An operating lease involves the lessee paying a rental for
the hire of an asset for a period of time which is normally
substantially less than its useful economic life. The lessor
retains a significant portion of the risk and rewards of ownership
of the asset. Under the existing regime (IAS 17 or SSAP 21),
operating leases are not on the lessee's balance sheet at all. The
lease payments are an operating expense of the lessee and therefore
a charge to the income statement (P&L). The underlying asset is
owned by the lessor so sits on the lessor's balance sheet.
A finance lease involves the lessee paying a rental for
the hire of an asset for a period substantially corresponding to
the expected useful economic life of the asset. The lessee takes on
substantially all the risk and rewards associated with the
ownership of an asset. Since leasing an asset under a finance lease
is economically akin to ownership, the existing regime (IAS 17 or
SSAP 21) requires finance leases to be capitalised in the lessee's
balance sheet (as a fixed asset), with a corresponding liability
recorded on the other side of the balance sheet representing the
present value of the future lease commitments. That treatment is
thus broadly as if the lessee had borrowed the money and bought the
asset. The asset is then depreciated over time (through a charge to
the P&L) and the lessee is treated as servicing the debt. This
means that the rental payment is characterised as (i) a part
payment of principal which reduces the balance sheet liability and
therefore offsets the asset depreciation and (ii) part interest
payment which is a charge to the P&L. While the assets and
liabilities should broadly match at the start and end of the lease,
there can be significant mismatches during the term of the finance
lease due to the different amortisation profiles.
Under the existing rules, lessees are required to show broadly
equal and opposite assets and liabilities on their balance sheet in
respect of finance leases but not for operating leases. The
International Accounting Standards Board's (IASB) view is that that
distinction is inappropriate since all lessees rely on their leased
assets and cannot operate without paying for them. Accordingly, all
lessees, whether under operating or finance leases, should include
the relevant liabilities on their balance sheet.
The IASB has produced what may be the final draft of the new
International Financial Reporting Standard on leases (the Draft
IFRS) which requires lessees to show (broadly) equal and opposite
assets and liabilities on their balance sheet in respect of all
leases without distinguishing between finance and operating leases.
Who is affected?
Companies incorporated within an EU Member State which have
securities admitted to trading on a regulated market of any EU
State are required to produce their consolidated accounts in line
with those IFRS approved by the Commission.
There is no requirement for UK incorporated companies to adopt IFRS
for their individual company accounts although many banks and
listed companies have done so. Larger companies that use UK GAAP
are likely to be affected at some point due to UK GAAP converging
rapidly with IFRS and the ASB normally introducing a UK GAAP
standard which mirrors the IFRS standard. It remains to be seen
whether the simplified accounting requirements for certain smaller
companies will follow the approach in the Draft IFRS.
The UK tax treatment of lessees and lessors is heavily dependent on
the accounting treatment. The question of whether a particular
lease is, as a matter of accounting, an operating lease or a
finance lease is, for example, one of the factors relevant in
determining which party is entitled to any capital allowances.
In the loans and derivatives area, where slightly less momentous
accounting changes are in the offing, HMRC has been granted powers
to amend the loan relationships and derivative contracts
legislation, effectively as they see fit (section 62 and schedule
19 of the Finance Act 2010). In the context of leasing, the
approach taken is simpler. The draft Finance Bill 2011 released on
9 December effectively contains a standstill provision so that the
tax law will continue to apply as if there had been no change to
the accounting standards for leasing. That deals with the issue in
the short term but this is surely an area which has been ripe for
simplification for some time and these accounting changes can only
increase the need for that.
Further details on lessee accounting
Consider a tenant under a vanilla 20-year lease of real estate.
