HMRC reveals the remaining detail of their tax response to IFRS16, including its interaction with CIR.
All lessees who have transitional adjustments on moving to IFRS16, lessees (and to some extent lessors) of plant and machinery, and companies who use either IFRS or FRS 101 in their accounting framework and who are lessees of any type of asset, including tenants under property leases and lessees of plant and machinery.
Changes to the tax treatment of finance lessees and the long funding lease rules for plant and machinery
The new proposals are broadly as announced in the 1 December 2017 consultation documents. There are however some important changes.
Section 53 FA 2011 is repealed as expected.
A lessee under a right-of-use lease (i.e. an IFRS16 lease) in general will be treated as if the lease were a finance lease. Depreciation of the right-of-use asset will be in effect allowed as a tax deduction in the case of non-long funding leases.
A new tax test applies to establish whether the lease would be a finance or operating lease under GAAP if the lessee were required to ask such a question (which under IFRS16 he is not). This is used to identify ‘finance’ leases which will continue to suffer different treatment under the hire purchase rules (s67 CAA 2001), and under certain other anti-avoidance provisions (s228J CAA 2001, the sale of lessor rules, the oil and gas ring fence and the real estate investment trust (REIT) rules). It is not however going to be used universally - so for example there will be no IFRS16 long funding operating leases for lessees.
For a lessee adopting IFRS16 there may be a transitional adjustment which is taken to reserves. The proposed rules governing the tax treatment of such an amount are extremely complex. A company must determine the transitional adjustment for each of its leased assets. There is then a weighted averaging calculation done by reference first to the relative size of each adjustment and then to the length of each the remaining lease terms. This calculation is used to determine the period over which the aggregated transitional adjustment must be tax effected.
The long funding lease rules for plant and machinery are to change in a couple of minor aspects. There will no longer be a deemed lease termination for the lessee under a long funding operating lease on adopting IFRS16. This is good news for those affected especially if they had claimed first year allowances and were facing an accelerated balancing charge under the original HMRC proposals.
As originally proposed the test for a ‘long’ lease is to be simply seven years and the complex rules for leases between five and seven years long are swept away.
In applying the lease payments test (s70O CAA2001), if the implicit interest rate is not ascertainable the rate to be used is now specified as LIBOR plus 1 percent (formerly it was the temporal discount rate, currently 3.5 percent).
New provisions are introduced (s377A CTA 2010) to ensure that a long funding finance lease lessee can obtain a deduction for additional rents if there is a remeasurement of the lease liability.
For oil and gas ring fence companies there are some specific rules. There are tweaks to the rules on finance costs which are not deductible for SCT purposes (s331 CTA 2010). This makes it clear that the disallowed amounts include all of the following:
The oil and gas sale and finance lease rules (s288 CTA 2010) incorporate the new finance lease test used in other areas (e.g. s67 CAA 2001) in order to preserve existing policy. Right-of-use lessees will thus have to assume that GAAP still requires them to distinguish finance and operating leases.
Interaction of IFRS 16 with the CIR rules
HMRC have summarised the responses received to the consultation document released on 1 December 2017 entitled Corporate Interest Restriction: Tax response to accounting changes for leasing. They have also released draft legislation to implement their chosen option.
The draft legislation will apply to lessees using IFRS or FRS 101 in their accounting framework. They would be required to classify the lease of each right-of-use asset as either an ‘operating lease’ or a ‘finance lease’ for corporate interest restriction (CIR) purposes. Practically, this lease classification would be done by applying the lease classification tests for lessees in FRS 102 (broadly similar to the existing lease classification tests in IAS 17). Where the lease is classified as a finance lease, the finance expense would be included in the calculation of interest for CIR purposes. On the other hand, where the lease is classified as an operating lease, the finance expense arising from that lease would be excluded in the calculation of interest for CIR purposes, with the full lease rental instead being included in calculating EBITDA.
Furthermore, the proposals deal with transitional adjustments for CIR purposes for certain leases of low value assets or short leases which switch from a finance lease treatment under IAS 17 to applying the off-balance sheet exemption under IFRS16. These transitional amounts will be treated as tax-EBITDA amounts for CIR purposes rather than as tax interest expense or income.
The new rules for finance lessees and long funding leases for plant and machinery include some welcome simplifications, in particular the long funding lease tests will be easier to apply. The carve-out from the lease termination/recommencement rule on moving to IFRS16 is very welcome to the small affected population of operating lessees, especially those in the oil and gas sector.
The taxation of transitional adjustments for lessees moving from operating lease to IFRS16 will be arithmetically challenging (with a double weighted average calculation). We had hoped for a much more straightforward method of spreading.
The new tax finance lease test is applicable in a number of areas to preserve existing policy. This test seems not yet to have been introduced in some other areas where it may also be appropriate such as the Type 1 finance arrangement (‘structured finance arrangements’) rules.
We consider the new CIR rules to be a welcome proposal that puts lessees accounting under IFRS or FRS 101 in broadly the same tax position as similar entities accounting under FRS 102. There was a concern that, absent these proposed rules, lessees adopting IFRS16 would recognise higher finance expense and consequently could suffer a higher disallowance under the CIR rules. This proposal effectively creates a level playing field for lessees regardless of which accounting framework they use.
Notwithstanding this, an additional compliance burden will result as lessees accounting under IFRS or FRS 101 will need to separately classify their leases for CIR purposes as being either ‘operating’ or ‘finance’ leases. It will then be necessary to separately identify the interest expense arising on the ‘operating’ leases and exclude this in their calculation of interest for CIR purposes. For groups making the group ratio election, the extra compliance burden could be significant. Accounting systems might need to be adapted to flag such leases to enable groups to perform the necessary tax calculations for CIR purposes.
Whilst this exercise might be beneficial for groups above the £2 million aggregate net tax interest expense threshold, groups below this threshold are unlikely to receive any benefit from performing this extra work to classify all leases of right-of-use assets.
Please contact us if you are concerned how this could impact your group and we would be happy to discuss whether there might practical solutions.
The new rules for finance lessees and long funding leases for plant and machinery apply to a company’s first accounting period commencing on or after 1 January 2019. Early adopters of IFRS16 thus have a period of grandfathered treatment before moving to the new tax rules.
The new CIR rules would apply for periods of account beginning on or after 1 January 2019.
For further information please contact:
Michael Everett, Director - Tax at KPMG in the UK
T: +44 (0)20 7311 6587
Peter Casey, Senior Manager - Tax at KPMG in the UK
T: +44 (0)20 7694 2798