Adopting IFRS16 – unpicking the tax issues for lessees

Companies that apply IFRS/FRS 101 were obliged to adopt IFRS 16 in 2019 and the tax issues that this triggered were addressed in changes introduced in Finance Act 2019.

Basic impact on lessees

For periods of account starting on or after 1 January 2019, IFRS 16  requires companies using IFRS or FRS 101 to capitalise their assets held under operating leases. This brought on balance sheet a right of use (RoU) asset and a lease liability. This did 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For tax purposes, the leasing ‘frozen GAAP’ provision (s53 FA 2011) was repealed from 1 January 2019 broadly allowing tax to follow the accounts (rather than having to maintain two sets of books).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 was an interest expense charge and an RoU depreciation charge. In line with the SP 3/91 treatment for finance leases, tax relief was available for the P&L charges. It is, however, still necessary to disallow depreciation to the extent it is attributable to non-allowable expenditure eg, lease premium, SDLT, capitalised legal fees, etc.

Where the asset subject to an operating lease s held under a long funding lease, then the lessee may claim capital allowances instead of the depreciation charge.

Level playing field?

The Government’s intention was that lessees should be left in broadly the same position whether they used UK GAAP or IFRS. In fact, there may have been 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 were occasionally issues around non-depreciable assets.

Transitional rules

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 is recognised initially at the same value as the lease liability. The other main approach requires the RoU asset to be calculated as if IFRS 16 had applied since the start of the lease. This latter approach may have given the advantage of a lower starting value in 2019 and thus a higher reported profit going forward.

Any transitional adjustment was 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, the transitional amount was a debit (unless there was 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 adopted IFRS 16, the rules in Finance Act 19 required it to be spread over the weighted average remaining life of the leases which gave rise to it.

The transitional spreading was fixed on conversion and carried over even if leases were terminated/assets sold. It appears that a bullet unwind only arose where the lessee ceased 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 were 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 have produced broadly similar results in each case (assuming the impairment isn’t subsequently reversed).

Capital allowances

Existing long funding leases were grandfathered for capital allowances purposes, so there was no rebasing of capital allowances via a deemed disposal/re-acquisition in the case of mandatory conversion to IFRS 16. This may have been important for companies that claimed a 100% FYA, who would otherwise have faced an emerging balancing charge.

For companies under IFRS 16, long funding leases are always 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. Finance Act 2019 inserted a new rule to provide that where a lease was subject to re-measurement, eg due to a change in rentals based on outturn performance, tax relief could be claimed for an upward increment (if relief was not available via the capital allowances computation). Similar tax adjustments applied to a downward increment.

The IFRS 16 funding lease test is met where:

1. Present value of minimum lease payments is greater than 80% of the asset’s fair market value or
2. 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 was a simplification in the definition of long funding lease. Since 2019, only leases with a term of at least seven years will be potentially subject to the long funding lease rules (previously it was five years, in some cases).

Deferred tax

In many cases, it was likely that a deferred tax liability arose in respect of the transitional adjustments. In corporation tax computations the transitional adjustment needed to be grossed up before the spreading calculation was done.

Some quoted companies preparing consolidated accounts under IFRS also had complex deferred tax calculations to perform (where the solus accounts were prepared under UK GAAP).

Early adopters of IFRS 16 had to continue using the old basis for tax in 2018, but then had a transitional adjustment for tax purposes to align with the IFRS 16 accounts values, and this was again spread from 2019. There may also have been a deferred tax impact for 2018, given the mismatch between accounts and tax.

Corporate interest restriction (CIR)

IFRS 16 dropped the previous distinction between a finance lease and an operating lease. However, for tax purposes, IFRS companies may still have to distinguish between them using hypothetical GAAP in the following four situations:

1. For the CIR, where operating lease rentals are not subject to restriction but are reflected in a lower EBITDA (this ensures a level playing field for lessees regardless of which accounting framework they adopt)
2. For certain leased assets which are subject to subleases
3. For the hire purchase rule in s67 CAA 2001 (which only applies to finance leases)
4. Special provisions for oil and gas companies or REITs.

Some companies saw that some of their leased assets fell off their balance sheet on conversion to IFRS 16, ie their low value assets or very short leases. Those no longer had to be treated as finance leases for CIR.

The fall-out from conversion to IFRS 16

Property occupiers (eg retailers that lease their premises) and businesses faced a substantial information gathering exercise and had to make changes to their reporting systems to convert to IFRS 16.

The impact of the different accounting options available upon their current and deferred tax position also needed to be considered carefully. We helped many clients through this process and to manage the practical impacts on their business.

FRED 82 – UK GAAP alignment from 2025

It is expected that UK GAAP will align with IFRS 16 for accounting periods starting on or after 1 January 2025. This may boost EBITDA but adversely impact gearing. Once the transitional methodology is known, companies accounting under FRS 102 will have to consider the transitional impact for tax purposes. The IFRS 16 conversion experience should inform many of the tax issues likely to arise for UK GAAP accounts preparers. 

How we can help

For help and advice on how the transition was commonly handled and unpicking/understanding the tax implications of switching to IFRS 16, or the tax impact of any other accounting changes, please contact David Porter.