RMC No. 11-2024 — Clarifying the tax treatment of lease accounting by lessees under Philippine Financial Reporting Standard 16 in relation to Sections 34(A), 34(K), 106, 108, 179, 194 of the Tax Code, as amended, Revenue Regulations (RR) No. 19-86, as amended, and RR No. 02-98, as amended Digest | Full Text | Annex A

BUREAU OF INTERNAL REVENUE REPUBLIC OF THE PHILIPPINES DEPARTMENT OF FINANCE Quezon City BUREAU OF INTERNALREVENUE TNNTTYNT JAN 22 2024 COONC. o D

RECORDS MGT DIVISION September 12, 2023

A

REVENUE MEMORANDUM CIRCULAR NO. /- @0&4

SUBJECT: Clarifying the Tax Treatment of Lease Accounting by Lessees Under

Philippine Financial Reporting Standard 16 in Relation to Sections 34(A), 34(K), 106, 108, 179, 194 of the Tax-Code, as Amended, Revenue Regulations (RR) No. 19-86, as Amended, and RR No. 02-98, as Amended

TO: All Internal Revenue Officials, Employees and Others Concerned

Background:

various'concepts related to lease accounting, such as the Right-of-Use-Asset (ROUA), short- term leases and low-value assets, have been introduced in the Philippine business setting. "This -With the implementation of Philippine Financial Reporting Standard (PFRS) 16,

accounting by lessees under PFRS 16 in relation to Sections 34(A), 34(K), 108, 179, 194 of the Tax Code, as amended, RR No. 19-86, as amended, and RR No. 02-98, as amended. circular is being issued to provide guidelines with respect to the tax treatment of lease

PART I. OVERVIEW OF PFRS AND TAX TREATMENT

1 Particulars Depreciation of Right-of- Generally recognized as approachi General PFRS Not recognized. exemption2 Lease Not allowed as deduction. Lease Taxation Depreciation of leased asset can Conditional sale

2 Interest on lease liability use asset recognized as expense. expense. Generally Not recognized. Not allowed as deduction. Interest on lease deduction from be claimed as liability can be claimed as deduction from gross income.

3 Rent expense Generally not Recognized on a Allowed as Not recognized. gross income.

recognized. lease term. straight-line basis over the income. the gross deduction from

2 Option not to recognize lease as ROUA 1 Recognizes the Right-of-Use Asset

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Particulars approacht General PFRS exemption? Lease Lease Taxation Conditional sale 4. Gain or loss Recognized in Not recognized Not included Does not apply

5. Initial direct costs paid/incurred modification on lease by Iessee These are determining the time of modification. profit or loss at j included in the cost of the but may affect the amount of rent expense to be recognized in the subsequent period/s. Recognized as an outright expense. income. Recognized as in the an outright determination of taxable expense during the period that Recognized as expense during qualify as an outright to leases that conditional sale: the period that

ROUA. Accordingly, paid. the same is accrued or accrued or paid. the same is

recognized as they are

depreciation expense over

lease. the term of the

PART II. PFRS TREATMENT

At the inception of a contract, an entity assesses whether the contract is, or contains, a lease based on the substance of the transaction. A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. [PFRS 16.9]

A. Initial recognition

At"the commencement date, a lessee recognizes a ROUA and a lease liability. (PFRS 16.22). This applies to all leases unless the lessee elects the short-term lease and/or lease of low-value asset recognition exemptions available in PFRS 16.

B. Initial measurement

payments discounted using the interest rate implicit in the lease, if that rate can be A lessee initially measures the lease liability at the present value of the future lease

readily determined. If that rate cannot be readily determined, the lessee uses its incremental borrowing rate. (PFRS 16.260).

