May 2018 Tax Services The impact of IFRS 16 on the UK tax position Understanding the impact of IFRS 16 International Financial Reporting Standard 16 Leases (IFRS 16) comes into force for annual periods beginning on or after 1 January 2019, although earlier adoption is permitted. It replaces International Accounting Standard 17 Leases (IAS 17). Although IFRS 16 applies to both lessors and lessees, in practice most of the changes resulting from the introduction of IFRS 16 will affect lessees. On 1 December 2017, HMRC released two consultation documents on lease taxation. The broad theme of the proposals set out in the documents is to try to maintain the existing position. The first consultative document sets out the proposals for lessee taxation, and highlights the relevant legislative changes required to try and ensure the tax rules continue to operate as they currently do, following the introduction of IFRS 16. The second consultative document sets out the impact of IFRS 16 on the corporate interest restriction (CIR) rules contained in Part 10 TIOPA 2010 and outlines three options for dealing with the potential impact of IFRS 16 on the CIR rules. These consultations closed for comment on 28 February 2018. This alert summarises the changes to the tax legislation and HMRC interpretation proposed in both consultation documents, together with potential next steps. It should be noted that the proposed legislative changes are expected to have a significant impact on companies with a large leased asset portfolio, particularly with regard to the accounting adjustments arising on transition to IFRS 16 and this is likely to have both current and deferred tax consequences.
Accounting changes In essence, the operating and finance lease distinction will disappear for lessees applying IFRS or Financial Reporting Standard 101 (FRS 101), and all leases (except those with a term of less than 12 months or over assets with a market value of less than $5,000) will be required to be brought on-balance sheet on commencement of the lease with lessees recognising a financial lease liability and an equivalent right to use asset. Subsequent accounting will be similar to the finance lease model under IAS 17. The standard sets out three permitted methods for transition to IFRS 16. The modified transition method (alternative 2) sets the amount of the right of use asset as equal to the amount of the lease liability on transition (as if a new lease had been entered on the day of adoption). However, adopting the fully retrospective or modified retrospective method is likely to result in an accounting adjustment on transition since, in these cases, the right of use asset and the lease liability are unlikely to be equal. Tax response As announced in the 2017 Spring Budget, the Government has decided to broadly retain the existing tax treatment for leased plant and machinery, including keeping the capital allowance/long funding lease regime, albeit with some changes. This decision is welcomed since, in practice, it will mean that all lessors, and lessees applying FRS 102 (or FRS 105), can continue to apply the existing tax rules and therefore should not be materially impacted by the introduction of IFRS 16. With regard to non-long funding leases, including property leases, lessees applying IFRS will see some changes, however these changes are designed to achieve a degree of simplicity without fundamentally changing the tax treatment of lessee payments. It should be noted that the tax effects of adjustment arising on transition is not straight forward. Repeal of section 53 FA 2011 As anticipated, the consultative document proposes to repeal section 53 Finance Act 2011 for accounting periods commencing on or after 1 January 2019. Section 53 was introduced as a temporary measure and required businesses to continue to apply the existing tax treatment to leasing transactions disregarding changes in Generally Accepted Accounting Practice. It would have negated the effect of IFRS 16 for tax purposes and would have imposed a requirement on taxpayers to continue to maintain records for tax purposes by reference to historical accounting definitions. Statement of Practice3/91 HMRC has confirmed its view that lease rentals are revenue payments for the use of the asset over time and that the appropriate treatment for tax purposes is that the whole of the rentals should be allocated to the periods of account for which the asset is leased in accordance with the accruals concept. This is effectively the accounting basis that applies to operating leases under IAS 17. In the absence of any change, lessees with non-long funding leases who are applying IFRS 16 would be required to make an adjustment in the tax computation to ensure that relief is obtained for the full amount of the rental payment accrued in each period. However, the consultation document clarifies that a deduction of rentals equal to the amount shown in the accounts in respect of the finance charge and the depreciation of the right of use asset, will normally be or appropriate way of achieving a spread of the lessee s gross rentals which is consistent with the accruals concept (this effectively extends SP3/91 treatment to all IFRS 16 leases). We welcome this clarification, however note that it would be helpful for HMRC to expressly state that SP3/91 represents an alternative method for computing tax relief on lease payments, and that basic tax principles provide an entitlement to tax relief for properly accrued gross payments under the lease. Furthermore, we consider that it would be useful if HMRC could confirm that lessees are required/entitled to perform a true-up calculation to ensure that the aggregate tax relief claimed under SP3/91 principles is equal to the The impact of IFRS 16 on the UK tax position
