IFRS 16 is fully effective for accounting periods beginning on or after 1 January 2019 and brings about significant changes for lessee accounting. The new rules require nearly all existing and future operating leases to be brought onto the balance sheet as right-of-use assets, along with an associated lease liability.
Final legislation was enacted in Finance Act 2019 and detailed HMRC guidance is due to be published. However, HMRC have not confirmed when this will be.
The right-of-use asset will be treated similarly to other non- financial assets and will be depreciated in line with IAS 16. The lease liability will be initially measured at the present value of the lease payments payable over the lease term and discounted using an appropriate interest rate. It is likely that tax relief will be available for the P&L charges associated with this asset and liability subject to other tax reliefs being available, e.g under the long funding lease rules.
On adoption of IFRS 16 it is expected that the net assets of entities will decrease given the difference between the value of the lease liability and that of the asset. Generally, entities can chose whether to take the corresponding debit upfront through equity, spread it over future periods, or take part of it through equity and part over future periods.
There are exemptions from applying this accounting treatment for short term and low value leases. Lessors should generally be unaffected by these changes.
Key points to consider from a tax perspective:
1. Complex transitional adjustments on adoption of IFRS 16
On adoption of IFRS 16, any transitional adjustment taken through equity will not be immediately tax deductible, as per the change of basis rules, but will be spread over the life of the various leases for tax purposes. The spreading calculation is complex, will require a significant amount of data and companies will have to maintain a separate tax basis for each lease going forwards. These transitional adjustments are likely to have a significant deferred tax impact depending on the profit/loss profile of the group.
2. Increased administration in relation to Corporate Interest Restriction (CIR) calculations
The financial costs incurred in relation to existing operating leases will continue to be excluded from the ‘qualifying finance costs’ calculation post conversion to IFRS 16. However, if accounts are being produced under IFRS, this operating lease accounting data will no longer be required. Therefore, groups will have to maintain separate tax only calculations in relation to their right-of-use assets so that the associated finance cost can be stripped out of the total interest expense recorded in the IFRS accounts.
3. Consolidation tax accounting will be more complex
Groups who apply IFRS in their consolidated accounts and have not adopted IFRS in company-only accounts, or which have subsidiaries reporting under FRS 102 (for example), will have to annually adjust for the difference in lease accounting between FRS 102 and IFRS 16. These complex consolidation adjustments will also lead to potentially complex deferred tax implications for the group.
4. Basis for capital allowances will change for new leases
Tax relief for capital allowances under the long funding lease rules will continue to be available and the tax treatment for long funding operating leases will be aligned with long funding finance leases. The amount of capital allowances available to a company for their long funding operating leases is currently based on the market value of the asset but under IFRS 16 it will be based on the present value of the minimum lease payments remaining. Any long funding operating lease held at the time that the new rules take effect will be grandfathered meaning that it will continue to be taxed on the same basis as before.
If the company acquires new right-of-use assets that are treated as long funding leases, the change in initial value of the asset will have to be reflected in deferred tax calculations.
5. Keep track of the changes in the leasing definitions
Plant and machinery leases of 7 years or less will now be treated as short leases and fall out of the long funding lease rules. The short lease definition has also been simplified.
Please note that the above list is not exhaustive and there may be other areas relevant to your tax position thatare not covered here. For example, a particular area of complexity arises from sale and leaseback arrangements. The application of all tax rules in relation to IFRS 16 will be company and fact specific.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.