Chapter 3: Business combinations achieved without consideration transferred

An acquirer could obtain control of a business without transferring any consideration.

This might occur where: The acquiree buys back enough of its own shares that the acquirer manages to gain control. The rights of other (minority) shareholders that stopped the acquirer from controlling the acquiree lapse. The acquirer and acquiree combined businesses through a contract, but with no transfer of consideration. No equity interest is held in the acquiree, either at the acquisition date or earlier. This might be achieved through a stapling transaction or through the formation of a dual-listed entity.

Reverse acquisitions

Identifying the acquirer in a business combination is based on the concept of ‘control’. Normally, where an acquisition is effected by an exchange of equity interests, the shareholders of the entity that issues securities (the legal parent entity) retain the majority holding in the combined group. The positions might be reversed in certain circumstances. It is the legal subsidiary entity’s shareholders who effectively control the combined group, even though the other party is the legal parent. The legal subsidiary entity’s board will normally dominate the combined group’s board in such circumstances. This is illustrated by the following diagram:                                                

In some business combinations, the acquirer is the entity whose equity interests have been acquired, and the issuing entity is the acquiree. These combinations are commonly referred to as ‘reverse acquisitions.

Reverse acquisition of established private entity by small-listed entity

An example of a reverse acquisition is where a well-established unlisted trading entity arranges to have itself ‘acquired’ by a listed smaller entity that is a business and, as part of the agreement, the listed entity’s directors resign and are replaced with directors appointed by the unlisted entity and its former owners. The motive for such transactions is often that, by combining with the listed entity, the unlisted trading entity obtains a listing for itself. Although, legally, the listed entity is regarded as the parent and the unlisted entity is regarded as the subsidiary, the legal subsidiary is the accounting acquirer if it controls the legal parent. If so, the combination is accounted for as the acquisition of the listed entity by the trading entity − in other words, reverse acquisition accounting. Situations where the listed entity does not meet the definition of a business are not business combinations. Generally, these are treated as capital reorganisations.

New entity formed to affect a business combination

Business combinations are often effected by incorporating a new entity. A new entity formed to effect a business combination is not necessarily the acquirer. One of the existing combining entities should be determined to be the acquirer in a business combination involving the issuance of equity interests by a newly formed entity.

 New entity formed to affect a business combination

IFRS 3 assumes that, where a new entity is set up to issue equity shares to affect a business combination, the new entity has no economic substance. The formation of such entities is often related to legal, tax or other business considerations that do not affect the identification of the acquirer. A combination between two entities that is structured so that one entity directs the formation of a new entity to issue equity instruments to the owners of both of the combining entities is, in substance, no different from a transaction in which one of the combining entities directly acquires the other. Therefore, the transaction is accounted for in the same way as a transaction in which one of the combining entities directly acquires the other.

IFRS 3 does not specify the accounting for the ‘combination’ of the new entity and the acquirer, since the new entity is not a business. However, under the principles of IFRS 3, the combination of the new entity and the existing entity deemed to be the acquirer is not a business combination. [IFRS 3 App B para B18]. The combination of these two entities is, in substance, a reorganisation. This means that the acquiring entity’s net assets are recorded at book value in the new entity’s consolidated financial statements.

Example 1 – Business combination using a new entity – new entity is not considered substantive

The shareholders of entities A and B agree to merge, to benefit from lower delivery and distribution costs. The business combination is carried out by setting up a new entity (new company), that issues 100 shares to entity A’s shareholders and 50 shares to entity B’s shareholders in exchange for the transfer of the shares in those entities. The number of shares reflects the relative fair values of the entities before the combination. Is new company the acquirer? If not, which entity is the acquirer, and how is the combination accounted for? No, new company is not the acquirer. The transaction has brought together entities A and B. Legally, it has been affected by new company acquiring entities A and B, rather than one of these entities acquiring the other.

New company is a new entity that has been formed to issue equity instruments to affect a business combination. One of the combining entities that existed before the combination is identified as the acquirer. [IFRS 3 App B para B18]. Entity A seems to be the acquirer – it is the largest entity, and its previous owners control the combined group, with 67% of the shares (100 ÷ 150). New company’s consolidated financial statements reflect entity A as the acquirer and New Co as a continuation of entity A presenting entity A’s historical book values. Entity B is the acquiree, and acquisition accounting is applied to entity B’s assets and liabilities.

Example 2 – Business combination using a new entity – new entity is considered substantive

A Newco is formed by various unrelated investors for the purpose of acquiring a business. Newco issues equity to the investors for cash. Using the cash received, Newco purchases 100% of the equity of a company. In this case, Newco could be determined to have economic substance and identified as the accounting acquirer, because it was established for the purpose of acquiring control of a business and not simply a vehicle to combine two existing businesses. Newco, itself, obtained control of a business and is not controlled by the former shareholders of the acquired entity. In addition, Newco was not formed to issue equity interests to affect the business combination, but rather it used cash received from the various unrelated investors to fund the acquisition.

