How do lessees account for deferred taxes on leases when they have made advance lease payments and incurred initial direct costs?

In June 2021 Accounting News, using a detailed example, we demonstrated how a lessee applies the recent amendments to IAS 12 Income Taxes when accounting for deferred tax relating to transactions that give rise to an asset and liability in a single transaction. The amendments require that the ‘initial recognition exemption’ cannot be used when the carrying amount of a right-of-use (ROU) asset and lease liability are the same at commencement date (i.e. they give rise to equal taxable and deductible temporary differences). But what if they are not the same?

This article explains the impact on deferred tax calculations by lessees who have made advanced lease payments and incurred initial direct costs for leases, resulting in the carrying amount of the ROU asset and lease liability not being equal on Day 1.

Summary of IAS 12 changes

As noted in June 2021 Accounting News, changes were made to the ‘initial recognition exemption’ so that it could not be applied to leases and restoration liabilities that give rise to an equal and opposite asset and liability. Before the changes, such transactions would have met the all the requirements for the ‘initial recognition exemption’ to apply (refer table below):

Initial recognition criteria	Assessment for a lease
Does the difference arise from the initial recognition of an asset or a liability?	Yes, recognition of a ROU asset and a lease liability
Is the transaction not a business combination?	Yes, not a business combination
At the time of the transaction, is neither accounting profit nor taxable profit affected?	Yes, neither accounting profit nor taxable profit affected

The amendments to IAS 12 added one additional criterion to those listed in the table above. That is, at the time of the transaction, for the ‘initial recognition exemption’ to apply, it must not give rise to equal taxable and deductible temporary differences. Because in many cases the ROU asset and lease liability are the same on Day 1, we demonstrated in Example 2 in June 2021 Accounting News that the initial recognition exemption would not apply.

Advanced lease payments and initial direct costs

IFRS 16, paragraph 24 requires that a ROU asset be recognised at commencement of the lease at ‘cost’. ‘Cost’ comprises the amount of the initial measurement of the lease liability, plus advance payments and initial direct costs.

The cost of the right-of-use asset shall comprise:

the amount of the initial measurement of the lease liability, as described in paragraph 26;
any lease payments made at or before the commencement date, less any lease incentives received;
any initial direct costs incurred by the lessee; and
an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories. The lessee incurs the obligation for those costs either at the commencement date or as a consequence of having used the underlying asset during a particular period

IFRS 16, paragraph 24

Example

At the beginning of Year 1, Lessee enters into a five-year lease for office premises. The present value of future lease payments at commencement date is $50,000.

Prior to commencement of the lease, Lessee makes an initial lease payment of $5,000 and also pays initial direct costs associated with the lease of $1,500.

Assume that the advance lease payment and initial direct costs are deductible for tax purposes when payments are made. The tax rate is 20%.

The ROU asset is amortised over five years on a straight-line basis.

New Illustrative Example 8 added to IAS 12

As part of the amendments to IAS 12, the IASB added Illustrative Example 8 to IAS 12 to illustrate how we should deal with deferred tax on leases when the carrying amount of the ROU asset and lease liability are not the same at commencement. Specifically, it illustrates a two-stage approach, where we determine deferred tax separately for:

The advance payments and initial direct costs ($5,000 plus $1,500), and
The lease liability ($50,000) and related component of the ROU asset’s cost ($50,000).

Although we have used different amounts to that used in Example 8, the approach for determining deferred tax for these different components is the same.

Stage one: Determine deferred tax on the advanced lease payments and the initial direct costs

In order to determine the deferred tax using this two-stage approach, we firstly need to analyse the carrying amount and tax bases of the different components. This is shown in the table below:

	Carrying amount at initial recognition	Tax base at initial recognition
	$	$
ROU asset
Advance lease payment	5,000	- ^{Note 1}
Initial direct costs	1,500	- ^{Note 1}
Amount of the initial measurement of the lease liability	50,000	- ^{Note 2}
Lease liability	50,000	- ^{Note 3}

Note 1: The tax base of the advance lease payment and the initial direct costs is zero because Lessee has already received a tax deduction for these amounts

Note 2: The tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to the entity when it recovers the carrying amount of the asset (IAS 12.7). As the ROU asset is not tax deductible, its tax base at initial recognition is zero.

