COMMENTARY: Who should claim tax depreciation?

Clarification to the law on direct taxes on income in 2010 may have passed the casual observer but caused controversy between tax administrators and the players in the leasing industry on the claiming of capital allowances on finance lease assets.Article 24 of the law on direct taxes on income states that, “depreciation of leased assets shall be allowed to the lessee in case of finance lease and to the lessor in case of operating lease.” The law came into force on May 28, 2010The amendment makes it clear that the lessee in a finance lease is entitled to claim capital allowances and the lessor cannot claim capital allowances.The controversy is what the capital allowances treatment should be for finance leases between August 18, 2005 when the law on direct taxes was passed and May 28, 2010 when the clarification was made. It is important for the tax administration to consider the full implication of the clarification on the affected enterprises. The Government of Rwanda aggressively promoted foreign investment in the period from 2005 to 2010. Many enterprises registered with Rwanda Investment and Export Promotion Agency (RIEPA) — one of the institutions that were merged to form Rwanda Development Board (RDB), take advantage of the incentives offered under the Investment Code and do business in Rwanda. Naturally, the enterprises chose to use equity, debt or a mixture of both to finance acquisition of assets for their business. As we examine the controversy further, and decipher the reason for the 2010 clarification, let us look at the difference between finance leases and operation leases. A lease is defined as an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time. A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. Title may or may not eventually be transferred. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership.Risks of ownership include the possibilities of losses from idle capacity or technological obsolescence and of variations in return because of changing economic conditions. Rewards may be represented by the expectation of profitable operation over the asset’s economic life and of gain from appreciation in value or realisation of a residual value.Consequently, the effective owner in a finance lease is the lessee and the effective owner in an operating lease is the lessor. The International Accounting Standards (IAS) has adopted this treatment for finance leases. The lessee should capitalise the assets under a finance lease regardless of the legal form of the lease. The Lessor recognises assets held under a finance lease in his balance sheet and presents them as a receivable at an amount equal to the net investment in the lease. Rwanda has adopted the same treatment as the IAS on capital allowances for assets under leases. Article 4 of Law N° 24/2010 of 28/05/2010 emphasized this by stating that the Minister of Finance should, by way of a Ministerial Order and basing on internationally recognized accounting standards revise depreciation rates. Most tax jurisdictions allow capital depreciation to the lessee for assets acquired under a finance lease. In Uganda, the lessee is treated as the owner of the property, where a lessor leases an asset to a lessee under a finance lease. The lessee is allowed to depreciate plant and machinery for use in farming, manufacturing and mining operations at 30 per cent under section 59 of the Income Tax Act. In Kenya the income tax (leasing) rules, 2002 effectively allow the lessee in a finance lease to claim capital allowances. The lessor is entitled to capitalise the asset leased and claim capital allowances. Where the lessor sells the assets upon the expiration of the lease, the difference between the sale price and the book value is deemed to be a gain or loss to the lessor. Where however at the termination of the lease, the lessee is allowed to use, enjoy and deal with the asset as he may deem fit, without the payment of any consideration or subject to a nominal consideration or at an amount less than the market value, the lessee will be deemed to have acquired the asset. The tax administration will recover the lease deductions enjoyed by the lessee. The lessee will be allowed to claim capital allowances from the time of commencement of the lease. The Commissioner will also make an adjustment of the capital allowances enjoyed by the lessor.In Tanzania, where an asset is leased under a finance lease, the lessor is treated as transferring ownership of the asset to the lessee under section 32(4) of the Income Tax Act. In the United Kingdom, the lessee in a long funding lease is allowed to claim capital allowances with effect from 2006. The lessee bears most of the economic risks of ownership. In Australia, capital allowances are allowed to the lessor. There are however ongoing efforts to amend the law. In conclusion, the law on direct taxes was not clear on who should claim capital deductions on assets under a finance lease in the period 2005-2010. Under the IAS, the lessee is allowed to claim capital allowances. The capital allowances granted under the law on direct taxes and the finance lease expenses under a finance lease will rarely be the same. It is therefore inappropriate simply to recognize the lease payments payable as an expense.In 2005, Rwanda intended to follow the IAS position, though this was only vindicated with the 2010 clarification. The clarification also stated that the Minister should be guided by the IAS. Most tax jurisdictions, including countries of the East Africa Community of which Rwanda is a member allow capital deductions to the lessee in a finance lease. The Rwanda tax administration should tax each taxpayer’s unique circumstances into consideration in determining taxes arising from capital allowances on finance leases. Most importantly, a taxpayer should not be prejudiced by an interpretation taken when the law was not clear on who should claim tax depreciation. Starlings Muchiri is a Tax Manager with PKF