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NSION

The ROUA is recognized initially at the amount of lease liability adjusted for:

:An estimate of any decommissioning costs. - Any initial direct costs incurred by the lessee; and/or Any payments made to the lessor at or before the commencement date of the lease. less any lease incentives received;

C. Subsequent measurement $

or loss any interest incurred on lease liability. (PFRS 16.38). After the commencement date, a lessee measures the lease liability by increasing the amount to reflect the lease payments made (PFRS 16.37). A lessee recognizes in profit carrying amount to reflect interest on the lease liability and reducing the carrying

ROUA is generally measured in the statement of financial position at cost less accumulated depreciation and accumulated impairment losses.

depreciation is permitted to be capitalized (e.g. to inventory) under other PFRS. The depreciation of the right-of-use asset is also recognized in profit or loss, unless

When a lessee depreciates the ROUA on a straight-line basis, the total periodic expense (i.e. the sum of interest-and depreciation expense).is generally higher in the early

iease liability, the interest expense decreases as cash payments are made during the lease term and the lease liability decreases. Therefore, more interest expense is incurred periods and lower in the later periods. Because a constant interest rate is applied to the

in the early periods and less in the later periods. This trend in the interest expense, combined with straight-line depreciation of the right-of-use asset, results in a front- loaded expense recognition pattern.

D. Lease Modification

A lease modification is a change in the scope of a lease, or the consideration for a lease. A). Examples of lease modifications are adding or terminating the right to use one or more underlying assets or extending.or shortening the contractual lease term. that was not part of the original terms and conditions of the lease (PFRS 16. Appendix

In contrast, a lease modification that decreases the scope of a lease will require a partial de-recognition of the ROUA and lease liability. The difference between the amounts of reduction in the right-of-use asset and lease liability is recognized immediately in profit recalculation of lease liability with a corresponding adjustment to the ROUA. This type of modification will not normally result in any gain or loss in the statement of income or loss. A lease modification that does not decrease the scope of a lease will normally require

E. Lease Exemptions

months or less, but takes into-consideration lease renewal options. A lease of low-value PFRS 16 provides a recognition exemption for short-term leases and leases of low- value items. PFRS 16 defines a short-term lease as a lease with a lease term of 12 I ANLFVENLe

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item, on the other hand, is a lease for which the underlying asset is of low value (per the standard, with a value of US$5.000.00 or the equivalent for new sinilar asset).

Lessees who avail of these exemptions do not have to recognize ROUA and the related lease liability in the statements of financial position. Instead. lease payments are recognized as expense, on a straight-line basis, or another systematic basis, if that basis is more representative of the pattern of the lessee's benefit.

PART HII. TAX TREATMENT

Q1: For Income Tax Purposes, how are operating leases and finance Ieases

defined?

AY: An operating lease is a contract under which the asset is not wholly amortized

during the primary period of the lease, and where the lessor does not rely solely on the rentals during the primary period for his profits, but looks for the recovery of the balance of his costs and for the rest of his profits from the sale or re-lease of the returned asset of the primary lease period.

"Finance lease" or full payout lease, on the other hand, is a contract involving payment over an obligatory period (also called primary or basic period) of

amortize the capital outlay of the lessor and to provide for the lessor's borrowing specified rental amounts for the use of a lessor's property, sufficient in total to

costs and profits. The obligatory period refers to the primary or basic non cancellable period of the lease which in no case shall be less than 730 days. The lessee, not the lessor, exercises the choice of the asset and is normally responsible for maintenance, insurance and such other expenses pertinent to the use, preservation and operation of the asset. Finance leases may be extended, after the expiration of the primary period, by non-cancellable secondary or subsequent periods with the rentals significantly reduced. The residual value shall in no instance be less than five percent (5%) of the lessor's acquisition cost of the leased asset.

Q2: What are the similarities and differences between the income tax treatment

of operating and finance leases?

A2: Under an operating lease, the lessee may deduct the amount of rent paid or

IINEAE a 2 CC G so arranged as to constitute advance rentals, such payments shall be duly apportioned or applied over the lease term. lessee is required to pay to or for the account of the lessor. If the payments are the lessor may be allowed a depreciation during the primary lease period, but accrued, including all expenses which, under the terms of the agreement, the such period shall not be less than sixty percent (60%) of the depreciable life of The foregoing income tax treatment also applies to a finance lease, except that

the amortization are not accounted for separately from the principal payments. the property. For income tax purposes, the interest expenses computed based on

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T

Q3: For income tax purposes, how is a finance lease differentiated from a

conditional sale?