tax entitlement under basic principles, and to make an adjustment in the tax computation where the amounts differ to bring the tax deductions in line with the total rental payments made. Tax treatment of the impact on transition The repeal of section 53 FA 2011 means that accounting adjustments arising on transition to IFRS 16 will need to be taken into account for tax purposes. Property lessees, in particular, could have significant transitional adjustments in their accounts representing: (i) A difference between the right of use asset and the lease liability. This adjustment is likely to arise when applying the fully retrospective and modified retrospective (alternative 1) method. (ii) The release of IAS 17 provisions which have been established in respect of inducements/rent-free periods in order to arrive at an even accruals based profit and loss charge. This adjustment could arise under all transition methods. The normal taxation treatment would be to tax affect the accounting adjustments that arise on the change from one valid basis to another and this is the treatment that is currently proposed to apply to the release of IAS 17 provisions (referred to in (ii) above). However, the consultation document proposes that, for tax purposes, the adjustment for the initial difference between the right of use asset and the lease liability should be disregarded. Instead, the amount of the initial lease liability should be amortised for tax purposes on the same basis as the accounting amortisation of the right of use asset, thereby spreading the tax relief on any transitional adjustment in the accounts (set out in (i) above) over the duration of the lease term. For lessees adopting the fully retrospective or modified retrospective transition method, it is unlikely that the right of use asset will be the same amount for accounting and tax purposes and therefore the lessee would be required to maintain a separate accounting and tax basis for the right of use asset for the duration of each lease. This could be a significant administrative burden for companies with a large leased property portfolio, for example any company with numerous retail units. In addition the proposal to adopt different tax treatment for the constituent elements of the transitional adjustment could well mean that in relation to the same lease arrangement there is a current tax charge on the release of the IAS 17 provision, but deferred relief for any difference between the right of use asset and the lease liability. One potential solution to these transition issues would be to provide for a fixed spreading period to be applied to all transitional adjustments. This could operate in a similar way to the Change of Accounting Practice (COAP) Regulations 2004 (SI 2004/3271). The various lease terms would mean that any period for amortisation would be arbitrary and could result in tax timing benefits for some taxpayers and disadvantage other taxpayers, however in our view this approach offers a simpler solution than the onerous administrative burden that would otherwise be imposed on companies with a large leased property portfolio and would also provide a more consistent treatment for the various elements of the transitional adjustments. The taxpayer could also be provided with an option to apply an actual spreading basis rather than fixed spreading where the latter may produce an unjust or unreasonable result, for example if the taxpayer had a significant portfolio of short lease arrangements. As a final point, deferring relief for an element of the transitional adjustment produces a deferred tax asset for accounts purposes, and consideration will need to be given to the recoverability of this asset in determining recognition. Long funding leases The consultation document proposes simplifying the definition of a short lease such that plant or machinery leases of 7 years or less should fall outside the long funding lease rules, which represents a useful simplification of section 70I Capital Allowances Act (CAA) 2001. The impact of IFRS 16 on the UK tax position 3
A new definition of finance lease is proposed for section 70, likely to be based on the accounting definition of a finance lease in IAS 17 and FRS 102, to ensure that finance lease type arrangements can be identified under IFRS 16 as well as IAS 17. It is expected that any lease that would be classified as a long funding lease today, would also continue to be classified as a long funding lease following introduction of the proposed legislative changes. Given the removal of the operating lease/finance lease distinction, it is proposed that the quantum of qualifying capital expenditure under a long funding operating lease for a lessee applying IFRS 16 will be determined as an amount equal to the present value of the minimum lease payments under the lease rather than the market value of the asset (as currently). This basis will therefore apply for all IFRS 16 leases. Unfortunately, existing leases are not grandfathered and on adoption of IFRS 16, it is proposed that lessees will be treated as making a deemed disposal of their existing long funding operating leases with a deemed entry into a new lease. We are concerned that the current proposal requires lessees under existing long funding operating leases to compute a deemed disposal and reacquisition for capital allowance purposes, with the allowance entitlement on reacquisition being at the present value of the minimum lease payments since this will produce a reduction in the capital allowance entitlement. This seems inequitable since, on commencement of a long funding lease, a lessee has the option to claim capital allowances under the long funding lease regime or to claim rental deductions under basic principles (section 70H CAA 2001). An operating lessee claiming capital allowances under the long funding lease regime facing a deemed disposal and reacquisition on the introduction of IFRS 16 might, in retrospect, have opted at inception to claim tax relief under basic principles, on the basis that this would be more beneficial or administratively easier following these legislative changes. In our view the taxpayer should have the option to claim rental deductions post adoption of IFRS 16, unless existing lease arrangements are grandfathered. IFRS 16 and the CIR rules The CIR rules limit deductions for interest expense and similar finance costs. As currently constructed these rules include the finance charges under finance leases as tax interest. Since