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LET'S TALK TAX

Accounting and taxation of short-term leases and lease for low-value assets

Nikkolai F. CanceranNikkolai F. Canceran

Philippine Financial Reporting Standard (PFRS) 16 is the new accounting standard for lease of assets or
arrangements that contain a lease. It became effective on Jan. 1. It replaces Philippine Accounting
Standard (PAS) 17, which means that entities reporting under PFRS shall apply this new standard in their
lease transactions starting on the effectivity date.

On the other hand, taxation for leases generally remains unchanged since the issuance of Revenue
Regulations (RR) No. 19-86 on Jan. 1, 1987 which prescribes the rules to govern the tax treatment of
lease agreements.

As we all know, accounting standards and tax rules differ in many instances, and PFRS 16 is no
exception. The purpose of this article is to provide a useful reference for taxpayers in knowing and
dealing with the differences of accounting and tax rules for leases.

SHORT-TERM LEASE AND LEASE FOR LOW VALUE ASSETS

PFRS 16 defines short-term lease as a lease with a lease term of 12 months or less but taking into
consideration the renewal options. On the other hand, lease for low-value assets is a lease for which the
underlying asset is of low value (i.e., $5,000 or equivalent for a new similar asset).

ACCOUNTING TREATMENT FOR LESSEE AND LESSOR

Leases of these kind are accounted for in a way that is similar to current operating lease accounting —
which means that payments are recognized by the lessee as an expense or cost and revenue by the
lessor on a straight-line basis or another systematic basis that is more representative of the pattern of
the benefits. Simply put, lease expense or revenue is generally reported equally over the lease term.
However, for short-term lease, the lessee has the option to recognize right-of-use asset (ROUA) and a
corresponding lease liability instead of the straight-line basis. The discussion on accounting and tax
treatment for ROUA and lease liability will be tackled in part 2 of this article.

When the lessee pays advance rental and security deposit, the lessee shall account these as asset at the
time of payment. These shall be reported as lease expense/cost in the period when applied to lease. On
the part of the lessor, the advance/prepaid rental and security deposit shall be recorded as liability in
the period of receipt and shall be reported as lease income in the period when applied to lease.
TAX RULES

RR No. 19-86 defines a lease as an agreement between a lessor and a lessee giving the lessee possession
and use of a specific property upon payment of rentals over a period of time (which may be definite or
indefinite). The equivalent of short-term lease or lease for low value assets for tax purposes is an
operating lease.

Operating lease is defined in RR No. 19-86 as 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.

LESSEE TAXATION

In an operating lease, the lessee may deduct the amount of rental actually due under the lease
agreement during the year. This is subject to 5% expanded withholding tax (EWT).

In addition to the rent actually paid or payable to the lessor, the lessee should also report all the
expenses/costs which under the terms of the agreement the lessee is required to pay or for the account
of the lessor, as additional rental expense/cost which is also subject to 5% EWT. An example is the real
property tax on the leased property if paid by the lessee should be claimed by the lessee as rental
expense/cost and not as tax expense.

In case the lessee pays advance/prepaid rentals, if the lessee adopts the accrual basis of accounting,
according to tax rules, the lessee should treat the advance/prepaid rentals as an asset subject to 5%
EWT at the time of payment. These shall be claimed as deductible at the time of its application to the
lease.

If the lessee, on the other hand, adopts the cash basis of accounting, the advance/prepaid rentals are
deductible items at the time of payment provided the advance/prepaid rentals do not extend beyond 12
months. Otherwise, advance rentals/prepaid rentals corresponding to the period beyond 12 months
shall be accounted for as an asset and will be claimed as deductible items at the time of its application
to the lease. For withholding tax purposes, the entire advance/prepaid rentals including those for the
period beyond 12 months shall be subject to 5% EWT at the time of payment.
With respect to security deposit for the faithful performance of certain obligations of the lessee, the
lessee, whether adopting accrual or cash basis of accounting, should treat the same as an asset and not
subject to 5% EWT at the time of payment because of its being in the nature of a conditional deposit.
These deposits shall be claimed deductions subject to 5% EWT at the time of its application to the lease.

LESSOR TAXATION

Generally, the taxation of the lessor in operating lease is similar to that of the lessee but with opposite
effects.

The lessor should report as taxable income only the rental payments that it is entitled to receive for the
year, as provided under the lease agreement. For VAT purposes, the lessor shall report the lease income
based on gross receipts or on collection basis.

Costs/expenses related to the leased property that are the responsibility of the lessor, if paid by the
lessee, are deemed additional rental income of the lessor which is also subject to VAT (e.g., real
property taxed on leased property that are paid by the lessee is reported as part of the lessor’s taxable
rental income).

For advance/prepaid rentals, lessor taxation is different from the lessee because these are reported as
taxable income of the lessor and also for VAT purposes in the year when received whether the lessor is
using the accrual or the cash method of accounting.

Security deposit when received by the lessor, whether the lessor is using the accrual or the cash method
of accounting, should be treated as a liability at the time of receipt and will be recognized as income
which is subject to VAT at the time of application to lease.

DEALING WITH THE DIFFERENCES

For accounting purposes, the lease income/expense will be averaged on a straight-line basis over the
lease term such that the monthly or annual lease income/expense is the same for the entire period of
the lease including the rent-free period. For tax purposes, the actual lease income/expense for each
period indicated in the lease contract should be reported as lease income/expense for that period. The
difference between accounting and tax usually happens when there is escalation of the lease amount
over the lease term or when a rent-free period is present.
The monthly/annual difference of lease income/expense shall be accounted for by the lessee and lessor
as a temporary difference with the recognition of either deferred tax asset or liability as the case maybe.
The reason why the difference is just temporary is that at the end of the lease term the total lease
income/expense is equal under accounting and tax purposes.

To illustrate, say for example the lease agreement states that the lease term is for six months, the first
month of the term is free, the second month’s lease is P20,000 and shall increase by P20,000 every
month.

Shown in the table below the monthly lease income/expense for accounting and tax purposes.