In the case of a LILO where the leases were both finance leases, following the GAAP P&L might mean the expected net amount is taxable/deductible, and HMRC would generally expect this approach to be taken. However, as a matter of law, the full rentals are deductible and taxable on revenue account. Section 46 CTA 2009 thus has to be supplemented by taxing/relieving not merely the finance income and charge which go through the GAAP P&L. In the case of a finance lessor, it is a commonplace that the balance sheet element of rentals receivable needs to be taxed. In the case of a finance lessee, Statement of Practice (SP) 3/91 requires depreciation of an asset, however in a LILO scenario there will be no fixed (or right of use) asset as it will have been derecognised and replaced by a financial receivable. Despite this, the underlying ‘longhand’ analysis is that the full rental payable is tax deductible.
These questions are now relevant in a wider number of situations. This is because under IFRS 16 (and FRS 102 when it introduces right of use concepts from 2026) the sublease will be a finance lease where it broadly matches a right of use headlease.
It is important to remain focused on the true nature of the rentals.
On the grant of a sublease which triggers derecognition of a headlease, an accounting gain or loss may arise. This will represent the difference between the Present Value of rentals and the carrying value of the headlease. This will not be taxable as it is capital but there is no capital sum (assuming no premium) nor a disposal of the headlease interest. The difference between the headlease and sublease rentals should be recognised in future periods on revenue account. To ensure that revenue deductions for headlease rentals are given, it is necessary to proceed as though the headlease right of use asset has not been derecognised in order to obtain the legally correct rental deductions.
This is a practice area which seems to trouble a number of taxpayers and advisers. If HMRC go on to cover it in their manual this is likely to be of benefit.
