Profits Tax Treatment of Leases Where HKFRS 16 Applies

• Assessing Practice Relating to Lease Expenditures
• Impairment and Revaluation Adjustment
• Sub-leased Asset Accounted for under Fair Value Model

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Assessing Practice Relating to Lease Expenditures

HKFRS 16 Leases applies with effect from annual reporting periods beginning on or after 1 January 2019.  Early application is permitted with application of HKFRS 15 Revenue from Contracts with Customers.  With the adoption of HKFRS 16 for accounting purposes, the Commissioner will adopt the following assessing practice:

Lessor

Current profits tax treatment for lessors under the Inland Revenue Ordinance (IRO) remains unchanged since there is no substantial change in accounting treatment for lessors.  This means that profits tax treatment for lessors would depend on whether the ownership of the leased asset will pass to the lessee at the end of the lease term (i.e. a sale under tax law).

Lessee

Lessees will be allowed deduction of expenditures (i.e. interest on lease liability and depreciation on right-of-use (ROU) asset charged in the profit and loss account)  in respect of leased assets, which are recognised in accordance with the principles in HKFRS 16, subject to the following conditions:

• the lease is not a sale for tax purposes;
• the deduction relates to expenditures/losses that have been incurred/realised; and
• the legal characterisation of the expenditures is consideration for the right to use leased assets for a period of time.

All along, the accrual basis of accounting is required to be applied in computing the assessable profits, with any necessary adjustments to conform with the IRO.  Where a lessee accounts for a lease on the basis of HKFRS 16, the expenditures charged in the profit and loss account will equal the depreciation relating to the leased asset and interest relating to the corresponding lease liability.  This will normally be the appropriate way of achieving a spread of the lessee’s gross rental payments which is consistent with the accrual concept.  There is no requirement that an expenditure has to be charged to the year in which it contractually falls due.

In straightforward cases, the total deductions in the profit and loss account in respect of the leased asset (i.e. interest and depreciation) over the term of the lease will equal the total lease payments over the term of the lease though the two amounts are not necessarily equal in one particular accounting period.

Where a lease in relation to plant or machinery is regarded as a sale for tax purposes (e.g. hire purchase or conditional sale with the passing of ownership), the lessee is eligible to claim interest expense and depreciation allowances under Part 6 of the IRO on the leased asset instead of a deduction on the lease payments.

Example 1

Corporation-HK entered into a 5-year operating lease for a piece of equipment.  The annual lease payment was $100,000 payable at the end of each year.  The interest rate implicit in the lease was 5%.  Corporation-HK measured the lease liability at the present value of the 5 payments of $100,000 discounted at the interest rate of 5% per annum, which was $432,948.

Initial recognition and measurement of the lease by Corporation-HK:

The aggregate of the “interest expense” and “depreciation” (i.e. $67,052 + $432,948) charged in Years 1 to 5 represented consideration for the right to use the leased equipment.  For profits tax purposes, deduction would be allowed in respect of the interest expense and depreciation charged to the profit and loss account in accordance with HKFRS 16.

Though the lease payment paid each year equalled $100,000, there was no requirement that the lease payment had to be charged to the year in which it contractually fell due.  For Year 1, the deduction allowable under section 16(1) would be $108,237 (i.e. $21,647 + $86,590).

Deduction could be claimed on the basis of contractual payments so long as the basis was consistently applied and there was no indication of any element of tax avoidance.  If claimed, $100,000 would be allowed for deduction for Year 1 instead of the accounting charges of $108,237 (i.e. $21,647 + $86,590).

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Impairment and Revaluation Adjustment

If the ability to derive benefit from a leased asset is adversely affected, an impairment loss of the leased asset is required to be recognised in the profit and loss account, with a corresponding reduction in the carrying amount of the ROU asset.  Depreciation in respect of the ROU asset would also be reduced in subsequent years.

If there is any indication that an impairment loss recognised in prior periods for the leased asset may no longer exist or may have decreased, the carrying amount of the ROU asset is required to be increased.  However, the reversal of the impairment loss should not exceed the carrying amount that would have been determined had no impairment loss been recognised for the asset in prior years.

Example 2

In January 2019, Retail Corporation-HK rented a shop for 5 years.  It closed its accounts on 30 June each year.

Retail Corporation-HK had significantly curtailed their operations due to COVID-19.  It had to assess whether its leased asset (i.e. ROU asset - the shop lease) under the 5-year operating lease was impaired.  Though the net book value of the ROU asset as at 30 June 2020 in respect of the shop was $3 million, the recoverable amount of the ROU asset was only $1 million in accordance with the principles laid down in HKAS 36.  As such, Retail Corporation-HK recognised an impairment loss of $2 million in its profit and loss account for the year ended 30 June 2020.

