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Accounting and tax implications of sale and leaseback

Summary

4 November 2011

I wrote an article on this subject which was published in the 10 August 2011 copy of Islamic Finance News. It is reproduced below with the concurrence of the editor.

Accounting and tax implications of sale and leaseback

MOHAMMED AMIN explores the differences in accounting approach between the International Financial Reporting Standards (IFRS) and the accounting standards of the AAOIFI, and the relevant tax implications.

Conventional loan transaction

As a starting point, it is worthwhile considering the accounting treatment of the following transaction:

Ignoring any difference in the number of days from 2012 being a leap year, this is equivalent to borrowing money at approximately 8.0766% as demonstrated by the loan table:

Economics of conventional loan

 

B/F

Interest

Repayment

C/F

2012

100.00

8.08

-5.00

103.08

2013

103.08

8.33

-5.00

106.41

2014

106.41

8.59

-5.00

110.00

The borrower will report interest expense of US$8.08, US$8.33 and US$8.59 during the three-year period, with the lender reporting the same amounts as interest income. These differ from the US$5 cash interest payments, since the US$10 loan repayment premium must be spread over the three year life of the loan.

Sale and leaseback transaction

Meanwhile company C also happens to own a building worth US$150 which it bought many years ago. Company C enters into the following transaction with Islamic bank D:

This sale and leaseback transaction has many similarities with the conventional loan transaction, as well as some differences.

Similarities

Differences

Accounting for the sale and leaseback under IFRS

IFRS is about reporting the economic substance of the transactions. From an economic perspective, Islamic bank D has provided US$100 to company C, in exchange for company C’s obligation to pay it US$5 on the 31st December 2012 and 2013, and to pay it US$115 on the 31st December 2014.

Accordingly Islamic bank D would account as follows:

Islamic bank D extracted accounting figures

 

2012

2013

2014

Income statement

Financial income from leasing

8.08

8.33

8.59

Balance sheet

Investment in finance lease
(Zero in 2014 as lease finishes)

103.08

106.41

0

The accounting for company C would be the mirror image of Islamic bank D’s accounting.

Company C extracted accounting figures

 

2012

2013

2014

Income statement

Expense of obtaining finance

8.08

8.33

8.59

Balance sheet

Building (original cost)

20.00

20.00

20.00

Finance lease obligation
(Zero in 2014 as lease finishes)

103.08

106.41

0

Company C continues to show the building on its balance sheet at all times. The IFRS view is that company C continues to have full economic participation in increases or reductions in the value of the building, since it has the right and obligation to buy the building back on the 31st December 2014 at the fixed price of US$110. All that company C has done, in economic terms, is to use the building to obtain US$100 of finance.

Its accounts should look no different to the accounts of company A, and under IFRS they do not differ apart from some footnote disclosures so that investors are fully aware of the sale and leaseback transaction.

Accounting for the sale and leaseback under AAOIFI

The introduction to AAOIFI’s 1993 Statement of Financial Accounting No. 1: Objectives of Financial Accounting for Islamic Banks and Financial Institutions says:

“Financial accounting in Islam should be focused on the fair reporting of the entity’s financial position and results of its operations, in a manner that would reveal what is halal (permissible) and haram (forbidden).”

To achieve this, it appears appropriate under AAOIFI to account for the transaction that is actually taking place, which is a sale of the building and its eventual repurchase. Islamic bank D will show the building it purchases on its balance sheet, and report the rental income and the gain from selling the building in the periods when they arise.

This leads to the following accounting for Islamic bank D:

Islamic bank D accounting figures under AAOIFI

 

2012

2013

2014

Income statement

 

 

 

Rental income from building

5.00

5.00

5.00

Gain on sale of building

 

 

10.00

Balance sheet

 

 

 

Building (cost)
(Zero in 2014 as building sold back)

100.00

100.00

0.00

The accounting for company C under AAOIFI follows the same principles. In 2012 company C sells for US$100 a building which it bought for US$20, and reports that gain of US$80 as well as reporting the rental expense of US$5 each year. The US$110 payment in 2014 is simply accounted for as the purchase of a building. This leads to the following accounting for company C:

Company C figures under AAOIFI

 

2012

2013

2014

Income statement

Rental expense

5.00

5.00

5.00

Gain on sale of building

80.00

 

 

(Cost US$20, sale price US$100)

 

 

 

Balance sheet

Building (cost)

 

 

110.00

It is not meaningful to ask which is right. The IFRS and AAOIFI accounting have different objectives and perspectives. IFRS analyzes the transaction entirely on the basis of its economic substance and sees it as a financing transaction. Fundamentally, this derives from the requirement to repurchase the building at a fixed price irrespective of the market value.

The main purpose of AAOIFI accounting is to satisfy the religious needs of the users of the accounts. Accordingly AAOIFI does not allow economic substance to determine the presentation of the accounts but instead gives significant weight to the legal form of contracts, and Shariah requirements are overriding.

Tax implications

Tax law varies from country to country. However in generic terms two tax questions need to be considered.

Is real estate transfer tax chargeable on the sale and the repurchase of the building?

In 2012 company C sells the building to Islamic bank D for US$100, and in 2014 Islamic bank D sells it back for US$110. Many countries have a tax chargeable on the transfer of real estate which should apply to these sales.

The UK introduced a special relief from its real estate transfer tax called Stamp Duty Land Tax (SDLT) several years ago. Accordingly the above sales by company C and Islamic bank D should not suffer any SDLT. A number of other countries have introduced a similar relief from their real estate transfer tax to facilitate Islamic finance.

Does company C’s sale give rise to a taxable gain?

Even though the economics of the transaction do not differ materially from the conventional loan, company C begins in 2012 by selling for US$100 a building it bought for US$20. At first sight, this gain would appear to be taxable.

In the UK, under current law this sale would give rise to a taxable capital gain. The UK has already brought in a relief which applies if a sale and leaseback takes place with a special purpose vehicle that issues investment bonds (the tax law equivalent of sukuk), but this relief does not apply if the sale and leaseback transaction takes place with a bank.

Given the precedent of relief for sukuk transactions, it is probable that in the near future the UK will bring in a similar relief for transactions with banks.

In other countries, such as the US and the Netherlands, tax is primarily based on the economic substance of transactions. In such countries, the sale for US$100 and repurchase for US$110 are likely to be seen as primarily a financing transaction. The consequence would be that the sale and repurchase would be disregarded for tax purposes, so that company C would retain its historical tax basis in the building of US$20.

Mohammed Amin is an Islamic finance consultant and was previously the UK head of Islamic finance at PwC.

 

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