While Example 1 above is a scenario that you do see in practice (i.e. where an entire lease building is being sub-leased), the more common scenario is where an entity sub-leases out a portion of the asset that it is leasing (i.e. it will retain a portion of the leased asset for its “own use”).
The question then arises, can (and should) the RoU asset from the (head) lease as lessee be split into separate components, and the operating lease versus finance lease assessment be made with respect to the separate components (i.e. looking at the sub-leased portion of the RoU Asset separately).
That is, what is a RoU asset’s “unit of account” (i.e. where accounting treatments are applied).
Because (part of) the RoU asset of property sub-leased is being held to collect rental income, (part of) the RoU asset will meet the definition of an “Investment Property”, and accordingly the requirements and guidance of NZ IAS 40 Investment Property (particularly with respect to “dual use” property) must be considered.
In relation to dual-use properties, NZ IAS 40 states that:
- If separate portions of the property (i.e. RoU asset from the (head) leases) cannot be sold separately, then an Investment Property can only exist for the property (i.e. RoU asset) in its entirety – i.e. there are no separate “units of account”.
Comment
With respect to sub-leases, the ability to “sell” separate portions is made with reference to the actual contractual terms associated with the RoU asset from the (head) lease as lessee, rather than the hypothetical rights associated with the actual, physical property in question.
Therefore, the ability to “sell” a portion of a RoU asset will depend on whether the entity as lessee under the (head) lease has the unilateral right (i.e. without the permission or authority of the lessor) to assign portions of the building it is leasing to other third-parties.
It is important to note that a right to assign a lease is very different to a right to sub-lease a lease – i.e. a right to assign acts to transfer (amongst other things) the obligation to make lease payments, and to make-good damage, from the original lessee to another party, whereas under a sub-lease, as far as the lessor is concerned, the original lessee (not the sub-lessee) still has the ultimate responsibility back to the lessor in all respects (i.e. there is no transfer of obligations).
In our experience, most property lease agreements (in New Zealand) have an explicit clause that expressly prohibits the unilateral right of assignment of a lease (whether in full or in part).
Commercially, this makes sense, as lessors will ultimately want to “vet” the parties to which it is ultimately exposed to risk (i.e. credit risk (non-payment), damage to the property etc.).
- The entire property (i.e. RoU asset from the (head) lease) is treated as an Investment Property (i.e. as one unit of account) if, and only if, only an insignificant portion is retained for “own use”.
Comment
Note that “insignificant portion” is not defined in NZ IAS 40 (or any other NZ IFRS).
In practice, quite a high threshold is applied (typically, where 5% or less is retained for “own use”, it will ordinarily be determined that the entire property (RoU asset) is an Investment Property – i.e. one unit of account).
Comment
If more than an insignificant portion is retained for “own use”, and (1) above is not met, then the RoU Asset is still only one “unit of account” (i.e. it cannot be separated), it just means that it does not meet the definition of an Investment Property.
Whether or not a RoU asset that is a single “unit of account” is an Investment Property is still an important distinction to make, as there are additional and consequential presentation and measurement requirements under NZ IFRS 16 for RoU assets that meet the definition of Investment Property.
Example 2(a) – “No assignment” clause, and more than an insignificant portion retained for own use
Details:
- Entity A leases a 25 floor office building for 5 years at $250k per year.
- Entity A sub-leases 1 floor of the office building for 5 years at $10k per year, and
- There is a “No assignment” clause in the (head) lease agreements as lessee.
Comments on the treatment to be applied:
- The presence of the “No assignment” clause indicates that the RoU asset associated with the leased office building would likely not be permitted to be split into separate components (i.e. individual floors).
- As more than an insignificant portion of the leased office building is retained for Entity A’s “own use” (i.e. 24 of 25 floors).
- The RoU Asset is not an Investment Property (in its entirety), and
- The sub-lease does not meet the indicators to be a finance lease with reference to the RoU asset in its entirety, and as such, the sub-lease is (simply) accounted for as an operating lease.
Example 2(b) – Ability to assign, and more than an insignificant portion retained for own use
Details:
- Same as 2(a) above, except that the (head) lease agreement as lessee does permit the entity to assign portions of the (head) lease unilaterally to other parties.
Comments on the treatment to be applied:
- The presence of the unilateral ability to assign portions of the (head) lease indicates that the RoU asset associated with the office building would likely be permitted to be to be split into separate components (i.e. separate floors).
- Accordingly, in this case, the RoU asset would be split between:
- An “own use” portion (apportioned 24 / 25ths ), and
- A “sub-lease” portion (apportioned 1 / 25th).
- Accordingly, the “Sub-lease” portion of the RoU Asset:
- Is an Investment Property, and
- Does appear to meet the indicators to be a finance lease with reference to the “sub-lease portion of the RoU asset, as:
- The term of the sub-lease (5yrs) is for a major part of “sub-lease” portion of the RoU asset (also 5yrs in this case), and/or
- The present value of the sub-lease payments will be substantially all[1] of the portion of the (head) lease payments apportioned to the floor being sub-leased.
Example 3(a) – “No assignment” clause, and less than an insignificant portion retained for own use
Details:
- Entity A leases a 25 floor of office building for 5 years at $250k per year.
- Entity A sub-leases 24 floors of the office building for 5 years at $240k per year, and
- There is a “No assignment” clause in the (head) lease agreements as lessee.
Comments on the treatment to be applied:
- The presence of the “No assignment” clause indicates that the RoU asset associated with the leased office building would likely not be permitted to be split into separate components (i.e. floors).
- As an insignificant portion of the office building is retained for “own use” (i.e. 1 of 25 floors).
- The RoU Asset is an Investment Property in its entirety, and
- The sub-lease will likely meet the indicators to be a finance lease with reference to the RoU asset in its entirety, as:
- The term of the sub-lease (5yrs) is for a major part of the RoU asset (also 5yrs in this case), and/or
- The present value of the sub-lease payments will be substantially all[1] of the portion of the (head) lease payments apportioned to the floor being sub-leased.
Example 3(b) – Ability to assign, and less than an insignificant portion retained for own use
Details:
- Same as 3 (a) above, except that the (head) lease agreement as lessee does permit the entity to assign portions of the (head) lease unilaterally to other parties.
Comments on the treatment to be applied:
- The presence of the unilateral ability to assign portions of the (head) lease indicates that the RoU asset associated with the office building would likely be permitted to be split into separate components (i.e. floors).
- However, because less than an insignificant portion has been retained for Entity A’s “own use” means that the entire RoU asset balance associated with the office building is accounted for as an Investment Property in its entirety.
- Accordingly, the same treatment as 3 (a) above is applied.
[1] Given that they are $240k per year versus $250k per year, and the lease is for the same length of time (5 years).
[1] Given that they are the same in terms of the gross amount per year (i.e. $10k vs [(1/25) x $250k]), and the lease is for the same length of time (5 years).