Understanding the Tax Impact for UK Businesses
The lease accounting rules for many UK businesses are changing from January 2026 hence its important to know about the FRS 102 lease changes tax treatment as well. This article is an essential guide to tax implication of FRS 102 lease changes. While the accounting impact is widely discussed, the tax consequences are equally important and in some cases more immediate. It is essential to understand the FRS 102 lease changes tax treatment as these changes unfold.
These changes arise from amendments to FRS 102, the main UK accounting standard for small and medium sized entities. The revised standard applies to accounting periods starting on or after 1 January 2026, with early adoption permitted. One of the most significant changes affects how lessees account for leases, and this will have implications for both companies and partnerships.
This article explains the changes, how they affect tax deductions, and what UK businesses should be doing now to prepare for the FRS 102 lease changes tax treatment.
Existing lease accounting rules under FRS 102
Under the current version of FRS 102, leases are classified as either finance leases or operating leases, with different accounting and tax treatments.
Finance leases
A lease is treated as a finance lease where the lessee has substantially all the risks and rewards incidental to ownership of the leased asset.
Under this treatment:
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the lessee recognises a lease asset and a corresponding liability on the balance sheet
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the asset is depreciated over its useful life
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a finance cost is recognised on the lease liability
For tax purposes, both the depreciation charge and the finance cost are generally allowable deductions, subject to normal tax rules.
Operating leases
Where the lessee does not have substantially all the risks and rewards of ownership, the lease is treated as an operating lease.
Under an operating lease:
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rental payments are recognised as an expense in the profit and loss account
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the expense is typically spread on a straight line basis over the lease term
These rental expenses are also fully deductible for tax purposes when incurred.
New lease accounting rules and right of use assets
From January 2026, the distinction between finance leases and operating leases for lessees will be removed.
Instead, most leases will be recognised on the balance sheet as:
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a right of use asset
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a corresponding lease liability
This applies to almost all leases, subject to exemptions for:
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short term leases, where the lease term ends within 12 months of commencement
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low value asset leases, which are entity specific but likely to include items such as laptops and mobile phones
Accounting and tax treatment under the new rules
The right of use asset is initially measured at the present value of lease payments and depreciated on a straight line basis over the lease term.
In the profit and loss account, the lessee recognises:
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depreciation on the right of use asset
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a finance cost on the lease liability
For tax purposes, both amounts remain allowable deductions, but the timing of those deductions changes.
Example: impact of FRS 102 lease changes on tax deductions
To illustrate how the revised rules affect the timing of tax deductions, consider the following example.
Scenario
A UK business has a three year operating lease with:
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annual lease payments of £24,000
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a 5 percent discount rate
Under the old FRS 102 rules, the lease would have been treated as an operating lease and £24,000 would have been deducted each year for tax purposes.
Under the new rules, the lease is recognised on the balance sheet as a right of use asset with a corresponding lease liability.
Accounting and tax charges under the new rules
| Year 1 (£) | Year 2 (£) | Year 3 (£) | |
|---|---|---|---|
| Cash payments | 24,000 | 24,000 | 24,000 |
| Finance cost (interest) | 3,250 | 2,413 | 1,333 |
| ROU asset depreciation | 21,668 | 21,668 | 21,668 |
| Total lease expense | 24,918 | 24,081 | 23,001 |
| Expense under old rules | (24,000) | (24,000) | (24,000) |
| Difference in tax deductions | 918 | 81 | (999) |
What the example shows
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In Year 1, tax deductions are higher than under the old rules because the finance cost is highest when the lease liability is largest.
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In Year 2, the difference reduces as interest unwinds.
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In Year 3, deductions are lower than under the old rules because most of the interest has already been recognised.
Although the total amount deducted over the life of the lease is unchanged, the deductions are front loaded into the earlier years. This timing difference can affect taxable profits and cash flow.
Transitional adjustments on adoption
FRS 102 does not permit restatement of comparative figures when adopting the revised lease standard.
Any cumulative difference arising on transition is recognised as an adjustment to opening retained earnings at the date of adoption.
Tax treatment of transitional adjustments
For tax purposes, the total transition adjustment must be spread over the mean average length of the affected leases.
This spreading requirement can result in timing differences between accounting and tax, which may give rise to deferred tax balances.
Interaction with IFRS and group structures
The revised FRS 102 lease model broadly aligns with IFRS 16, which introduced on balance sheet lease accounting in 2019.
However, FRS 102 does not allow retrospective restatement of comparatives. This means transition outcomes may differ from IFRS.
In group situations where a subsidiary reports under FRS 102 but is consolidated into IFRS accounts, the subsidiary is permitted, but not required, to use previously calculated IFRS lease figures on transition. This can significantly reduce administrative complexity.
Other key tax considerations
Capital elements within right of use assets
Any capital elements included within the right of use asset, such as stamp duty land tax, must be separately identified.
Depreciation relating to capital elements remains non deductible for tax purposes.
Specific considerations for companies
Corporate interest restriction
The new accounting treatment increases reported finance costs. Where a lease would previously have been an operating lease:
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the finance cost should be excluded from net tax interest expense
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depreciation and finance costs should be adjusted when calculating Group EBITDA
This broadly preserves the previous tax outcome.
Impact on gross assets
Bringing operating leases onto the balance sheet increases gross assets, which may affect eligibility for:
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Enterprise Investment Scheme relief
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Seed Enterprise Investment Scheme relief
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SME exemptions from transfer pricing
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the Senior Accounting Officer regime
Considerations for partnerships
For partnerships, changes in accounting profits feed directly into partners’ taxable income.
This means:
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higher than expected tax payments may arise as early as January 2026
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decreasing deductions over time may lead to increasing tax liabilities in later years
Advance cash flow planning is essential.
Tax planning and next steps
Businesses with operating leases should assess the impact of the FRS 102 lease changes well before adoption.
Key actions include:
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reviewing lease portfolios and identifying tax sensitive items
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modelling the impact on taxable profits and cash flow
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preparing for transitional adjustments and deferred tax
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considering wider impacts such as banking covenants and financial ratios
While the commercial substance of leases does not change, the timing of tax deductions and reported profits does. Early planning will help businesses manage compliance, cash flow, and stakeholder expectations effectively.
