Brackenwell Retail: sale and leaseback and the related deferred tax (IFRS 16 / IAS 12)
On 1 January 20X5 Brackenwell Retail plc sold a freehold distribution centre to an institutional investor for £30.0m, its fair value, and immediately leased it back for ten years. Annual rentals of £3.0m are payable in arrears and the arrangement is a single lease component. The property had been carried at £24.0m within property, plant and equipment and had a remaining useful life of 25 years. Brackenwell's incremental borrowing rate is 6% and the present value of the ten lease payments, using the rate implicit in the lease, is £22.08m. The sale satisfies the IFRS 15 criteria for recognising a sale. Brackenwell's tax rate is 25%. Tax deductions for the lease are given on the rentals as they are paid, and the tax base of the property immediately after the sale is £30.0m. The finance director has already recorded a £6.0m gain on disposal, a £30.0m cash inflow and a lease liability of £22.08m, and has recognised a right-of-use asset at £22.08m.
1. Correct the 1 January 20X5 entries and quantify the gain to be recognised.
Read the worked answer
The finance director's entries overstate the gain. Because the seller retains a right of use, IFRS 16 requires the entity to recognise only the portion of the gain relating to the rights transferred to the buyer, not the whole £6.0m.
- Right-of-use asset recognised = previous carrying amount × (PV of lease payments ÷ fair value of the property) = £24.0m × (22.08 ÷ 30.00) = £17.664m. The right retained is 73.6%.
- Gain recognised = total gain on disposal × proportion transferred = (£30.0m − £24.0m) × (1 − 0.736) = £6.0m × 26.4% = £1.584m.
- The remaining £4.416m of the £6.0m is not recognised; it is embedded in the right-of-use asset and released through lower depreciation over the ten-year term.
Correcting entry:
| Dr | Cr | £m |
|---|---|---|
| Cash | 30.000 | |
| Right-of-use asset | 17.664 | |
| Property, plant and equipment | 24.000 | |
| Lease liability | 22.080 | |
| Gain on disposal (P&L) | 1.584 |
This replaces the £6.0m gain with £1.584m, removes the PPE of £24.0m and records the right-of-use asset at £17.664m rather than £22.08m. The lease liability of £22.08m is correctly stated.
2. Compute the deferred tax arising on the transaction and explain the IAS 12 reasoning.
Read the worked answer
Two separate temporary differences arise.
1. The lease. Under the IAS 12 amendment for leases, the initial-recognition exemption does not apply to lessee right-of-use assets and lease liabilities, because they give rise to equal and offsetting temporary differences.
- Lease liability: carrying amount £22.080m; tax base nil (future tax deductions of £22.080m, so tax base = carrying amount − future deductible = nil). That is a deductible temporary difference of £22.080m.
- Right-of-use asset: carrying amount £17.664m; tax base nil (the tax deductions are the rentals, not the asset), giving a taxable temporary difference of £17.664m.
Net deductible difference = 22.080 − 17.664 = £4.416m → net deferred tax asset of £1.104m (4.416 × 25%). It unwinds over the lease term as the liability is reduced by rental payments faster than the asset is depreciated. Recognise it only to the extent that taxable profits are probable; with ten years of profitable operations and a gearing covenant to satisfy, recoverability should be documented.
2. The sale. The property has been sold and replaced by a right-of-use asset, so the old carrying amount of £24.0m is no longer relevant. The gain is taxable on a proceeds basis and the tax base is £30.0m, matching the amount that will be deductible in future; there is no residual temporary difference on the property itself after the sale.
Disclosure: the deferred tax asset on the lease should be shown separately, and the temporary differences explained in the tax note.
3. Show the lease accounting at 31 December 20X5 and state the total 20X5 charge to profit or loss.
Read the worked answer
Lease liability (effective interest method at 6%).
| £m | |
|---|---|
| Opening liability 1 Jan 20X5 | 22.080 |
| Interest 6% | 1.325 |
| Rental paid (in arrears) | (3.000) |
| Closing liability 31 Dec 20X5 | 20.405 |
Current portion at 31 December 20X5 is the reduction in the liability during 20X6: opening 20.405 × 1.06 = 21.629, less 3.0 = 18.629, so the 20X6 capital repayment is £1.776m; the balance of £18.629m is non-current.
Right-of-use asset. Depreciated straight-line over the ten-year lease term (the lease does not transfer ownership and there is no purchase option): 17.664 ÷ 10 = £1.766m depreciation, leaving £15.898m.
20X5 charge to profit or loss:
- Depreciation on right-of-use asset: £1.766m
- Interest on lease liability: £1.325m
- Total: £3.091m, compared with £3.0m of rent paid, plus the £1.584m one-off gain recognised on 1 January 20X5.
There is no separate rent expense. The deferred tax asset unwinds by the movement in the temporary differences at 25%; the closing net deductible difference is 20.405 − 15.898 = £4.507m, giving a deferred tax asset of £1.127m, a credit to the tax charge of roughly £0.023m.