After recognition of the impairment loss, the interest and depreciation (reduced) charged in the profit and loss account continued to represent the spreading of lease payments as accounted for in accordance with HKFRS 16.  Thus, the interest and depreciation (reduced) charged in the profit and loss account would be allowed for deduction.

To approximate the accounting effect (i.e. the original depreciation) and therefore tax deductions that would have been available had the impairment not been made, the impairment loss of $2 million would be allowed for deduction over the remaining term of the lease on a straight-line basis.

If there was a subsequent partial or full reversal of the impairment loss, the carrying amount of the ROU asset would be increased.  The interest and depreciation (increased) charged in the profit and loss account continued to represent the spreading of lease payments as accounted for in accordance with HKFRS 16.  Thus, the reversal would be spread over the remaining term of the lease on a straight-line basis and taxed accordingly .  The interest and depreciation (increased) charged in the profit and loss account would be allowed for deduction.

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Sub-leased Asset Accounted for under Fair Value Model

In Nice Cheer Investment Ltd v CIR (2013) 16 HKCFAR 813, the Court of Final Appeal ruled that profits computed on a fair value basis could not be taxed if the profits had not been realised.  As a principle of law, “profits” connotes actual or realised and not potential or anticipated profits; and neither profits nor losses may be anticipated.

Unrealised profits or losses arising from accounting for the ROU asset under the fair value model in accordance with HKAS 40 would not be taxed or allowed as and when they are recognised in the profit and loss account.  Instead, the aggregate of the fair value changes would be spread and deducted over the term of the lease on a straight-line basis.

Example 3

Head Lessor-HK owned an office building that it agreed to lease out to Sub-Lessor-HK under a lease with the following terms:

• the lease would be for a period of 5 years;
• the annual rental would be $200,000 payable annually in arrears.

Sub-Lessor-HK subleased the whole office building  to 10 different tenants for 1 to 3 years with no renewable option.  As the office building was located in a prime location, Sub-Lessor-HK was sure that it could find new tenants very soon upon expiry of the old leases.

Sub-Lessor-HK accounted for these sub-leases as operating leases.  The fair value model was adopted to account for its ROU asset (i.e. office building lease) under HKAS 40.  Sub-Lessor-HK’s incremental cost of borrowing was 2%, and there were no initial direct costs, prepayments or restoration costs associated with the head lease.

For the purpose of computing the fair value of the ROU asset, it was assumed that:

• the interest rate implicit in the sub-leases was on average 2%.
• lease liability at the commencement of the head lease (i.e. the net present value of the lease payments) was $942,692 at a discount rate of 2%.
• expected annual rental income was $400,000 receivable annually in arrears.

Initial recognition and measurement of the lease by Sub-Lessor-HK:

Sub-Lessor-HK would recognise annual sub-leasing income of $400,000 in the profit and loss account for Year 1 to Year 5.

Sub-Lessor-HK would recognise the interest expense in the profit and loss account based on the following schedule:

The interest expense charged in the profit and loss account would be allowed for deduction.

Sub-Lessor-HK would account for the fair value changes of the ROU asset at the end of each year during the lease period, based on the following expected cash flows:

The annual fair value gain/(loss) charged to the profit and loss account would be ignored for profits tax purposes.  Instead, the aggregate of the fair value changes of $942,692 (i.e. $580,400 – $369,538 – $376,929 – $384,468 – $392,157), representing the value of the ROU asset at the initial recognition of the lease, would be spread and deducted over the term of the lease on a straight-line basis.

If information which impacts the calculation of fair value in each year (e.g. changes in interest rate/ occupancy rate) could not be ascertained, it might be difficult to determine the aggregate fair value changes of the ROU leased asset over the term of the lease accurately.  In such situations, the ROU leased asset as recognised (i.e. $942,692) would be allowed for deduction on a straight line basis over the term of such a head lease.  The straight-line tax depreciation of the ROU leased asset, together with the deductible interest on lease liability as reflected in the accounts would approximate the annual lease payments made under the head lease.

Deduction could be claimed for the rental payments in respect of the head lease based on contractual payments (i.e. $200,000) so long as the basis was consistently applied and there was no indication of any element of tax avoidance.  If claimed, $200,000 would be allowed for deduction for Year 1 to Year 5 instead of the deductions for interest expense, depreciation or fair value change.