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Let's Talk Tax

Accounting for and taxation of finance and operating lease

Nikkolai F. Canceran Nikkolai F. Canceran

Last week’s article discussed the accounting treatment for a short-term lease and a lease for low-value assets under the new Philippine Financial Reporting Standard (PFRS) 16 and taxation of operating lease as prescribed in Revenue Regulations (RR) No. 19-86 both for the lessee and the lessor. The discussion also tackled how the lessee and the lessor will record in their respective books various transactions related to leases, such as prepaid rentals and security deposits, and the proper reporting of these transactions for income tax purposes.

Now, this article will tackle the accounting for and taxation of lease contracts other than short-term leases and low-value assets.

Under the new PFRS 16, lessees will no longer distinguish between an operating lease or a finance lease. All leases by the lessee, other than those that qualify as short-term leases and low-value assets, are essentially treated as a finance lease based on the principle that, in economic terms, a lease contract is similar to a financed asset acquisition.

The new standard requires that lessees generally recognize right-of-use asset (ROUA) and a corresponding lease liability to almost all contracts with lease at the commencement date of the lease.

The ROUA is initially measured at the amount of the lease liability plus any initial direct costs incurred by the lessee. Adjustments may also be required for lease incentives, payments at or prior to commencement, and restoration obligations. If the lessee is contractually obliged to return the leased asset to the lessor in a specific condition or to restore the site on which the leased asset has been located, this amount should also be included in the initial measurement of the ROUA.

Refundable deposits are considered a financial asset of the lessee measured at present value. The discount is capitalized as part of ROUA, which is also depreciated.

Under the cost model, the ROUA is subsequently amortized or depreciated on a straight-line basis or another systematic basis that is more representative of the pattern in which the entity expects to consume the ROUA. The ROUA requires impairment testing. Any impairment loss is accounted for in the profit or loss statement. Gains or losses arising from changes in the value of ROUA, if accounted for under the revaluation model (if it relates to a class of property, plant, and equipment) or the fair value model (if it is classified as an investment property) must be included in other comprehensive income or profit or loss, respectively, for the period in which it arises.

Lease liability is initially measured at an amount equal to the present value of the following payments: fixed payments less lease incentives receivable over the lease term; variable lease payments based on rate or index; expected payment under residual value guarantee; purchase options; and termination costs.

The discount rate shall be the interest rate implicit in the lease. If this rate cannot be readily determined, the lessee should instead use its incremental borrowing rate.

The lease liability is measured in subsequent periods using the effective interest rate method.

Interest expense is recognized by the lessee in the profit or loss statement.

PFRS 16 does not contain substantial changes to lessor accounting. The lessor still has to classify leases as either a finance or operating lease, depending on whether substantially all of the risks and rewards incidental to the ownership of the underlying asset have been transferred. For a finance lease, the lessor recognizes a receivable at an amount equal to the net investment in the lease, which is the present value of the aggregate of lease payments receivable by the lessor and any unguaranteed residual value.

The lessor shall recognize finance income over the lease term based on the pattern reflecting a constant periodic rate of return on the lessor’s net investment in the lease. The lessor shall apply the lease payments relating to the period against the gross investment in the lease to reduce both the principal and the unearned finance income.

A finance lease transfers substantially all the risks and rewards incident to the ownership of an asset. The title may or may not eventually be transferred. A lease is classified as a finance lease if it meets all of the criteria: the contract must be a noncancelable lease; the lessor purchases or acquires movable or immovable property at the instance of the lessee; the consideration for the purchase is a fixed amount of money and must be sufficient to amortize at least 70% of the price over a period of not less than two years; and, at the end of the lease contract, the lessee has no obligation or option to purchase the lease property from the owner-lessor.

For tax purposes, if the finance lease is not in the nature of a conditional sale, then the transaction shall be reported as a simple operating lease.

A conditional sale is a contract or agreement purported to be a lease that shall be treated as a conditional sale contract if one or more of the compelling persuasive factors are present: the lessee is given the option to purchase the asset at any time during the obligatory period of the lease, notwithstanding that the option price is equivalent to or higher than the current fair market value of the asset; the lessee acquires automatic ownership of the asset upon payment of the stated amount of “rentals” which, under the contract, they are required to make; portions of the periodic rental payments are credited to the purchase price of the asset; and the receipts of payment indicate that the payment made were partial or full payments of the asset.

