Deferred tax impact on lease liability and right-of-use assets

Prelude
IASB on May 5, 2021 issued an amendment to IAS 12 (Deferred tax related to assets and liabilities
arising from a single transaction) to specify how companies should account for deferred tax on
transactions such as leases and decommissioning obligations.

IAS 12 Income Taxes specifies how a company accounts for income tax, including deferred tax, which
represents tax payable or recoverable in the future.

In specified cirBDTmstances, companies are exempt from recognising deferred tax when they
recognise assets or liabilities for the first time. Previously, there had been some uncertainty about
whether the exemption applied to transactions such as leases and decommissioning obligations—
transactions for which companies recognise both an asset and a liability.

The amendments clarify that the exemption does not apply and that companies are required to
recognise deferred tax on such transactions. The aim of the amendments is to reduce diversity in
the reporting of deferred tax on leases and decommissioning obligations.

The amendments are effective for annual reporting periods beginning on or after 1 January 2023, with
early application permitted.

What’s the issue?

Currently, there is diversity in practice when accounting for deferred tax on transactions that involve
recognising both an asset and a liability with a single tax treatment related to both.

For example, a company may be entitled to a tax deduction on a cash basis for a lease transaction that
involves recognising a right-of-use (ROU) asset and a corresponding lease liability under IFRS 16
Leases. A temporary difference may then arise on initial recognition of the ROU asset and the lease
liability. When applying the current IRE to this temporary difference, a company may apply one of the
following approaches:

Approach Outcome
Apply the current IRE separately to the ROU Recognise the tax impacts in profit or loss when
asset and lease liability they are incurred and therefore recognise no
deferred tax on the lease
Assess the ROU asset and lease liability together Recognise deferred tax on a net temporary
as a single or ‘integrally linked’ transaction on a difference that arises after the initial recognition
net basis and is not subject to the IRE
Choose not to apply the IRE Recognise deferred tax as usual

Amendments to IAS 12
The amendments clarify that the exemption does not apply to transactions such as leases and
decommissioning obligations. These transactions give rise to equal and offsetting temporary
differences at the time of initial recognition in the financial statements.

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Deferred tax impact on lease liability and right-of-use assets

All companies (which are required to comply with IFRSs) will now need to reflect the future tax
impacts of these transactions and recognise deferred tax.

How will deferred tax on lease (or decommission obligations) be recognised?

To recognise deferred tax on lease (or decommission obligations), an entity will need to
determine the tax base of asset and liabilities.

Determining the tax base of assets and liabilities

An entity that applies IFRS 16 Leases recognises a right-of-use asset (lease asset) and a lease
liability at the commencement date of a lease. On initial recognition, the entity needs to
assess the tax base of the lease asset and liability by identifying the amounts attributable to
them for tax purposes. In a jurisdiction where an entity receives tax deductions when it makes
lease payments, it applies judgement in determining whether those tax deductions are
attributable to:

• The lease asset (and interest expense) because the deductions relate to the expenses
(i.e., depreciation and interest expense) arising from the lease
Or
• The lease liability (and interest expense) because the deductions relate to the
repayment of the lease liability and interest expense.
[Para BC74-BC77]

If the tax deductions are attributed to the lease asset, the tax bases of the lease asset and
lease liability equal their carrying amounts, and no temporary differences arise on initial
recognition.
If the tax deductions are attributed to the lease liability, the tax bases of the lease asset and
lease liability are nil, giving rise to taxable and deductible temporary differences in respect of
the asset and the liability, respectively. If those gross temporary differences are equal, the
Amendments require that a deferred tax liability and a deferred tax asset are recognised.
The Board decided not to provide application guidance to help entities assess whether tax
deductions are attributable to the lease asset or lease liabilities, as the costs of doing so would
outweigh the benefits. An entity will need to make a judgement, having considered the
applicable tax law, whether tax deductions relate to the lease asset or lease liability.

Changes to the initial recognition exception

IAS 12 contains exceptions from recognising the deferred tax effects of certain temporary differences
arising on the initial recognition of some assets and liabilities, generally referred to as the ‘initial
recognition exception’ or ‘initial recognition exemption’, sometimes abbreviated to ‘IRE’. ‘Exception’
is the more acBDTrate description, since a reporting entity is required to apply it, rather than having
the option to do so implicit in the term ‘exemption’. Before the Amendments were issued, views
differed on whether (and to what extent) the IRE applied to transactions and events, such as leases,
that lead to the recognition of an asset and a liability. To address this problem, the IASB decided to

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Deferred tax impact on lease liability and right-of-use assets

narrow the scope of the recognition exception so that it does not apply to transactions that, on initial
recognition, give rise to equal taxable and deductible temporary differences.

Only if the recognition of a lease asset and lease liability (or decommissioning liability and
decommissioning asset component) give rise to taxable and deductible temporary differences that are
not equal, would the IRE be applied.

