Tax Treatment of Leases Under IFRS 16 - South Africa

Introduction

Understanding the tax consequences of different lease types is crucial for both lessees and lessors. The way a lease is structured — whether as an Instalment Credit Agreement (ICA) or a standard rental agreement — can have a significant impact on the tax treatment, both from the perspective of VAT and income tax.

This article will provide a breakdown of the key tax implications associated with ICAs versus normal rental agreements. We will also discuss the specific VAT treatment for both types of leases and explore the various accounting and tax positions.

Types of Leases: ICA vs Normal Rental Agreement

Instalment Credit Agreements (ICAs)

An Instalment Credit Agreement (ICA) refers to any agreement under which goods are supplied with the payment being made in instalments, and the total payable exceeds the cash value of the supply. The full definition can be found in section 1 of the Value-Added Tax Act. VAT for an ICA is levied upfront, on the earlier of any payment, or delivery of the asset to the lessee, rather than being levied on each payment.

There are two types of ICAs:

• Sale ICA (ISA): The lease is treated similar to a sale, with the lessor providing financing (a loan) to the lessee. Ownership of the leased asset effectively transfers to the lessee for tax purposes. The lease payments are treated as capital repayments of the financing provided by the lessor.
• Lease ICA: Ownership remains with the lessor, but lease payments are treated as income for tax purposes. The lessor may claim allowances on the asset, subject to the relevant sections.

Normal Rental Agreement

For normal rental agreements, VAT is levied per payment. There is no transfer of ownership, and the lease payments are considered deductible for the lessee.

Current Tax Implications for Lessees and Lessors

The distinction between a Sale ICA, Lease ICA, and a normal rental agreement has important tax consequences for both lessees and lessors. If the lessor is a VAT vendor, they become liable for the full VAT amount on the lease on the earliest of the first payment, or transfer of the asset to the lessee. If the lessee is also a VAT vendor, the lessee can claim this amount as input VAT, given that the leased asset will be used to produce taxable supplies. The lessor will take VAT into account when structuring payments and will recover the VAT from the lessee over the lease term. Sale ICAs, also referred to as Instalment Sales Agreements, are unique in that they also affect the income tax treatment of the lease.

Lessee Tax Treatment

• Sale ICA (ISA): The lessee is eligible to claim wear and tear (W&T) and capital allowance deductions, as well as finance costs. Lease payments are considered capital repayments rather than income in nature.
• Lease ICA: Lease payments are income in nature and could qualify for deduction, given it complies with section 11(a). The lessee cannot claim W&T or capital allowances.
• Normal Rental Agreement: Same as Lease ICA, however, VAT is levied on each payment instead of upfront.

Lessor Tax Treatment

• Sale ICA (ISA): Finance income will be included in the lessor's gross income for tax. They may lose the ability to claim allowances on the asset as ownership has effectively transferred to the lessee from a tax point of view. Lease payments themselves, are not taxable.
• Lease ICA or Normal Rental Agreement: The lessor retains ownership, meaning they can continue to claim wear and tear and capital allowances on the asset. Lease payments are taxable and included in the lessor's gross income.

Deferred Tax Consequences for Lessees

ISA

The right-of-use asset could have a tax base as the lessee is eligible to deduct wear and tear.
Since lease payments are not deductible, the tax base of the lease liability will be the same as the carrying value (IAS 12).

Lease ICA

• ROU-Asset tax base is zero (lessee cannot claim allowances).
• Liability tax base =
  • Carrying amount less amount deductible in future, or
  • Amount not deductible in future
• Amount not deductible in future, in determining the tax base of the lease liability:
  • VAT attributable to future payments. If the lessee can claim input VAT, SARS will not allow a double tax-benefit.
    • This amount is calculated with the following formula:
      [Upfront VAT * remaining lease payments/ total lease payments]
  • Sometimes, a portion of a future lease payment has already been claimed as a tax deduction. This amount is also not deductible in the future.

Normal Rental Agreement

• ROU-Asset tax base = 0 (no capital allowances).
• Liability tax base =
  • Carrying amount less amount deductible in future, or
  • Amount not deductible in future
• Amount not deductible in future:
  • Portion of future payment already deducted (if any).
• Take note:
  • As VAT does not form part of the lease liability in a non-ICA rental agreement (payments used in calculations were VAT exclusive), the portion not deductible in respect of VAT is 0.
  • However, remember that the payment itself will have VAT consequences when invoiced.

Deferred Tax Consequences for Lessors

Finance Leases

• Net investment in the lease (lease receivable) tax base = Amount Deductible in future = Amount not taxable in future.
  • Part of next payment already taxed (accrue day-to-day).
  • ICA (Non-ISA): VAT attributable to future payments (already taxed for VAT).
• Leased asset doesn’t have a carrying amount (derecognised), but can have a tax base if the lessor is still eligible for future wear and tear deductions or capital allowances (therefore not applicable if the lease is an ISA).

Operating Leases

• If there is income in arrears (asset) caused by the straight-lined lease income differing from the lease payments, the tax base of the income in arrears equals the amount deductible/non-taxable in the future.
• Since everything receivable in the future will generally be taxable in the future, the income in arrears has a tax base of zero.

Conclusion

It is essential to understand the different tax consequences of Sale ICAs, Lease ICAs, and normal rental agreements, as they affect lessees and lessors in terms of taxable income, VAT treatment, and deferred taxes. Leases generally fall in three categories, as described above, which impact the taxation treament.

For more information or specific queries, please contact us at insight@leash.co.za.