Five years ago, we looked at the issue of an entity that settles a loan due to a shareholder by issuing equity instruments, and the accounting for the difference between the fair value of the consideration paid and the carrying value of the loan extinguished.

Canada’s IFRS Discussion Group (as it was called at the time) agreed that if it’s clear that the shareholder is acting “in its capacity as a shareholder,” the difference isn’t treated as a gain or loss in income, on the basis that a contribution from a shareholder clearly belongs in equity. They added the following:

• “Group members agreed that the question of whether or not the shareholder is acting in its capacity as a shareholder should determine the appropriate accounting treatment, but that the answer to that question is not always clear. As a result, several Group members suggested that beginning with the presumption that a shareholder is acting in his or her capacity as a shareholder might be appropriate, unless there is clear and convincing evidence to the contrary.
• Group members agreed that evidence of the same or similar transactions executed with other non-shareholder creditors is a factor to consider in determining whether the transaction is with a shareholder acting in his or her capacity as a shareholder. However, they noted that other factors are not relevant in this determination (for example, whether the amount due to the shareholder originated from fees for services rather than advances of cash, or whether the shareholder agreed to extinguish the loan through a cash payment that is less than the carrying amount of the loan rather than the issuance of shares).”

This issue must be more common than one might imagine, because my old post on the topic continues to be among the most popular of all the 700+ entries on this blog: in 2023 for example it was approximately the eighth most viewed (I wouldn’t personally rank it among the eight all-time best, but I’m pleased to be useful once in a while). The group recently returned to the issue, this time generating a more comprehensive list of factors that might be relevant to the determination – contrary to the passage cited above, they seemed this time to take the view that almost any factor might be potentially relevant (although not of course in itself determinative). I’ll list some of the items here:

• The extent of the shareholder-creditor’s involvement in the entity’s operations, decision-making processes, or governance structures – for example, perhaps the debt was originally a loan advanced in cash, the terms of which have subsequently been extended or modified over multiple fiscal periods to provide greater repayment flexibility (compared for instance to a simpler scenario of a debt with a management entity shareholder that arose from a recent invoice for management services).
• The size of the ownership interest: “Under Canadian securities legislation, shareholders that own or control 10 per cent or more of an issuer’s securities are required to submit insider reports. The ownership interest must be disclosed therein. The ownership percentage held by the shareholder-creditor, particularly if it is at or above an insider level, could indicate influence over the entity. That level of influence may not be present in a creditor-only relationship.” Also the duration of that interest: “When a shareholder-creditor holds its equity interest in the entity for a longer period, that might indicate a strategic intention (net asset growth) typical of a shareholder over a profit intention (yield) typical of a creditor.”
• Extent and diversity of other creditors – if the shareholder-creditor is the only party willing to lend, that could indicate they are acting in a shareholder capacity.
• Magnitude of the debt – a shareholder-creditor that holds significant debt may be compelled to act in ways that appear as if they are acting in a shareholder capacity. However, they may simply be trying to recover what little they can because recovering a small amount is better than recovering nothing.
• Objective of the counterparty – a lender will seek to maximize their return even when they are willing to accept alternatives to cash as repayment of debt (such as when the debtor is under duress). A shareholder-creditor acting in a shareholder capacity may be willing to accept less-favourable terms than a party acting in a creditor capacity.

Overall: “Group members discussed the importance of understanding the economics of the transaction, such as how the negotiations are done and the entity’s interactions with other shareholders and creditors. They also noted that the balance of factors is important (e.g., an insider-level ownership interest is not a bright line indicator), but that some factors may carry more weight than others. For example, several Group members commented that transacting at fair value would be a particularly strong indicator that a shareholder-creditor is acting in a creditor capacity.

So, no fundamental shake-up of the approach there, but plenty of additional possible factors and indicators to throw into the judgement mix. And there you go, a blog post to be savoured for years to come…

The opinions expressed are solely those of the author.