For an investor to have control over an investee it must have exposure, or rights, to variable returns from the investee.
IFRS 10 provides the following examples of variable returns:
- dividends, The investor’s exposure or right to variable returns
- other distributions of economic benefits (for example, interest from debt securities),
- changes in value of an investment,
- remuneration for servicing an investee’s assets or liabilities,
- fees and exposure to loss from providing credit or liquidity support,
- residual interests in the investee’s assets and liabilities on liquidation,
- tax benefits, The investor’s exposure or right to variable returns
- access to future liquidity, The investor’s exposure or right to variable returns
- returns that are not available to other interest holders such as:
- use of own assets in combination with investee’s assets
- combining operating functions to achieve economies of scale
- cost savings
- gaining access to proprietary knowledge
IFRS 10 also makes it clear that returns that are ‘fixed’ in contractual terms are nonetheless regarded as variable for the purposes of the control assessment. For example:
- a bond with fixed interest payments still exposes its holder to default risk and credit risk The investor’s exposure or right to variable returns
- fixed performance fees for managing an investee’s assets are variable returns because they expose the investor to the performance risk of the investee.
Variable returns are therefore defined very broadly and extend well beyond the ownership benefits obtained through equity shares. The example illustrates one type of less conventional variable return:
Entity B is a bank in the US and Entity S is an information technology (IT) outsourcing company in India. Entities B and S form a new Entity C, with the sole activity of providing IT services to B on an outsourced basis. Some key facts relating to the arrangement are as follows:
This fact pattern raises two main issues:
It is clear that Entity S has rights to variable returns through its ownership of ‘class B’ shares, which enable it to participate in net profits. However, Entity B also has a variable return that relates to Entity S’s performance. This is because the pricing mechanism results in Entity B sharing in any efficiency benefits achieved by Entity S. These benefits vary depending on Entity S’s performance.
There are some mixed indicators on this question. Entity B appoints the majority of the Board but Entity S nominates the CEO, has more day-to-day involvement in the operations, and provides most of the staff with expertise. However, Entity C’s Board oversees both the CEO and day-to-day operations and is empowered to direct these activities. Accordingly, it is likely that Entity B has the ability to direct the relevant activities and therefore controls Entity C.