Deferred Tax on Leases Under IFRS 16 - IAS 12 Tax Bases

Deferred Tax on Leases

Leases, like many transactions, give rise to deferred tax consequences when the tax treatment of the contract differs from the accounting treatment. Under IFRS 16 a lessee recognises an asset and a liability for almost every lease, while tax authorities in most jurisdictions allow a deduction for the lease payment itself.

A lease produces two temporary differences, because IFRS 16 recognises two items for a single contract. The right-of-use asset is carried at an amount that may have no equivalent at all in the tax computation, and the lease liability is carried at an amount the tax authority will relieve only as the payments are made. Each is compared with its own tax base, and deferred tax is recognised on both.

Why a Lease Creates a Temporary Difference

Consider the timing of the two sets of figures over the life of a lease.

The accounting expense is depreciation of the right-of-use asset plus finance cost on the lease liability. Depreciation is constant where the straight-line basis is used; finance cost is highest in the first period and declines as the liability is repaid. The combined charge is therefore front-loaded, even though the cash payments may be identical every year.

The tax deduction, where the payments themselves are deductible, is simply the amount paid. It is level where the payments are level.

Two consequences follow. In the early years the accounting expense exceeds the tax deduction, so taxable profit is higher than accounting profit and the entity pays tax on an amount it has not yet recognised as profit. In the later years the position reverses. Across the full term the two totals are identical, because the sum of depreciation and finance cost equals the sum of the payments. Nothing is permanently different; only the timing is, which is precisely the condition IAS 12 addresses.

Tax Bases of the Asset and the Liability

Where the tax authority allows a deduction for the lease payments and grants no allowances on the underlying asset, the tax bases are straightforward.

The right-of-use asset. Nothing is deductible against the economic benefits the asset generates, because the deduction attaches to the payments rather than to the asset. Its tax base is nil, and the whole carrying amount is a taxable temporary difference giving rise to a deferred tax liability.

The lease liability. The entire carrying amount will be deducted as the remaining payments are made. Applying the definition, the tax base is the carrying amount less the amount deductible in future, which is nil. The whole carrying amount is a deductible temporary difference giving rise to a deferred tax asset.

When Part of the Next Payment Is Already Deductible

The nil tax base on the liability holds only where none of the future payments has yet been deducted. Where the deduction accrues from day to day rather than falling due on the payment date, and the reporting date sits between two payment dates, a portion of the next payment has already been deducted in the current period. That portion will not be deductible again in future, so it increases the tax base of the liability by the same amount and reduces the deductible temporary difference.

A lease with annual payments of 74,000 on 31 March and a 31 December reporting date illustrates the point: nine months of the payment falling due the following March has already been deducted, so 55,500 of the liability is no longer deductible in future and the tax base is 55,500 rather than nil.

The Initial Recognition Exemption

IAS 12 requires deferred tax to be recognised on all temporary differences, subject to a small number of exceptions. One of them is the initial recognition exemption, which applies where an asset or liability is recognised in a transaction that is not a business combination and that affects neither accounting profit nor taxable profit at the time of the transaction. Recognising a right-of-use asset and a lease liability meets that description literally, which created a genuine difficulty: a strict reading appeared to prohibit recognition of the very deferred tax the temporary differences called for, and practice diverged as a result.

The amendment issued in May 2021, Deferred Tax related to Assets and Liabilities arising from a Single Transaction, resolved it by narrowing the exemption. It does not apply where a transaction gives rise to equal taxable and deductible temporary differences on initial recognition. Leases are the principal case, alongside decommissioning and restoration obligations, which have the same two-sided structure. The amendment is effective for annual periods beginning on or after 1 January 2023.

Why It Matters When the Net Effect Is Nil

At commencement the deferred tax asset and the deferred tax liability are equal, so the net balance is nil and the amendment appears to change nothing. Four things make the gross recognition consequential:

• The two balances do not remain equal for a single day after commencement, so a policy that recognised nothing on day one has no natural starting point for the periods that follow.
• The deferred tax asset is assessed for recoverability in its own right, which a net nil figure conceals.
• Where the offsetting conditions are not met, the asset and the liability are presented gross in the statement of financial position.
• The amounts are disclosed by category of temporary difference, so the lease position is visible in the notes whether or not it is offset on the face.

Deferred Tax Over a Four-Year Lease

An entity leases a machine for four years from 1 January 2026, paying 74,000 annually in arrears each 31 December. The rate implicit in the lease is 5 per cent. Ownership does not transfer and there is no purchase option, so the right-of-use asset is depreciated over the four-year lease term. The tax authority allows a deduction for each lease payment when it is incurred and grants no allowances on the asset. The tax rate is 25 per cent throughout.

