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4.7 VIE Characteristic 5: lack of right to receive residual returns
Publication date: 31 Dec 2022
us Consolidation guide
Characteristic 5 is based on the principle that traditional voting entities issue equity interests that allow the holder to receive the entity’s residual profits. The VIE model indicates that an entity is also considered a VIE if, as a group, the holders of the equity investment at risk lack the following:
The right to receive the expected residual returns of the legal entity. The investors do not have that right if their return is capped by the legal entity’s governing documents or arrangements with other variable interest holders or the legal entity. For this purpose, the return to equity investors is not considered to be capped by the existence of outstanding stock options, convertible debt, or similar interests because if the options in those instruments are exercised, the holders will become additional equity investors.
The intent of Characteristic 5 is also illustrated in the excerpt below:
Excerpt from ASC 810-10-15-14(b)
If interests other than the equity investment at risk provide the holders of that investment with these characteristics or if interests other than the equity investment at risk prevent the equity holders from having these characteristics, the entity is a VIE.
An evaluation of whether Characteristic 5 is present should focus on the equity interests as opposed to the identity of the equity investors. In most cases, a reporting entity should be able to make this assessment qualitatively.
If an entity is designed to issue equity interests that do not allow the holder to participate in the entity’s expected residual returns (i.e., the equity interests have embedded fixed-price callable features), we believe the entity may be a VIE. Additionally, when other variable interests that do not qualify as equity at risk share in, or fully absorb an entity’s expected residual returns, the entity that issued those equity interests may be a VIE.
In other instances, a variable interest that does not qualify as equity at risk may share in the entity’s expected residual returns. For example, an entity may enter into arrangements with a service provider that include a performance-based compensatory element. If that other variable interest was not entered into as part of the entity’s purpose and design, but was entered into as part of the entity’s normal course of business (i.e., normal course sharing arrangements), the entity would not be a VIE. In making this evaluation, we believe that variable interests that share in a large portion (e.g., 30%) of an entity’s expected residual returns would not likely be a normal course of business feature.
4.7.1 Examples of how to evaluate an entity under Characteristic 5
The following sections illustrate how certain contractual arrangements impact the assessment of whether the entity being evaluated for consolidation is considered a VIE under Characteristic 5.
4.7.1.1 Disproportionate sharing of returns among equity investors
Disproportionate sharing of expected residual returns among the holders of equity at risk does not cause an entity to be considered a VIE under Characteristic 5. Characteristic 5 focuses on whether the group of at-risk equity investors has the rights to the entity’s expected residual returns, as opposed to the manner in which the expected returns are shared among the group.
Disproportionate sharing arrangements change the manner in which the individual holders of equity at risk receive the entity’s expected returns. Although individual holders of equity at risk may individually be prohibited from receiving the entity’s expected residual returns to some extent, the group would continue to fully receive the entity’s expected returns.
4.7.1.2 Written fixed-price call option on the entity’s assets
Written call options on an entity’s assets that represent less than a majority of the entity’s total assets on a fair value basis would not be considered a variable interest in the entity as a whole (from the holder’s perspective). If the written call option does not represent a variable interest in the entity, it would not cap the ability of the holders of equity at risk, as a group, from receiving the potential VIE’s expected residual returns.
If the assets underlying the written call option represent more than 50% of the entity’s total assets on a fair value basis, then the written call option may cap the investor’s ability to receive the entity’s expected residual returns. Determining whether the written call option functions as a cap depends on the specific facts and circumstances. Relevant factors will include whether the option’s strike price is fixed, formula-based, or at fair value. A call option with a fair value strike price would not meet Characteristic 5, whereas a call option that is formula-based may meet Characteristic 5.
4.7.1.3 Written fixed-price call options on the entity’s equity interests
Written fixed-price call options on an entity’s equity interest would allow the holder of the call to participate in the entity’s expected residual returns. If the amount of the expected residual returns absorbed by the call was large in relation to the expected residual returns absorbed by the entity’s total equity, the entity would be a VIE.
Example CG 4-24 illustrates the assessment of the impact of a written call on an equity interest.
