When should a purchase of investment property (or properties) be accounted for as a business combination, and when as a simple asset purchase? This is an important issue because the IFRS accounting requirements for a business combination are very different from asset purchases. Acquisition of investment properties
The purchase of investment property (or properties) is a business combination if the acquired set of assets and activities meets IFRS 3’s definition of a business
(IFRS 3 Appendix A and supporting guidance). That guidance explains that a business consists of ‘inputs’ and ‘processes’ applied to those inputs that together have the ability to create ‘outputs’ (IFRS 3.B7). Determining whether a purchase of investment property is a business combination therefore requires a careful evaluation of the transaction and of what has been acquired (the ‘acquired set’). This often requires judgment.
When purchasing an investment property the ‘input’ part of the definition is always met because the property itself is an input. If the property has in-place tenants and leases, the ‘output’ part is also met because rental is an output. Even with no in-place leases at the purchase date, a property that is substantially complete and available for letting may have the ability to earn rentals and therefore be capable of creating outputs. In these situations, deciding whether the acquired set is a business depends on whether any ‘processes’ are transferred and, if so, their nature and significance.
When an investment property has tenants, various services must also be provided, some of which may be specified in the leases. These and other services (or contracts for services outsourced to third parties) may be transferred to the buyer on purchase, in which case they are part of the acquired set. Acquisition of investment properties
However, many basic services commonly associated with investment property are administrative functions that do not meet the definition of processes (IFRS 3.B7). Examples include: rent collection, basic tenant administration, basic maintenance, security and cleaning.
By contrast services that go beyond administrative matters are likely to be ‘processes’. Processes typically involve specific knowledge or skills and can be significant to the decision to purchase the property(ies) and/or its value. The presence of processes in the acquired set is indicative of a business.
However, the presence of a relatively unimportant process may not be enough – for example if other, more important processes are excluded. Acquisition of investment properties
Accordingly, the transfer of some services does not necessarily mean that the acquired set is a business. Acquisition of investment properties
In conclusion, the generally predominant accounting practice is as follows: Acquisition of investment properties
- the purchase of a property or properties with or without tenants in which no services are transferred should be accounted for as an asset purchase Acquisition of investment properties
- the purchase of a property or properties with tenants and with the transfer of only administrative-type services should also be accounted for as an asset purchase
- the purchase of a property or properties with tenants and more sophisticated services/activities should generally be accounted for as a business combination (in accordance with IFRS 3).
Scenario 1 – single property, no tenants or services
ShellCo holds a single investment property. The property is complete but has no tenants. ShellCo has no staff and does not undertake any services.
This is an asset purchase. ShellCo has no tenants or in-place leases (ie it does not generate outputs) and no services are transferred to PropCo.
Scenario 2 – single property with tenants
ShellCo holds a single investment property. The property has in-place tenants and leases but no support services or contracts are transferred when ShellCo is acquired.
This is an asset purchase. ShellCo is revenue-generating, but no processes have been transferred to PropCo. Although the rental agreements are likely to contain servicing obligations, PropCo has not acquired any actual activities.
However, an alternative view is that the property could meet the definition of a business if market participants are capable of generating a return from the acquired ‘set’ by integrating it with their own inputs and processes (IFRS 3.B8).
However, although Scenario 2 is less clear-cut than Scenario 1, predominant practice in most jurisdictions is to classify the purchase as an asset purchase when the acquired set does not include any processes.
Scenario 3 – single property with tenants and simple services
ShellCo holds a single investment property. The investment property has tenants subject to rental agreements. Certain outsourced contracts for maintenance and security services are also transferred. PropCo intends to allow these contracts to run to expiry and will then replace them with its own in-house services.
Generally, this is also treated as an asset purchase. In this case, support services have been transferred, even though they will be performed by external providers. However, these services are relatively simple, administrative-type services. The service contracts are unlikely to be a significant factor in PropCo’s investment decision or valuation. In accordance with the guidance provided, such services are not considered to be processes that are used to create outputs.
As for Scenario 2 it is also possible to argue that the acquired set is a business, on the basis of:
Scenario 4 – multiple properties, tenants, services and staff
ShellCo holds eight investment properties. The investment properties have tenants subject to rental agreements. B also employs several staff dedicated to the properties’ management, the provision of services included in the rental agreements, and administration such as invoicing, cash collection and management reporting. The transferred staff also include managers responsible for portfolio management, raising finance and marketing.
This is a business combination. PropCo has acquired a group of revenue-generating assets along with various staff and activities that clearly go beyond activities ancillary to the properties and their tenancy agreements.