IFRS 16 - Tax Treatment

Gone are the days when operating leases could be kept off the books. Under IFRS 16, companies must now recognize a right-of-use asset and a corresponding lease liability for nearly all lease agreements. This shift enhances transparency, improves comparability, and gives stakeholders a clearer view of a company’s financial commitments.

The impact of IFRS 16 extends well beyond the realm of accounting, significantly influencing key financial metrics and performance indicators. For CFOs, accountants, and financial analysts, a thorough understanding of IFRS 16 is not merely beneficial—it is essential for navigating today’s complex financial reporting landscape with clarity and confidence. Equally important, however, is the need to assess the tax implications arising from the adoption of IFRS 16. This article explores the tax treatment of leases under IFRS 16 in the Mauritian context, examining both the historical framework and the changes introduced through recent amendments

Tax Implications for Leases Prior IFRS 16

An operating lease is a contractual arrangement in which a company (the lessee) obtains the right to use an asset for a specified period without acquiring ownership. The legal title of the asset remains with the lessor, and the lessee pays a rental fee—typically on a monthly basis—for the duration of the lease term.

From a tax perspective, Section 18 of the Income Tax Act 1995 (ITA 1995) provides that any expenditure incurred wholly and exclusively in the production of gross income is allowable as a deduction. Accordingly, rental payments made under an operating lease are generally treated as allowable business expenses, provided they meet the criteria set out in the ITA.

However, since the leased asset is not legally owned by the lessee, the lessee is not entitled to claim annual allowance (capital allowance) on the asset

A finance lease is a lease arrangement in which the lessee assumes substantially all the risks and rewards associated with ownership of an asset, even though legal title remains with the lessor. Under such agreements, the lessee typically gains control over the asset for the majority of its useful life and is responsible for key ownership-related obligations such as maintenance, insurance, and repairs. These leases often include a purchase option at the end of the lease term—usually at a nominal price—further reinforcing the economic substance of ownership.

From an accounting standpoint, finance leases are treated similarly to asset purchases financed through borrowing. Lease payments are split into two components: a principal portion, which reduces the lease liability on the balance sheet, and an interest portion, which is recognized as an expense in the income statement.

In terms of tax treatment under Section 19 of the Income Tax Act 1995 (ITA 1995), interest incurred on capital employed in the production of gross income is considered an allowable deduction. Therefore, the interest component of lease payments under a finance lease qualifies as a tax-deductible expense. Additionally, since the lessee bears the economic risks and rewards of ownership, they may also claim annual allowance (capital allowance) on the leased asset in their tax computation, provided the asset is used in the production of income.

Accounting Aspect of IFRS 16

IFRS 16 fundamentally changed lease accounting by introducing a single lessee accounting model.

Under this standard, lessees are required to recognize nearly all leases on the balance sheet. This includes recording a right-of-use asset (representing the lessee’s right to use the leased asset) and a lease liability (representing the obligation to make lease payments).

The lease liability is initially measured at the present value of future lease payments, while the right-of-use asset includes the initial lease liability, plus any initial direct costs and restoration obligations.

Over the lease term, the lessee recognizes depreciation on the right-of-use asset and interest expense on the lease liability, similar to how a financed asset is treated.

Under IFRS 16, short-term leases (with a term of 12 months or less) and leases of low-value assets (typically valued at or below MUR 50,000) are exempt from the requirement to be recognized on the balance sheet. Instead, lease payments for such arrangements may be accounted for as an expense on a straight-line basis over the lease term, thereby remaining off-balance sheet.

For lessors, IFRS 16 retains the dual classification model from IAS 17, distinguishing between finance leases and operating leases. The accounting treatment for lessors remains largely unchanged, with finance leases resulting in derecognition of the leased asset and recognition of a receivable, while operating leases continue to recognize lease income on a straight-line basis.

Tax Implications Post-IFRS 16

When IFRS 16 is applied, lessees recognize right-of-use (ROU) asset depreciation and interest expense in the income statement. The actual lease payments made are recorded against the lease liability recorded on the balance sheet.

However, for tax purposes, Section 26(c) of the Income Tax Act 1995 (ITA 1995) stipulates that any reserve or provision of any kind is not allowable as a deduction. Since ROU depreciation is considered a provision and interest expense represents the unwinding of the lease liability, these amounts are generally not deductible for tax purposes.

This raises the question: what lease-related expenses are allowable for tax purposes?

Finance Lease – Tax Treatment

In the case of a finance lease, the lessee may claim the interest expense as a deductible item under Section 19 of the ITA 1995, provided the capital is employed in the production of gross income. Additionally, the lessee may claim annual allowance on the leased asset, as they are deemed to bear the economic risks and rewards of ownership.

Operating Lease – Tax Treatment

For operating leases, the rental payments made by the lessee are treated as tax-deductible expenses, provided they satisfy the conditions set out in Section 18 of the ITA 1995—namely, that the expenditure is incurred wholly and exclusively in the production of gross income. However, the lessee is not entitled to claim interest expense or annual allowance in respect of the leased asset.

Tax Deducted at Source (TDS) Implications

Lease payments made under operating leases to any person other than an individual or an exempt body are subject to Tax Deducted at Source (TDS). These payments are classified as rent, and a TDS rate of 7.5% applies.

In contrast, lease payments under a finance lease are not subject to TDS, as they are treated as financing arrangements rather than rental payments.

Practical Aspects

One of the most significant challenges is the divergence between IFRS 16 accounting requirements and the tax rules under the Income Tax Act 1995. While IFRS 16 requires lessees to recognize right-of-use (ROU) assets and lease liabilities on the balance sheet, the tax legislation does not align with this approach. Specifically, Section 26(c) disallows provisions, which includes ROU depreciation and interest expense, creating a disconnect between financial reporting and tax deductibility. This, in turn lead, to deferred tax implications from a financial reporting perspective.

Moreover, companies must maintain dual records—one for accounting under IFRS 16 and another for tax purposes. This increases administrative burden and the risk of errors, especially when reconciling lease-related expenses for tax filings. Determining what qualifies as deductible (e.g., rental payments vs. interest and capital allowances) requires careful classification and documentation.

Conclusion

The implementation of IFRS 16 has significantly transformed lease accounting by bringing greater transparency and consistency to financial reporting. However, this shift has also introduced a range of practical challenges, particularly in aligning accounting treatments with existing tax legislation in Mauritius.

Understanding the tax implications—especially the distinction between finance and operating leases—is essential for accurate tax reporting and compliance. Finance leases allow for the deduction of interest expenses and capital allowances, while operating leases permit rental deductions but exclude interest and depreciation claims. Additionally, the application of TDS rules adds another layer of complexity that businesses must navigate carefully.

As leasing continues to be a common financing tool, it is crucial for businesses, tax professionals, and financial decision-makers to stay informed and ensure that lease arrangements are structured and reported in a manner that is both IFRS-compliant and tax-efficient. At Forvis Mazars in Mauritius, we assist our clients in reducing compliance burdens and ensuring consistency in practice.