BLM11230 - Lease accounting: lease classification: practical issues with borderline issues

This manual is being updated to reflect FRS 102 (2024 amendments). For guidance on the tax treatment of accounts prepared under IFRS 16 or the revised FRS 102, please refer to pages within the BLM50000 chapter.

 This section is applicable to entities applying FRS 102 pre 2024 amendments or FRS 105, and for lessors only under IFRS 16 and FRS 102 (2024 amendments). 

See BLM17000 for lessee accounting under the on-balance sheet model under IFRS 16 and FRS 102 (2024 amendments). 

 Lease classification involves an element of judgement. For example: 

  • What is the fair value of the asset? Valuers could have different views. 

  • What is the present value of the minimum lease payments? Calculating that sum could involve estimating future interest rates and also any residual value of the asset which the lessor could keep. 

There is a fair amount of scope for taking a pessimistic or optimistic view of a range of possible numbers. 

It follows that the sometimes ambiguous line between finance leases and operating leases is open to issues ranging from error to potential exploitation to secure the advantages of ‘off balance sheet’ finance for the lessee. Furthermore, even without exploitation, as financing arrangements grow more sophisticated it becomes increasingly difficult to decide whether a lease is a finance lease or an operating lease. 

It is also important to remember that the application of many anti-avoidance rules depends on whether the lease is accounted for as a finance lease. There can, therefore, be a tax incentive to ensure that a lease is structured so that it may be properly accounted for in a particular way – either as a finance lease, or as an operating lease, depending on what is required. 

Because there is an element of judgement in applying GAAP  it is possible for a lessor and lessee to reach opposite conclusions as to what type of lease they have. Furthermore, the facts used by each party to the lease in establishing what type of lease they have may differ, for example, the use of guarantees.  The lessor could regard the deal as a finance lease while the lessee could treat it as an operating lease. 

If the only issue is the timing of deduction (or taxation) of rentals, it is very unlikely to be cost-effective to spend time exploring whether an agreement satisfies the accounting definition of a finance lease or is an operating lease. In either case the tax treatment is to allocate rentals to periods of account in accordance with GAAP and the timing differences that may arise from the way a lease is classified are likely to be small. 

There are, however, some exceptions to this general rule and the basis on which receipts and deductions are recognised for accountancy purposes could be very different. 

In addition, and generally more significantly, whether a lease should be classified as a finance lease under GAAP may affect: 

  • whether the lease is a long funding lease or not (BLM20000) 

  • the application of anti-avoidance legislation, much of which applies only to finance leases (for example the sale and finance leaseback and lease and finance leaseback provisions in Chapter 17 of CAA 2001, see CA28000 and CA28900 onwards) 

  • Remember that the classification of leases for lessor and lessee may diverge for good reasons. But if you have had cause to investigate a borderline lease, you should consider sharing the information you have obtained about the lease with the case owner dealing with the other party to the lease 

In practice the amount of lease rentals is the most commonly considered indicator for lease classification, but it is not conclusive. Other aspects of the lease terms may provide clues as to the classification of the lease, and the following are indicators that the lease may be a finance lease. This should be read in conjunction with BLM11200 which provides a list of indicators as per accounting standards. 

  • where the agreement refers to implied rates of interest; 

  • where rentals vary with changes in the lessor’s tax treatment, for example the rate of corporation tax or capital allowances on the leased asset; 

  • where the lessee is responsible for maintenance and servicing of the leased asset; 

  • where the agreement provides for the lessee to receive the benefit of any residual value of the asset 

Any queries regarding lease classification should be referred to an Advisory Accountant.