On 1 December, HMRC released two consultations on lease taxation: Leasing: tax response to accounting changes and Corporate interest restriction: Tax response to accounting for leasing. Peter Casey, senior manager, tax and financial services at KPMG, considers what is proposed by the two consultations and what actions lessors might wish to take.
The HMRC consultations are in response to the forthcoming introduction of the new lease accounting standard, IFRS 16, which will bring most operating leases onto the balance sheet for lessees accounting under IFRS or FRS 101.
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This new lease accounting standard will apply for accounting periods commencing on or after 1 January 2019.
In essence, the operating versus finance lease distinction will disappear for lessees and everything – apart from low-value assets of less than $5,000 (€4,170) or short leases of less than 12 months – will now be accounted for as a finance lease.
What does the first consultation, Leasing: Tax response to accounting changes, propose?
At the time of the March Budget earlier this year, HMRC announced that it wished to maintain the current system of lease taxation. This includes keeping the long-funding lease regime, under which entitlement to claim capital allowances moves to lessees where the lease is categorised as a long-funding lease.
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By GlobalDataSimilarly, entitlement to claim capital allowances will pass to the user of the asset where there is a hire-purchase arrangement. Otherwise, entitlement to claim capital allowances will remain with the lessor.
Maintaining this current system of lease taxation will, in practice, mean the following:
- The tax regime for those under FRS 102 and FRS 105 (micro-entities) is expected to remain largely unchanged;
- The tax regime for lessors under IFRS is also expected to remain largely unchanged;
- The tax regime for lessees under IFRS will see some changes – however, these changes will broadly aim to keep the current system of lease taxation working as intended. In particular, this will entail:
- Non-long funding lessors remain entitled to claim capital allowances;
- The long funding lease rules continue to operate to transfer entitlement to capital allowances to the lessee; and
Non-long funding finance lessees (those under either FRS 102 or IFRS) will continue to use SP 3/91 principles in calculating allowable deductions.
In order to maintain the status quo, there will need to be some changes to the definition of a ‘funding lease’, given that the accounting definition under IFRS 16 can no longer be relied upon to distinguish those leases providing a true financing function.
The existing ‘funding lease’ test has three separate legs, one of which tests whether the lease is categorised as a finance lease in the statutory accounts. HMRC proposes replacing this test with a new finance lease test. It suggests that this will apply for all leases, not just those under IFRS. This new test will be based on whether substantially all of the risks and rewards of ownership pass to the lessee, which is similar to the current finance lease definition in IAS 17 and FRS 102.
No change is proposed for the other two ‘funding lease’ tests. Consequently, the expectation is that a lease which is classified as a long-funding lease today would still be classified as a long-funding lease if it were to be entered into at some point after 2019.
Other proposed changes to the legislation involve the amount of qualifying expenditure for long-funding lessees under operating leases accounted for under IFRS 16.
Currently, such lessees can claim capital allowances based on the market value of the asset. After 1 January 2019, it is proposed that the qualifying expenditure will be restricted to the present value of minimum lease payments. This change will not, however, apply to long-funding operating lessees under FRS 102 who will remain entitled to claim capital allowances based on the asset’s market value.
The definition of a ‘long’ lease will be simplified to remove the conditions for testing finance leases of five to seven years in length. In future, all leases of seven years and less will be ‘short’ (and hence, not long), with an anti-avoidance exception for recycled leases.
These proposals mean there is no need for a grandfathering regime or transitional regime. Leases which are long funding leases before IFRS 16 should continue to be treated as long-funding leases after the introduction of the new lease accounting standard.
Any adjustments to opening reserves would be taxable/deductible in line with the normal rules for a change in accounting basis. However, HMRC has indicated that where an initial adoption of IFRS 16 results in a right-of-use asset which does not match the lease liability, the amounts arising from such a mismatch would not be deductible under the change of basis rules.
It is also worth noting that HMRC proposes abolishing section 53 Finance Act 2011: this section would have required a ‘frozen GAAP’ basis of lease taxation under which IFRS lessors and lessees would have taxed leasing transactions based on the old IAS 17 lease accounting standard.
In practice, this would have been burdensome as entities would have had to prepare separate accounts for tax purposes based on IAS 17 to tax the debits and credits arising from leasing transactions. The proposals mean that this ‘frozen GAAP’ rule is no longer needed, and so will be abolished with effect from 1 January 2019.
For those accounting under FRS 102 or FRS 105, the impact of the proposed changes should be minimal. Most of the tax complexity will arise for lessees accounting under IFRS, early adopters of IFRS 16 and as a result of the adoption method used in the accounts.
What does the second consultation, Corporate interest restriction: Tax response to accounting changes for leasing, propose?
