Tax Alert No. 7 [Revenue Memorandum Circular (RMC) No. 11-2024 dated 12 September 2023] (2024)

Clarifying the Tax Treatment of Lease Accounting by Lessees Under Philippine Financial Reporting Standard (PFRS) 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.

Please be informed that RMC No. 11-2024 was issued to provide guidelines with respect to the tax treatment of lease accounting by lessees under PFRS 16 in relation to Sections 34(A), 34(K), 108, 179, and 194 of the Tax Code, as amended, RR No. 19-86, as amended, and RR No. 02-98, as amended. The overview of the PFRS and tax treatment of this matter is presented in the table below.

Particulars	PFRS		Taxation
Particulars	General Approach	Lease exemption	Lease	Conditional Sale
1. Depreciation of Right-of- use asset (ROUA)	Generally recognized as an expense.	Not recognized.	Not allowed as deduction.	Depreciation of leased assets can be claimed as deduction from gross income.
2. Interest on lease liability	Generally recognized as an expense.	Not recognized.	Not allowed as deduction.	Interest on lease liability can be claimed as deduction from gross income.
3. Rent expense	Generally not recognized.	Recognized on a straight-line basis over the lease term.	Allowed as deduction from the gross income.	Not recognized.
4. Gain or loss on lease modification	Recognized in profit or loss at the time of modification.	Not recognized but may affect the amount of rent expense to be recognized in the subsequent period/s.	Not included in the determination of taxable income.	Does not apply to leases that qualify as conditional sale.
5. Initial direct costs paid/incurred by lessee	These are included in determining the cost of the ROUA. Accordingly, they are recognized as depreciation expense over the term of the lease.	Recognized as an outright expense.	Recognized as an outright expense during the period that the same is accrued or paid.	Recognized as an outright expense during the period that the same is accrued or paid.

The RMC also discussed the accounting treatment under PFRS 16 of lease contracts (i.e., initial recognition, initial measurements, subsequent measurement, lease modification, and lease exemptions).

Meanwhile, the following are the salients points of the tax treatment laid down in this RMC for various lease contracts and related transactions:

The RMC defines an operating lease and finance lease for income tax purposes and provides similarities and differences on their income tax treatment.
Finance lease is differentiated from a conditional sale.The criteria on how to properly characterize a transaction. (i.e., compelling persuasive factors and other factors) are also set-out in this RMC.
The depreciation expense pertaining to the ROUA and the interest expense that are recognized for financial accounting purposes shall not be treated as deductible expenses for income tax purposes. Only the actual amount of rent paid or incurred, including any other payments to lessors shall be allowed as deductions in arriving at the net taxable income.
The tax treatment of the (a) initial direct cost paid or incurred by the lessee, (b) amounts paid by the lessee for certain expenses which are for the account of the lessor, (c) short-term lease and lease for low-value assets, (d) gains or losses from lease modifications, (e) security deposit, and (f) estimated costs to be incurred by the lessee in dismantling, restoring, and removing the underlying asset are likewise provided.
The corresponding input value-added tax shall only be creditable to the lessee upon payment of the rentals. For conditional sale of real property, the rules on installment sale of real property shall apply.
The actual rental paid or accrued shall be subject to five percent (5%) Expanded Withholding Tax (EWT). For conditional sale of personal property, the applicable EWT rate is one percent (1%).The interest related thereon shall be subject to fifteen percent (15%) EWT rate on interest income from any other debt instruments not within the coverage of deposit substitutes. Meanwhile, if it is a conditional sale of a real property, then the rules of withholding on the sale of real property shall apply.
Finance lease transactions shall be subject to the applicable documentary stamp tax (DST) rates on debt instruments. Operating lease is subject to DST on Lease Agreements.

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