The International Financial Reporting Standards (IFRS)— adoption of which is mandatory for businesses preparing statutory financial statements under IFRS—have undergone significant changes in the last decade.
Companies across the globe have made considerable efforts to implement revenue recognition (IFRS 15) and financial instruments (IFRS 9) standards for their 2018 reporting. The next big change is in IFRS 16 (leases standard), which is mandatory from 1 January 2019. Earlier adoption is permitted for entities under certain conditions.
Under IFRS 16, both finance as well as operating leases need to be reported on the balance sheet of lessees, with some exceptions. The balance sheet of lessees would, for the first time, show an operating lease as a ‘Right of Use’ (ROU) asset with the associated liability for future payments.
Depreciation on ROU and interest expense on the liability will be charged to the income statement instead of showing the operating lease payment as an expense. From a lessee’s perspective, this is a significant change compared to the existing standard (IAS 17). The Oman Income (the tax law) requires all taxpayers to follow IFRS when preparing their financial statements.
The also requires adjustments to the accounting profit to arrive at the taxable income, only in case of matters which are specifically addressed by the such as depreciation, remuneration to members, provisions, etc. There have been many changes to the IFRS.
Changes include interpretations occasionally issued when taxpayers have also followed the accounting treatment for tax purposes in the absence of specific provisions in the tax law, requiring them to disregard the accounting treatment specified by IFRS. As this does not require changes to the accounting profit with respect to IFRS 16, the taxable income/loss should be the same as the accounting profit.
However, there are several factors that need to be considered before reaching such a conclusion. In order to allow deductions for expenses during the tax assessment process, the tax authority usually requires documents such as agreements, invoices and proof of payment to support claims.
With respect to depreciation on ROU and interest expenses on the liability for future lease payments, the lessee will not have supporting documents to directly support a claim for expenses. They will instead have to provide a reconciliation between the expense appearing in the income statement and the underlying supporting documents evidencing the operating lease payments.
The expense claim will not agree with the legal form of the operating lease agreement and payments, however the reconciliation mentioned above will demonstrate that the claim is in agreement with the underlying documents and the substance of the arrangements. There is nevertheless a risk that the tax authority might disregard a claim as shown in the income statement and instead allow deductions only for the periodical operating lease rental payments, as is currently being done (prior to the adoption of IFRS 16).
Other challenges that will arise include the classification for ROU assets (intangible assets) and therefore the rate of tax depreciation (applying over the period of benefit or right of use) and the applicability of thin capitalisation rules with respect to the operating lease liability, if the lessor and lessee are related parties.
If the tax authority considers the form of the transaction to take precedence over its substance, it would allow deductions for lease rental payments and disregard depreciation on ROU and interest on lease liability for tax purposes. This would give rise to temporary differences. In this case, deferred tax would need to be recognised in accordance with IAS 12–Income Taxes.
Lastly, under the tax law, withholding tax (WHT) is applicable on specific categories of payments made to foreign persons. Lease payments and interest payments form part of the categories that are subject to WHT.
In case the tax authority accepts the accounting, treatment followed under IFRS 16, then the question will be whether WHT should be accounted for at the time the operating lease payments are due or on the recognition of liability associated with the ROU asset. Accrual of interest cost will also need to be considered. The latter could result in the WHT liability possibly accruing much earlier.
However, this is not appropriate as the liability created towards the ROU asset is only for the purpose of the accounting requirement under IFRS 16. The payment to the lessor is not due and it will be payable only at a later stage as per the lease agreement.
In accordance with the tax law, for the purpose of WHT, the liability should arise only when amounts become due or paid, whichever is earlier. Given the uncertainties involved, it would be important for businesses to carefully evaluate the tax implications of adopting IFRS 16 and account for taxes appropriately.