FRS 102 lease accounting changes: tax implications

The lease accounting rules for many businesses leasing assets are changing from January 2026. As well as preparing for the impact on their financial statements, businesses should understand and plan for the tax consequences of these changes.

As summarised in our article Changes to UK GAAP – how they might affect your business, the main financial reporting standard applying to many businesses in the UK (FRS 102) is changing for accounting periods starting on or after 1 January 2026 (with early adoption permitted). One of the key changes is to how lessees account for leases, which will have tax implications for both companies and partnerships.

Existing lease accounting rules

Under the current FRS 102 rules, there is a distinction between finance leases and operating leases:

Finance leases

Where a lessee has substantially all the risks and rewards incidental to ownership of an asset, it is considered to be a finance lease. The lessee recognises both a lease asset and corresponding liability on the balance sheet. In the profit and loss account, a depreciation charge is recognised in respect of the asset and a finance cost is recognised in relation to the lease liability. Both the depreciation and finance cost are allowable deductions for tax purposes.

Operating leases

Where a lessee does not have substantially all the risks and rewards incidental to ownership, it is considered to be an operating lease. The lessee records the rental payments as an expense in the profit and loss account, usually on a straight-line basis over the length of the lease. This expense is also an allowable deduction for tax purposes.

New lease accounting rules and right-of-use assets

Under the new rules the distinction between finance leases and operating leases for lessees will be removed. Instead, lessees will recognise all leases on the balance sheet as a ‘right-of-use’ (ROU) asset with a corresponding lease liability, subject to exemptions for:

• Short-term leases, where the lease term ends within 12 months of the start date, and
• Leases of low value assets, which are entity specific but likely to include items such as laptops and mobile phones.

The ROU asset will initially be measured at the present value and depreciated on a straight-line basis over the length of the lease. In the profit and loss account, lessees will recognise both a depreciation charge on the ROU asset and a finance cost on the lease liability. The depreciation and finance cost will be allowable deductions for tax purposes.

The finance cost will be calculated using the effective interest rate applied to the outstanding lease liability. This will typically result in a higher expense in the earlier years of the lease when the liability is greater, and a lower expense in later years as the liability reduces. As a result, the allowable tax deduction is likely to be higher in the earlier years and decreasing over the length of a lease.

Example of the impact on tax deductions

In this example a business has a three-year operating lease with a 5% discount rate:

Although the accounting treatment and the timing of tax deductions will change, the commercial substance of a lease should be the same and the total expense recognised in the profit and loss account (and allowable for tax) over the life of the lease will be the same.

Transitional adjustments

Businesses won’t be permitted to restate comparative amounts as a result of adopting the revised standard. Any cumulative difference arising on the initial recognition of the asset and liability will be recognised as an adjustment to the opening retained earnings at the time of adoption. For tax purposes the lessee is required to spread the total adjustment across the mean average length of the leases that have given rise to the adjustments.

The changes bring FRS 102 in line with International Financial Reporting Standards (IFRS). IFRS 16 Leases introduced the on balance sheet lease model in 2019. It gave different transition options including the ability to adjust the prior year comparatives. This was not included in FRS 102 and therefore transition adjustments may look different.

However in a group scenario where a subsidiary is consolidated into IFRS financial statements of the parent, the previously calculated IFRS figures used for the purposes of group reporting are permitted (but not required) to be used upon transition to FRS 102 in the subsidiary financial statements. This would minimise the administrative burden of running two sets of books.

To the extent that there are transitional adjustments that are subject to spreading, this is likely to give rise to deferred tax considerations on account of the difference in timing between the recognition of the item for accounting purposes and the timing of the recognition of taxable income or expenditure.

Other tax issues

It’s important to identify and track any capital elements included in the carrying value of ROU assets (such as stamp duty land tax) as depreciation on the capital elements remains non-deductible.

Companies

Corporate interest restriction

Prima facie the change in accounting will lead to an increase in the financing costs included in the company’s financial statements. To the extent that a ROU asset would have been classified as an operating lease under the previous GAAP rules, these financing costs should be excluded from the calculation of net-tax interest expense amounts. Similarly, the financing cost and the depreciation charge should be adjusted for when determining Group-EBITDA, essentially restoring the position to the status quo as if the combined cost had been recognised as a rental payment above the EBITDA line.

Impact on gross assets

With operating leases coming onto the balance sheet, the gross assets of a company will increase, which could affect its ability to qualify for some of the tax reliefs intended to encourage investment in smaller UK businesses, such as the:

• Enterprise Investment Scheme (EIS) – where the company’s gross assets must be no more than £15 million, and
• Seed Enterprise Investment Scheme (SEIS) – where the company’s gross assets must be no more than £200,000.

For larger companies, the impact of an increase in gross assets could cause groups to breach the thresholds for the current exemptions from mandatory transfer pricing for SMEs and the Senior Accounting Officer (SAO) regime.

Partnerships

Similarly, the changes may affect the profits of a partnership which in turn could impact the amount and timing of partners’ tax payments:

• If the initial change results in an unexpected increase in the profit of the partnership, the partners need to prepare for higher tax payments than they were expecting, potentially as early as 31 January 2026, and
• If the partnership has higher taxable profits caused by decreasing tax deductions over the life of a lease, the partners need to prepare for potentially increasing tax payments over time.

Tax planning

Businesses with operating leases that are likely to be within the scope of the changes should evaluate the impact for both accounting and tax purposes.  There will inevitably be an additional compliance burden associated with identifying the tax sensitive items in the financial statements and ensuring that the tax returns correctly reflect these.

While this article is focused on the basic tax considerations, there are a number of other non-tax considerations such as the impact on banking covenants and other financial ratios.

How we can help

We can help you prepare for the tax consequences of the lease accounting changes, ensuring you meet your compliance obligations and make the most of any planning opportunities. If you’d like to discuss how the FRS 102 amendments are likely to affect your tax position, please get in touch with Jonathan Hornby for companies or Ian Harlock-Smith for partnerships.