IFRS proposals for accounting treatment of leases (Tax newsletter, November/December 2010)

Background

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.

What's changing?

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.

Tax position

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 rent-free period.

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 period).

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.

Lessor accounting

The treatment of lessors is also changed under the Draft IFRS although there is an important carve-out for certain lessors of real estate.

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.

Transition

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 instrument.

 

Please click on the links below for the other articles in the November/December 2010 tax newsletter. 

 
Contacts

John Watson
T: +44 (0)20 7859 1308
E: john.watson@ashurst.com

Richard Palmer
T: +44 (0)20 7859 1289
E: richard.palmer@ashurst.com

Ian Johnson
T: +44 (0)20 7859 1304
E: ian.johnson@ashurst.com 

Alexander Cox
T: +44 (0)20 7859 1541
E: alexander.cox@ashurst.com

Paul Miller
T: +44 (0)20 7859 1786
E: paul.miller@ashurst.com

Simon Swann
T: +44 (0)20 7859 1882
E: simon.swann@ashurst.com


 

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.

 

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