Note 3: The tax base of a liability is its carrying amount, less any amounts that will be deductible for tax purposes in respect of that liability in future periods (IAS 12.8). Lease payments are deductible for tax purposes, and these include a capital and interest portion. The capital portion represents future tax deductions against the lease liability. Therefore, the tax base at initial recognition is the carrying amount of the lease liability of $50,000 less $50,000 future tax deductions, which equals zero.

For the advance lease payment and initial direct cost components noted above, there is a difference between their carrying amounts and their respective tax bases on initial recognition. We therefore need to consider whether the criteria for the ‘initial recognition exemption’ have been met (refer table below):

Initial recognition criteria	Assessment for a lease
Does the difference arise from the initial recognition of an asset or a liability?	Yes, the advance lease payments and initial direct costs arise from the initial recognition of a lease
Is the transaction not a business combination?	Yes, not a business combination
At the time of the transaction, is neither accounting profit nor taxable profit affected?	No. Taxable profit is affected because both these amounts are tax deductible at the time of payment
At the time of the transaction, does the transaction not give rise to equal taxable and deductible temporary differences	N/A

The ‘initial recognition exemption’ therefore cannot be applied in this instance because at the time of the transaction, taxable profit is affected. Therefore, a deferred tax liability (DTL) of $1,300 should be recognised for the taxable temporary differences of $5,000 and $1,500 on the advance lease payment and the initial direct costs (as shown in the table below):

	Carrying amount at initial recognition	Tax base at initial recognition	Deductible / (taxable) temporary differences @ 20%
	$	$
ROU asset
Advance lease payment	5,000	-	(1,000)
Initial direct costs	1,500	-	(300)

Stage two: Determine deferred tax on lease liability and related component of the ROU asset’s cost

We can see from the table below that at initial recognition, the carrying amount of the lease liability and remaining component of the ROU asset are the same, and both have zero tax bases.

	Carrying amount at initial recognition	Tax base at initial recognition
	$	$
ROU asset
Advance lease payment	5,000
Initial direct costs	1,500
Amount of the initial measurement of the lease liability	50,000	- Note 1
Lease liability	50,000	- Note 2

Note 1: The tax base of an asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to the entity when it recovers the carrying amount of the asset (IAS 12.7). As the ROU asset is not tax deductible, its tax base at initial recognition is zero.

Note 2: The tax base of a liability is its carrying amount, less any amounts that will be deductible for tax purposes in respect of that liability in future periods (IAS 12.8). Lease payments are deductible for tax purposes, and these include a capital and interest portion. The capital portion represents future tax deductions against the lease liability. Therefore, the tax base at initial recognition is the carrying amount of the lease liability of $50,000 less $50,000 future tax deductions, which equals zero.

There is a difference between the carrying amounts and tax bases on initial recognition of the lease liability and its related ROU asset component. Similar to Stage one above, we therefore need to consider whether the criteria for the ‘initial recognition exemption’ have been met (refer table below):

Initial recognition criteria	Assessment for a lease
Does the difference arise from the initial recognition of an asset or a liability?	Yes, the difference arises due to the initial recognition of the lease
Is the transaction not a business combination?	Yes, not a business combination
At the time of the transaction, is neither accounting profit nor taxable profit affected?	Yes. Neither accounting profit or taxable profit is affected at the time of the transaction
At the time of the transaction, does the transaction not give rise to equal taxable and deductible temporary differences	No. The lease liability and related ROU asset component do give rise to equal taxable and deductible temporary differences

The ‘initial recognition exemption’ therefore cannot be applied because at the time of the transaction, the lease liability and related ROU asset component give rise to equal taxable and deductible temporary differences. Therefore, a DTL of $10,000 is recognised for the taxable temporary differences of $50,000 on the ROU asset component, and a deferred tax asset (DTA) of $10,000 is recognised for the deductible temporary difference of $50,000 relating to the lease liability:

	Carrying amount at initial recognition	Tax base at initial recognition	Deductible/ (taxable) temporary differences @ 20%
	$	$
ROU asset
Amount of the initial measurement of the lease liability	50,000	-	(10,000)
Lease liability	50,000	-	10,000

Accounting over the life of the lease

Example 2 in June 2021 Accounting News shows the detailed accounting entries for DTAs and DTLs relating to the lease liability and ROU asset component over the life of the lease.

The tables below detail the accounting entries for the initial recognition of DTLs for the advance payment and initial direct costs, as well as the subsequent unwinding of these balances over the life of the lease.

Note: The initial balance of advance lease payments and initial direct costs that form part of the ROU asset are amortised at 20% p.a., which is the same rate as the ROU asset.

Year	Carrying amount of advance lease payment component of ROU asset	Tax base	Assessable temporary difference	DTL @ 20%	Journal entries for deferred tax expense
	$	$	$	$
0	5,000	-	5,000	1,000	Dr Deferred tax expense $1,000 Cr Deferred tax liability $1,000
1	4,000	-	4,000	800	Dr Deferred tax liability $200 Cr Deferred tax expense $200
2	3,000	-	3,000	600	Dr Deferred tax liability $200 Cr Deferred tax expense $200
3	2,000	-	2,000	400	Dr Deferred tax liability $200 Cr Deferred tax expense $200
4	1,000	-	1,000	200	Dr Deferred tax liability $200 Cr Deferred tax expense $200
5	-	-	-	-	Dr Deferred tax liability $200 Cr Deferred tax expense $200

Year	Carrying amount of initial direct costs component of ROU asset	Tax base	Assessable temporary difference	DTL @ 20%	Journal entries for deferred tax expense
	$	$	$	$
0	1,500	-	1,500	300	Dr Deferred tax expense $300 Cr Deferred tax liability $300
1	1,200	-	1,200	240	Dr Deferred tax liability $60 Cr Deferred tax expense $60
2	900	-	900	180	Dr Deferred tax liability $60 Cr Deferred tax expense $60
3	600	-	600	120	Dr Deferred tax liability $60 Cr Deferred tax expense $60
4	300	-	300	60	Dr Deferred tax liability $60 Cr Deferred tax expense $60
5	-	-	-	-	Dr Deferred tax liability $60 Cr Deferred tax expense $60

Assume Lessee has an accounting and taxable profit of $10,000 each year, before any accounting amortisation of the advanced lease payments and initial direct costs shown above, and before any tax deduction for these payments. Recognising the above assessable temporary differences over the life of the ROU results in a consistent combined tax charge in profit or loss as shown below:

	(A)	(B)	(C)	(D)	(E)
Year	Accounting profit of $10,000 less accounting depreciation for advance lease payments and initial direct costs - $1,300	Taxable profit of $10,000 less up front deduction for advance lease payments and initial direct costs - $6,500 in Year 1	Current tax expense (Taxable profit X 20%) (B) X 20%	Deferred tax expense (from tables above)	Combined tax expense in profit or loss (C) + (D)
	$	$	$	$	$
1	8,700	3,500	700	1,040 ($1,000 + $300 - $200 - $60)	1,740
2	8,700	10,000	2,000	(260)	1,740
3	8,700	10,000	2,000	(260)	1,740
4	8,700	10,000	2,000	(260)	1,740
5	8,700	10,000	2,000	(260)	1,740

In all of the above years, the combined tax expense in Column (E) equals the prima facie tax on accounting profit or loss, i.e. Column (A) X 20%.

More information

For a more in-depth explanation of these amendments, including detailed worked examples, please refer to BDO’s International Financial Reporting Bulletin IFRB 2021/10 IASB issues amendments to IAS 12 – Deferred tax related to assets and liabilities arising from a single transaction.