Identifying the acquirer through domination of key management

Entities E and F agree to combine their operations and form entity G. All of the voting shares of entities E and F are exchanged for shares in entity G. Entity E’s fair value is C510; entity F’s fair value is C490. The shareholders of each entity maintain the same relative voting rights in the combined entity. Entity E’s shareholders own 51% of the voting rights in entity G, and entity F’s shareholders own 49%. Entity G’s board of directors has eight members, four of whom are appointed by entity E’s shareholders and four by entity F’s shareholders. All key decisions require approval of 55% of the shareholders.

The parties have agreed that entity F’s shareholders will have the right to appoint entity G’s CEO and CFO. How is the transaction accounted for in entity G’s financial statements? This is a business combination between entities E and F. Entity G cannot be identified as the acquirer because it is a new entity formed to issue shares to affect the business combination. The acquirer is the existing combining entity that obtains control of the other combining entities or operations.

All key decisions require 55% approval, so neither entity E nor entity F has control as a result of their respective voting rights. However, control can be obtained through means other than a majority of voting rights. An acquirer can be identified if one of the parties to a business combination is able to dominate the selection of the combined entity’s management. Entity F will dominate the key management appointments of the combination, suggesting that entity F has dominated the selection and is the acquirer.

New company set up by venture capital entity to acquire business

Holding company, A is owned 100% by Mr X. It has a group of businesses, the ‘B businesses’, which it is intending to sell. Several potential purchasers have been identified. Management of holding company A is conducting negotiations and preparing the B businesses for sale. Management incorporates new company, which issues shares to acquire 100% of the various legal entities that comprise the B businesses. Acquisition company A is the winning bidder and negotiations are concluded. Acquisition company A establishes a new entity, ‘Acquisition company B’, that raises substantial amounts of debt, conditional on the acquisition of the B businesses. Acquisition company B buys 75% of the shares of new company from holding company A for cash.

Accounting for the transaction at step B This is a transaction amongst entities under common control, because Mr X is the controlling party both before and after the transaction. The accounting treatment of this specific example is out of scope of this chapter. Accounting for the transaction at step C Should management of acquisition company B identify acquisition company B as the acquirer under IFRS 3 and apply the acquisition method to the transaction? Yes, acquisition company B is the acquirer. Acquisition company B is an extension of acquisition company A, and it controls the new company group. The debt raising by acquisition company B creates economic substance. Acquisition company B has acquired new company and the B businesses from holding company A. It records the assets and liabilities of the acquired businesses in its consolidated financial statements at fair value in accordance with IFRS 3. It also records a 25% non-controlling interest to holding company A, either measured at fair value or at the non-controlling interest’s proportionate share in the identifiable net assets.

New company is not the acquirer

Entity A owns entity B before the transaction. Entity A arranges loan funding from a financial institution in a new wholly owned subsidiary, new company. The loan is used by new company to fund the acquisition of entity A’s 100% shareholding in entity B, for cash consideration. Entity A applies IFRS 3 to account for common control transactions, and new company will adopt the same policy.

Can new company be identified as the acquirer in a business combination and apply acquisition accounting in its consolidated financial statements? No. Under IFRS 3, new company cannot be the acquirer. Entity A has created new company and is the seller, so new company has effectively been formed and issued shares to effect the business combination.

New company is not a business, and the transaction between entity B and new company is not a business combination. It is a reorganisation of entity B. As a result, entity B’s assets and liabilities are included in new company’s consolidated financial statements at their pre-combination carrying amounts, without a fair value uplift.

New entity formed to acquire an existing group

A new parent entity added to an existing group is not an acquirer in a business combination. The transaction is unlikely to be a business combination as defined by IFRS 3: “The accounting acquiree must meet the definition of a business”. The situation where a new entity is added to an existing group is not a business combination.

New entity formed to acquire an existing group

It is not uncommon for a new parent entity to be added to an existing group by setting up a new shell entity that issues equity shares to the existing shareholders in exchange for the transfer of shares in the existing group, such that there is no change in the substance of the reporting entity.

This might be done for a variety of reasons, including taxation and profit distributions. There is no specific guidance in IFRS 3 when a new entity is placed on top of an existing group by issuing shares to the existing shareholders, that the transaction would not be a business combination because the acquiree is not a business. It can be argued that the transaction is a reorganisation of an existing entity that has not changed the substance of the reporting entity. The consolidated financial statements of the new entity are presented using the values from the consolidated financial statements of the previous group holding entity. The equity structure (that is, the issued share capital) would reflect that of the new entity, with other amounts in equity (such as revaluation reserve, retained earnings and cumulative translation reserves) being those from the consolidated financial statements of the previous group holding entity. The resulting difference that will arise would be recognised as a component of equity. Local regulatory or legal requirements might specify how this difference is presented; for example, it might be referred to as a reorganisation reserve. The diagram below illustrates a transaction in which a new entity is added to the top of an existing group. The addition of new company to entity A is not a business combination. The transaction is a reorganisation of entity A, and the consolidated financial statements of new company show the assets and liabilities of entity A for all periods presented.