Except in the very unusual case where that is treated as a finance
lease, the lessee would not currently hold any asset or liability
on its balance sheet in respect of that lease. Rather, for each
accounting period, it would show a deduction in P&L for the
rental payable in respect of that accounting period. That P&L
deduction is calculated on an accruals basis so may be different to
the amount actually paid in that period if there is, for example, a
The changes introduced by the Draft IFRS will impact both the size
of the balance sheet and the timing of P&L deductions. The size
of the balance sheet will increase as the present value of the
rentals owing over the 20-year period must be calculated and,
broadly, that amount will be shown as both:
- an asset (reflecting the right to use the land for 20 years); and
- a liability (reflecting the obligation to pay rental over the
The net balance sheet impact will be nil since those two figures
will cancel out (or very nearly do so; there may be small
differences relating to initial costs), but the gross liabilities
will be significantly increased. While the assets and liabilities
should broadly match at the start and end of the lease, there may
be significant mismatches during the term of the lease due to the
different amortisation profiles.
In many cases, there will be some acceleration of P&L expenses
for lessees under operating leases as compared with the accruals
treatment under current GAAP. That is because of the way in which
interest is treated as accruing on reducing sums over the term of
the lease. The acceleration of P&L expenses is more pronounced
the higher the interest rate that would be charged to the lessee on
its borrowings. There is an example in the table here.
There are a number of rules around how to calculate these balance
sheet values which stipulate, among other things, how to calculate
the deemed length of a lease for these purposes. We have seen
behaviour that suggests some lessees are already building certain
break clauses in to best ameliorate the effect of the Draft IFRS.
More particularly some lessees who want to reduce their balance
sheet size are incentivised to try to insert a strategic tenant
break right at a point when they consider it more likely than not
that they will exercise that right.
Other knock-on effects for lessees
The Draft IFRS will also affect calculations for the Government's
proposed bank levy. The bank levy payable is calculated as a
percentage of equity and liabilities. As the lease liability
arising under the Draft IFRS for lessee banks will not fall within
one of the categories of excluded liabilities, the result of the
Draft IFRS will be to increase the bank levy payable. However, the
legislation is still in draft form and it remains to be seen how
(if at all) this issue will be addressed in the final Bill.
The increase in balance sheet size is also likely to require an
increased regulatory capital requirement although if the impact is
significant, that may be a good reason to lobby for a change to the
Basel Capital Accord or the Capital Requirements Directive.
The treatment of lessors is also changed under the Draft IFRS
although there is an important carve-out for certain lessors of
Lessors of real estate using IFRS currently apply IAS 40 which
requires them to hold their properties at either fair value or at
cost. Investors who hold their properties at fair value under that
standard are not directly affected by the Draft IFRS but
nevertheless, the Draft IFRS is likely to have a major impact on
lessors of real estate even where the lessor accounts at fair value
under IAS 40 because tenants are likely to push for shorter leases
or break clauses at strategically chosen points (see above).
Lessors that account under IAS 40 under the cost model will be
impacted more directly by the Draft IFRS. Broadly, there are two
alternative treatments in that case, the first of which will
increase both the asset and liability side of a lessor balance
sheet, and the second of which may have a less significant impact
on the size of the balance sheet. The timing of revenue recognition
in the lessor's P&L may also be affected.
The consultation period ended on 15 December 2010. Notwithstanding
general resistance to the new rules from most quarters, it looks
increasingly likely that they will be implemented at some point in
the not-too-distant future.
There is no grandfathering for existing leases.
Lessees will need to bring their leases on balance sheet at the
date of transition (which has not yet been determined) at the
present value of the remaining leased payments at that date. That
will be unwelcome news for those that did sale and leaseback
transactions to get property assets off their balance sheet. We
anticipate that such entities will be looking for solutions which
keep their liabilities off the balance sheet by structuring the
payments as something other than under a lease or a financial
Please click on the links below for the other articles in
the November/December 2010 tax newsletter.
T: +44 (0)20 7859 1308
T: +44 (0)20 7859 1289
T: +44 (0)20 7859 1304
T: +44 (0)20 7859 1541
T: +44 (0)20 7859 1786
T: +44 (0)20 7859 1882
This newsletter is not intended to be a comprehensive review of
all developments in the law and practice, or to cover all aspects
of those referred to. Readers should take legal advice before
applying the information contained in this publication to specific
issues or transactions.