The possible impact for M&A deals as a result of the new lease accounting standard, IFRS 16.
A new lease accounting standard, IFRS 16, will become mandatory for entities using IFRS or FRS 101 for accounting periods commencing on or after 1 January 2019. This article considers the possible impact for M&A deals.
Summary of accounting changes
IFRS 16 will require companies to bring most leases on-balance sheet from 2019, including leases which are currently classified as operating leases, for example, leases of land and buildings.
Under this new standard, companies will recognise new assets and liabilities, bringing added transparency to the balance sheet. At present, many analysts adjust financial statements to reflect lease transactions that companies hold off-balance sheet (typically increasing fixed assets and debt by seven times the annual operating lease expense).
For the first time, analysts will be able to see a company’s own assessment of its lease liabilities, calculated using the methodology under IFRS 16. All companies that lease assets are likely to see an increase in reported assets and liabilities. This will affect a wide variety of sectors, from airlines that lease aircraft to retailers that lease stores. The larger the lease portfolio, the greater the impact on key reporting metrics – on the balance sheet, companies will appear to be more asset-rich, but will also be more heavily indebted whilst on the income statement operating costs will decrease and will instead be replaced by depreciation of the right-of-use asset and a finance charge.
Tax impact of IFRS 16
Given the change will impact future periods, the area of focus for M&A transactions will be on budgeting and forecasting. In particular, the key tax issues will be:
• Impact on timing of tax deductions for lease rental payments and the impact on tax payments and tax cashflows;
• Current and deferred tax modelling and forecasting; and
• Modelling the interaction with the corporate interest restriction rules.
Addressing the first point, HMRC’s position is that they are keen to preserve the status quo. For lessees, this means maintaining the link between the accounting expense for leases and the tax deductions available. For example, where an operating lease of property is now brought on-balance sheet as a right-of-use asset, the depreciation charge and finance expense associated with this lease should be deductible in line with the accounting treatment.
This is likely to be different to the actual cash payments made to the landlord, particularly as IFRS 16 will front-load the lease rental expense. This is driven by the finance cost recognised on the lease liability, which is higher in earlier years than in later years. Whilst the aggregate expense under IFRS 16 throughout the lease term is the same as it would have been under the old lease accounting standard (IAS17), the front-loading effect of IFRS 16 could be significant for entities with long leases of land and buildings.
From a tax viewpoint, this is good news for profitable entities who have significant operating lease commitments as they can accelerate tax deductions compared to under IAS17. Deal teams should ensure the tax forecasts take into account the new expense profile under IFRS 16 when modelling tax deductions and cash tax payments as this could significantly reduce the cash tax outflows as compared to the cash tax position under IAS17. Consideration should also be given to the new quarterly instalment payment rules which come into effect for accounting periods commencing on or after 1 April 2019 – this requires larger companies to now pay all their estimated corporation tax liability entirely in the year, rather than splitting tax payments 50:50 within the year, then within four months after the end of the accounting period.
The impact of IFRS 16 goes beyond an acceleration of tax deductions. It will also impact current and deferred tax forecasts. Aside from the acceleration of tax deductions reducing the current tax charge in future periods, there are other ways tax forecasts could be impacted:
• Taxation of transitional adjustments;
• Subsidiaries using different GAAPs; and
• Overseas subsidiaries with different tax rules.
In the UK, any transitional adjustments will not qualify for immediate tax relief under the change of basis rules – instead, any transitional adjustments arising from adoption of IFRS 16 will be spread over the weighted average of the remaining lease term. This is likely to give rise to a deferred tax asset upon transition.
Deal teams will need insight into this spreading calculation as this will impact the rate of unwind of this deferred tax asset – in turn, this will impact the current tax forecasts and cash tax outflows.
Regarding subsidiaries using accounting frameworks other than IFRS/FRS 101, it is likely that consolidation adjustments in respect of operating leases will be required to arrive at the consolidated balance sheet and income statement. These adjustments will need careful review for their deferred tax impact – if this is not correctly accounted for, the total tax charge (including the deferred tax charge / credit) could be mis-stated. This in turn could give rise to erroneous effective tax rate forecasts which are likely to be of importance to listed groups.
Similarly, these rules describe only the UK tax changes. Thought should be given to how overseas subsidiaries will tax leases upon adoption of IFRS 16. This could have current and deferred tax impacts at a solo and consolidated level.
Lessees adopting IFRS 16 will be required to classify the lease of each right-of-use asset as either an ‘operating lease’ or a ‘finance lease’ for CIR purposes. Practically, this lease classification would be done by applying the lease classification tests for lessees in FRS 102. 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 depreciation and finance charge instead being included in the calculation of tax-EBITDA.
From a policy perspective, the intention of this draft legislation is to put lessees accounting under IFRS or FRS 101 in broadly the same tax position as similar entities accounting under FRS 102. For the purposes of CIR, this effectively creates a level playing field for lessees regardless of which accounting framework they use.
An additional compliance burden will result as lessees under IFRS or FRS 101 will need to separately classify their leases for CIR purposes as either ‘operating’ or ‘finance’ leases. The interest expense arising on the ‘operating’ leases must then be excluded in their calculation of interest for CIR purposes. For groups making the group ratio election, the extra compliance burden could be significant as separate records would need to be maintained for the worldwide group. Accounting systems might need to be adapted to flag such leases to enable groups to perform the necessary tax calculations for CIR purposes.
This is mandatory and HMRC would expect groups to perform the calculations correctly, including those filing only abbreviated interest restriction returns.
From a deal perspective, enquiries should be made on how groups will deal with this requirement and what systems and processes are in place to distinguish and track operating vs finance leases going forwards.
Deal teams should also model the CIR position taking these new rules into account. For deals involving high leverage, accurate modelling using the figures under IFRS 16 plus systems to distinguish the two different types of leases will be vital for accurate tax forecasting and to ensure compliance with CIR in future.
For more information please contact Peter Casey.