Finance Lease & its impact on Income Tax

Introduction

With Ind AS 116 replacing the erstwhile Ind AS 17, differentiation between operating lease and finance lease is eliminated in the books of lessee. Contrary to the previous standard, Ind AS 116 mandates the lessee to recognize a Right-of-Use (RoU) Asset and a corresponding Lease Liability while entering most of the lease transactions. This change has implications on both Financial Reporting and Taxation.

Before analyzing the impact of lease accounting in Income Tax, let us briefly understand the accounting treatments in the books of lessee and lessor.

Accounting treatment in the books of lessee and lessor

In Lessee’s books

As Ind AS 116 introduces a single accounting model for lessees, the following key principles need to be followed while recognizing a lease transaction:

• At commencement of a lease, the lessee recognizes a lease liability measured at the present value of future lease payments; and a corresponding RoU Asset.
• Lease liability is subsequently measured at Amortized cost using the Effective Interest method, provided under Ind AS 32 & 109. The finance cost so derived is taken to Profit & Loss account as an expense.
• ROU Asset is depreciated over the lease term or useful life of the asset, whichever is shorter. Depreciation so computed is charged to Profit & Loss account.

Recognition of both ROU Asset and Lease Liability increase the assets and liabilities of lessee’s Balance Sheet, thereby impacting financial ratios. Further, the interest expense and depreciation contribute towards higher expenses in the initial years when compared to straight-line expenditure under the earlier operating lease accounting.

In Lessor’s books

Unlike the accounting in lessee’s books, Ind AS 116 differentiates between operating and finance leases in the books of lessor. In brief, lessor classifies a lease as a finance lease if substantially all the risks and rewards incidental to ownership are transferred to the lessee. In all other cases, lessor classifies a lease as an operating lease.

Operating Lease

• The lessor continues to recognize the leased assets in his books; and depreciation on such assets is charged in accordance with depreciation policy of the lessor.
• Lease income is recognized on a straight-line basis over the lease term, unless another systematic basis more appropriately represents the benefits derived from the leased assets.

Finance Lease

• Unlike operating lease, the lessor in finance lease de-recognizes the leased asset and recognizes a lease receivable in his books. The lease receivable is measured at the Net Investment in the lease.
• The lessor recognizes the lease income over the lease term using the Effective Interest method, based on the appropriate pattern reflecting a constant rate of return on the lessor’s net investment in the lease.

Impact of Finance Lease on Income Tax

Ind AS 116 requires the lessee to recognize an RoU Asset and a corresponding Lease Liability, leading to incurring depreciation and finance cost expenses. However, Income Tax Act, 1961, does not recognize RoU Asset separately, and charge of tax continues to be based on the legal ownership.

Ind AS 116 creates a legal fiction of ownership in favor of lessee only for the purpose of books of accounts, and not for the purpose of law in general. As per provisions of Section 32 of the Income Tax Act, 1961, the owner of the asset is entitled to depreciation if the same is used in the business. Even though the lessee charges depreciation in his books, the legal ownership is still with the lessor, and hence, the lessor is allowed to claim depreciation on such leased asset under Section 32 of Income Tax Act, 1961.

The debate of determination of ownership under finance lease was put to rest by the Hon’ble Supreme Court in the case of ICDS Ltd. Vs CIT [2013] wherein the Hon’ble Apex Court has ruled that depreciation can only be claimed by the legal owner of the asset, re-affirming the principle that the lessor is eligible for claiming depreciation. Incidentally, depreciation is disallowed in the hands of lessee, in the computation of income.

Interest expenses are generally deductible under Section 36(1)(iii) of the Income Tax Act, 1961 if they pertain to borrowed capital. However, in the case of lease liabilities, the finance cost so arising is out of an accounting treatment and not through a conventional borrowing. Hence, the finance cost component arising out of the lease agreement shall not be allowed as a deduction while computing the income, which is in line with the Hon’ble Supreme Court’s judgement in the case of CIT Vs Gujarat Lease Financing Ltd. (2010).

However, the periodical lease payments made to the lessor shall be allowed as a deduction while computing the income of the lessee, based on the terms and nature of the lease agreement.

On the other hand, in the case of lessor, the lease income received over the lease term is taxable under the head “Profits and Gains of Business or Profession, based on accrual accounting system. In the case of Cosmo Films Ltd. Vs CIT (2011), the Delhi High Court has re-affirmed that the rental lease income should be treated as business income, and the lessor is entitled to depreciation on the leased assets.

Due to unique treatments of Finance Lease as per Ind AS 116 and Income Tax, deferred tax implications also arise. Lessee records depreciation and finance cost as per Ind AS 116 which front-loads expenses in the Profit & Loss account, while tax deductions are based on the lease payments made, leading to deductible temporary differences requiring recognition of Deferred Tax Asset (DTA) in the initial years.

Conclusion

In summary, introduction of Ind AS 116 has opened new doors in the lease accounting with emphasis on RoU Asset & Lease Liability. However, taxation under Income Tax Act, 1961 continues to be based on legal ownership rather than the right-of-use concept.

The lessor continues to be eligible for claim on depreciation, while the lessee is allowed the lease payments as a deduction. With all the complexity and timing differences leading to deferred taxes, businesses should ensure accurate compliances with both the financial reporting standards as well as the taxation provisions.