Clauses in the draft Finance Bill 2018-19 seek to address the many tax issues that will arise for lessees of companies which apply IFRS/FRS 101 and will, therefore, be obliged to adopt IFRS 16.
Basic impact on lessees
For periods of account starting on or after 1 January 2019, IFRS 16 will require companies using IFRS or FRS 101 to capitalise their assets held under operating leases. This will bring on balance sheet a right of use (RoU) asset and a lease liability. This will not apply to companies using FRS 102 (full UK GAAP), which are likely to continue using the existing approach until at least mid-2020s.
For tax purposes, the leasing ‘frozen GAAP’ provision (s53 FA 2011) will be repealed from 1 January 2019 broadly allowing tax to follow the accounts (rather than having to maintain two sets of books). Instead of an operating lease rental charge to P&L, there will be an interest expense charge and an RoU depreciation charge. In line with the SP 3/91 treatment for finance leases, tax relief will be available for the P&L charges.
Where the asset subject to an operating lease is held under a long funding lease, then the lessee may claim capital allowances instead of the depreciation charge.
Level playing field?
The Government indicates that the intention is that lessees should be left in broadly the same position whether they use UK GAAP or IFRS. In fact, there may be a slight tax acceleration for companies using IFRS as, rather than having straight line rental deductions, the interest expense is likely to be front-loaded (as for a repayment mortgage) - though there may occasionally be issues around non-depreciable assets.
IFRS 16 offers certain accounting options over how to deal with the transition when bringing assets onto balance sheet for first time. Under the simplest approach, the RoU asset will be recognised initially at the same value as the lease liability. The other main approach would require the RoU asset to be calculated as if IFRS 16 had applied since the start of the lease. This latter approach may have the advantage of giving a lower starting value in 2019 and thus a higher reported profit going forward.
Any transitional adjustment is made either to prior year opening equity (under the full retrospective approach (FRA)) or to current year opening equity (under the modified retrospective approach (MRA)). Typically, we would expect the transitional amount to be a debit (unless there is a material onerous lease provision to be unwound).
For tax purposes, the transitional amount would normally have been taxable/allowable in the year of conversion under existing ‘change of basis’ rules. But, where an IAS/FRS 101 taxpayer adopts IFRS 16, the new rules in Finance Bill 2018-19 will require it to be spread over the weighted average remaining life of the leases which gave rise to it.
The transitional spreading is fixed on conversion and carries over even if leases are terminated/assets sold. It appears that a bullet unwind only arises where the lessee ceases to be within the charge to corporation tax.
Onerous lease provisions
Depending upon the lessee’s accounting choice (FRA or MRA, with or without ‘practical expedients’), onerous lease provisions are either released in the transitional adjustment or rebadged as RoU asset impairment. In both cases, the pre-conversion tax benefit unwinds over the remainder of the lease, either via the transitional spreading or via a lower RoU depreciation charge. Since the transitional rule aligns ‘lease term’ with GAAP, this should produce broadly similar results in each case (assuming the impairment isn’t subsequently reversed).
Existing long funding leases will be grandfathered for capital allowances purposes, so there will be no rebasing of capital allowances via a deemed disposal/re-acquisition in the case of mandatory conversion to IFRS 16 . This may be important for companies that have claimed a 100% FYA, who could otherwise have faced an emerging balancing charge.
Going forward, for companies under IFRS 16, long funding leases will always be assumed to be long funding finance leases and capital allowances can be claimed on the present value of minimum lease payments (a figure which may or may not be equal to the RoU asset recognised in the accounts). This contrasts with UK GAAP operating leases where capital allowances are based on the opening market value.
Tax relief for rentals payable under long funding finance leases is limited to the finance charge. The Finance Bill will insert a new rule to provide that where a lease is subject to re-measurement, eg due to a change in rentals based on outturn performance, tax relief can be claimed for an upward increment (if relief is not available via the capital allowances computation). Similar tax adjustments will apply to a downward increment.
The IFRS 16 funding lease test is now met where:
- Present value of minimum lease payments is greater than 80% of the asset’s fair market value or
- The lease term is greater than 65% of the remaining useful economic life of the asset.
Note, the finance lease gateway test is disapplied for companies accounting under IFRS 16.
Finally, there has been a simplification in the definition of long funding lease. From 2019, only leases with a term of at least seven years would be potentially subject to the long funding lease rules (previously it was five years, in some cases).
It is likely that a deferred tax liability will arise in respect of many transitional adjustments. This should be borne in mind by those preparing corporation tax computations where the transitional adjustment may need to be grossed up before the spreading calculation is done.
Quoted companies preparing consolidated accounts under IFRS may also have complex deferred tax calculations to perform (where the solus accounts are prepared under UK GAAP).
Early adopters of IFRS 16 will need to continue using the old basis for tax in 2018, but will then have a transitional adjustment for tax purposes to align with the IFRS 16 accounts values, and this will again be spread from 2019. There may be a deferred tax impact for 2018, given the mismatch between accounts and tax.
Corporate interest restriction (CIR)
IFRS 16 drops the distinction between a finance lease and an operating lease. However, for tax purposes, IFRS companies may still need to distinguish between them using hypothetical GAAP in the following four situations:
- For the CIR, where operating lease rentals are not subject to restriction but are reflected in a lower EBITDA (this will ensure a level playing field for lessees regardless of which accounting framework they adopt)
- For certain leased assets which are subject to subleases
- For the hire purchase rule in s67 CAA 2001 (which only applies to finance leases)
- Special provisions for oil and gas companies or REITs.
Some companies may see that some of their leased assets may fall off their balance sheet on conversion to IFRS 16, ie their low value assets or very short leases. These will no longer be treated as finance leases for CIR.
Preparing for conversion to IFRS 16
Property occupiers (eg retailers that lease their premises) and businesses preparing to convert to IFRS 16, face a substantial information gathering exercise along with the need to make numerous changes to their reporting systems.
They may also need to assess whether or not a lease classification exercise is required for the purposes of CIR calculations. The impact of the different accounting options available upon their current and deferred tax position will also need to be considered carefully.
For help and advice on the tax implications of switching to IFRS 16 please contact David Porter.