Know It All Purchase Of 1 Property Investment – FAQ | IFRS

Know it all purchase of 1 property investment

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Know it all purchase of 1 property investment – 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.

Distinguishing business combinations and asset purchases can also be challenging for many other types of transaction and judgement is often required. This is particularly the case when investing in assets that generate cash flows on a stand alone basis such as retail outlets and hotels. Here the focus is on investment property but the underlying arguments apply more broadly.

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 judgement. Know it all purchase of 1 property investment

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 ‘outputs’ part isKnow it all purchase of 1 property investment 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. Know it all purchase of 1 property investment

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. In our view, 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. Know it all purchase of 1 property investment

Accordingly, the transfer of some services does not necessarily mean that the acquired set is a business. As a general indication, the following criteria could be assessed:

  • 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
  • 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).

However, some commentators interpret IFRS 3’s definition of a business in such a way that each of these scenarios could be a business combination. This is explained further below.

Asset purchase versus business combination Know it all purchase of 1 property investment

It is important to distinguish asset purchases from because business combinations the IFRS requirements are very different. Some of the key differences are summarised in the following table:

IFRS topic

Asset purchase

Business combination

Recognition of identifiable assets and liabilities

total cost is allocated to individual items based on relative values

measured at fair value

Goodwill or gain on bargain purchase

not recognised

recognised as an asset (goodwill) or as income (gain on bargain purchase)

Transaction costs

typically capitalised

expensed when incurred

Deferred tax on initial temporary differences

not recognised unless specific circumstances apply

recognised as assets and liabilities

IFRS 3’s definition of a business Know it all purchase of 1 property investment

IFRS 3 Appendix A defines a business combination as “a transaction or event in which an acquirer obtains control of one or more businesses. Transactions sometimes referred to as ‘true mergers’ or ‘mergers of equals’ are also business combinations”. A business is then defined as “an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants.”

IFRS 3 Appendix B provides application guidance relating to the definition of a business. Paragraph B7 states that: Know it all purchase of 1 property investment

“A business consists of inputs and processes applied to those inputs that have the ability to create outputs. Although businesses usually have outputs, outputs are not required for an integrated set to qualify as a business. The three elements of a business are defined as follows:

  1. Input: Any economic resource that creates, or has the ability to create, outputs when one or more processes are applied to it. Examples include non-current assets (including intangible assets or rights to use non-current assets), intellectual property, the ability to obtain access to necessary materials or rights and employees.
  2. Process: Any system, standard, protocol, convention or rule that when applied to an input or inputs, creates or has the ability to create outputs. Examples include strategic management processes, operational processes and resource management processes. These processes typically are documented, but an organised workforce having the necessary skills and experience following rules and conventions may provide the necessary processes that are capable of being applied to inputs to create outputs. (Accounting, billing, payroll and other administrative systems typically are not processes used to create outputs.)
  3. Output: The result of inputs and processes applied to those inputs that provide or have the ability to provide a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants.”

Further guidance is provided in IFRS 3.B7-B12. Know it all purchase of 1 property investment

Revision of guidance Know it all purchase of 1 property investment

The IASB clarified the interaction between IFRS 3 and IAS 40. Know it all purchase of 1 property investment

They added paragraph 14A to IAS 40 (as part of ‘Annual Improvements 2011-13 Cycle’) which clarifies that: Know it all purchase of 1 property investment

  • judgement is needed to determine if an acquisition of investment property is the acquisition of an asset or a group of assets or a business combination within the scope of IFRS 3
  • this judgement is made by reference to IFRS 3 (and not by reference to the discussion in IAS 40 7-14, which relates to whether property is owner-occupied property or investment property).

IAS 40.14A removes an argument that the generation of rental income, and activities such as property servicing and rent collection that are ancillary to earning rentals, can be disregarded when considering the definition of a business. Know it all purchase of 1 property investment

Before the clarification some commentators argued that these features are implicit in the definition of investment property and, for that reason, should not be viewed as ‘outputs’ or ‘processes’.

Applying the revised guidance and definition to investment property

Despite this clarification applying the definition of a business to the purchase of an investment property remains challenging. This is particularly the case for purchases of property(ies) with in-place leases in which some services are transferred. For these purchases, the acquired set clearly includes ‘inputs’ and ‘outputs’. The overall conclusion then depends on the assessment of the transferred services against the ‘processes’ component of IFRS 3’s guidance. That assessment can be divided into two questions:

  • are the transferred services ‘processes’? Know it all purchase of 1 property investment
  • if so, are the transferred processes sufficient to meet the definition of a business? Know it all purchase of 1 property investment

Are the transferred services ‘processes’?

