Written By Donald E. Greenfield, Q.C. and Kyle H. Donnelly
The monetary threshold for the review of the acquisition of control of a Canadian business by an investor ultimately controlled in a World Trade Organization member state (other than a state-owned enterprise) under the Investment Canada Act (ICA) is based on the enterprise value (EV) of the assets of the Canadian business. The EV is to be determined in accordance with section 3.3, 3.4 or 3.5 of the Investment Canada Regulations (SOR/85-611) (the "Regulations"), depending on how control is acquired and, if control of an entity is being acquired, whether the securities of the entity are publicly traded. There are two thresholds, and which one applies depends on whether the foreign buyer is a “trade agreement investor”.
Where control of an entity is acquired, total liabilities (excluding “operating liabilities,” a term that is used but not defined in the Regulations), as listed in the entity’s most recent quarterly financial statements, are to be added in calculating EV. Abandonment and reclamation obligations (or asset retirement obligations or decommissioning liabilities) (AROs) are normally a line item on an entity’s balance sheet. When assets are purchased, the total liabilities (other than operating liabilities) that are to be assumed by the buyer, “as determined in accordance with the transaction documents that are used to implement the investment", are added to be in making the EV calculation.
In our view, AROs associated with the assets of a Canadian upstream oil and gas business should not be part of the EV calculation, regardless of whether the investor is buying control of an entity or is buying all or substantially all of the assets used in carrying on the Canadian business. The Regulatory Impact Analysis Statement that accompanied the Regulations stated that the inclusion of certain “liabilities” could overstate enterprise value; hence, “operating liabilities” are excluded from the EV calculation. Including AROs when determining EV would have the effect of overstating value.
Firstly, in an asset acquisition, the amount of the assumed AROs must be determined in accordance with the transaction documents and, implicitly, not the seller's financial statements. There is normally an express statement in an asset purchase and sale agreement that the dollar amount attributed to the AROs is nil. It is not generally possible to purchase upstream oil and gas businesses (as well as many other kinds of businesses) without assuming these obligations. AROs are inextricably linked to the assets, so it is not reasonable to argue that the buyer paid less than it might otherwise have paid had it not been required to assume the AROs; the opportunity to pay more is not available.
Secondly, in the view of accountants and valuators with whom we have spoken, AROs are properly characterized as operating liabilities. Therefore, they should not be part of the EV calculation, because operating liabilities are expressly excluded from that calculation by the Regulations. This is true whether we are talking about a purchase of assets or of an entity.
We read this exclusion to capture even the “current” portion of AROs. Accounting standards for the preparation of financial statements are helpful even though the seller’s financial statements themselves are not relevant in an asset acquisition, As we understand these standards, current liabilities are financial liabilities (as distinct from operating liabilities) that the company expects or could be required to settle in its normal operating cycle or within 12 months after the reporting period. AROs are liabilities that are created in the course of operating a business; they are not financial liabilities to the owner’s creditors.
We understand that the Investment Review Division has taken the position that AROs (excluding the current portion on the basis that it is an “operating liability”) should be included in the EV calculation. The size of the ARO line item on a balance sheet can be very large and, if counted, could push a transaction that would not otherwise be reviewable over the ICA review threshold. We believe that including any of the AROs is not supported by the legislation or the accounting principles described above; having regard to the seller’s financial statements in an asset transaction is also not supported by the legislation, absent a contrary provision in the transaction documents. Inappropriate treatment of AROs could lead to significant differences in the EV of a Canadian business, depending on whether the transaction is structured as a share deal or an asset deal, which seems to be a perverse result.