Accounting and taxation of plant and machinery leases
Updated: Jul 5, 2020
After previous consultation and debate on the future of lease taxation, which was triggered by the new accounting standard (IFRS16), the government has now published its draft legislation on the taxation of plant and machinery leases.
These amendments are most technical in nature and have effect for periods of account beginning on or after 1 January 2019 and focus on the following areas:-
long funding lease rules;
corporate interest restriction rules; and
other rules which make reference to finance leases, including the tax rules for hire purchase contracts, oil activities, real estate investment trusts, and the sale of lessors rules.
Entities applying IFRSs or FRS 101 will be required to adopt IFRS 16 for periods of account beginning on or after 1 January 2019 which will change the accounting treatment for leases. The main change will affect the treatment for the lessee.
Currently, lessees and lessors are required to make a distinction between finance and operating leases. Where the lessee has substantially all the risks and rewards incidental to the ownership of an asset (a finance lease) it recognises a finance lease asset and liability on its balance sheet. Where the lessee does not have substantially all the risks and rewards incidental to the ownership of the asset (an operating lease) it recognises lease payments as an expense over the lease term. This treatment will continue under the Financial Reporting Standard 102 (FRS 102), the main Financial Reporting Standard applicable in the UK and Republic of Ireland.
The new accounting standard will remove the distinction between finance leases and operating leases for a lessee. Going forward under IFRS 16 a lessee will recognise all leases on its balance sheet other than certain exempted leases which are of low value or are short term.
Long funding lease rules
The long funding lease rules in Part 2 of CAA 2001 provide that where a plant or machinery lease is in substance a funding lease for the lessee (because the effect of the lease is substantially equivalent to the lessee having borrowed funds to acquire the asset) the lessee is entitled to claim capital allowances on the asset even though they are not the legal owner. The changes ensure that those rules will continue to apply as intended for an IFRS 16 lessee.
A lessee of plant and machinery using IFRS 16 will have a long funding finance lease if the lease is not short and it meets either the lease payments test or the useful economic life test. There is no need to distinguish between long funding operating leases and long funding finance leases for a lessee using IFRS 16 because all leases will be accounted for in the same way. Furthermore, this measure will ensure that a lessee using IFRS 16 with a long funding finance lease will be able to adjust the deduction claimed in certain circumstances where the rentals increase or decrease.
The schedule also makes several simplifications to the tests to identify a long funding lease which are not connected to the accounting standard changes, one of which includes increasing the definition of a short lease from 5 to 7 years.
Corporate interest restrictions (CIR)
The CIR rules operate to limit interest and other financing costs that are deductible for corporation tax purposes. These rules are consistent with the recommendations of Action 4 of the OECD’s Base Erosion and Profits Shifting (BEPS) project. The OECD report recommended that the rules should apply to the finance cost element of finance lease payments. These changes to the legislation ensure that CIR continues to be consistent with the OECD’s recommendations, and mean that any interest restriction will not vary significantly depending on the accounting framework used.
In particular, where a lessee has a right-of-use asset under IFRS, the legislation will require the company to determine whether they would have accounted for the lease as a finance lease or not for accounting purposes. For leases classified as finance leases for tax purposes, any finance charges in the accounts are tax-interest amounts for CIR. For leases classified as operating leases for tax purposes, any finance charges in the accounts are not tax-interest amounts for CIR. Therefore, lessees will not suffer any interest restriction on amounts paid in respect of operating leases.
Section 53 of FA 2011 was introduced in anticipation of these accounting changes but before the new accounting standard was settled. Section 53 has the effect of disregarding for tax purposes most changes in the accounting treatment for leases after 1 January 2011. This gave certainty to affected businesses and permitted the government to consult fully over the future tax treatment of leases. However, it was not intended to be a long-term solution.
This measure repeals section 53 of FA 2011. This reduces the administrative costs for businesses by removing the requirement that a lessee, adopting IFRS 16 recalculate for tax purposes its lease accounting using the frozen accounting policy.
Lessees can opt to apply several accounting options upon adoption of IFRS 16 and under some of those options it is expected that they will recognise a transitional adjustment in equity. Under the change of basis provisions that amount would be recognised in the period of transition. In addition, the adoption of IFRS 16 may lead to certain other provisions being remeasured. It is expected that most entities adopting IFRS 16 and who choose an adoption method that recognises a net transitional adjustment will have a net debit. The spreading of that transitional adjustment for tax purposes over the average remaining term of the lessee’s leases therefore protects Exchequer receipts whilst ensuring fairness for lessees regardless of which of the accounting options they choose.
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