This article looks at HMRC’s consultation on the interaction of the CIR rules and the new lease accounting standard IFRS 16.
The consultation period has closed for responding to HMRC’s consultation document Corporate Interest Restriction (CIR): Tax response to accounting changes for leasing. This set out three options for dealing with the new lease accounting standard, IFRS 16, which will significantly change lease accounting for lessees. For accounting periods beginning on or after 1 January 2019, IFRS 16 will bring most leases on-balance sheets for lessees who will consequently recognise a finance expense in respect of these leases. Absent any change to the existing CIR rules, this might result in a different CIR outcome to the current position, with many lessees potentially facing a greater CIR disallowance under IFRS 16 than under the current lease accounting standard IAS 17. HMRC called for views on their three proposed approaches. Once they have decided which option to adopt, draft legislation will be released this summer with an expected ‘go-live’ date of 1 January 2019.
IFRS 16 is likely to increase the finance charge for lessees as what were previously accounted for as operating leases will now be brought on-balance sheet as finance leases. The most significant example of leases being brought on-balance sheets are property leases. This could result in different CIR outcomes for lessees adopting IFRS 16 compared to lessees under FRS102.
To deal with this, HMRC proposed three options. Option 1 is entitled ‘Follow the accounting’ and proposes no changes to the CIR rules. Lessees under IFRS 16 with higher interest expense could therefore have a higher CIR disallowance and Option 1 proposes no changes to the tax outcome – hence the CIR outcome follows the accounts.
Option 2 proposes allowing lessees to test whether their leases are performing a true financing function. If they are not performing such a function, then the interest expense arising from such leases may be ignored for CIR purposes. The way Option 2 would test whether a lease is performing a financing function is to require lessees to ask the lessor how they classify the lease in their GAAP-compliant accounts.
The rationale is that lessor accounting is not changing and lessors still distinguish operating leases from finance leases. This should result in a similar CIR outcome for lessees regardless of which accounting standard is adopted. This would be optional and the default would be for Option 1 to apply.
Option 3 proposes that all lessees and lessors, regardless of which GAAP they use, will be required to determine whether a lease is a ‘funding lease’ using the tests in the long funding lease rules. Only leases which pass any of the three funding lease tests would be required to bring interest income/expense into account for CIR purposes.
Our view is that it would be desirable to have the same CIR outcome for lessees regardless of which accounting framework is used: hence Option 1 is not attractive. Whilst Option 3 achieves the same outcome for lessees, it would create a significant compliance burden requiring all leases to be tested against the funding lease tests: hence Option 3 is also unattractive.
Option 2 has the attractions of producing the same CIR outcome and being relatively simple to understand: however, we are not convinced by the practicalities of lessees asking lessors for their accounting treatment. We have suggested HMRC instead require lessees to make an assessment themselves of whether a lease is performing a financing function by reference to the new funding lease test that will replace s70N CAA2001. In our meetings, HMRC were receptive to our suggestion. We will find out this summer whether it has been adopted in the final legislation.
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