Commercial SubstanceDefined along with Examples

Written By:
Adiste Mae

What is Commercial Substance?

Commercial Substance is said to exist when there is a change in the expected future cash flow of the business as a result of the transaction.

The change in cash flows is only considered when there are significant changes in the risk, timing, and amount received without tax considerations.  

Determining Commercial Substance?

In order for a transaction to be considered as having Commercial Substance, a change in the following has to happen without its tax effects:

Change in Risk

There is a commercial substance when a transaction has risk.

For example, due to a transaction, there is an increased risk that future cash inflows will no longer occur.

For example, a business, in exchange for receiving a larger repayment, accepted a junior security status. 

Change in Timing

When the timing of the cash inflow changes as a result of a transaction, it is considered as having a commercial substance.

An example would be if a company agrees to receive delayed payment, provided that they receive a larger payment amount. 

Change in Amount

If there is a change in the amount paid or received as a result of the transaction, there is a commercial substance.

For example, as a result of a transaction, a business receives a payment earlier than expected. 

Example of Commercial Substance

Suppose XYZ Company enters into an agreement for an exchange of machinery with ABC Corp whereby XYZ Company gives a piece of machinery with a purchase price of $750,000 and total accumulated depreciation of $450,000 in exchange for newer machinery from ABC Corp. with a fair market value of $350,000. 

Given the above example, the book value of XYZ Company’s asset is $300,000 while the fair market value of ABC Corp’s asset is $350,000.

Bearing this in mind, there clearly is a commercial substance in the transaction because of the change in the amount. 

In the books of XYZ Company, they will be posting a journal entry for the exchange as:

When businesses exchange assets and there is a commercial substance, a gain or a loss will also have to be recorded.

If there is no commercial substance, the exchange only needs to be recorded at book value. 

Commercial Substance of Contract 

Commercial Substance exists in a contract when the following scenarios occur:

• Change in the cash flow timing
• Change in the risk
• Cash flow increment
• More benefits

For example, a manufacturer of shoes has signed a contract with a producer of leather, thereby giving them access to preferential rates. 

As a result of the contract being signed, the cost of shoes has decreased, as well as their sales price.

The decrease in sales price resulted in higher sales for the company. 

Commercial vs. Non-Commercial Substance

There are key elements for a commercial substance to exist in transactions.

They are the following:

• There must be an exchange. A key element for a transaction to be considered as having a commercial substance is the presence of an exchange. All other monetary transaction is considered non-commercial substance. 
• There must be a change in the timing, amount, and risk. Monetary gain is also an essential element for a commercial substance to exist. Without this, a transaction is a non-commercial substance. 
• A transaction that has a commercial substance is recorded at its Fair Market Value, while a transaction that has a non-commercial substance is recorded at Book Value. 

Conclusion

Identifying whether a transaction has a commercial substance can be done through the presence of the following changes in the cash flow: changes in the risk, timing, and amount.

Without the presence of these, all other transactions are considered to be non-commercial substances.