Paying tax on income not yet received seems a little unfair, if not rather draconian, especially during a pandemic and the impending global recession.
Draconian or not, this could be the case for many landlords who are considering the provision of (or indeed have already provided) concessions in relation to rent (including deferrals, rent holidays and rent reductions) to tenants as part of their response to current economic pressures.
Despite the seismic shift in socioeconomic patterns enforced by Covid-19 and its wider impact on the UK legislature, landlords will need to know how to account for any such rent concessions appropriately, rather than possibly ending up with unfavourable timing differences between tax liabilities and cash rentals received. Certain approaches could result in landlords being out of pocket in the short-term, by much more than they would expect as a result of the tax treatment.
In times of financial constraint, one would hope for a legislative system that encourages and rewards flexibility in business negotiations that support the going concern of both parties. However, the current system (albeit potentially inadvertently) may hinder rather than empower landlords and therefore tenants in reaching these sorts of agreements.
Tax now, cash later?
Accounting standards and rental recognition
FRS 102 provides very little guidance on the accounting for rental income generally other than to require recognition in profit or loss, typically on a straight-line basis over the lease term, even if the receipt of payments is not on that basis. The cost of a lease incentive is similarly recognised as a reduction to rental income over the lease term, and not allocated solely to the period to which the incentive relates.
Rent concessions which are provided by landlords mid-lease to alleviate the impact Covid-19 might have on tenants’ businesses are not lease incentives to enter into the lease and so the question arises as to how they should be accounted for. FRS 102, however, does not provide any specific guidance on how to account for modifications to the terms and conditions of a lease.
That said, FRS 102 does cater generally for situations in which it contains no specific guidance. It requires management to apply judgement to determine a policy that is both relevant and reliable, factoring in the requirements applicable to “similar” issues dealt with elsewhere in FRS 102. It also suggests looking to the requirements of EU-adopted IFRS in making such determination.
Although a modification to a lease that provides a waiver or deferral of rent to a tenant is not a lease incentive to enter into the lease, it is arguably similar. Further, the most recent standard on leases in IFRS 16 would require, in many instances, lease modifications to be accounted for by the lessor as if the revised terms were a new lease, which gives the same accounting to that of a lease incentive (i.e. revised rent spread over the remaining lease term).
“Base Case” Accounting
Going forward, it is generally thought that a policy that recognises revised rental receipts as income spread evenly over the remaining term of the lease is likely to be appropriate for FRS 102 purposes, but this is an area where views could change.
If there was a rent concession provided, such a policy would not result in the pattern of income recognition changing. However, such a policy would result in landlords recognising rental income in a period during which a commensurate amount of cash was not being received. Where tax follows the accounting, tax would be due on any such rental revenues as part of taxable profits, even though there may be no related periodic cash inflow. Depending on individual circumstances, landlords could, rather unfairly, have to pay tax on cash they haven’t received (which was only the case because they offered to help the business of the underlying tenant).
A lease modification is not a lease incentive and there is no explicit requirement in FRS 102 to apply the requirements of IFRS 16. The question therefore arises whether an alternative accounting policy (which is both relevant and reliable), which ameliorates the negative tax consequences of the help provided by landlords to tenants, might be permissible.
In other words, might it be permissible for rent waivers to be recognised as a reduction to rental income in the period in which they are waived rather than being spread over the remaining term of the lease? Such a policy could alleviate the potential cash tax trap issue at hand for many landlords.
Whilst the reduction in rent being spread over the remainder of the lease term is likely to be treatment generally applied, arguably, with lease concessions not specifically dealt with under FRS102, when premises are not available for use, and this is outside of the lessee’s control, then matching the rental income to only the period when the premises were made available to the lessee may also be seen to result in a fair presentation. Views on whether this is seen as a viable alternative under FRS 102, given certain facts and circumstances, may develop in the coming months and will ultimately require agreement from your auditors.
A practical compromise
In the absence of guidance in FRS 102 on how to account for lease modifications, it remains to be seen whether a consensus will develop in the accounting profession as to how landlords that prepare financial statements in accordance with FRS 102 should account for rent concessions provided to tenants. Suffice it to say different accounting policies could have different tax cash flow consequences.
For now, it appears up to landlords to determine a relevant and reliable policy and, if audited, obtain agreement from their auditors for the policy they plan to apply.
Certain Real Estate bodies such as the BFP are lobbying the IASB on behalf of the sector to allow for an income recognition policy for lessors which matches the updated proposals for lessees.
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