The Philippine Financial Reporting Standard (PFRS) 16 on Leases became effective on 1 January. The new standard requires lessees to recognize all leases on their balance sheet except for relatively small-value assets and leases with terms of 12 months or less.
The lessee is required to recognize a right-to-use asset and a lease liability, measured at the discounted value of the future lease payments in the balance sheet. A depreciation expense of the right-to-use asset and the interest charged on the outstanding lease liability are then recognized in the Income Statement. Any lease payment is treated as a reduction from the lease liability.
Moreover, this single accounting model no longer distinguishes a finance lease from an operating lease unlike the old Philippine Accounting Standard (PAS) 17.
From a lessee’s perspective, see the table below for the comparison of the two standards.
|Finance Leases||Operating Leases|
|Off-balance sheet obligations||-||-|
For tax purposes, however, the rules remain unchanged. Under Revenue Regulations (RR) No. 19-86, a lease arrangement may be treated as either an operating lease, a finance lease or a conditional sale, depending on the substance of the transaction. The RR sets out the rules to govern the tax treatment of lease agreements and provides guidelines for determining whether transactions purporting to be leases are in reality conditional sales contracts.
Section 2.02/1 of the RR defines an operating lease as “a contract under which the asset is not wholly amortized during the primary period of the lease, and where the lessor does not rely solely on the rentals during the primary period for his profits, but looks for the recovery of the balance of his costs and for the rest of his profits from the sale or re-lease of the returned asset of the [sic] primary lease period.”
For income tax purposes, the lessee may deduct the amount of rent paid or accrued from gross income, including all expenses under the lease agreement which the lessee is required to pay to or for the account of the lessor.
The depreciation expense for the right-to-use asset and the interest expense that are recognized under PFRS 16 are not deductible expenses for income tax purposes. After all, from the initial recognition of the asset or liability, the transaction affects neither accounting profit nor taxable profit. Thus, as has been the longstanding tax treatment, only the periodic lease payments are treated as deductible expenses given that the substance of the transaction does not change but only the accounting disclosure.
For Value-Added Tax (VAT) purposes, the monthly payments to the lessor are reported monthly since this is subject to VAT upon payment, and not at the inception of the lease. For withholding tax purposes, the transaction remains a lease, which is subject to a 5% withholding tax.
Section 2.02/2 of the RR defines a finance lease or full payout lease as “a contract involving payment over an obligatory period (also called primary or basic period) of specified rental amounts for the use of a lessor’s property, sufficient in total to amortize the capital outlay of the lessor and to provide for the lessor’s borrowing costs and profits.” The obligatory period refers to the primary or basic non-cancellable period of the lease, which in no case shall be less than 730 days (or two years).
In a finance lease, the lessee (not the lessor) chooses the asset and is normally responsible for the maintenance, insurance, and other expenses related to the use, preservation, and operation of the asset. Finance leases may be extended after the expiration of the primary period by non-cancellable secondary or subsequent periods with the rentals significantly reduced. The residual value of the leased asset shall in no instance be less than 5% of the lessor’s acquisition cost.
For income tax, VAT, and withholding tax purposes, an agreement that constitutes a finance lease remains a lease and shall be taxed like an operating lease. Consequently, the lessee may deduct the amount of rent paid or accrued from gross income when filing income tax returns. This tax treatment remains true even with the implementation of PFRS 16.
Under Section 4.03/2 of RR 19-86, a contract or agreement purported to be a lease shall be treated as a conditional sales contract if one or more of the following compelling persuasive factors are present: (1) there is an option to purchase the asset at any time; (2) the lessee acquires automatic ownership of the asset payment of the rentals under the contract; (3) portions of the periodic rental payments are credited to the purchase price; and (4) the receipts of payments indicate that partial payments of the assets were made.
In addition, even in the absence of compelling persuasive factors, the RR states that the lease agreement may still be viewed as a conditional sale if, for example, one or more of the following conditions are present: (1) portions of the periodic payments are made specifically applicable to an equity to be acquired by the lessee; and (2) the property may be acquired under a purchase option, at a price which is nominal in relation to the value of the property at the time when the option may be exercised, as determined at the time of entering into the original agreement, or which is a relatively small amount when compared with the total payments which are required to be made.
If the lease is treated as a conditional sale, the amounts paid by the lessee will be considered payments for the purchase price of the leased asset, to the extent that such amounts do not represent interest or other charges. The lessee can therefore claim a depreciation expense on the leased asset. For VAT purposes, since the transaction is, in substance, a purchase of goods rather than a purchase of service, payment of the entire VAT amount is due outright, at the start of the transaction. Similarly, for withholding tax purposes, since the transaction is considered a purchase of goods, the lessee is only required to withhold 1% on the transaction if it has been classified by the BIR as a top withholding agent. This tax treatment remains valid to date.
With the adoption of a new accounting standard for leases, taxpayers must adjust their recording processes to comply with the new directives. As the adage goes, out with the old and in with the new. On one end, this entails the challenge of reviewing existing lease agreements, and understanding the impact of the new standards on the business. But on the bright side, when we blow away the cobwebs to clear the air, the new standards may be an opportunity for accounting to bring up to date its documentation and install more efficient programs to support its operations.
The views or opinions expressed in this article are solely those of the author and do not necessarily represent those of Isla Lipana & Co. The content is for general information purposes only, and should not be used as a substitute for specific advice.
Anthony C. Tampoco
Tax Services - Client Accounting Services Manager, PwC Philippines
Tel: +63 (2) 88452728 ext. 3400