Singapore’s Tax Treatment of New Lease Accounting Standard FRS 116

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Tay Lek Tan

Tan Tay Lek PwC Singapore

Tan Tay Lek is a Corporate Tax Partner at PwC Singapore

Changes proposed to Singapore's tax rules, for leases accounted for under Singapore's leases standard FRS 116, could create difficulties—taxpayers need to consider their options to mitigate the issues ahead.

With a slew of revisions to Singapore's Financial Reporting Standards (“FRS”) that will come into effect over the next few years, the Inland Revenue Authority of Singapore (“IRAS”) has been busy working out the tax treatments under the new accounting standards. The new FRS 116 will give rise to a number of tax considerations given the new lease classification rules for accounting purposes. The divergence between accounting and tax principles will require adjustments to the statutory accounts to determine the amount of taxable income. In its draft circular on FRS 116 tax treatment, the IRAS considered the impending accounting changes and proposed certain tax positions to address these. In so doing, the IRAS finds that it has to make choices between adhering to tax principles and facilitating compliance by taxpayers.

Status Quo for Lessors but Complexity Remains

Under FRS 116, the accounting treatment for lessors remains substantially unchanged so IRAS is proposing in its draft circular that the existing tax treatment remains the same for lessors.

We had hoped that the Singapore tax authority would take this opportunity to review the capital allowance quarantining rules under section 10D(2) of the Income Tax Act (“ITA”). These broadly operate to restrict capital allowances deductions to a lessor carrying on finance lease activities, until such time when the finance leasing business ceases. These rules were meant to prevent finance lease activities from being used as a tax shelter by restricting capital allowances on the leased asset from setting off against other sources of income derived by the lessor. These provisions are complex and since income tax rates have steadily declined over the years, the risk of abuse should have reduced.

Lessees—Sea Change (of Tax Adjustments) Ahead

The concept of operating leases and finance leases is no longer relevant for lessees under FRS 116. Instead, all lessees will now recognize a Rights-of-Use (“ROU”) asset with corresponding depreciation and interest expenses.

The draft circular proposes that a lessee, in a situation where the ROU asset is treated as a sale for tax purposes, be allowed to claim interest expense and capital allowance on the ROU asset as deduction. This presupposes that the lease qualifies as a finance lease as defined in section 10D(3) of the ITA, which reads “a lease of any plant and machinery…which had the effect of transferring substantially the obsolescence, risks or rewards incidental to ownership of such machinery or plant to the lessee.”

The definition has created uncertainties for taxpayers given there is no quantitative criteria in the Act and while one can look at the accounting standards for guidance, there is no guarantee the IRAS will accept the position that a lease qualifies as a finance lease for tax purposes. It should be useful to include some quantitative factors to guide taxpayers on the lease classification.

On the other hand, for a ROU asset that neither qualifies as a finance lease nor one treated as a sale, the lessee can claim tax deduction only on the contractual lease payments incurred. This requires adjustments from the accounting position to derive tax deductions for only the lease expense actually incurred under the contract. To avoid placing an onerous burden of proof on taxpayers, the IRAS should consider measures such as a de minimis rule under which businesses do not have to provide agreements or other source documents to support the amount of tax deductions claimed.

Characterization of Lease Payments and Receipts

A fundamental tenet of Singapore's tax regime is that the tax treatment of transactions should follow the legal characterization, unless there are statutory provisions to the contrary. This has been established in a long line of cases, both local and foreign, such as Thomson Hill Ltd v. The Comptroller of Income Tax [1983–1984] SLR (R) 297 and ABD Pte Ltd v. Comptroller of Income Tax [2010] 3 SLR 609. The accounting treatment can offer valuable guidance, but can never define the tax treatment.

In a typical lease agreement involving a piece of equipment, the receipts and payments are essentially rental payments for the use of the asset. Current accounting standards require the distinction between a finance lease and an operating lease. This take a “substance over form” approach where the former is seen as a financing arrangement and the lessor will recognize a “finance lease income”, essentially breaking the lease payments into an interest element and a capital principal.

In its draft circular, the IRAS reiterated its current position of similarly regarding an element of, well, financing exists in finance leases. This brings with it the attendant withholding tax and interest deduction tax consequences (paragraphs 7.11 to 7.13). In addition, specific rules exist in the legislation to require lessees, rather than lessors, to claim the capital allowances on the leased assets in certain situations (the “deemed sale rule”). As the IRAS has proposed these to remain unchanged (as previously stated), administrative changes to legislation will be required to make references to the lease on the ROU asset rather than a finance or operating lease which are concepts no longer relevant to a lessee.

An important point remains. IRAS continues to take the view that there will be interest withholding tax obligations on their payments for ROU assets which are treated as sale transactions. Given that many transactions, especially cross-border ones, will be impacted by this interpretation, it is suggested that the IRAS should provide clear guidance on common scenarios and perhaps introduce legislation for Parliament provide certainty to taxpayers in their business planning.

Transitional Issues

Lessors with existing leases classified as operating leases under the current FRS 17 could reclassify some of these as finance leases when FRS 116 comes into effect. This may happen in back-to-back transactions. Both the lessor's and lessee's financial results and balance sheet numbers may be impacted by the new accounting standards. For lessors, the IRAS has proposed the position that no further tax adjustment is needed.

It is pertinent to note that under current practice, whether a lease is treated as a finance lease or operating lease for tax purposes is heavily influenced by the accounting classification. A sub-lessor may have previously accounted for a lease as an operating lease and brought to tax the lease payments with capital allowance claims on the cost of the asset. These capital allowances claims could be lost when FRS 116 takes effect, if the lease changes accounting treatment to that of a finance lease and qualifies as a tax sale. This differential tax treatment as a result of the accounting change may not have been factored by the sub-lessor in its business plans. The IRAS should consider allowing a transitional measure for these sub-lessors to retain the existing tax treatment for their existing leases at the point of application of FRS 116 so that businesses are not inadvertently affected.

Policy Considerations

The impending adoption of FRS 116 is just one in a slew of recent accounting standards revisions that could have consequential impact on the tax treatment of businesses. It brings to fore the age old question of “Should tax treatment follow accounting?” On the one hand, accounting treatment or records have been held as useful but not definitive guidance to ascertain the amount of taxable profits. On the other hand, financial statements based on accounting principles form the starting point of tax calculations so to require taxpayers to use different methodologies to determine taxable profits will add to the compliance burden.

Given that tax policy and accounting standards are developed with different objectives in mind, tax policy makers will continue to have to grapple with striking a balance between aligning to principles and making compliance easier for taxpayers. There will always be a chorus of voices to “just follow accounting”. To its credit, the IRAS has been proactive in understanding the accounting changes under FRS 116 and devising the corresponding tax treatments since the standard was finalized a year ago. It is important now to be able to communicate tax policy considerations clearly and discuss the feedback from industries on the proposed tax changes in order to minimizing unintended impact on taxpayers.

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Tan Tay Lek is a Corporate Tax Partner at PwC Singapore

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