A3: Notwithstanding the foregoing definition of finance lease in Al, when an

agreement, which in form is a lease, but in substance a conditional sales contract based upon the intent of the parties as evidenced by the provisions of the agreement, read in the light of the facts and circumstances existing at the time the agreement was executed, such contract shall be considered as a conditional sale.

following criteria for characterizing the transaction: In this regard, Section 4.03/2 and Section 4.03/3 of RR No. 19-86 set the

1. Compelling Persuasive Factors: A contract or agreement purported to be a lease shall be treated as conditional sales contract if one or more of the following compelling persuasive facts are present:

a) The lessee is given the option to purchase the asset at anytime during b) The lessee acquires automatic ownership of the asset upon payment of is equivalent to or higher than the current fair market value of the asset: the obligatory period of the lease, notwithstanding that the option price the stated amount of "rentals" which, under the contract, he is required

to make: c) Portions of the periodic rental payments are credited to the purchase

) The receipts of payment indicate that the payments made were partial or price of the asset;

full payments of the asset.

Na +20 E 2. In the absence of the above compelling persuasive factors or contrary general be said to exist if, for example, one or more of the following as a purchase and sale rather than as a lease or rental agreement may in implication, an intent warranting treatment of a transaction for tax purposes conditions are present:

G ) a) Portions of the periodic payments are made specifically.applicable to an equity to be acquired by the lessee.

b) The property may be acquired under a purchase option, at a price which 1 is nominal in relation to the value of the property at the time when the

option may be exercised, as determined at the time of entering into the compared with the total payments which are required to be made. original agreement, or which is a relatively small amount when

Q4:What shall be the tax treatment of the depreciation on ROUA and the corresponding interest expense on Iease liability for Income Tax Purposes?

A4: Under PFRS 16, no distinction is made between operating and finance leases. but rather, lessees are required to recognize the ROUA and the corresponding

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then recognized on the value of the ROUA, together with the recognition of interest expense on the outstanding lease liability, both of which are recognized lease liability to the lease contract at the inception of the lease. Depreciation is in the Income Statement.

ROUA and the interest expense that is recognized for financial accounting purposes shall not be treated as deductible expenses. As such, only the actual However, for income tax purposes, the depreciation expense pertaining to the

taxable income pursuant to Section 34(A)(1)(a)(iii) of the Tax Code, as amount of rent paid or incurred, including any other payments to lessors, based on the lease agreements, shall be allowed as deductions in arriving at the net amended.

Q5: For reporting purposes on leases, what are the disclosures in the Notes to

Financial Statements (NTFS) accompanying the Audited Financial Statements?

A5: Taxpayers may disclose the following information in the NTFS, in relation to

Ieases, to wit:

Depreciation charge for right-of-use assets by class of underlying asset;

The expense relating to short-term leases. This expense need not include Interest expense on lease liabilities; the expense relating to leases with a lease term of one month or less: The expense relating to leases of low-value assets. This expense shall not

The expense relating to variable lease payments not included in the include the expense relating to short-term leases of low-value assets: measurement of lease liabilities: Income from subleasing right-of-use assets; Total cash outflow for leases: Additions to right-of-use assets: Gains or losses arising from sale and leaseback transactions: and

by class of underlying asset. The carrying amount of right-of-use assets at the end of the reporting period

Q6: What shall be the income tax treatment of initial direct costs paid by the

Iessee in relation to the lease of an asset?

A6: For purposes of taxation, Initial Direct Costs shall be defined as payments which

to substantiation and withholding requirements pursuant to Section 34 of the initial direct cost paid or incurred by the lessee in relation to the lease agreement shall be claimed as outright expenses in the year it was paid or incurred subject are directly related to the negotiation and execution of a lease agreement. The Tax Code, as amended.

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Q7: What shall be the income tax treatment of expenses paid or incurred by the lessee which are properly for the account of the lessor?

A7: The amounts paid by the lessee for certain expenses, which are properly for the

account of the lessor as indicated in the"contractual agreement between the parties, shall be allowed as deductions during the year the same has been paid or accrued pursuant to Section 34 of the Tax Code, as amended. Provided. however, that the lessor shall issue invoices/receipts in the name of the lessee (e.g., realty tax, association dues, etc.).

Q8: What shall be the income tax treatment of short-term leases and lease of

How-value assets?

A8: For purposes of taxation, short-term lease and lease for low-value assets shall

be accounted for as an operating lease. Hence, only the actual rentals paid or accrued during the taxable year, in relation to the lease contracts, shall be recognized by the lessee as deductible expenses.

Q9:: What shall be the income tax treatment of gains and losses from lease

modifications?

