Changes in IFRS Lease Accounting Potential Tax Consequences

1. Changes in IFRS Lease AccountingPotential Tax Consequences Philip Marwood, Tax Partner – KPMG LLP

2. Key lease accounting issues potentially affecting tax • Will the changes be adopted? Many false starts • Which approach will be adopted? • Right of use • Whole asset (Risks and rewards/executory contract approaches are unlikely) • What will be the scope of the new standard? • What assets will be covered? (real property, intangibles?) • Boundary between lease and service contracts • Measurement/valuation issues: • Income recognition • Balance sheet valuation (amortised cost, FMV, other current values?) • Disclosures

3. Lease Taxation in the UK - Background • One of the most complex regimes in the world • Complexity stems from decision in 1979 by UK tax authorities (HMRC) to continue following legal form when operating/finance lease distinction was introduced into UK GAAP • Ever since, HMRC has been playing catch-up, introducing and amending special rules for: • Finance leases; and • Long funding leases • But basic principle remains that UK tax starts by treating all leases as rental contracts (i.e legal form), even though the accounting treatment may be as a sale/financing • Description below of UK lease taxation relates to plant and machinery. Different principles apply to property and to intangibles

4. Lease Taxation in the UK - Definitions • Finance Lease • Starting point is accounting test • UK GAAP (unless IFRS adopted, in which case IFRS) • May be affected by treatment in related companies/consolidated accounts • Long Funding Lease (LFL) - A lease when any of the following apply: • Accounted for as a finance lease; • Lease term >65% of expected remaining useful life; or • Minimum lease payments >80% of fair market value at start of lease unless, it is a short lease, either • Term <5 years, or • Term 5-7 years, and lease rentals not back end loaded (Above is a highly simplified summary)

5. Lease Taxation in the UK – Current state of play (Lessors) • Operating leases (other than operating LFLs) • Based on accounting treatment, but replacing deduction for accounts depreciation with capital allowances (tax depreciation) • Finance leases (other than finance LFLs) • Not based on accounting treatment. The gross rent attributable is taxed, less finance expense and capital allowances. (However, lease rents recognised for tax must not be less than finance income.) • Operating LFLs • Based on accounting treatment, replacing deduction for accounts depreciation with a straight-line write-off over the lease term down to expected residual • Finance LFLs • Based on accounting treatment, i.e taxation of finance margin

6. Lease Taxation in the UK – Current state of play (Lessees) • Operating leases (other than operating LFLs) • Based on accounting treatment Finance leases (other than finance LFLs) • Based on accounting treatment (i.e accounting depreciation can be allowed for tax) Operating LFLs • Based on accounting treatment, adding back a straight-line write off over the lease term down to expected residual, and instead deducting capital allowances. • Finance LFLs • Based on accounting treatment, replacing deduction for accounts depreciation with capital allowances

7. Lease Taxation in the UK – Dependencies on Accounting • Most tax treatments start with the accounting treatment • Tax treatment critically dependent on the finance/operating lease distinction (as per previous slides) • Definition of a LFL depends on finance/operating lease distinction • Minimum rental recognition on non-LFL finance lease depends on accounts finance income • Numerous anti-avoidance provisions apply or not depending on finance/operating lease distinction

8. Lease Taxation in the UK – the future as accounting changes • HMRC well aware that current system would need fundamental overhaul once lease accounting reform occurs • Not seen by HMRC as a hot issue currently, because lease reform has long been proposed, but has never so far got to really concrete proposals • The “bright line” that is seen by accountants as a problem is potentially an advantage for tax purposes, where decisions may have to be taken as to whether a contract is basically a sale/financing or a rental contract • Scope of any standard will be important. UK has different tax rules for property and intangibles, which would also need to be reconsidered. Boundary between lease and service contract would become a greater tax issue • Any proposal for tax reform has to be practical, and the information necessary to apply it has to be available to taxpayers (not just the lease counterparty) • So what might HMRC do?

9. Lease Taxation in the UK – Options for change • Tax follows accounts: • Historically HMRC have been reluctant to let accountants determine the tax liability. HMRC have always wanted to tinker with the accounts figures • Particularly difficult if accounting is fair market value based. Profits not based on cash receipts are difficult to tax. [N.B. Treatment of financial instruments.] • Restricts government’s ability to use capital allowances as an incentive (e.g for SME’s or “green” expenditure) • Capital allowances (tax depreciation) split between lessor and lessee depending on their respective interests: • Problematic if the “whole asset” approach were adopted; • Complex rules would be needed to deal with terminations/extensions (but the UK has these already) • A further “patch” to the existing system, e.g a statutory definition of a finance lease • New regime just for tax: • Creating the regime would be hugely complex. Probably beyond HMRC resources • Boundary issues between lease/service contracts particularly difficult

10. Implications for other tax systems • UK system is undoubtedly unique • But similar issues may arise in other tax systems based on special tax rules rather than on simply following local GAAP accounts, particularly if the tax rules start from the legal form of the contract • These features are typical within Common Law (Anglo-Saxon) jurisdictions