IFRS 3’s guidance explains that “Accounting, billing, payroll and other administrative systems typically are not processes used to create outputs” (IFRS 3 B7). Accordingly, under our preferred view, it is also reasonable to conclude that the purchase of an investment property with in-place tenants and either no services or purely administrative functions is an asset purchase. In the context of investment property, examples of services that may be considered administrative functions include:

  • rent collection and basic tenant administration Know it all purchase of 1 property investment
  • basic maintenance Know it all purchase of 1 property investment
  • security Know it all purchase of 1 property investment
  • cleaning. Know it all purchase of 1 property investment

These services would usually be easy to replace. They are also unlikely to have a significant impact on the acquirer’s investment decision or on its valuation. Know it all purchase of 1 property investment

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 investment decision and the valuation. In the context of investment property, ‘processes’ might include:

  • marketing Know it all purchase of 1 property investment
  • portfolio management (investment, disposals, upgrades, and associated activities) Know it all purchase of 1 property investment
  • financial management Know it all purchase of 1 property investment
  • more sophisticated property management services. Know it all purchase of 1 property investment

Assessing whether an acquired service is an administrative function or a process may require judgement.

Are the transferred processes sufficient to meet the definition of a business?

In our view, the acquired set is not a business if no processes at all are transferred. In acknowledging IFRS 3 B8, which explains that: “a business need not include all of the inputs or processes that the seller used in operating that business if market participants are capable of acquiring the business and continuing to produce outputs, for example, by integrating the business with their own inputs and processes.” Based on this guidance, some commentators reason that an absence of processes does not necessarily mean that the acquired set is a purchase of assets. As always judgement is required and it is important to be aware that divergent views exist. Know it all purchase of 1 property investment

Even if some processes have been transferred, the acquired set may not always be a business. The transfer of a relatively unimportant process may not be conclusive if other, more important processes necessary to generate returns have not been transferred. Know it all purchase of 1 property investment

Unfortunately, IFRS 3 does not expand on the number or type of processes that can be missing for an acquired set to be an asset purchase rather than a business combination. This has led to questions and divergent views.Property, plant and equipment Property, plant and equipment

Additional factors to consider

Additional factors that indicate a business combination include: Know it all purchase of 1 property investment

  • a purchase that includes separately identifiable assets and/or liabilities that would not ordinarily be considered as part of the property
  • the purchase of an entity (or group of entities) that previously operated independently as a property business (in contrast for example to a subsidiary with a single investment property sold by one group to another) Know it all purchase of 1 property investment
  • the purchaser’s motivation for the acquisition goes beyond adding to its property portfolio
  • the existence of goodwill in the acquired set (IFRS 3 B12).

Considerations for investment property held in a separate legal entity

It is common in some jurisdictions for a single investment property to be held in a separate legal entity and for a purchaser to acquire that entity rather than the property. The acquisition of a legal entity does not necessarily mean the acquired set is a business. The assessment of the acquired set is based on the same analysis discussed above; however, the acquisition of a legal entity brings with it all of the entity’s assets, liabilities, contractual agreements and obligations and therefore may trigger the need for additional questions and analysis.

IFRIC research

Research undertaken in 2013 by the staff of the IFRIC has identified various challenges in applying the existing definition and some diversity in practice. This diversity mainly related to the types of acquired process considered necessary for an acquired ‘set’ to constitute a business. Two broad approaches were identified by IFRIC staff:

  • one broad approach is that any processes that, when applied to an input or inputs, create or have the ability to create outputs, give rise to a business
  • the other broad approach is to distinguish between relatively simple processes and more ‘sophisticated’ processes or processes that involve a degree of knowledge unique to the assets that would need to be acquired for the acquired set to constitute a business.

The guidance provided above follows the second broad approach. This approach is more common in most jurisdictions that apply IFRSs.

Taxation – Asset purchase versus business combination

Legal entity sale/purchase

Asset deal

The acquirer in a business combination is the combining entity that obtains control of the legal acquiree sale entity

The acquisition of a collection of assets that does not constitute a business is not a business

Taxation

Legal acquiree entity

Legal acquiree entity’s shares sold by a legal entity or a private person may be taxed based on tax jurisdiction

Legal acquirer entity

Consideration transferred is fiscal costs of the legal acquirer entity

Consolidation of fiscal results may be possible in a fiscal consolidation unit

Asset/liability sale

The legal entity or private owner very likely records a taxable profit

Legal acquirer entity

Acquires a higher depreciation, amortisation impairment potential

IFRS Accounting

Acquisition balance sheet by legal acquirer entity

Assets transferred

Liabilities assumed

Liabilities incurred by the acquirer to the previous owners of the acquiree and

Equity interests issued by the acquirer.

Legal acquirer entity

Legal acquirer entity allocates the cost of acquisition to the assets acquired and liabilities assumed based on their relative fair values at the acquisition date. No goodwill is recognised.

Identifiable assets at fair value by legal acquirer entity

The identifiable assets (including intangible assets and (remainder) goodwill) acquired and liabilities assumed are recognised separately from goodwill at the acquisition date if they meet the definition of assets and liabilities and are exchanged as part of the business combination.

Fair values increase the potential for higher depreciation, amortisation and impairments (all assets)

Depreciation, amortisation and impairment potential for legal acquirer entity

Fair values increase the potential for higher depreciation, amortisation and impairments (all assets)

See also: The IFRS Foundation

Know it all purchase of 1 property investment

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