Variable Interest Entities – Guidance on ASU 2015-02: Part 1

The variable interest entity (VIE) rules continue to be a hot topic for restaurants. Many times, a restaurant may set up separate legal entities for various purposes, such as a real estate entity that owns the restaurant facility or a separate entity to operate a commissary. These organizational structures are typically driven by a potential positive tax outcome. However, under the VIE rules, the separate entities may be required to consolidate. These rules address situations in which an entity is structured in such a way that normal voting interest consolidation concepts may be ineffective in determining which party has a controlling financial interest. In other words, there are times when a controlling financial interest is achieved through an arrangement that may not depend on the voting rights of equity holders. 

Once a company has determined that none of the scope exceptions are applicable, analyzing whether an entity must be consolidated under the VIE guidance typically involves answering the following three questions: 
  1. Does the company hold a variable interest in the entity?
  2. Is the entity a VIE?
  3. Is the company the primary beneficiary of the VIE? 
Early last year, the FASB issued ASU 2015-02, Amendments to the Consolidation Analysis, revising the VIE guidance, impacting each of the above questions. Over the course of two blog posts, we will explore each of these questions in more detail to illustrate how your restaurant business may be affected.

Does the company hold a variable interest in the entity? 
Some arrangements may obviously constitute variable interests, such as   if the reporting entity holding an equity or debt interest in the entity, or if there are any guarantees exposing the reporting entity to risk of loss.  However, other situations may not be as obvious.  For example, licensing or royalty arrangements or management fee contracts may also be considered variable interests.

ASU 2015-02 specifically addresses management and similar fees, providing three criteria to assess in determining whether these types of arrangements have a variable interest:
  1. The fees represent compensation for services provided and are commensurate with the level of effort required to provide those services.
  2. The decision maker or service provider does not hold other interests in the VIE that individually or collectively would absorb a significant amount of expected losses or residual returns.
  3. The service arrangement includes only terms, conditions or amounts that are customarily present in arrangements for similar services negotiated at arm’s length.
If all three criteria are met, then the fee is not a variable interest.  If not, the fee must be included when determining whether the company receiving the fee is the primary beneficiary or not.

Is the entity a VIE? 
Under the VIE guidance, an entity is a variable interest entity if either of the following are true: 1) The entity’s total equity at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support or 2) As a group, the holders of the equity at risk lack the power to direct the activities of the entity that most significantly impact its economic performance; the obligation to absorb the expected losses of the entity ; and the right to receive the expected residual returns of the entity.

The equity investors as a group also lack power if both:
  1. The voting rights of some equity investors are not proportional to their obligations to absorb the expected losses of the entity or their right to receive the expected residual returns; and
  2. Substantially all of the entity’s activities involve or are conducted on behalf of an investor that has disproportionately few voting rights.
ASU 2015-02 clarified this guidance by providing additional factors to consider when determining whether the equity investors as a group lack power.  Those factors are different depending on whether the entity in question is a limited partnership or not.

Stay tuned to the Selections blog for the second installment of this series, in which we’ll discuss how the ASU impacts limited partnerships and other types of legal entities, as well as an explanation of the third must-answer question—whether the business is the primary beneficiary of the VIE.

For more information, please contact Giselle El Biri at gelbiri@bdo.com. And be sure to keep up with our practice’s latest thoughts by following us on Twitter at @BDORestaurant.

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