EXAMPLE CG 4-24
Assessing the impact of a written call on an equity interest
Assessing the impact of a written call on an equity interest
Company A and Company B formed Corporation X. At formation, Company A received a 75% equity interest in exchange for a $750 cash contribution. Company B received a 25% equity interest in exchange for a $250 cash contribution. All of Corporation X’s profits and losses are shared among Company A and Company B in accordance with the relative ownership percentages.
Subsequent to the formation of Corporation X, Company A wrote a call option to Company C allowing Company C to purchase Company A’s 75% equity interest for $1,000 at any time for a period of two years. The call option was entered into as a part of the redesign of Corporation X and is a freestanding financial instrument.
Does Company C’s call option on Company A’s 75% equity investment cause Corporation X to be a VIE under Characteristic 5?
Analysis
Maybe. While the call provides Company C with rights to a portion of Company Xs expected residual returns, the extent of those rights would need to be assessed. The call is written out of the money and has a limited term of two years. These features together with the relevant facts around Company X’s operations may support a conclusion that the amount of expected residual returns absorbed by the call may not be substantial (in which case the entity would not be a VIE).
In some cases, the potential VIE may write a call option on its own equity interests. The call option may be freestanding and issued as compensation, or embedded in another financial instrument that was issued as part of a financing transaction. Examples include employee stock options, convertible debt, or similar interests. These variable interests should not cause the issuer of such interests to be a VIE under Characteristic 5 since the purchaser or holder of these options will become part of the group of at-risk equity investors upon exercise.
4.7.1.4 Outsourced decision-making fee arrangements
An entity may enter into an arrangement with a service provider that includes a performance-based compensatory element. If a reporting entity concludes that a decision-making fee arrangement is not a variable interest in the entity as discussed in CG 3.4, we do not believe the fee arrangement would cause the entity to be a VIE. Such arrangements are consistent with other normal course sharing arrangements and do not demonstrate the existence of Characteristic 5.
If a reporting entity concludes that a service provider arrangement represents a variable interest in the entity, further analysis would be required to determine whether the reporting entity can participate in a large portion of the entity’s profits. If so, we believe such arrangements may be inconsistent with normal course sharing arrangements and the entity should be considered a VIE.
The following arrangements should be carefully considered to determine whether they cause an entity to be a VIE under Characteristic 5:
- Service contracts that are indexed to the entity’s performance
- Decision-making fees
- License, royalty, and other similar arrangements
We believe profits should be interpreted more broadly and not limited to items such as net income or earnings before taxes. Other performance measures (e.g., revenue, operating income, EBITDA) should also be considered. However, only those arrangements that share in a large portion of the entity’s expected residual returns would cause an entity to be a VIE under Characteristic 5.
In most entities, these arrangements would not demonstrate the presence of this characteristic; however, a reporting entity should evaluate the terms of each contract and the level of the entity’s returns that the counterparty is entitled to share in.
4.7.1.5 Other equity investments that are not considered “at risk”
In some situations, equity may be issued in return for the promise to provide services to the entity (sometimes referred to as “sweat equity”). Because “sweat equity” does not qualify as equity at risk, a reporting entity must consider whether this equity investment caps the at-risk equity investors’ ability to receive the entity’s expected residual returns. We believe this would be the case when equity investments that do not qualify as equity at risk share in a large portion of the entity’s expected residual returns.
Example CG 4-25 illustrates the assessment of the impact of an equity investment that is not at risk under Characteristic 5.
EXAMPLE CG 4-25
Assessing the impact of an equity investment that is not at risk under Characteristic 5
Assessing the impact of an equity investment that is not at risk under Characteristic 5
Company A and Company B formed Corporation X. At formation, Company A received a 65% equity interest in exchange for a $1,000 cash contribution. Company B received a 35% equity interest in return for future services. All of Corporation X’s cash flows are distributed to Company A and Company B in accordance with the relative ownership percentages.
Because Company B received its interest in exchange for future services, its equity investment does not qualify as equity at risk.
Does the existence of Company B’s 35% equity investment cause Corporation X to be a VIE under Characteristic 5?
Analysis
Since Company B participates in the entity’s expected residual returns, Characteristic 5 may be present if Company B is entitled to a large portion of returns in relation to the entity’s total expected returns. If so, Characteristic 5 would be present and the entity would be considered a VIE. Generally, a 35% sharing rate would be considered large.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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