by Ali Muraad

Background

Historically, users of IFRS have accounted for leases under IAS 17- Leases (“IAS 17”), which classified leases as either ‘finance leases’ or ‘operating leases’. Under IAS 17, leases which transfer substantially all the risks and rewards incidental to ownership of an asset to the lessee used to be considered as finance leases, while all other leases were considered as operating leases. IAS 17 required lease classification by both lessor and lessee to determine the appropriate accounting treatment.

With effect from annual reporting periods beginning on or after 1 January 2019, IAS 17 was replaced by IFRS 16 – Leases (“IFRS 16”). One of the main differences between IAS 17 and IFRS 16 is that the latter introduced a single lessee accounting model, removing the distinction between finance leases and operating leases for lessees. That is, IFRS 16 required lessees to bring all their leases, except for short term leases or low value assets, on the balance sheet. In consequence, for the accounting periods starting on or after 1 January 2019, IFRS 16 requires businesses to capitalise the assets that used to be held under operating leases classified in accordance with IAS 17. This had the effect of bringing a right-of-use (“RoU”) asset and a lease liability on the balance sheet. Lessors will continue to classify leases as either finance leases or operating leases, similar to IAS 17.

Of course, many businesses in the Maldives follow IFRS for SMEs and the introduction of IFRS 16 did not have any impact on them. The IFRS for SMEs standard is designed for small and medium-sized entities and retains principles similar to IAS 17 for lease classification, i.e., it distinguishes between finance leases and operating leases, with lessees being only required to recognise finance leases on their balance sheet. Again, unlike IFRS 16, IFRS for SMEs does not introduce exemptions for short term leases or low value assets.

Prevailing income tax rules

Similar to IAS 17 and IFRS for SMEs, the Income Tax Act ¹ (“ITA”) retains the “risks and rewards” approach and determines the applicable tax treatment based on the lease classification. As such, taxpayers are required to classify their leases as “tax finance leases” or “tax operating leases” based on the classification criteria prescribed in ITA, in spite of the accounting standard they have adopted. Pursuant to section 79(dd) of the ITA, “tax finance lease” refers to any lease under which all the risks and rewards incidental to ownership of an asset is substantially transferred to the lessee. Any lease that is not within the definition of tax finance lease is considered as a tax operating lease.

Under the ITA, tax finance leases are considered as financing arrangements and hence, for income tax purposes, the owner of an asset acquired through a tax finance lease is considered to be the lessee instead of the lessor. In this regard, below are the two main tax adjustments that the lessees are required to keep in mind with respect to tax finance leases.

1. Application of interest limitation rules (6% cap and thin-cap) prescribed in the ITA with respect to interest on lease liabilities; and
2. Claim capital allowance with respect to RoU assets obtained rather than claiming a general deduction as it would impact thin-cap calculations set out in the tax return.

For tax operating leases, taxpayers can deduct the lease expenses in accordance with the accounting standard they have adopted.

Again, regardless of the accounting standard adopted (whether full IFRS or IFRS for SMEs), taxpayers are required to classify their leases as “tax finance leases” or “tax operating leases”. Interestingly, unlike IFRS 16, no lease recognition exemptions are given for leases with a term of less than 12 months or leases for which the underlying asset is a low value asset. Once this classification is made, ITA requires you to consider the tax finance lease as a “finance arrangement” subject to interest limitation rules under the ITA, and tax operating lease to be claimed as an expense in accordance with the adopted accounting standard. With respect to tax operating leases, taxpayers adopting IFRS 16 will therefore deduct RoU amortization and interest on lease liability without any tax adjustments, while those adopting IFRS for SMEs will generally claim the lease expense on a straight line basis as required by the standard.

Mismatch between tax treatment and IFRS 16 treatment

As mentioned earlier, although IFRS 16 introduces a single lessee accounting model, lessees must still assess the nature of leases for income tax purposes. This creates an additional burden for lessees, as determining the classification of underlying leases is not a requirement under the accounting rules in IFRS 16.

The absence of specific guidance on lease classification for tax purposes has led both taxpayers and the Maldives Inland Revenue Authority (“MIRA”) to rely on various sources and accounting standards. For instance, in some of the past audits, MIRA has referred to examples from paragraphs 63 and 64 of IFRS 16, which pertains to lessor accounting. In contrast, taxpayers have often adhered to the guidance provided in IAS 17 as it specifically provides guidance on lease classification for lessees.

While the lease classification principles in IFRS 16 (for lessors) and IAS 17 both follow the “risk and rewards” approach, they differ significantly in certain areas. One notable example is the classification of subleases, where contradictions arise between the two standards.

The sublease dilemma

Prior to the adoption of IFRS 16, subleases were classified under IAS 17 with reference to the underlying asset rather than the RoU asset. Thus, under IAS 17, where the head lease is an operating lease, the sublease must always be classified as an operating lease. As a result, a significant proportion of subleases were classified as operating leases under IAS 17, including resort island subleases where the island is subleased for a major part of the remaining headlease period. Moreover, back then, this IAS 17 classification was generally adopted to determine the necessary tax adjustments.

As explained above, with the adoption of IFRS 16, lessees are no longer required to classify leases as either a finance lease or an operating lease. However, IFRS 16 introduced a new requirement for sublessors, mandating that they reassess the classification of subleases with reference to the RoU asset created by the head lease rather than the underlying asset. This change has led to many subleases previously categorized as operating leases being reclassified as finance leases in the accounts of the sublessors. In this regard, with respect to the operating leases being reclassified as finance leases under IFRS 16, sublessors had to derecognise the existing RoU assets in their balance sheets and recognise a lease receivable equal to the net investment in the sublease. Nonetheless, in light of this change in accounting rules, neither the ITA nor the Income Tax Regulation² (“ITR”) offers any guidance on determining the classification of subleases in relation to the RoU asset.

While this change has no bearing on the accounting treatment adopted by sublessees and while there is no explicit guidance in the ITA or ITR on this issue, MIRA seems to be leaning towards the IFRS 16 approach – that is, considering the RoU asset rather than the underlying asset to determine lease classifications of sublessees for tax purposes³ . This interpretation has caused subleases, previously treated as tax operating leases under IAS 17 and IFRS for SMEs, to be reclassified as tax finance leases. This reclassification carries significant tax consequences, in the form of restrictions on deductible interest, since interest on lease liabilities under finance leases is capped at 6% and subject to thin-capitalisation rules.

Conclusion

Although we are yet to see how this matter is deliberated in the Tax Appeal Tribunal and Courts, there is insufficient legal basis to apply the distinction between the RoU asset and the underlying asset as outlined in IFRS 16 for tax purposes. Instead, the principles in IAS 17 and IFRS for SMEs standard should take precedence when interpreting the term “an asset” stipulated in section 79(dd) of the ITA.

The reason for the above conclusion is that while the ITA was enacted after IFRS 16 came into effect, it adopted the approach in IAS 17, which is also the approach adopted in IFRS for SME’s standard, in the classification of leases for tax purposes. The likely rationale is that IFRS 16 does not require such classifications from the perspective of the lessee. Furthermore, had the ITA intended to align with the IFRS 16 approach, it would presumably have included exemptions for low-value assets and short term leases, as stipulated under IFRS 16.

Unlike IFRS 16, IAS 17 mandates this determination based on whether the arrangement transfers the risks and rewards incidental to ownership of the underlying asset. Consequently, the approach aligns more closely with the lease classification requirements outlined in the ITA.