IFRS 16 removes the distinction between operating leases and finance leases and adopts an on balance sheet model for lessees, in the absence of any legislative change (other than the repeal of section 53 Finance Act 2011), the CIR definition of tax interest would include finance charges associated with IFRS 16 leases which would have been classified as operating leases under IAS 17. The consultative document puts forward three proposals for legislative change (although it recognises that the options proposed do not represent an exhaustive list): Option 1 proposes a simple accounts based approach where amounts included as a finance charge in the accounts are brought into the scope of the CIR calculations. This would result in a different treatment for lessees depending on whether IFRS 16 or FRS 102 is adopted and could substantially increase the tax interest expense of lessees with existing operating leases following the adoption of IFRS 16. It could also result in a mismatch in treatment between the lessor and lessee under a lease, and in an intragroup scenario could result in a purely intragroup transaction producing additional net tax interest expense in the group s CIR calculations. Option 2 potentially avoids some of the mismatch outcomes arising under option 1 (set out above) by providing for the financing charge in the lessee s accounts to be excluded from tax interest expense where the lessor prepares GAAPcompliant accounts and treats the lease as an operating lease, thereby not recognising the equivalent finance income in relation to the leased asset. However in practice it is expected that many lessees would be unable to benefit from the proposed exemption. Many property lessors are pension funds, insurance funds or non-resident landlords and therefore may not produce GAAP- The impact of IFRS 16 on the UK tax position 4
compliant accounts. Furthermore, plant or machinery lessors may be reluctant to provide the lessee with the required information on the accounting treatment. As a result the mismatches and issues set out in relation to option 1 could apply equally to option 2. Option 3 proposes that the tax rules used to identify a funding lease would be used to isolate those leases that perform a financing function, such that only the leases meeting one or more of the funding lease tests would be brought into the scope of the CIR rules. This would involve the inclusion of a finance lease definition into tax legislation. It is proposed that these rules would be intended to apply for both lessors and lessees and for all leases irrespective of whether they are covered by IFRS 16. In our view this approach closely aligns with the intended conceptual scope of the CIR rules whilst also avoiding the mismatches of tax treatment produced by option 1. However, this option would impose a significant administrative burden on the taxpayer since it requires all lessors and lessees to consider the funding lease tests for every lease held. For companies with a large lease portfolio this represents a significant additional administrative burden. Furthermore, the approach imposes this administrative burden and the associated cost on parties that would otherwise be largely unaffected by the introduction of IFRS 16, for example lessors and lessees applying FRS 102 and lessees with exempt IFRS 16 leases. Next Steps The consultation period ended on 28 February 2018 and we do not expect to get further clarity on the proposals until the summer of 2018. Consequently there is still some uncertainty as to precisely how the tax rules will operate although the consultative documents enable the principal issues to be identified. On the basis that the adoption of IFRS 16 may well give rise to tax adjustments, tax functions should be involved in preparing for the adoption of the new accounting standard. It may be especially important to establish the likely size and makeup of the adjustments that arise on transition, at both a solus company and consolidated level, and how these could impact the current and deferred tax position of the group. Whilst we consider option 3 to represent the fairest approach, we consider that its application should be limited to lessees (since lessors retain a distinction between operating and finance leases) and only to those leases affected by IFRS 16. Furthermore, in order to reduce the potential administrative burden on lessees, option 3 could be applied by the lessee on an elective basis. Under such a proposal, an accounts based approach (i.e. proposed option 1) would apply unless the lessee elects to identify and calculate the effect of those leases meeting the funding lease definition. The impact of IFRS 16 on the UK tax position 5
EY Assurance Tax Transactions Advisory How we can help We have a detailed understanding of the potential impact of the proposals and can advise on the potential tax treatment of particular adjustments. For further information please contact one of the following or your usual EY contact: Kevin Paterson +44 20 7951 1347 kpaterson@uk.ey.com Jenny Sawbridge +44 20 7951 0085 jsawbridge@uk.ey.com About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization and may refer to one or more of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Ernst & Young LLP The UK firm Ernst & Young LLP is a limited liability partnership registered in England and Wales with registered number OC300001 and is a member firm of Ernst & Young Global Limited. Ernst & Young LLP, 1 More London Place, London, SE1 2AF. 2018 Ernst & Young LLP. Published in the UK. All Rights Reserved. ED None In line with EY s commitment to minimise its impact on the environment, this document has been printed on paper with a high recycled content. Information in this publication is intended to provide only a general outline of the subjects covered. It should neither be regarded as comprehensive nor sufficient for making decisions, nor should it be used in place of professional advice. Ernst & Young LLP accepts no responsibility for any loss arising from any action taken or not taken by anyone using this material. ey.com/uk The impact of IFRS 16 on the UK tax position 6