CFM97810 - Interest restriction: leasing: overview

TIOPA10/S460

While payments under a lease are legally ‘rental payments’, they may, depending on the nature of the leasing agreement, be treated in several different ways for accounting and tax purposes.

The starting point is that where a lease is treated as a finance lease for accounting purposes, the implicit finance cost in the lease payments should be included in tax-interest for both the lessor and the lessee. Likewise these amounts are also included in relevant income and expense amounts for calculating group-interest.

Where the tax and accounting treatment of the lease are aligned, the normal rules should be followed for calculating tax-EBITDA by excluding any capital allowances claimed by the company. This will be the case where:

  • An operating lease is not treated as a long funding lease; and
  • A finance lease is treated as a long funding lease.

However, where the tax and accounting treatment of the lease differ, then the calculation of tax-EBITDA is modified. This will be the case where:

  • An operating lease is treated as a long funding lease; and
  • A finance lease is not treated as a long funding lease.

Introduction of IFRS 16

In January 2016, the International Accounting Standards Board (IASB) issued a new accounting standard (‘IFRS 16’) for dealing with leases. IFRS 16 is mandatory for all accounts prepared using International Financial Reporting Standards for periods commencing on or after 1 January 2019, with early adoption permitted. In addition, if an entity uses the UK GAAP standard FRS 101, they will also have to adopt IFRS 16 from the effective date. Hereafter references to IFRS 16 will apply to entities using either full IFRS or FRS 101.

Prior to IFRS 16, the relevant standard for IFRS or FRS 101 users was IAS 17. An entity using the UK GAAP standard FRS 102 will continue to account for leases in accordance with the relevant section of FRS 102, and will not be impacted by the introduction of IFRS 16.

Lessee accounting under IFRS 16 is very different to under IAS 17. For lessees, IFRS 16 removes the distinction between finance leases and operating leases and instead introduces a single lessee accounting model that requires assets and liabilities from all but exempt lease agreements to be recognised on the balance sheet. The lessee will recognise a right-of-use asset reflecting their right to use the leased asset for the lease term.

For lessors, IFRS 16 retains the distinction between finance lease and operating lease and is therefore similar to the previous standard IAS 17.

Tax treatment for periods beginning before 1 January 2019

For early adopters of IFRS 16, FA11/S53 applies; this means that the tax rules are applied on the basis that there has been no change in the accounting standards dealing with leases. As such, any company which early adopts IFRS 16 will need to prepare their tax computations on the basis of the old accounting requirements (IAS 17 or FRS 102). This will also apply for the corporate interest restriction (CIR) rules.

Thus for CIR purposes, the distinction between operating leases and finance leases remains. Where a lease would be classified as an operating lease under IAS 17 or FRS 102, there will be no finance cost included in tax-interest but where a lease would be classified as a finance lease, there will be a finance cost included in tax-interest, and that finance cost will be calculated in accordance with IAS 17 or FRS 102 accounting rather than IFRS 16 accounting. Thus IFRS 16 accounting is ignored for periods beginning before 1 January 2019.

Tax treatment for periods beginning on or after 1 January 2019

As a result of the introduction of IFRS 16, HMRC made certain legislative changes to the CIR rules in Finance Act 2019, effective for periods beginning on or after 1 January 2019. The changes are intended to ensure that only those amounts that are similar to financing costs continue to fall in the definition of tax-interest for the CIR.

Classification

TIOPA10/S494 was amended in Finance Act 2019 to change the definition of a ‘finance lease’ for CIR purposes. This change introduced the concept of a ‘right-of-use lease’ to consider the position for lessees using IFRS 16 who no longer have to classify leases as either finance or operating leases.

For CIR purposes, a company is required to identify whether or not it has a right-of-use lease and if so, whether that lease would be classified as an operating lease or a finance lease, if that lease were required to be classified under an accounting standard (such as FRS 102).

So, if a company has a lease, and under IAS 17, it was classified as an operating lease, that lease should continue to be classified as an operating lease for CIR purposes upon the company adopting IFRS 16.

Where a company uses an accounting standard (such as FRS 102 or IAS 17) that itself requires the company to classify the lease as an operating lease or a finance lease, i.e. the company does not adopt IFRS 16, that classification continues to be followed for CIR purposes.

If a company enters into a new lease after the introduction of IFRS 16 and applies IFRS 16, then for CIR purposes, the company would still need to assess whether that lease would have been classified as a finance or operating lease under either FRS 102 or IAS 17.

Measurement

Although the classification of a lease (into either an operating lease or finance lease) continues as it did under the old accounting, the measurement of a lease that is used for CIR purposes follows the new accounting standard IFRS 16.

So where a company has a finance lease, the finance charge element that is included under tax-interest is calculated using the new accounting standard that the company actually adopts, i.e. IFRS 16 either because the company applies IFRS or FRS 101.

Where a company does not adopt IFRS 16, the finance charge element will continue to be calculated using the actual accounting standard, i.e. FRS 102.

Where a company has an operating lease, the finance charge element that is calculated using the new accounting standard that the company actually adopts, i.e. IFRS 16 either because the company applies IFRS or FRS 101, is ignored for CIR purpose.

Exception

Where a lease was (i) classified as a finance lease under the old accounting (IAS 17 or FRS 102) but (ii) the lessee company adopts IFRS 16 and opts not to treat the lease as giving rise to a ‘right-of-use’ asset because it is either a short-term or low-value lease, there will be no finance charge element under the new accounting IFRS 16.

In such a circumstance, for CIR purposes, no finance charge will be included in tax-interest, i.e. the company will not be required to calculate a finance charge just for CIR purposes. Any transitional accounting adjustments will be treated as tax-EBITDA amounts (and not tax-interest amounts) for CIR purposes.