IMPLICATIONS ON INTERMEDIATE LESSORS
The first article on tax treatment for lessees post-FRS 116, published in IS Chartered Accountant Journal, April 2019, explained the change from a dual lessee model to a single lessee model for accounting purposes with the adoption of FRS 116 and the related tax implications. In this second article, we continue to focus on lessees. We discuss the accounting changes on lessees who are intermediate lessors in a sublease under FRS 116 and the related tax implications raised by the Inland Revenue Authority of Singapore (IRAS) in its e-Tax Guide.
DEFINITION OF SUBLEASE
In a sublease arrangement, a lease (head lease) for the underlying asset is entered into by the head lessor (HL) and the intermediate lessor (IL), who re-leased (sublease) the same asset to another sublease lessee (SL) (Figure 1).
Figure 1 Definition of sublease
CLASSIFICATION OF SUBLEASE
Under Financial Reporting Standard (FRS) 17, an IL would have to classify its lease arrangement into an operating lease (OL) or a finance lease (FL) using indicators in paragraphs 10 and 11. Note that while FRS 17 was not explicit, it was common in practice for the IL to classify the sublease with reference to the underlying asset arising from the head lease for accounting purposes. For tax purposes, the classification of the sublease is also made with reference to the underlying asset.
Suppose a Head Lessor Company Limited (HLC) and the Intermediate Lessor Company Limited (ILC) enters into a three-year lease (head lease) for a piece of equipment (that has an economic life of 10 years) with an annual lease payment of $70,000 made at the end of each year by ILC to HLC. The implicit interest rate is 5%.
Then, ILC enters into a sublease of the same equipment with Sublease Lessee Company Limited (SLC) immediately on the same day as commencement date of the head lease. The annual payment is $72,000 at the end of each year to ILC and the implicit interest rate is 6.518%.
Under FRS 17, in order to determine the classification of the sublease, ILC would consider the underlying asset arising from the head lease, that is, the equipment with an economic life of 10 years. Under FRS 17 para 10(c), since the lease term is three years and the economic life of the underlying asset is 10 years, the lease term is not for the major part of the economic life and, assuming all other indicators point to an OL classification, the sublease is treated as an OL for accounting purposes. For tax purposes, the classification is also made with reference to the underlying asset, the sublease is also treated as an OL for tax purposes. Hence, under the FRS 17 regime, the sublease classification for an IL is likely to be the same for both accounting and tax purposes.
Under FRS 116, an IL will classify a sublease as an OL if the IL elects to treat the head lease as a short-term lease. In all other cases, the classification of the sublease is made with reference to the right-of-use (ROU) asset arising from the head lease using indicators in paragraphs 63 and 64.
Under FRS 116, in order to determine the classification of the sublease, ILC would have to consider the ROU asset arising from the head lease. Under FRS 116 para 63(c), since the lease term is three years and the economic life of the ROU asset is three years, ILC would classify the sublease as an FL. It is believed that post-FRS 116, given that the classification is made with reference to the ROU asset, rather than the underlying asset, arising from the head lease, it is more likely that an IL would classify its sublease as an FL rather than an OL.
However, post-FRS 116, for tax purposes,1 the classification of the sublease is still made with reference to the underlying asset. In this example, the IL would classify its sublease as an OL. Therefore, it is important to note that in some cases, post-FRS 116, a sublease can be treated as an FL for accounting purposes but as an OL for tax purposes.2
Given the case of a sublease that is classified as an FL for accounting purposes but as an OL for tax purposes, we next examine the accounting entries and the tax adjustments required.
INTERMEDIATE LESSOR ACCOUNTING TREATMENT OF HEAD LEASE AND SUBLEASE POST-FRS 116
Continuing with our example above, given the single ROU lessee model, the ROU asset and the lease liability in ILC’s books is measured at the present value of the three payments of $70,000 discounted at 5% per annum, which is $190,627. The amortisation is provided in Table 1.
For the head lease, under FRS 116, at the start of year 1, ILC (the lessee) will debit ROU Asset $190,627 and credit Lease Liability $190,627.
At the start of year 1, under FRS 116, ILC (the lessor) will classify the sublease as a finance lease. The net lease receivable is measured at the present value of the three payments of $72,000 discounted at 6.518% per annum, which is $190,627. The amortisation is provided in Table 2.
For the sublease, under FRS 116, at the start of year 1, ILC will (i) derecognise the ROU Asset of $190,627, that is, credit ROU Asset $190,627; (ii) recognise the net investment in the sublease, that is, debit Lease Receivable $216,000 and credit Unearned Interest Income $25,373. The Lease Liability recognised under the head lease continues to be retained.
At the end of year 1, ILC will recognise the interest expense of $9,531 for its head lease liability.
At the end of year 1, for the sublease, ILC will debit Cash $72,000, credit Lease Receivable $72,000, debit Unearned Interest Income $12,425 and credit Interest Income $12,425.
INTERMEDIATE LESSOR TAX TREATMENT OF HEAD LEASE AND SUBLEASE POST-FRS 116
In our example, ILC classifies the sublease as an OL for tax purposes, even though the sublease is classified as an FL for accounting purposes. In IRAS e-Tax Guide paragraph 7.5(a), it is stated that “If the sublease, classified by reference to the underlying asset, is regarded as an OL, the IL would be taxed on the lease income.” Hence, in ILC’s tax computation for the first relevant year of assessment, it would then have to subtract interest income of $12,425 and add lease income of $72,000, that is, the total cash receipt on the sublease.
Depending on whether the head lease is classified as (i) an OL, (ii) an FL not regarded as a sale or (iii) an FL regarded as a sale,3 IL as lessee of the head lease would be allowed either a deduction on the contractual lease payments incurred or the capital allowance on the leased asset (IRAS, 2018, paragraph 7.6).
Suppose the head lease is classified as an OL or FL not regarded as a sale for tax purposes, when ILC files its tax return for that first relevant year of assessment, it will be allowed a deduction of the contractual lease payments of $70,000 and no capital allowance will be granted. Suppose the head lease is classified as an FL regarded as a sale for tax purposes, ILC will be allowed a deduction of the interest expense of $9,531 and capital allowance of $20,156, that is, $60,469/3.4
SUMMARY AND CONCLUSIONS
Under the FRS 17 regime, the sublease classification for an IL is likely to be aligned for both accounting and tax purposes. Post-FRS 116, it is possible for the sublease classification for an IL to be an FL for accounting purposes and an OL for tax purposes. This article presents an example and discusses the tax adjustments required in that scenario.
Koh Wei Chern is Associate Professor, and Tommy Yee Chun Tsian is Senior Lecturer, Accountancy Programme, School of Business, Singapore University of Social Sciences.
1 Note that a sublease treated as an FL for tax purposes, has to be further determined whether it is regarded to be a sale agreement under Regulation 4(1) of the Section 10D Regulations
2 The following example was provided in paragraph 7.3 of the e-tax guide “Tax Treatment Arising from Adoption of FRS 116 or SFRS(I) 16 – Leases”: “If the useful life of an asset is 20 years and is leased by the IL for eight years and is immediately subleased out for eight years, the sublease will be classified as an FL under the accounting treatment, as determined by reference to the ROU asset (that is, 8/8 years). However, for tax purposes, such a lease will be treated as an OL as the lease term is not for the major part of the economic life of the underlying asset (that is, 8/20 years)”
3 The classification of the three categories for tax purposes for lessees were discussed in the first article
4 Assume three years under S19A(1) of the ITA