The new International Financial Reporting Standard 16 changes the treatment of leases, with a number of resulting implications for both corporate tax and value-added tax.
International Financial Reporting Standard 16 (“IFRS 16”) is effective for public business entities in fiscal years beginning after December 15, 2018, i.e. from January 1, 2019 onward. For most other entities, it is deferred for one year, meaning that most calendar-year private companies will be required to adopt the new standard in 2020. Early adoption is permitted for all entities.
Overview of IFRS 16
Under the new Standard, all leases (with limited exceptions) must be reported on the balance sheet for lessees. Lessees need to reflect on the balance sheet their “right of use” (“ROU”) as an asset, and the associated “lease liability” for the future payments.
Prior to the new standard, a lessee did not recognize assets and liabilities arising from most operating leases. While recognizing the related expense in the income statement, the lease obligations were off-balance-sheet liabilities under previous GAAP (Generally Accepted Accounting Principles).
Key principles of IFRS 16 are:
- A lease is a contract, or part of a contract, that conveys the right to use an identified asset (underlying asset) for a period in exchange of consideration.
- A customer has the right to obtain all economic benefits from the use of the identified asset and right to direct the use of assets.
Based on the above principles, most operating leases may be reclassified as finance leases in the lessee’s books of account. Lessees are required to initially recognize a lease liability for the obligation to make lease payments and ROU asset for the right to use the underlying asset for the lease term. The lease liability is measured at the present value of the lease payments to be made over the lease terms.
There is an exception to the above measurement:
- Lessees are allowed to make accounting policy election, by class of underlying asset, to apply a method like International Accounting Standard 17 (“IAS 17”) operating lease accounting, and not to recognize lease assets and lease liabilities for leases with a lease term of less than 12 months; or
- For low value assets (which the International Accounting Standards Board suggests are those under a threshold of $5,000).
Based on the above accounting policy election, there will be three types of leases with different tax treatment:
- operating lease for which the lessee elected to apply IFRS 16 accounting policy, to recognize lease asset and lease liabilities;
- operating lease for a period less than 12 months for which the lessee elected not to apply the accounting policy of IFRS 16 and to apply a method like IAS 17;
- finance leases.
This is a significant change, since under the current guidance of IAS 17 only financial leases are reflected/capitalized on the balance sheet of the lessee, and not operating leases.
Consequently, the new standard will affect virtually all commonly used financial ratios and performance metrics for lessees, such as EBITDA (earnings before interest, tax, depreciation and amortization), operating profit and net income, in case of an operating lease agreement for more than one year in the lessee books.
Please note that the guidance for lessor accounting remains largely unchanged and therefore probably will not have a tax (accounting) impact.
From a lessee’s perspective, the most significant change from prior lease guidance is that lessees are required to recognize the rights and obligations resulting from most operating leases as assets and liabilities on their balance sheet.
The initial measurement of a lease liability equals the present value of the lease payments discounted using the rate implicit in the lease. If that rate cannot be readily determined, the lessee will use its incremental borrowing rate, i.e. rate at which the lessee can borrow funds at similar terms and conditions. The lessee depreciates the Rest of Useful life (“ROU”) of an asset on a straight line basis—the aggregate of interest expenses on the lease liability and depreciation on the ROU of asset will result in higher expenses in the earlier periods of lease.
Let’s take an example.
Tax Analysis in U.K.
• Tax implication: Operating lease for which lessee elected to apply accounting policy of IFRS 16, to recognize lease asset and lease liabilities
In the example, the charge to Income Statement for initial years will be higher and will reduce in the later period of a lease. This will lead to the creation of temporary difference for an operating lease given the change in GAAP accounting. The differences between the GAAP and tax basis of the ROU asset and related lease liability will result in taxable income or deductions upon their reversal; such differences are temporary in nature.
Accordingly, a company must recognize a deferred tax liability for the excess GAAP basis in the ROU asset and a deferred tax asset for the excess GAAP basis in the related lease liability. Businesses should recognize deferred tax asset and liabilities on right to use asset and lease liability.
In the example:
- Depreciation as per IFRS 16 is added back and claimed as allowance under the U.K. Capital Allowances Act 2001 rules in the return.
- Interest expenses would attract the Interest Restriction rules on deductibility, revised in 2017, to ensure conformity with the recommendations of the Organization for Economic Co-operation and Development (“OECD”). Finance (No. 2) Act 2017 introduced the revised regime. The rules take effect for periods of account beginning on or after April 1, 2017. The key features are as follows:
- restriction on the deduction of net interest expenses (including similar financing costs) within the charge to corporation tax. The restriction is expressed as a percentage of taxable earnings before EBITDA;
- the restriction works on a worldwide group basis, and applies to the group’s ultimate parent;
- the amount of net interest expense that a worldwide group may deduct should not exceed 30 percent of its taxable EBITDA. Under the workings of a “modified debt cap,” the net interest deduction should not exceed the group’s total net interest expense;
- there is a de minimis exception for groups that have net interest expense of less than 2 million pounds ($2.54 million) falling within the scope of corporation tax per year, which can be claimed in the year it is incurred;
- it is possible to substitute a “group ratio” for the 30 percent figure. This is the ratio that net interest expense bears to EBITDA for the worldwide group, based on its consolidated accounts;
- regarding the calculation of “interest” and “EBITDA,” there are provisions allowing groups to make irrevocable elections (i.e. the “chargeable gains election” and the “alternative calculation election”) whereby they ensure alignment of their accounting figures with the U.K. tax rules; and
- excluded from the interest restriction rules: qualifying interest expense incurred by qualifying companies on funds invested in long-term infrastructure for the public benefit.
