On 13 January, 2016, the International Accounting Standard Board (IASB) announced the issuance of a new accounting standard: International Financial Reporting Standard (IFRS) 16, on leases, which took effect on 1 January 2019. The new standard has changed the basis of accounting for leases which was in force for more than thirty years. While IFRS 16 completely replaces the old rule under International Accounting Standard (IAS) 17, the major impact is on the recognition, measurement and disclosure requirements for lessees. The new standard eliminates the classification of leases as either operating or finance for lessees and, instead, introduces a single lessee accounting model. According to an IASB survey conducted in 2016, listed companies around the world had around US$3.3 trillion worth of leases. Based on IAS 17 requirements, over 85% of the leases are labelled as operating leases and are not recorded on the balance sheet of these companies. This amounts to about $2.8 trillion worth of leases off the balance sheet of such entities.
Given the effective date of 1 January 2019 for the adoption of the new standard, most companies had about three years to evaluate the legal, commercial and financial reporting impact of the new standard on their financial positions and transactions. In this article, we have discussed the extent to which the new rule disrupts the Nigerian tax space, and the options available to companies and businesses moving forward.
The Old Wine Explained
In line with the Federal Inland Revenue Service (FIRS) information Circular No.2010/01 on Guidelines on the tax implication of Leases , a lease can be broadly defined as a contractual agreement between an owner (the lessor) and another party (the lessee) which conveys to the lessee the right to use the leased-asset for consideration usually periodic payments called rents. With the adoption of International Financial Reporting Standards (IFRS) in 2012, recognition of leases have been based on IAS 17 (the old rule).
Under the old rule, a lease arrangement is classified as either an operating lease or a finance lease. Finance leases are arrangements that transfer risk and rewards relating to the use of an asset from the lessor to the lessee. This means that in a finance lease arrangement, the lessee is deemed the economic owner of the asset since he is able to apply the asset to generate economic benefits from continuous usage. All other types of lease arrangements are classified as operating lease.
Accounting by Lessee and Lessor under the Old Rule - Finance Lease
Under the old rule, lessees were required to recognize a finance lease arrangement as both an asset and a liability at an amount equal to the fair value (sale price agreed upon by a willing buyer and seller, assuming both parties enter the transaction freely and knowledgeably) of leased asset. Where this value is lower than the fair value, recognition should be based on the present value of the minimum lease payments to be made by the lessee.
Finance (interest) charge is also accrued on the liability over the term of the lease. Subsequently, the annual lease payment made by the lessee is applied towards settling the liability and finance charge that has accrued in relation to the arrangement. Thus, by the end of the lease term, the lessee would have paid for the fair value of the asset plus the finance charge on the leased assets. The lessee depreciates (it may fair value or revalue alternatively) the leased assets annually and charges the annual finance (interest) cost to its income statement.
Since risk and rewards are transferred in a finance lease, lessors are not allowed to recognize the leased asset in their books. Rather, they recognize a receivable (from the lessee) equal to the fair value of the leased asset. Additionally, lessors recognize annual finance income receivable from lessee over the term of the lease.
Accounting by Lessee and Lessor under the Old Rule - Operating Lease
Under operating lease, lessors retain the risk and rewards. Hence, lessees are not allowed to recognize any asset. Lessees recognize operating lease payment as periodic expense on a straight-line basis over the term of the lease. Lessors however continue to carry the asset in its books, depreciating them on annual basis. Additionally, they recognize the operating lease rental receivable from lessee over the term of the lease from lessees as periodic income in the income statements.
Tax Implications of the Old Rule
The Companies Income Tax Act provides for the tax treatments of leases. The tax treatments are also explained in the Federal Inland Revenue Service (FIRS) Circular on the Tax Implication of the Adoption of the IFRS. It should be noted that the prescribed tax treatment aligns with the old rule under IAS 17.
Under a finance lease arrangement, lessees have the responsibility to deduct withholding tax on the annual finance/interest charge while they claim capital allowance on the leased asset. The interest charge constitutes a deductible expense when computing their income tax liability. For lessors, the finance income constitutes a taxable income and they are not allowed to claim capital allowance on the leased assets.
For operating lease arrangement, the lessee deducts withholding tax on the annual operating lease rental while the lessor accounts for the VAT on the amount. The lease rental constitute deductible expense and taxable income in the books of the lessee and lessor respectively. Additionally, the lessor continues to claim capital allowance on the asset.
What has Changed?
