Understanding the Tax Impact of IFRS 16 Leases

Understanding the Tax Impact of IFRS 16 Leases in the UAE

The introduction of IFRS 16 *Leases* was a seismic shift in accounting, fundamentally changing how businesses report their lease obligations. By bringing virtually all leases onto the balance sheet, the standard aimed to provide greater transparency into a company’s financial commitments. However, this major accounting overhaul has created one of the most significant and widespread complexities for businesses now navigating the UAE’s Corporate Tax regime: the accounting treatment for leases is not the same as the tax treatment. This divergence is not a minor technicality; it is a critical area that impacts a company’s taxable income, requires careful reconciliation, and has strategic implications for financing and investment decisions.

Many businesses mistakenly assume that the expenses recognized in their IFRS-compliant financial statements can be used directly for their tax return. For leases, this assumption is incorrect. The UAE Corporate Tax law focuses on the actual economic substance of the transaction—the rental payments made. This creates a “book-to-tax” difference that must be calculated and adjusted for in every tax filing period. Failure to manage this difference correctly can lead to inaccurate tax calculations, potential disputes with the Federal Tax Authority (FTA), and significant penalties. This guide provides a definitive overview of the tax impact of IFRS 16 for both lessees and lessors, outlining the necessary adjustments and strategic considerations.

Section 1: The Lessee’s World Under IFRS 16 – A Quick Recap

To understand the tax impact, we must first recall what IFRS 16 changed for lessees (the company leasing an asset).

From Off-Balance Sheet to On-Balance Sheet

Under the old standard (IAS 17), operating leases (like office rent) were simple. A company paid rent, and that rent was recorded as an operating expense on the income statement. The lease did not appear on the balance sheet.

IFRS 16 eliminated this distinction for lessees. Now, for almost all leases longer than 12 months, the lessee must:

1. Recognize a Right-of-Use (ROU) Asset: This represents the lessee’s right to use the underlying asset for the lease term.
2. Recognize a Lease Liability: This represents the obligation to make future lease payments.

The Impact on the Income Statement

The single, straight-line “rent expense” is replaced by two separate, non-linear expenses:

• Depreciation Expense: The ROU asset is depreciated, typically on a straight-line basis over the lease term.
• Interest Expense: An interest expense is recognized on the lease liability. This is calculated using the effective interest method, meaning the expense is higher in the early years of the lease and declines over time as the liability is paid down.

The result is that the total lease-related expense on the income statement is “front-loaded”—higher at the beginning of the lease and lower at the end.

Section 2: The Corporate Tax Treatment for Lessees – The Critical Divergence

While IFRS 16 dictates the accounting, the UAE Corporate Tax law has its own perspective. The guiding principle for tax deductions is that expenses must be incurred “wholly and exclusively” for the purposes of the business. For a standard operating lease, the law looks at the actual rental payments as the true business expense incurred.

What IS Deductible for Tax?

For a lessee, the amount that can be deducted when calculating taxable income is the lease rental expense paid or payable for the relevant tax period. This is the straightforward, straight-line rent amount as stipulated in the lease agreement.

What is NOT Deductible for Tax?

The two expenses created by IFRS 16 are disregarded for tax purposes:

• The depreciation charge on the Right-of-Use asset.
• The interest expense on the lease liability.

This is the most critical point to understand. Your accounting profit includes deductions for IFRS 16 depreciation and interest. Your taxable profit must be calculated using the actual rent payments. You must perform a reconciliation between the two. A specialized Corporate Tax advisor is essential to manage this correctly.

Section 3: The Book-to-Tax Reconciliation in Practice

This divergence creates what is known as a “temporary difference” or “timing difference.” The total expense recognized over the entire life of the lease is the same for both book and tax purposes, but the timing of when that expense is recognized is different.

Illustrative Example

Imagine a 5-year office lease with an annual rental payment of AED 100,000. Let’s look at the difference in the first and last year.

The Reconciliation Process

To calculate your taxable income, your finance team must perform the following adjustment:

1. Start with Accounting Profit: Take the net profit figure from your IFRS-compliant income statement.
2. Add Back IFRS 16 Expenses: Add back the total IFRS 16 lease expense (depreciation + interest) that was deducted to arrive at the accounting profit. In Year 1 of our example, you would add back AED 110,000.
3. Deduct Actual Lease Payments: Subtract the actual lease rental payments made during the period. In Year 1, you would deduct AED 100,000.

In Year 1, your taxable income will be AED 10,000 higher than your accounting profit. In Year 5, your taxable income will be AED 6,000 lower. This process requires meticulous account reconciliation services.

Section 4: The Lessor’s Perspective – A Closer Alignment

For lessors (the company leasing out an asset), the situation is generally less complex as the tax treatment tends to follow the accounting treatment more closely.

Operating Leases

• Accounting & Tax: The lessor keeps the asset on its balance sheet and depreciates it. The rental income received is recognized as revenue. The tax treatment mirrors this: the rental income is taxable revenue, and the depreciation on the asset is a deductible expense.

Finance Leases

• Accounting & Tax: The lessor derecognizes the leased asset and recognizes a lease receivable. The income is recognized over the lease term as finance income. The tax treatment again follows suit, with the finance income being subject to Corporate Tax.

The main takeaway for lessors is that their existing financial reporting under IFRS 16 is a much more reliable starting point for tax calculations than it is for lessees.

Section 5: The Systems and Data Imperative

Managing the book-to-tax differences for leases is a significant data challenge. Your standard accounting reports will not provide the figures you need for your tax return. You need a system that can track both sets of numbers in parallel.

This is where a modern, adaptable accounting platform is essential. A system like Zoho Books can be configured to manage this complexity. While it handles your core IFRS-compliant bookkeeping, you can use its features to tag and schedule actual lease payments separately. This creates a clear, auditable data trail that allows your tax advisors to efficiently perform the necessary year-end tax reconciliations without having to manually dig through contracts and bank statements.