Peter Casey, senior manager in the fixed assets tax group at KPMG, examines the most recent leasing tax consultation from Her Majesty's Revenue and Customs (HMRC), the UK tax agency.
Following Saad Ahmed’s article ‘HMRC presents possible tax responses to IFRS16’ on 22 August 2016, this article provides further comments on HMRC’s leasing tax consultation.
The new accounting standard, IFRS 16 Leases, will be effective from 1 January 2019 for UK companies that have adopted IFRS. For lessees, the effect of this new accounting standard is that the concept of an “operating” lease will no longer exist. Instead, lessees will be required to record each contract defined as a lease as a financial liability and a ‘right of use’ asset (there are exceptions from this rule (i) for leases of 12 months or less and (ii) for low value assets, generally under $5,000).
However, the proposed changes to lease taxation will affect both lessors and lessees, regardless of which accounting framework is used. It is vitally important that lessors recognise the impact tax changes could have on them and their clients and make representations to HMRC before the consultation closes on 30 October 2016.
What options are HMRC putting forward?
Summary of HMRC proposals for taxation of leased plant & machinery
Option 1 – Retain current tax rules with changes necessary to deal with loss of operating vs. finance lease concept
Option 2 – Base tax on the accounts income statement with only minor adjustments to prevent abuses with no further tax adjustments or incentives)
Option 3 – Base tax on the accounts income statement with only minor adjustments to prevent abuses with an optional “lease allowance” (accelerated depreciation) on the right of use asset
Option 4 – Base tax on the accounts income statement with only minor adjustments to prevent abuses with optional capital allowances on the right of use asset
Option 1: “Where it’s broke, fix it”
HMRC’s Option 1 is the current tax system with necessary adaptations which maintain the effect of the current rules, which may involve replacing current references to finance and operating leases with alternative definitions.
Capital allowances would remain available to lessors and the long funding lease rules would continue to transfer capital allowances entitlement to some lessees.
Options 2 – 4: “Follow the accounts”
HMRC also present three other related options which align the tax treatment of leased assets more closely with the accounting entries. HMRC consider anti-avoidance measures will be required in some areas, such as around the asymmetry between lessor and lessee treatment and “acceptable rates of depreciation”.
Option 3 involves the option of a “lease allowance” – in essence accelerated depreciation of the right of use asset.
Option 4 gives the lessee an option to claim capital allowances on the right of use asset in place of accounting depreciation.
How will the accounts basis for taxation work?
If an accounts based option is adopted, the lessor will be taxed on their income statement and will receive no capital allowances. Profit or loss on sale and rental rebates will also be taxable/deductible.
A lessee applying IFRS 16 will claim a tax deduction for their finance charge – which will be recognised so as to give a constant rate of return on the outstanding balance – and for the depreciation of their right of use asset, normally on a straight line basis. The lessee will be taxed on rebates received.
The incentives currently offered by capital allowances could potentially be preserved by giving the ultimate lessee an option to claim capital allowances on their right of use asset (Option 4), or by giving a ‘leasing allowance’ – essentially faster depreciation of the right of use asset for tax purposes (Option 3).
If capital allowances are available, the lessee would then be able to benefit from, for example, first year allowances, the Annual Investment Allowance or short life asset elections where relevant. Lessors would have no capital allowances options or other incentives under Options 2, 3 or 4.
What is the future of capital allowances?
Options 2 and 3 would remove capital allowances in the case of leased assets. We note that the Office of Tax Simplification is also considering options for the future of capital allowances and may well recommend capital allowances be replaced by tax depreciation.
What future for long funding leases?
The long funding lease code involves tax tests which can be difficult to apply, especially for some operating leases.
HMRC’s accounts-based proposals would mean that the long funding lease rules would be repealed (except to the extent “grandfathering” provisions continue for existing leases). They could also deliver further simplifying benefits.
Will there be “grandfathering” for existing arrangements?
We understand from discussions with HMRC that existing leases may benefit from “grandfathering”. If so, where capital allowances are available now to a lessor or lessee, they would continue to be available while the lease continues despite the change in lease accounting. Similarly the long funding lease rules would continue to apply to pre-existing leases.
What happens if taxpayers are not following IFRS?
HMRC are keen to ensure that the same tax solution can apply to all companies, without creating different tax rules for different versions of GAAP. If an accounts-based option is introduced, UK GAAP (FRS 102 or FRSSE) taxpayers would, if they are operating lessors, obtain a deduction for depreciation with rentals being fully taxable. Operating lessees would obtain a full rental deduction.
On the other hand, FRS 102 and FRSSE finance lessors would be taxed only on finance income with no “capital” income or relief (similar to a long funding lessor now) and finance lessees would obtain a deduction for finance charges and depreciation (similar to non-long funding finance lessees now).
How does this change impact lessors?
The change in the taxation of leased assets could lead to the decisions of potential lessees when deciding how to finance their new assets being driven by tax. For example, leasing assets with short economic lives (e.g., vehicles) may result in tax deductions for accounting depreciation being more favourable than claiming capital allowances which would be available by taking out a bank loan to buy the asset outright. Lessors should consider how the changes will affect their customers and how this will in turn impact their business.
What are the next steps?
There is a consultation period in respect of the discussion document ending on 30 October 2016. HMRC will be holding consultations with industry and the professions over the next two months. We understand a formal consultation document will then be issued setting out a chosen option in spring 2017. Legislation is expected to follow in Finance Act 2018, to take effect in 2019.
We expect these proposals will be a major area of focus over the next two years. Clearly those providing asset finance will want to assess what each of the suggested options might mean for them and their customers.