- Recognize deferred tax asset/liability in the books of account.
Under the VAT law of the U.K., an operating lease on the other hand is a “rental agreement” as defined in the VAT Act and means:
“(a) any agreement entered into before, on or after the commencement date for the letting of goods, other than a lease referred to in paragraph (b) of the definition of “instalment credit agreement”; and
(b) any rental agreement, as defined in the said Act where such agreement is in force on or after the commencement date.”
For an operating lease, the VAT should be claimed per installment and not upfront on the total cash cost, since it is a rental agreement and not an “installment credit agreement” as defined for VAT purposes.
• Tax implication: Operating lease for which lessee elected not to apply accounting policy of IFRS 16, and not to recognize lease asset and lease liabilities
For leases less than a 12-month period, the new lease standard will generally result in a constant annual cost similar to the expense pattern under current operating lease accounting. The lease payments will be tax-deductible expenses. There will not be any deferred tax asset or liabilities arising in the lessee’s book.
Under U.K. VAT law, it will be classified as an operating lease—the VAT should be claimed per installment and not upfront on the total cash cost, since it is a rental agreement and not an instalment credit agreement.
• Tax implication: Finance lease
Under the U.K. Capital Allowances Act 2001, a lease must satisfy the following test:
- The finance lease test—a lease meets the finance lease test in the case of any person if the lease is one which, under generally accepted accounting practice, falls (or would fall) to be treated as a finance lease or a loan in the accounts:
- of that person, or
- where that person is the lessor, of any person connected with him.
- Accounts are drawn up in accordance with generally accepted accounting standards of the U.K., or, if the person is nonresident and not subject to tax in the U.K., accounts are drawn up by reference to generally accepted accounting practice with respect to accounts prepared in accordance with international accounting standards.
- The lease payments test—a lease meets the lease payments test if the present value of the minimum lease payments is equal to 80 percent or more of the fair value of the leased plant or machinery. The present value of the minimum lease payments is to be calculated by using the interest rate implicit in the lease. “Fair value” means the market value of the leased plant or machinery, less any grants receivable towards the purchase or use of that plant or machinery. The interest rate implicit in the lease is the interest rate that would apply in accordance with normal commercial criteria, including, in particular, generally accepted accounting practice (where applicable), but if the interest rate implicit in the lease cannot be determined, it is the temporal discount rate for the purposes of section 70 of Finance Act 2005 (Valuation of “rights to guaranteed income” and “disposed rights”).
- The useful economic life test—a lease meets the useful economic life test if the term of the lease is more than 65 percent of the remaining useful economic life of the leased plant or machinery.
- Depreciation as per financial statement is added back and claimed as allowance under the Capital Allowances Act rules in the return.
- Interest expenses attract Interest Restriction rules on deductibility, revised in 2017, to ensure conformity with OECD recommendations. Finance (No. 2) Act 2017 introduced the revised regime. Please refer to interest deduction rules mentioned under “Operating lease for which Lessee elected to apply accounting policy of IFRS 16, to recognize lease asset and lease liabilities,” above.
- Recognize deferred tax asset / liability in the books of account.
A finance lease is an installment credit agreement for VAT purposes. In terms of part (b) of the definition of an installment credit agreement (that refers to a finance lease), an installment credit agreement means any agreement entered into on or after the commencement date, whereby any goods consisting of corporeal movable goods or of any machinery or plant, whether movable or immovable, are supplied under a lease under which:
- the rent consists of a stated or determinable sum of money payable at a stated or determinable future date or periodically in whole or in part in installments over a period in the future; and
- such sum of money includes finance charges, including any amount determined with reference to the time value of money, stipulated in the lease; and
- the aggregate of the amounts payable under such lease by the lessee to the lessor for the period of such lease (disregarding the right of any party thereto to terminate the lease before the end of such period) and any residual value of the leased goods on termination of the lease, as stipulated in the lease, exceeds the cash value of the supply; and
- the lessee is entitled to the possession, use or enjoyment of those goods for a period of at least 12 months; and
- the lessee accepts the full risk of destruction or loss of, or other disadvantage to, those goods and assumes all obligations of whatever nature arising in connection with the insurance, maintenance and repair of those goods while the agreement remains in force; or
- (a) the lessor accepts the full risk of destruction or loss of, or other disadvantage to those goods and assumes all obligations of whatever nature arising in connection with the insurance of those goods; and (b) the lessee accepts the full risk of maintenance and repair of those goods and reimburses the lessor for the insurance of those goods, while the agreement remains in force.
If the finance lease qualifies as an installment credit agreement (by complying with the listed requirements above) the input VAT should be claimed upfront by the lessee on the total cash cost of the underlying transaction and not per installment.
A business should consider and evaluate all its operating leases, covering the following aspects:
- Tax related processes and controls to capture required information;
- Deferred tax position in the books of account;
- Transfer pricing policy, considering key commercial ratios will undergo change such as interest coverage ratio, debt equity ratio, etc;
- Assess whether change in accounting policy would result in carry forward of tax loss situation in tax returns;
- Separate books of account for VAT compliance;
- Any stamp duty implication on operating lease.
Rajeev Agarwal is Head of Global Tax with Qatar Navigation QPSC. He may be contacted at: email@example.com.
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