A9: For income tax purposes, gains or losses from lease modifications shall not be

included in the determination of taxable income as defined under Section 31 of the Tax Code, as amended.

Q10: What shall be the income tax treatment of security deposits paid in relation

to a lease contract?

A10: For income tax purposes, if the advance payments made pursuant to a lease

contract are in the nature of a security deposit for the faithful performance of

the year the advance payment is received. However, if the advance payment is certain obligations of the lessee, the same shall only be recorded as an asset in

a security deposit and the conditions which make the security deposit the property of the lessor occur, then the lessee shall be entitled to a deduction based on the amount of security deposit applied to the lease.

O11: What shall be the income tax treatment of estimated restoration costs incurred relative to leased properties?

REAU GF TNTERNAI REVLVUF A A11: For income tax purposes, estimated costs to be incurred by the lessee in b .to.Section 34(A)(1)(a) of the Tax Code, as amended. located or restoring the underlying asset to the condition required by the terms dismantling and removing the underlying asset, restoring the site on which it is and conditions of the lease shall only be considered as deductible expenses during the taxable year that the same has been actually paid or incurred pursuant

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Q12: What are the business tax implications relative to leases?

A12: For business tax purposes, the following guidelines shall still be observed:

1. The corresponding input VAT shall only be creditable to the lessee upon

payment of the rentals, which shall be evidenced by a VAT Official Receipt

amended. pursuant to Section 110 in relation to Section 113 of the Tax Code, as

2. For transactions considered as conditional sale of real property rather than a lease, the following rules on installment sale of real property shall apply:

a) In cases when the initial payment during the year of sale exceeds 25% of gross selling price, the same shall be considered as a cash sale which

makes the entire selling price taxable in the year of sale: b) For installment sales where the initial payments in the year of sale do not

exceed twenty-five percent (25%) of the gross selling price, the corresponding VAT shall be recognized on the installment payments. including interest and penalties, actually and/or constructively received by the seller. c) In all cases, the lessee/buyer can only claim the input tax in the same

period as the lessor/seller recognized the output tax.

Q13:What are the withholding tax implications of leases?

A13: 1 .be subject_to five..percent (5%) Expanded_Withholding Tax (EWT) pursuant to For contracts considered as leases, only the actual rental paid or accrued shall Section 2.57.2 (B) of RR No. 02-98, as amended. Hence, only the actual rental

regard to the depreciation expense from the ROUA. paid or accrued shall be considered as the tax base for EWT purposes, without

For transactions considered as conditional sale of personal property, the same shall be considered as sales of goods, to the extent such amounts do not represent

local/resident supplier of goods pursuant to Section 2.57.2 (I) of RR No. 02-98. interest and other charges, the applicable EWT rate of which is one percent (1%) on income payments made by the Top Withholding Agents (TWA) to their

EWT rate on interest income from any other debt instruments not within the coverage of deposit substitutes pursuant to Section 2.57.2 (S).of RR No. 02-98. as amended. The interest related thereon shall be subject to fifteen percent (15%) as amended.

JREAU CF TERNALREVENUE H the rules of withholding on the sale of real property pursuant to Section 2.57.2(F) of RR No. 02-98, as amended, shall apply. On the other hand, if the subject of the conditional sale is a real property, then

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Q14: What shall be the tax treatment of lease transa ctions for Documentary

Stamp Tax purposes?

A14: For Documentary Stamps Tax (DST) purposes, lease transactions which qualify

No. 5980, as amended by RA No. 8556, shall be subject to the applicable DST as finance lease transactions pursuant to the provisions of Republic Act (RA)

rates on debt instruments pursuant to Section 179 of the Tax Code, as amended. Otherwise, the same shall be considered as operating lease transactions subject to DST on Lease Agreements pursuant to Section 194 of the Tax Code, as amended.

recording and reporting of lease aecounting by lessee. Illustrations and Accounting Entries are reflected in the Annex "A" hereof, as guide for

amended, modified or revoked accordingly. All revenue issuances and BIR rulings inconsistent herewith are hereby considered

strictly implement the provision of this Circular. All internal revenue officers, employees and others concerned are hereby enjoined to

This Circular takes effect immediately.

MAGU, JR. mmissioner of Internal Revenue

C (pfrs project)

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