As the International Financial Reporting Standards (IFRS) gain widespread adoption globally, it is crucial for companies to understand the tax treatment of IFRS 16 adjustments.
IFRS 16 was introduced to replace IAS 17 and mandates that companies account for all leases on their balance sheets, not just finance leases as previously required. Under IFRS 16, companies must recognise certain leased assets as Right-of-Use (ROU) assets on their balance sheets, depreciate these assets, and acknowledge a notional finance cost.
On the other hand, actual rental payments are no longer regarded as expenses but are used to reduce the Balance Sheet lease liability. These changes have a significant impact on the taxation of companies. In this article, words importing the masculine shall be deemed to include the feminine.
Tax principles
In general, tax expenses must be those which an entity can prove beyond doubt that it has a legal liability to pay for at year-end, such as a rental amount already invoiced but not yet paid. Expenditure already paid before year-end is obviously tax deductible if it relates to the running of the business. Revenue, on the other hand, is only taxed if it has unconditionally accrued to a business. With this in mind, we shall now proceed to analyse how IFRS 16 affects corporate tax computations.
Interest expense
This refers to the interest expense on the lease liability recognised under IFRS 16 and is usually reported as lease finance costs in accounts. The finance cost is a notional or imputed finance cost which doesn’t result in an actual cash outflow for a business and is added back when computing corporate tax. Only real interest expenses are allowed for tax purposes.
ROU depreciation
The above stands for IFRS 16 Right-of-use asset depreciation, which is basically the depreciation of the ROU asset recognised as part of the company’s assets. Since companies are now required to recognise some assets which they lease such as commercial or residential buildings as part of their assets, these are separately classified as ROU assets in the books of accounts. From that angle, the assets are then depreciated and this increases the impacted entity’s depreciation costs, reducing net profits. For corporate tax purposes, this is added back to net profits as it is a capital expense.
IFRS 16 rental payments
These are accounted for in the Balance Sheet because IFRS 16 introduced a new lease accounting model that recognises lease assets and lease liabilities in the Balance Sheet. This model aims to provide a more transparent view of a company’s leasing activities and their impact on the financial position of the impacted entity. Under the previous lease accounting standard, IAS 17, operating lease payments were generally recognised as an expense in the income statement and did not impact the Balance Sheet. The non-recognition of the lease payments actually incurred as an expense means that IFRS 16 results in understatement of lease expenses. The correct tax treatment of the payments is to deduct the said lease outgoings from net profits as the payments are a real expense deductible for tax purposes.
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