The International Accounting Standards Board (IASB) issued International Financial Reporting Standards (IFRS) 16 on leases, which became operational in January 2019. IFRS 16 was issued to replace International Accounting Standard (IAS) 17 on leases.
According to the Companies Income Tax Act (CITA), companies are expected to file their tax returns not more than six months after the end of the accounting year-end. In that respect, the first adopters of IFRS 16, will in few months be filing their tax returns with the Federal Inland Revenue Service (FIRS). There is the need to critically review the returns to be filed, to ensure that the ensuing tax implications as a result of the implementation of the new standard are thoroughly considered in line with the tax principles. The standard will affect entities that lease property and equipment including land and building, as an option to outright purchase.
Under IAS 17, leases are accounted for either as operating lease or finance lease. Prior to the introduction and implementation of IFRS 16, accounting for operating lease is treated off- balance. This means that the rights or obligations were not recognised on the balance sheet. The new regime requires that leases be recognised on the balance sheet. The essence is to recognize all the rights and the related liabilities to use an asset for a period of time.
The main difference between IAS 17 and IFRS 16 is that in the old standard, operating leases are treated off-balance sheet but in the new standard, leases are recognized as capitalized assets and recorded on the balance sheet. The impact of not accounting for all leases on the balance sheet, which is the limitation presented by IAS 17, is that it makes comparison difficult for companies that bought assets and the ones that leased the assets. Also, financial statements prepared under IAS 17 do not give users an accurate position of the company’s assets. Under IFRS 16, operating leases are capitalized and given the same accounting treatment as the finance lease. This is based on the ‘right of use’, where the asset is recognised in the books because they are used to generate revenue for the business. The focus is on the ‘right of use’ as opposed to the emphasis on risks and rewards in the old standards.
In analysing the tax implications, it is important to understand the key changes and their impact on the financial statements. CITA is the legal framework for the administration of companies’ income tax in Nigeria. However, FIRS Information Circular No. 2010/01 provides an interpretation guide on the treatment of lease transactions for tax purposes. The guide was provided based on two broad classes of a lease – operating and finance lease. The definition of a lease and the features of each class determined the accounting treatment and the related tax treatments. Under a finance lease, the lessor receives interest income from the lessee which is treated as taxable income. There is no tax implication for the capital repayment portion. The lessee claims the capital allowance related to the leased asset and interest expense on the lease payment is tax-deductible. For an operating lease, the lessor claims the capital allowance and the lease rental income is taxable. The lessee deducts the lease rental charges and it is treated as tax-deductible.
Under the new standard, there is no distinction between operating and finance lease, the key issue is to consider the impact on the right to use assets, while the obligation to pay periodic rentals (the lease liability) is recognized in the books. The new standard requires the recognition of leases on the balance sheet except leases for less than one year and low-value items. The ‘right of use’ of assets recognised on the balance sheet comes with related depreciation expenses which are recognised in the income statement. Also, an interest charge on the outstanding lease liability is also debited to the statement of profit or loss. The implication is that leases that were treated on the basis of operating lease by the lessee and not recognised in the company’s books would now be considered on this basis with the attendant tax implications.
Under IFRS 16, there is no change in the tax consequences of the treatment of finance lease. However, under the operating lease, the lessee does not claim capital allowance on the leased asset since this is the entitlement of the lessor. The interest element implicit in the lease is determined and debited to the income statement as well as the depreciation charge determined for each year based on the ‘right of use’ of assets. The depreciation charge would be treated as non-tax-deductible, while the interest charges are tax-deductible. The treatment follows the tax deductibility principles under section 24 of CITA. Where the carrying value of the ‘right of use’ and lease liabilities differ from the tax base, it will give rise to a temporary difference and a deferred tax position in the financial statements.
Given that certain financial ratios will change as a result of recognising the ‘right of use’, the implementation may have an impact on the transfer pricing policy of companies. However, there may be an argument as to whether the ‘right of use’ qualifies as an operational asset which could affect financial ratios. Further, Nigeria has recently introduced a thin capitalisation rule in Finance Act 2019, which became operational on 13 January 2020, taxpayers need to evaluate how that may affect the deductibility of interest due to any change that may arise on the debt/equity ratio.
As taxpayers whose businesses involve leasing of property and equipment, prepare to file their 2020 tax returns, it has become imperative that they consider the tax consequences of the implementation of IFRS 16. This is to reduce the potential tax risk and areas of disagreement with the tax authority which may arise from the adoption of the new standard.