Optional changes are on the way for the income tax treatment of leases subject to NZ IFRS 16
Tax Alert - July 2020
By Iain Bradley and Belinda Spreeuwenberg
The long awaited changes to the income tax treatment of leases subject to NZ IFRS 16 (Leases) are one step closer. Following an announcement in December 2019, draft legislation introducing a rule referred to as “applying NZ IFRS 16 for tax” is now before parliament as part of the Taxation (Annual Rates for 2020–21, Feasibility Expenditure, and Remedial Matters) Bill (“the June Bill”).
NZ IFRS 16 requires lessees to include most of their leases on their balance sheet, by recognising a right of use asset and a lease liability. This changes the timing of the accounting expenditure which now comprises depreciation of the right of use asset and a finance expense (compared to expenditure relating to operating lease payments under the previous accounting standard). The proposed legislation (“applying NZ IFRS 16 for tax”) allows IFRS taxpayers to choose to more closely follow the accounting treatment of certain personal property leases but it does come with complexity. This new rule will only apply to the lessee of the lease.
What leases are included?
All new and existing leases where NZ IFRS 16 applies qualify, with the exception of the following leases:
- A lease of real property
- A lease from an associated party
- A lease where the asset is subleased
If a taxpayer chooses to apply NZ IFRS 16 for tax they would be required to apply this to all leases that qualify. This includes leases that qualify at a later date (for example, a sublease is cancelled or a lessee and lessor are no longer associated). Likewise, if a lease no longer qualified, it would fall outside of this proposed rule and the existing income tax treatment would be applied. Wash-up adjustments may be required where leases of personal property transition out of or into the ambit of the new rule.
When can a taxpayer choose to apply NZ IFRS 16 for tax?
The proposed rule would apply to income years beginning on or after 1 January 2019 (to align with the application date of NZ IFRS 16 although earlier adoption of NZ IFRS 16 was permitted). A taxpayer does not need to apply this rule in the first year of adoption of NZ IFRS 16, and can start to apply NZ IFRS 16 for tax in any income year following adoption. Once a taxpayer has chosen to apply NZ IFRS 16 for tax it must apply this method for all future years that NZ IFRS 16 is applied for accounting purposes.
How does a taxpayer choose to apply NZ IFRS 16 for tax?
An election is made by filing an income tax return that calculates deductions under the proposed new rule. No separate election or notification is required.
Is it as simple as applying the accounting treatment of NZ IFRS 16 for tax?
Unfortunately not. NZ IFRS 16 has the effect of accelerating some deductions – for example, when there is an impairment or make good provision. As the intention of applying NZ IFRS 16 for tax is not to significantly accelerate these deductions, there are proposed tax adjustments that may still be required so that a deduction is available in a similar period to when the expenditure is incurred (although in some cases this is optional) as well as some ‘transitional’ adjustments. Departures from the accounting treatment could arise where:
- there is an impairment / revaluation adjustment – it is proposed that this expenditure would be added back where it is recorded through the profit and loss and then spread over the remaining term of the lease on a pro-rata basis.
- make-good expenditure is accounted for – these costs are only deductible when incurred and therefore an adjustment would be made to prevent this expenditure from being treated as deductible before it is incurred by adding this back, which is likely to be in equal proportions over the remaining life of the lease. A deduction would be available when the expenditure is incurred in restoring the asset.
- there are direct costs – these costs are generally incurred at the start of the lease, and therefore it is possible to include a deduction for tax purposes when incurred and add back the direct costs expensed in the profit and loss, likely in equal proportions over the remaining life of the lease. This would be an optional adjustment given it is more favourable than following NZ IFRS. A taxpayer can choose to follow their accounting treatment and make no adjustments for direct costs.
- a transitional adjustment is required – these arise where there has been a retrospective application of NZ IFRS 16 on adoption, an election to apply this rule occurs in a year after the adoption of NZ IFRS 16 or where a lease that previously did not qualify now qualifies. This adjustment can be income or expenditure and is proposed to be spread equally over the transition year and the four subsequent years.
The commentary has some useful examples that illustrate these adjustments and how they are proposed to be calculated.
At the end of the lease, where the lease is no longer a qualifying lease, or where the taxpayer no longer follows NZ IFRS 16 for accounting, the taxpayer would need to undertake a wash-up calculation. This concept is similar to a base price adjustment for financial arrangements, and can give rise to income or a deduction.
It is clear from the above that applying NZ IFRS 16 for tax is not as simple as following accounting. Following this rule may in fact increase compliance costs, particularly if not all lease assets qualify under this proposed rule and departures from accounting are required where, for example, there is an impairment. This rule is intended to only result in timing differences which should also be weighed up when deciding to choose to apply NZ IFRS 16 for tax.
The Commissioner has recently announced the exercise of her power to make variations (granted as a way to respond to COVID-19) and has varied the definition of a finance lease for tax purposes where certain criteria are met. Under the existing rules, a lease of “more than 75% of the asset’s estimated useful life” is a finance lease, however this time period is extended to “more than 75% of the asset’s useful life plus an additional 18 months” where the term of the leases is extended between 14 February 2020 and 30 September 2020 and the lease payment relating to the asset is less than $5,000 per month. For the variation to the definition of finance lease to apply, the lease must also be required to be extended because:
- The lessee was prevented or discouraged from returning the lease asset at its original date because of COVID-19 restrictions; or
- In the period between January 2020 and September 2020 the lessee’s business has experienced a significant decline in actual (or predicted) revenue related to COVID-19 which made it difficult to satisfy the existing lease agreement.
This variation is a reasonable compliance saving measure that will allow taxpayers to continue to treat qualifying leases as operating leases for tax purposes where they might have otherwise needed to treat these as finance leases for tax purposes.
July 2020 Tax Alert contents
- Changes are on the way for the income tax treatment of leases subject to NZ IFRS 16