The lease liability at commencement is the present value of four payments of 74,000 discounted at 5 per cent, which is 262,400. The right-of-use asset is recognised at the same amount and depreciated at 65,600 a year.

The Lease Liability Schedule

Temporary Differences at Each Reporting Date

Both tax bases are nil, so each temporary difference is simply the carrying amount of the item.

The net position is a deferred tax asset in every year, it peaks in 2027 rather than at the start, and it returns to nil when the lease ends. The shape follows directly from the liability declining more slowly than the asset in the early years and more quickly in the later ones.

Proving the Movement Against Profit or Loss

The same figures can be reached from the income statement, which is the more useful check because it ties the deferred tax movement to the charge it is smoothing.

The annual movements of 1,180, 419, (380) and (1,219) accumulate to the balances in the previous table, and both columns total nil. A temporary difference that does not reverse to nil over the life of the lease indicates an error in either the schedule or the tax base.

Journals and the Current Tax Computation

Taking 2026 as the illustrative year, and assuming profit before tax of 500,000 after charging the depreciation and finance cost above.

Journal Entries

Current Tax

The tax expense of 125,000 is exactly 25 per cent of the profit before tax of 500,000. This is the practical argument for the 2021 amendment in a single figure: with deferred tax recognised, the lease contributes nothing to the tax rate reconciliation. Had no deferred tax been recognised, the expense would have been the current tax of 126,180 against the same profit, an effective rate of 25.24 per cent, and the 1,180 would have had to be explained as a reconciling item in each of the four years, with the sign reversing halfway through the term.

Recognising the Deferred Tax Asset

A deferred tax liability is recognised for every taxable temporary difference within scope. A deferred tax asset is subject to a further test: it is recognised only to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised.

IAS 12 sets out how that probability is assessed. Sufficient taxable temporary differences relating to the same tax authority and the same taxable entity, and expected to reverse in the same period as the deductible difference or in periods into which a resulting tax loss could be carried back or forward, are themselves evidence that the asset will be recovered. Where they are insufficient, the entity looks to expected future taxable profits and to available tax planning opportunities.

A lease is unusually well supported on this test. The taxable temporary difference on the right-of-use asset arises from the same contract, reverses over the same term and is measured against the same tax authority, so it provides direct support for the deductible temporary difference on the lease liability. In the example above the deferred tax liability exceeds the deferred tax asset at commencement and remains within a few thousand of it throughout.

Two situations still require attention. Where the offsetting conditions are not met because the asset and the liability sit in different taxable entities or jurisdictions, the support is not available and the deferred tax asset stands on the taxable profits of its own entity. Where a deferred tax asset is not recognised in full, the unrecognised portion is not a permanent difference: the temporary difference continues to exist and is simply not provided for, which increases the tax expense and appears in the tax rate reconciliation in the year it arises. When the unrecognised amount is subsequently utilised or becomes recoverable, it reduces the reconciliation in that later year.

Short-Term and Low-Value Leases

Electing the short-term or low-value exemptions removes the right-of-use asset and the lease liability, but it does not remove deferred tax. IFRS 16 requires the payments to be recognised as an expense on a straight-line basis, or another systematic basis, over the lease term, while the tax deduction continues to follow the payments. Wherever those two patterns differ, a prepayment or an accrual sits on the statement of financial position and carries a temporary difference.

An entity leases office equipment for three years under the low-value exemption, paying 18,000, 21,000 and 24,000 in arrears. The total of 63,000 is recognised on a straight-line basis at 21,000 a year, while tax deducts each payment as made.

The accrued liability will be deducted when the escalated payments are made, so its tax base is nil and the full balance is a deductible temporary difference. The deferred tax asset of 750 is recognised in 2026, held through 2027 and released in 2028.

Where Tax Treats the Lease as a Purchase

Not every jurisdiction deducts the lease payment. Where the tax authority regards the arrangement as an acquisition of the underlying asset, typically because ownership transfers or the contract meets a statutory definition of an instalment credit sale, the lessee claims capital allowances on the asset and deducts the finance cost, and the capital element of the payments is not deductible. The deferred tax position changes completely.

The two-sided structure disappears, and with it the reason the initial recognition exemption was ever in question. What remains is an ordinary asset temporary difference of the kind that arises on any item of property, plant and equipment where tax allowances run faster or slower than accounting depreciation. The useful life used for depreciation also changes, because where ownership is expected to transfer the right-of-use asset is depreciated over the useful life of the asset rather than the lease term.

