Accounting

Deferred Tax on Leased Assets

Deferred Tax Implications of IFRS 16

In many jurisdictions, the recognition of lease liabilities and right-of-use assets will differ from the taxation treatment of leases. For tax purposes, it is common for leases to be included in the calculation of taxable income based on the cash paid in a particular period plus any unpaid, but accrued lease payments. This treats leases in a similar way to the ‘off balance sheet’ treatment of operating leases under IAS 17.

In many cases, the carrying amount of the right-of-use asset and corresponding lease liability for a lease may equal one another as at the commencement date of the lease. The difference in treatment between IFRS and taxation may give rise to deferred tax balances as the lease liability and right-of-use asset are subsequently reduced due to the subsequent measurement of the balances (e.g. reduction of the lease liability due to lease payments, amortization of the right-of-use asset, etc.). Consider the following example

Example – Measurement of Lease Contract and Deferred Tax
Company V enters into a lease with a lease term of 10 years, with lease payments of CU 1,000 paid in arrears. The interest rate implicit in the lease is not readily determinable, therefore, Entity V will use its incremental rate of borrowing, which is 5%. There are no incremental costs to obtain the lease, or other amounts that may cause the lease liability and right of-use asset to differ. At the commencement of the lease, the lease liability and right-of-use asset are both recognized at CU 7,722. As at the end of the fist year of the lease, the carrying value of the lease liability is CU 7,107 and the right-of use asset is CU 6,950.
The applicable income tax rate is 25%. In Company V’s jurisdiction, the only deduction permissible for leases are those made in cash. Depreciation of the right-of-use asset and fiance expenses on the lease liability are both non-deductible.

Assessment
As at the lease commencement date, the tax bases of the right-of-use asset and liability are both zero. The subsequent depreciation on the right-of-use asset will not be deductible for tax purposes, therefore, its tax base is zero. IAS 12 states that the tax base of a liability is its carrying value, less any amount that will be deductible for income tax purposes in respect of that liability in future periods, therefore, the lease liability also has zero tax basis.
The difference between the carrying value and tax base of the asset and liability meet the definition of temporary
differences, however, there has been inconsistency in practice as to whether the initial recognition exemption applies. The initial recognition exemption states that deferred tax assets and liabilities shall not be recognized if the deferred tax asset
or liabilities arises from:
– The initial recognition of goodwill; or
– The initial recognition of an asset or liability in a transaction, which is not a business combination and at the time of the transaction, affects neither accounting profit not taxable profit. It could be interpreted that for each of the lease liability and right-of-use asset, the initial recognition exemption applies since the recognition of each item individually does not relate to a business combination and the initial recognition
does not affect accounting profit or taxable profit at that time. The consequence of this assessment is that if the initial recognition exemption applies, deferred tax assets and liabilities would never be recognized with respect to the lease.
Others have interpreted that the initial recognition exemption does not apply in this situation.
In response to this issue, in July 2019 the IASB has proposed an amendment to IAS 12, Deferred Tax related to Assets and Liabilities arising from a Single Transaction. The exposure draft proposes to clarify that when equal amounts of taxable and deductible temporary differences arise from assets and liabilities in a single transaction (e.g. the initial recognition of a lease or an asset retirement obligation in the scope of IAS 37), the initial recognition exemption would not apply. At the time of this publication’s release, the exposure draft is open for public comment until 14 November 2019. For entities that have interpreted IAS 12 to mean that the initial recognition exemption does not apply, then assuming the proposals are finalized as drafted it is possible that the proposed amendment will have no impact. However, if entities have interpreted that the initial recognition exemption does apply, the amendment may have a significant impact. Assuming that Company V has an accounting policy that the initial recognition exemption does not apply, then equal and off-setting deferred tax assets and liabilities exist as at the commencement date, so zero net deferred tax exists, as the deferred tax asset and liability would meet off-setting criteria in IAS 12.74 (legally enforceable right of off-set and the taxes are levied by the same taxation authority).
As at the end of Year 1, the right-of-use asset gives rise to a deferred tax liability of CU 1,738 (CU 6,950 carrying value zero tax base) and the lease liability gives rise to a deferred tax asset of CU 1,775 (CU 7,101 carrying value – zero tax base).
The net deferred tax liability of CU 37 (CU 1,775 – CU 1,738) would be presented in the statement of financial position.

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