The Corporate Interest Restriction (“CIR”) rules, which came into force on 1 April 2017, limit the net financing costs which a group can deduct against its UK taxable income. The rules apply to interest and amounts economically equivalent to interest, which are referred to as “tax-interest” in the legislation. Tax-interest includes the financing costs of finance leases.
The operation of the CIR rules are in part dependent on the distinction made between finance leases and operating leases in the current lease accounting standards. However, the International Accounting Standards Board’s new international accounting standard on leases, IFRS 16 Leases (“IFRS 16”), which comes into force in respect of periods of account beginning on or after 1 January 2019, will eliminate this dichotomy in respect of lessees (while leaving lessor accounting largely unchanged).
HM Revenue & Customs (“HMRC”) has confirmed its intention to repeal section 53 Finance Act 2011, which currently applies to negate any change in a leasing accounting standard for tax purposes, in the next Finance Bill. Consequently, the CIR rules will now need to be amended to accommodate the changes being introduced by IFRS 16.
Following a consultation in respect of three options for amending the CIR rules, HMRC has decided to retain the distinction between operating and finance leases for CIR purposes (i.e. Option 2), but with some modifications.
Under the modified Option 2 approach, lessees applying IFRS 16 will need to continue to classify leases using the finance and operating lease dichotomy for tax purposes, notwithstanding that this distinction will no longer be required for accounting purposes. Lessees will be required to use a classification test that is equivalent to the one used by lessors under IFRS 16.
In respect of ‘finance leases’, tax-interest would include amounts which a lessee recognises as a finance charge in relation to a leased asset. In respect of ‘operating leases’, lease payments would not need to be included in the lessee’s tax-interest calculation.
The modified Option 2 approach will not require lessees to enquire into how the corresponding lessor classifies the same lease, which is an improvement to the original Option 2 proposals. Nonetheless, requiring lessees to continue to classify leases using the existing finance and operating lease dichotomy for tax purposes when this will no longer be required for accounting purposes does add to the tax compliance burden of companies.