The new rule retains the two categories of leases, operating and finance, for the lessor, as well as the recognition under the old rule. However, it prescribes a single accounting treatment for lessees. The new rule requires lessees to recognize a "right-of-use asset" and a lease liability at the inception of the lease. The lease liability is measured at the present value of outstanding lease payment. The recognized liability accrues finance (interest) charges over the term of the lease and any payment made by the lessee is used to settle the original liability and any finance charge that might have accrued for the period. Lessees subsequently depreciate (or fair value or revalue) the "right-of-use asset" over the term of the lease or life of asset.
One major implication of the above for the lessee is that, its balance sheet must recognize all lease assets and liabilities. Thus, lessees would now recognize operating lease arrangements as leased assets and liabilities. Another resulting implication is that both lessee and lessor will recognize an asset in their respective books for the same transaction. An example is a 20-year lease of a property. Based on the new rule, the lessee must recognize a "right-of-use asset" measured at the present value of annual lease payments over the 20 years, adding any other incidental costs to the arrangement. The lessee depreciates the right-of-use asset over 20 years and recognizes the finance/interest charge in his income statement. On the other hand, the lessor continues to carry the cost of the property in his books and depreciates it over its useful life. This calls for a review of the tax implication of leases since both the lessee and the Lessor are now allowed to recognize the assets in their books.
Tax Implications and Available Options
Addressing the tax implications of the new lease rule may be tricky. First, the Nigerian tax laws have not changed in this regard. Thus, it can be presumed that tax treatments of transactions remain the same, irrespective of changes to accounting practices. Secondly, the interpretation of tax laws usually follows the rule of commercial accountancy, except where specific provisions in the law exist to the contrary. Hence, where new accounting rules have been prescribed for a transaction, the accounting principle can guide the tax treatment except where it directly contradicts an existing provision of the tax law.
There are a number of tax issues to deal with relating to the new lease rule especially as it relates to operating lease arrangements since the existing tax rules are still relevant for Finance lease arrangements.
Consequently, it is important to determine the tax treatment of right-of-use assets recognized by the lessee. In addition, the tax treatments of finance cost and depreciation expense relating to this right-of-use-asset, needs to be ascertained. This is important as the lessor is also recognizing the same asset in its records, albeit at the historical purchase amount. Lastly, it is important to critically consider the impact of the new rule on deferred tax calculations for businesses.
Three alternative tax treatments can be given to the right-of-use asset. The right-of-use asset can be treated as a qualifying capital expenditure on which the lessee can claim capital allowance. Although there is no direct provision for this in our current law, the substance of the arrangement bestows upon lessees the title of economic user of the asset. Alternatively, the depreciation expense can be allowed as a deductible expense over the term of the lease. This option may also seem to contradict deductibility rule, but it is consistent with the current treatment of allowing amortization of intangibles as deductible expense. The third option will be to restrict the deductible expense to actual lease rental payable for each period over the term of the lease. This option is in line with the tax treatment under the old lease rule.
The tax treatment accorded the associated finance cost follows the option adopted for the right-of-use asset closely. Where the deductible expense is restricted to the actual lease rental, the finance cost also constitutes a non-deductible expense. The withholding tax obligation would then be on the actual lease rental. Where the depreciation expense is treated as deductible or capital allowance is claimed in lieu, the finance cost is also allowed as deductible expense. Withholding tax becomes due on the accrued finance/interest charge for the period.
Deferred tax liability or asset will also arise since the tax base of the leased assets and liability will be different from their carrying amount, depending on the tax treatment given the transactions. Subject to the circumstances and a company's tax accounting policy, this new lease rule will potentially have an impact on the deferred tax position of companies in their financial statements. It is also important to note that tax related processes and controls, transfer pricing policy and other key performance indicators may need to be up-dated in order to capture all required information.
In conclusion, companies and businesses should evaluate, in addition to legal, commercial and accounting review, the tax impact that the new lease rule will have on their balance sheet. This is even more critical for entities in the aviation, shipping, heavy equipment, banking and leasing sectors who have numerous operating lease contracts. Tax authorities in other jurisdictions such as US, UK and Europe are taking proactive steps in addressing the tax implications of new accounting rules by coming up with detailed guidelines and circulars that can be adopted by taxpayers (and their representatives) when filing their tax returns. This reduces uncertainty and frictions for the taxpayers and tax authority. The FIRS should therefore take the lead by coming up with a detailed circular to provide guidance on the tax treatments to be adopted by taxpayers as was done in the past.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.