EFFECTIVE Jan. 1, 2019, entities reporting under Philippine Financial Reporting Standards (PFRS) shall follow the new PFRS 16, replacing the previous Philippine Accounting Standard (PAS) 17. PFRS 16 introduces short-term leases and low-value assets, as well as the right of use asset (ROUA) in the recognition of leases.
This article shall discuss the changes introduced by PFRS 16, as well as the tax treatment of leases in accordance with Bureau of Internal Revenue (BIR) Revenue Regulations (RR) 19-1986.
Accounting for short-term leases and lease for low-value assets
PFRS 16 defines a short-term lease as a lease with a lease term of 12 months or less, but takes into consideration lease renewal options. A lease for low-value assets, on the other hand, is a lease for which an underlying asset is of low value (per the standard, with a value of US$5,000.00 or the equivalent for new similar asset).
Accounting for short-term leases and leases for low-value assets does not substantially differ from accounting for operating leases under the old standard. As usual, the lessee recognizes a lease or rental expense in its books, while the lessor recognizes lease or rental income. The lease expense/income shall both be recognized on a straight line basis or another systematic basis that best represents the pattern of benefits received under the lease contract.
Furthermore, when the lease agreement provides for advance rentals and/or security deposits, the lessee accounts for such at the time of payment and applies such as cost/expense in the applicable period. In the same vein, the lessor shall also account for such at the time of receipt and applies such advance rental/security deposit in the applicable period.
Taxation of short-term lease and lease for low-value assets
Under RR 19-1986, short-term lease and lease for low-value assets is the equivalent of an operating lease. As such, the lease paid or payable to the lessor must be recognized by the lessee as deductible cost/expense. Similarly, the lessor shall also recognize lease income on the lease payments that it is entitled to receive during the taxable period. For value-added tax purposes, the lessor shall recognize lease income as part of the lessor’s taxable rental income.
Additionally, other costs/expenses incurred by the lessee for the account and for the benefit of the lessee shall also be considered deductible cost/expense. In the same vein, such costs/expenses incurred by the lessee for the account of and for the benefit of the lessor shall be recognized as additional lease income on the part of the lessor.
If the lessee pays for advance rentals when the lessee adopts the accrual basis of accounting, for tax purposes, the lessee shall treat such as deductible expense when it is actually applied to the lease. If the lessee adopts the cash basis of accounting, the advance rentals shall be deductible at the time of payment, provided that such advance rental does not extend beyond 12 months; otherwise, it shall be made deductible at the time of application. On the part of the lessor, advance rentals shall be recognized as taxable lease income at the period of receipt, whether the lessor uses accrual or cash basis.
Security deposits, on the other hand, are to be considered receivables on the part of the lessee and a payable on the part of the lessor. These are only considered deductible cost/expense or taxable income when it is applied to the lease.
Lastly, the five percent expanded withholding tax on rentals shall also be applied to the actual lease payments by the lessee to the lessor, with the exception of security deposits, which shall only be applicable when the security deposit is applied to the lease.
Accounting for ROUA
Under PFRS 16, the lessee shall no longer distinguish between operating or finance leases; rather, the standard requires the lessees to recognize a ROUA and a corresponding lease liability to the lease contract at the inception of the lease. In essence, all leases entered into by the lessee, other than those mentioned earlier, are construed to be finance leases. The introduction of the ROUA brings about many challenges in the difference between accounting and taxation treatments.
Initially, the ROUA shall be recognized at the amount of the lease liability, plus any initial direct costs incurred by the lessee. It shall also include the adjustments for lease incentives, any payments prior to or at the inception of the lease, and any restoration obligations. Refundable security deposits shall be considered financial assets measured at present value. Subsequently, the ROUA shall be measured using either the cost model, taking into account any impairment losses, or using the revaluation model, if such ROUA is used as a property, plant, and equipment, or using the fair value model, if such ROUA is classified as an investment property.
On the other hand, the lease liability is initially measured at an amount equal to the present value of the fixed lease payments less lease incentives receivable over the lease term, variable lease payments based on rate or index, expected payments under residual value guarantee, purchase options and termination costs.
Subsequently, it shall be measured using the effective interest rate method, taking into account the discount rate implicit in the lease, or the incremental borrowing rate, if the discount rate is not readily determined. As the effective interest rate method is used, the interest expense shall be recognized in the lessee’s income statement.
On the part of the lessor, PFRS 16 does not provide for any substantial change, as the lessor still recognizes its lease contracts as either an operating or finance lease.
Taxation of leases and ROUA
As the ROUA is construed to be a finance lease, our tax laws state that, if the finance lease is not in the nature of conditional sale then, for taxation purposes, it is to be reported as an operating lease.
As the accounting treatment for ROUA purports than an asset is to be recorded and, as such, subsequent depreciation, impairment, or revaluation gains or less must be recognized, this is simply not the case for taxation purposes. The same goes for any interest expense that may be recognized by the lessee in accounting for its lease liability.
Again, as this lease is treated as a simple operating lease, only expenses in relation to the lease payments are to be recognized for tax purposes. As such, the lessee is to recognize the actual or constructive lease payments applicable during the period, which may also include the advance rentals and other expenses shouldered by the lessee on behalf of the lessor.
In the same vein, the lessor also does not recognize any interest income as recognized under the accounting treatment for lessors. Only the lease payments actually or constructively received, as well as any advance rental or security deposits applied in a certain taxable period, are to be recognized for tax purposes. Costs and/or expenses incurred by the lessee on behalf of the lessor shall also be recognized as taxable income on the part of the lessor.
Contrastingly, for documentary stamp tax (DST) purposes, the finance lease is construed as an extension of credit to another party, and as such, consequently subject to the DST on loans.
Temporary differences arising from contrast in accounting and taxation treatments
Inevitably, there will be temporary differences arising from the distinction in the treatments between accounting and tax. As such, these temporary differences may arise in a deferred tax asset or liability, as the case may be. These are to be reconciled to the net effect of zero between the accounting and taxation treatments at the end of the lease term.
All stakeholders—i.e., the BIR, as well as taxpayers—are urged to study the new PFRS 16, as this will change how one presents their financial statements and their tax returns.
Please be guided accordingly.
P&A Grant Thornton
As published in SunStar Cebu, dated 20 November 2019