.40.30 Similarly, common control transactions are accounted for using the same accounting policy in the separate financial statements, independently of the choice for the entity's consolidated financial statements, to the extent that the substance of the transaction is similar. This applies to both the accounting for acquisitions and disposals. [IAS 8.13] 5.13.40.40 Judgement is required in assessing the substance of a common control transaction to determine whether the specific facts and circumstances of a case warrant an accounting treatment that differs from that applied to previous common control transactions. [IAS 8.13] 5.13.40.50 However, in our view the nature of the investee does not affect the choice of accounting policy. For example, if the acquisition of a subsidiary in a common control transaction was accounted for previously using book value accounting (see 5.13.60), then we believe that the fact that a subsequent common control transaction involves the acquisition of an associate is not sufficient in itself to support a different accounting policy being applied. 5.13.50 Common control transactions in the consolidated financial statements of the acquirer 5.13.50.10 In the following group structure, if Company IP2 were to transfer its investment in Company S4 to Company S3, then S3 would be the acquirer for the purpose of applying the guidance that follows. 5.13.50.20 In our view, the acquirer in a common control transaction should choose an accounting policy in respect of its consolidated financial statements, to be applied consistently to all similar common control transactions (see 5.13.40), to use: 5.13.50.30 In addition, the accounting policy choice in 5.13.50.20 applies also in the acquirer's separate financial statements when it acquires assets and liabilities constituting a business under IFRS 3 (from an entity under common control) rather than acquiring shares in that business. 5.13.60 Book value accounting 5.13.60.10 In our view, in applying book value accounting, the acquirer should choose an accounting policy, to be applied consistently, in recognising the assets acquired and liabilities assumed using the book values in the financial statements of: 5.13.60.20 Continuing the example in 5.13.50.10, assume that S3 pays 2,000 to IP2 to acquire all of the shares in S4 on 1 July 2011. Based on the book values in the consolidated financial statements of IP2, the transferor (see 5.13.60.10), the following illustrates the consolidated position of S3 and S4 at the transaction date. 5.13.60.30 In our view, in its consolidated financial statements the acquirer is permitted, but not required, to restate its comparatives and adjust its current year prior to the date of the transaction as if the combination had occurred prior to the start of the earliest period presented. However, this restatement should not in our view extend to periods during which the entities were not under common control. 5.13.60.40 For example, Company D acquired Company E in a common control transaction on 1 June 2011; D's annual reporting date is 31 December. Both D and E have been owned by a single shareholder, X, since their incorporation many years ago. On that basis we believe that D may elect to restate its 2010 consolidated financial statements as if the acquisition had occurred prior to 1 January 2010. Additionally, the results of E will be included in D's financial statements for the period from 1 January to 1 June 2011. 5.13.60.50 In another example, Company G acquired Company H in a common control transaction on 1 June 2011; G's annual reporting date is 31 December. Both G and H are owned by a single shareholder, X; X acquired its investment in G in 2004, and its investment in H on 1 July 2010. On that basis we believe that G may elect to restate its 2010 consolidated financial statements as if the acquisition had occurred on 1 July 2010, but not earlier. Additionally, the results of H will be included in G's financial statements for the period from 1 January to 1 June 2011. 5.13.60.60 In our view, to the extent that the common control transaction involves transactions with non-controlling interests, the changes in non-controlling interests should be accounted for as acquisitions and/or disposals of non- controlling interests on the date that the changes occur (see 2.5.380). 5.13.60.70 For example, using the group structure below, 100 percent of the shares in Company S2 are transferred to Company S4 and the previous non-controlling shareholders in S2 obtain shares in S4; as a result, Company IP2's interest in S4 falls to 90 percent. 5.13.60.80 Therefore, IP2 has sold a 10 percent interest in S4 (100% - 90%), which IP2 should account for as a disposal without the loss of control (see 2.5.380); and has acquired a 10 percent interest in S2 (90% - 80%), which it should account for as an acquisition of non-controlling interests (see 2.5.380). 5.13.60.90 From S4's perspective, it has acquired a 100 percent interest in S2. However, if S4 chooses to restate comparatives, then it would be inappropriate for the restatement to be done as if S4 had always held a 100 percent interest in S2; this is because the group's holding in S2 was only 80 percent prior to the common control transaction. Instead, the restatement of comparatives should be done on the basis of a historical 80 percent interest in S2, with the 20 percent non-controlling interest being acquired at the date of the transaction (see 2.5.380). 5.13.70 Acquisition accounting 5.13.70.05 In developing an accounting policy through analogy to an IFRS dealing with similar and related matters, an entity uses its judgement in applying all aspects of the IFRS that are applicable to the particular issue (see 2.8.6). [IU 03- 11] 5.13.70.10 In our view, in applying acquisition accounting to a common control transaction, the acquisition accounting methodology in IFRS 3 should be applied in its entirety by analogy; this includes, for example, identifying the acquirer, identifying and measuring the consideration transferred, identifying and measuring the identifiable assets and liabilities and recognising goodwill. This is because a common control transaction remains a business combination even though it is outside the scope of IFRS 3. 5.13.70.20 However, to the extent that the acquisition accounting gives rise to an apparent gain on a bargain purchase, in our view such amount should be recognised in equity as a capital contribution from the shareholders of the acquirer. This is on the basis that the profit relates to a transaction with shareholders acting in their capacity as shareholders. 5.13.80 Common control transactions in the consolidated financial statements of the transferor 5.13.80.10 The requirements of IFRS 5 apply to the transferor in a common control transaction, regardless of whether the disposal occurs through non-reciprocal distribution of the shares in a subsidiary (a demerger or spin-off) or a sale (see 5.4.10). 5.13.90 Demergers 5.13.90.10 While IAS 27 deals with the loss of control in general, it does not deal with the loss of control through a demerger, i.e. non-reciprocal distributions of assets in the scope of IFRIC 17. However, the scope of IFRIC 17 excludes distributions in which the asset distributed ultimately is controlled by the same party or parties before and after the distribution; therefore common control transactions are excluded from the scope of IFRIC 17. [IAS 27.BC57, IFRIC 17.5] 5.13.90.20 In our view, a demerger that is not within the scope of IFRIC 17 may be accounted for using either book values or fair values. 5.13.90.30 For example, in the following group structure Company IP2 transfer