The texts of amended para 15 and para 24 are given below:

Para 15: A deferred tax liability shall be recognised for all taxable temporary differences, except to
the extent that the deferred tax liability arises from:
(a) the initial recognition of goodwill; or
(b) the initial recognition of an asset or liability in a transaction which:
(i) is not a business combination; and
(ii) at the time of the transaction, affects neither accounting profit nor taxable profit (tax
loss); and.
(iii) at the time of the transaction, does not give rise to equal taxable and deductible
temporary differences.
Para 24: A deferred tax asset shall be recognised for all deductible temporary differences to the
extent that it is probable that taxable profit will be available against which the deductible temporary
difference can be utilised, unless the deferred tax asset arises from the initial recognition of an asset
or liability in a transaction that:
(a) is not a business combination;
(b) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss);
and;
(c) at the time of the transaction, does not give rise to equal taxable and deductible temporary
differences.

Illustrative example
Lease
An entity (Lessee) enters into a five-year lease of a building. The annual lease payments are BDT1,000
payable at the end of each year. Before the commencement date of the lease, Lessee makes a lease
payment of BDT150 (advance lease payment) and pays initial direct costs of BDT50. The interest rate
implicit in the lease cannot be readily determined. Lessee’s incremental borrowing rate is 9% per year.
At the commencement date, applying IFRS 16 Leases, Lessee recognises a lease liability of BDT4,037.83
(measured at the present value of the five lease payments of BDT1,000, discounted at the interest
rate of 9% per year). Lessee measures the right-of-use asset (lease asset) at BDT4,192.83, comprising
the initial measurement of the lease liability (BDT4,037.83), the advance lease payment (BDT150) and
the initial direct costs (BDT50).
Period Lease Payment DF @ 9% PV
Year 1 1,000.00 0.952 952.38
Year 2 1,000.00 0.874 873.74
Year 3 1,000.00 0.802 801.60
Year 4 1,000.00 0.735 735.41
Year 5 1,000.00 0.675 674.69
Total PV 4,037.83

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Deferred tax impact on lease liability and right-of-use assets

Tax law
The tax law allows tax deductions for lease payments (including those made before the
commencement date) and initial direct costs when an entity makes those payments. Economic
benefits that will flow to Lessee when it recovers the carrying amount of the lease asset will be taxable.
A tax rate of 22.5% is expected to apply to the period(s) when Lessee will recover the carrying amount
of the lease asset and will settle the lease liability.
After considering the applicable tax law, Lessee concludes that the tax deductions it will receive for
lease payments relate to the repayment of the lease liability

Deferred tax on the advance lease payment and initial direct costs
Lessee recognises the advance lease payment (BDT150) and initial direct costs (BDT50) as components
of the lease asset’s cost. The tax base of these components is nil because Lessee already received tax
deductions for the advance lease payment and initial direct costs when it made those payments. The
difference between the tax base (nil) and the carrying amount of each component results in taxable
temporary differences of BDT150 (related to the advance lease payment) and BDT50 (related to the
initial direct costs).

The exemption from recognising a deferred tax liability in paragraph 15 does not apply because the
temporary differences arise from transactions that, at the time of the transactions, affect Lessee’s
taxable profit (that is, the tax deductions Lessee received when it made the advance lease payment
and paid initial direct costs reduced its taxable profit). Accordingly, Lessee recognises a deferred tax
liability of BDT33.75 (BDT150 × 22.5%) and BDT11.25 (BDT50 × 22.5%) for the taxable temporary
differences related to the advance lease payment and initial direct costs, respectively.

Deferred tax on the lease liability and related component of the lease asset’s cost
At the commencement date, the tax base of the lease liability is nil because Lessee will receive tax
deductions equal to the carrying amount of the lease liability (BDT4,037.83). The tax base of the
related component of the lease asset’s cost is also nil because Lessee will receive no tax deductions
from recovering the carrying amount of that component of the lease asset’s cost (BDT4,037.83).

The differences between the carrying amounts of the lease liability and the related component of the
lease asset’s cost (BDT4,037.83) and their tax bases of nil result in the following temporary differences
at the commencement date:
(a) a taxable temporary difference of BDT4,037.83 associated with the lease asset; and
(b) a deductible temporary difference of BDT4,037.83 associated with the lease liability.

The exemption from recognising a deferred tax asset and liability in paragraphs 15 and 24 does not
apply because the transaction gives rise to equal taxable and deductible temporary differences. Lessee
concludes that it is probable that taxable profit will be available against which the deductible
temporary difference can be utilised. Accordingly, Lessee recognises a deferred tax asset and a
deferred tax liability, each of BDT908.51 (BDT4,037.83 × 22.5%), for the deductible and taxable
temporary differences.

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Deferred tax impact on lease liability and right-of-use assets

Summary of recognised deferred tax

The table below summarises the deferred tax that Lessee recognises on initial recognition of the lease
(including the advance lease payment and initial direct costs):

Deductible
/ Deferred tax
Carrying
Tax base (taxable) asset /
amount
temporary (liability
difference

Lease asset:
-Advance lease payment 150.00 - (150.00) (33.75)
-initial direct costs 50.00 - (50.00) (11.25)
-the amount of the initial measurement
4,037.83 - (4,037.83) (908.51)
of the lease liability
Lease liability 4,037.83 - 4,037.83 908.51
(45.00)

Lessee recognises deferred tax assets and liabilities as illustrated in this example and recognises the
resulting deferred tax income or expense in profit or loss.

Presented by:

MOHAMMAD FARID MOLLA

IFSR Learning Center Bangladesh (ILCB)

farid.pq@gmail.com
https://www.linkedin.com/in/faridpq/
https://www.linkedin.com/company/ilcb-bd

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