Although the 2019 introduction of IFRS 16, the new accounting standard for international firms, has been on the schedule for two years now, grey areas persist around the implications of accounting policies in specific countries, writes Lorenzo Migliorato.
In the case of the UK, one of the main conundrums surrounding IFRS 16 is how HM Revenues and Customs (HMRC) will handle tax breaks on leases under the new framework.
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Under the previous standard, IAS 17, a lease could either classified as a ‘financial lease’, where risks and rewards pass to the lessee, as in the case of HP, or an ‘operating lease’, when the asset is leased for less than its full useful lifetime. Crucially, operational leases could be kept off lessees’ balance sheets.
IFRS 16 will do away with the category of operating lease on lessees’ ledgers. Under a lease, whatever the type, the lessee is assumed to have acquired a new asset with the associated liabilities – all of which need to show up in the books, as with a financial lease.
HMRC, however, still uses either operating or financial lease terminology when it comes to assessing taxes due and, most importantly, relief on interest expenses incurred. The amount of claimable relief, is limited to 30% of UK pre-tax income, for incomes over £2m: this is called Corporate Interest Restriction (CIR).
The worry for lessees is that this limit will be reached more quickly once leases are forced on-sheet by the new standards. The segment most likely to be affected is plant and machinery.
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By GlobalDataAs this is a UK-specific issue, HMRC has discretion on how to adapt its policies, and is looking for feedback from lessees that risk being negatively impacted.
“We need the evidence and the opinions of the taxpayers these rules are going to impact, and of their advisers,” HMRC’s Richard Thomas told KPMG’s most recent Leasing and Asset Finance Forum.
In December, HMRC opened a consultation on the CIR issue, which will close on 28 February. So far, three main solutions have been proposed.
The first proposal involves following IFRS 16 changes and sacrificing the operating lease category in tax legislation as well.
HMRC has acknowledged that this would reduce tax relief available to companies, though a solution has been proposed which would involve linking the CIR limit to finance ratios, rather than income, to keep things proportionate.
The second solution is to keep the ‘operating/financial’ distinction for CIR purposes, but rely on the lessor’s book for the assessment, not on the lessee’s.
Lessors will, in fact, continue to use the distinction on their books, even under IFRS 16, meaning that somewhere, a lease would still receive a categorisation. A lessee would then claim interest relief based on how the lessor’s books frame the lease.
The problem with this approach, in HMRC’s view, is that it creates a duplicate framework, potentially saddling companies’ accountancy departments with more work. Additionally, it would involve liaison between the lessee’s and lessor’s accountants that could become impractical and time-consuming.
The third and final option involves introducing a new test to assess whether a lease is ‘funding’ – and contributes to the CIR limit – or ‘non-funding’.
In short, a lease would be funding when it met one of three criteria: that it acts as a finance lease, the minimum lease payments cover 80% of the asset’s fair market value, and the lease covers 65% of the asset’s useful economic life.
Thomas and colleagues say HMRC has “no a priori preference”, and encourage lessee companies to give their opinions on what would be the more facilitating option. At the KPMG forum, they emphasised the wish for a smooth transition that did not alter business dramatically.
“We are not looking to bring in more [tax] income by bringing more leases under CIR scope,” said Thomas. “But neither do we want [legislation] to drive accounting.”
As one of the main drivers of the IFRS 16 changes was anti-avoidance, HMRC is keen to decouple the accounting process from business considerations. No modelling is currently in place, which is why HMRC is asking for evidence in the first place.
Should changes be implemented haphazardly, as Alex Sherwood, a colleague of Thomas’s expressed it, “we could arrive at the point that taxation guides commercial decisions – which is not really what we want to see.”