The corporate interest restriction (CIR) rules are a significant change to the UK corporation tax rules. They apply with effect from 1 April 2017 and, broadly, restrict interest deductibility for UK companies with aggregate net interest expense in excess of 30% of their tax-adjusted EBITDA.
There is a £2m (€2.28m) de minimis threshold below which interest expense is not restricted by the CIR rules, though it would still be necessary to assess whether other rules might deny deductions. CIR is therefore aimed at the larger groups, particularly large multinational enterprises, where it was felt many were leveraging entities with debt in order to reduce taxable profits in high-tax jurisdictions.
The rules are intended to restrict deductions for finance costs on financing transactions. However, from a lessee perspective, IFRS 16 will categorise all leases as finance leases, even where they are arguably not performing a financing function. HMRC has recognised that IFRS lessees might, therefore, suffer a restriction in the tax deductions available to them as a consequence of most leases being brought onto the balance sheet.
Consequently, HMRC is considering three options to address this:
Option 1: Follow the accounting approach
This approach acknowledges that lessees adopting IFRS 16 will have higher net tax interest expense, but nonetheless proposes keeping the rules as they are. This could result in some lessees under IFRS experiencing a restriction in the tax deductions they can claim on lease rental payments.
This would require the least legislative change, and would be simplest for lessees to implement. It might also be expected that where lessees are leasing assets from third parties, restrictions in finance costs might not arise if a group ratio election were to be made by the group. This is an alternative to the 30% fixed-ratio rule which broadly caps deductible interest expense to the finance charge recognised in the consolidated accounts, which should mean that lease rentals and finance costs paid to third parties should remain tax-deductible.
Option 2: Distinguish between operating and finance leases for CIR purposes
This approach asks if the lease is performing a financing function. If it is not – for example, if the lease has the characteristics of an operating lease – then the finance charge is disregarded for the purposes of the CIR rules and, hence, no restriction would arise to lessees under operating leases.
In order to decide whether or not a lease is performing a financing function, lessees would be required to determine how the lessor accounts for the same lease in its accounts. If the lessor accounts for the lease as an operating lease, then the lessee would document this and not be required to take the finance charge into account for the purposes of CIR.
It is worth noting that these proposals apply to all lessees, irrespective of whether they account under IFRS or FRS 102. In practice, it might be expected that only lessees under IFRS would be likely to ask lessors as this is where the divergence in lease accounting lies – however, this would create extra compliance burdens for both lessors and lessees if lessees were required to ascertain how lessors accounted for the arrangement. There might also be practical difficulties, for example, if the lessor was based overseas and did not prepare accounts under either IFRS or FRS 102.
Option 3: Introduce a distinction between funding leases and non-funding leases
Similar to Option 2, this approach would also distinguish between leases providing a financing function and those not providing a financing function.
The distinction would be made by reference not to the lessor’s accounts, but instead to a tax-based test that the lessee would apply. This tax-based test would follow the ‘funding lease’ rules currently used to assess whether a lease is a long-funding lease.
The proposal is that all lessees – irrespective of GAAP – would be required to test all finance and operating leases against the ‘funding lease’ rules, with a new test to replace the ‘finance lease’ test as described in the first consultation. Leases which meet any of the three funding lease tests would then be classified as performing a financing function, with the interest expense then subject to CIR.
Any leases which were long-funding leases would therefore automatically be within the regime. The regime would require all lessees – irrespective of GAAP – to test both their finance leases and operating leases. It might be expected that the compliance burden would again be high if lessees need to apply these complicated tests to each individual lease.
Next steps for lessors
The consultations are now open and HMRC is inviting lessors, lessees, representative bodies and others to comment on the proposals. The closing date for comments is 28 February 2018 for both consultations, and HMRC would also be happy to have meetings with interested parties.
On the face of it there does not appear to be much change for lessors, given the proposals will have most impact for lessees where the accounting is changing under IFRS from operating to finance leases. However, the lessor community might wish to make representations regarding certain areas such as:
- Further simplification: Consider using the opportunity to lobby for related simplifications, e.g. widening the scope for long-funding lease elections to apply to second hand assets, for short-life asset elections to apply where the lessee is a non-taxpayer such as a local authority, etc.;
- Option 2 of CIR consultation: This would require lessees to ask how the lessor accounts for a lease. This would be burdensome for both parties, and it might be worth considering alternative proposals, e.g. lessees assessing for themselves whether a lease might be accounted for as an operating lease under the existing IAS 17 or FRS 102 accounting criteria.
After the consultation closes, HMRC will release draft legislation in the spring which will then be enacted as Finance Act 2018. It is expected that all these changes will take effect from 1 January 2019.