An operating lease, on the other hand, is a contract under which the asset is not wholly amortized during the primary period of the lease, and where the lessor does not rely solely on the rentals during the primary period for their profits but looks for the recovery of the balance of their costs and for the rest of their profits from the sale or re-lease of the returned asset of the primary lease period.

As earlier stated, if the finance lease is not in the nature of a conditional sale, the lease shall be treated as an operating lease. Unlike in lessee accounting treatment, the lessee, for tax purposes, does not recognize an asset, but rather claims as rental expense the amount of rent paid or accrued including all expenses that, under the terms of the agreement, the lessee is required to pay to or for the account of the lessor. Given that the lessee does not recognize an asset, there is no depreciation expense, impairment, and changes in fair value elements in an operating lease as compared to the lessee’s accounting treatment.

Similarly, the lessee does not recognize lease liability as well as interest expense in an operating lease. For documentary stamp tax (DST) purposes, a finance lease is essentially a mode of extending credit and is, therefore, subject to DST as a loan and not as a lease.

For a detailed discussion on lessee taxation for operating leases, please refer to last week’s article.

Again, a finance lease is treated similarly to operating leases. The lessor should report as income only the rental payments that they are entitled to receive for the year, as provided under the lease agreement. In addition, prepaid rentals are reported as taxable income in the year received, even though the lessor is using the accrual or the cash method of accounting. The lessor does not recognize receivable and finance or interest income as compared to the lessor’s accounting treatment.

Costs and expenses related to the leased property that are the lessor’s responsibility, if paid by the lessee, are deemed additional rental income of the lessor (e.g., real property taxed on leased property that are paid by the lessee is reported as part of the lessor’s taxable rental income).

Please refer to last week’s article for the detailed discussion on lessor taxation for an operating lease.

For accounting purposes, the lessee shall recognize ROUA and its related amortization/depreciation, as well as impairment loss and, if applicable, gain or loss on changes in fair value of the ROUA. The lessee shall also recognize lease liability and interest expense. For tax purposes, however, the lessee does not recognize an asset and liability, but rather claims lease expense.

The difference between the expenses reported every year by the lessee for accounting and tax purpose may be accounted for as temporary difference with the recognition of either deferred tax asset or liability as the case may be. The reason the difference is just a temporary is because, at the end of the lease term, the total amortization/depreciation and interest expense for accounting is equal to the total lease expense for tax purposes.

In computing the lessee’s net taxable income, the lessee shall add back to its accounting net income the amortization/depreciation expense and interest expense and deduct the lease expense deductible for income tax purposes. The difference in lease expense should be reported in the schedule of reconciliation of net income per accounting books against taxable income of the income tax return.

The lessor, on the other hand, recognizes a receivable and finance income over the lease term for accounting purposes. For tax purposes, however, the lessor should report as income the rental payments that they are entitled to receive for the year, as provided under the lease agreement. Similar to the lessee, the difference between the accounting and tax treatment shall be accounted for by the lessee as a temporary difference.

These differences would not only affect the way the lessee and lessor record the transactions, but will also have an impact on the possible tax audit. For example, the Bureau of Internal Revenue (BIR) examiner will not see in the lessee’s financial statements the lease expense reported in its income tax return (ITR); as such, the BIR examiner would probably disallow the lease expense in the ITR. Another example is that the BIR examiner might impose DST on two transactions, which are DST on loan (lease liability reported in the financial statements) and DST on lease (lease expense reported in the ITR).

One way of preventing these possible BIR misinterpretations is to disclose in the notes to the financial statements to guide the BIR examiner on the true nature of the ROUA and lease liability. BIR examiners are also expected to know this new standard.

I hope that taxpayers find this article to be a useful reference and guide for analyzing and dealing with differences in the accounting for and taxation of leases.

Let’s Talk Tax is a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.


Nikkolai F. Canceran is a director from the Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.


As published in BusinessWorld, dated 05 November 2019