Indirect taxes can complicate the liability further. Where a recoverable amount such as input value added tax is embedded in the payments and has already been claimed, that amount is not deductible again for income tax, so it forms part of the tax base of the lease liability. Our article on the tax treatment of leases in South Africa works through that interaction under a specific regime.

Changes in the Tax Rate

Deferred tax is measured at the rates enacted or substantively enacted by the reporting date that are expected to apply when the temporary difference reverses. Two points govern the mechanics.

First, sequence the entries. Record the movements for the year at the rate that applied previously, then measure the effect of the rate change separately on the opening deferred tax balance. Applying the new rate to everything at once produces the correct closing balance but loses the split, and the tax rate reconciliation requires the rate change to be presented as its own line.

Second, check when the change was announced rather than when it takes effect. Where a rate was already substantively enacted before the previous reporting date, the previous year's deferred tax was measured at that rate, so no rate change arises in the current year even though the new rate becomes effective during it.

Where the tax effect of an item was recognised outside profit or loss, the effect of a rate change on that item follows it. A rate change on deferred tax recognised in other comprehensive income is recognised in other comprehensive income and is not a reconciling item, because it never passed through the tax expense.

Presentation, Offsetting and Disclosure

Deferred tax balances are presented as non-current. Offsetting is permitted only where the entity has a legally enforceable right to set off current tax assets against current tax liabilities and the deferred tax balances relate to income taxes levied by the same tax authority on either the same taxable entity or different taxable entities that intend to settle on a net basis. A lease held by one subsidiary and a lease held by another in a different jurisdiction do not meet that test, so their deferred tax positions are presented gross even though both arise from leases.

The note analysing the deferred tax balance is where the lease position becomes visible. Categories are presented by type of temporary difference rather than aggregated, which for a lessee typically separates the capitalised leases from those under the recognition exemptions:

Two related disclosures complete the picture. The tax rate reconciliation should carry no lease line at all once deferred tax is recognised in full, so the presence of one is a useful review signal. In the statement of cash flows the deferred tax movement is a non-cash item and never appears as a cash flow; it is reversed in the indirect method reconciliation, while tax paid is derived from the current tax liability. IFRS 16 disclosure requirements sit alongside these and are unaffected by the tax analysis.

Lessors and the Position Under ASC 842

A lessor derecognises the underlying asset in a finance lease and recognises a net investment in the lease. The tax base of that net investment depends on whether the tax authority follows the same characterisation. Where tax continues to treat the lessor as the owner, the asset remains on the tax computation and attracts allowances while the accounting records a receivable, which produces a temporary difference on both sides of the derecognition. Where tax follows the accounting, the difference is limited to the timing of finance income recognition. An operating lease lessor retains the asset and the analysis reverts to the ordinary comparison between accounting depreciation and tax allowances, with any straight-lining accrual carrying its own temporary difference.

Under US GAAP the question the 2021 amendment resolved never arose, because ASC 740 contains no equivalent to the initial recognition exemption: deferred taxes are recognised on the right-of-use asset and lease liability from the outset. The pattern of the difference also varies by lease classification. For a finance lease the expense profile mirrors IFRS 16 and the analysis in this article applies directly. For an operating lease under ASC 842 the lessee recognises a single straight-line lease cost, so where tax also deducts level payments the accounting and tax patterns are closer and the net temporary difference is correspondingly smaller, though the gross asset and liability differences remain. The broader comparison of ASC 842 and IFRS 16 sets out the classification differences that drive this.

Conclusion

Deferred tax on leases reduces to three questions asked in order. What does the tax authority actually deduct, and when? That determines the two tax bases. What are the carrying amounts of the right-of-use asset and the lease liability at the reporting date? The difference between each carrying amount and its tax base is the temporary difference. Does the resulting deferred tax asset meet the recoverability test in its own right, rather than only in aggregate with the matching liability?

The structural point worth carrying forward is that the two differences are equal only at commencement. Everything after day one is the consequence of straight-line depreciation running against an effective-interest liability, which is why the position settles into a net deferred tax asset that peaks partway through the term and unwinds to nil at the end. A balance that does not reverse to nil, or a lease line that persists in the tax rate reconciliation, points to a tax base that has been determined incorrectly rather than to a feature of the standard. Our complete guide to IFRS 16 covers the measurement of the underlying asset and liability that these tax bases are compared against.

For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.