Sub-leases of real estate
New classification guidance means that more sub-leases are finance leases under IFRS 16 than previously, impacting the financial position and financial performance of intermediate landlords.
A sub-lease is a transaction in which a lessee (or ‘intermediate lessor’) grants a right to use the underlying asset to a third party, and the lease (or ‘head lease’) between the original lessor and lessee remains in effect. (IFRS 16.3)
A company applies IFRS 16 to all leases of right-of-use assets in a sub-lease. The intermediate lessor accounts for the head lease and the sub-lease as two different contracts.
An intermediate lessor classifies the sub-lease as a finance lease or as an operating lease with reference to the right-of-use asset arising from the head lease. That is, the intermediate lessor treats the right-of-use asset as the underlying asset in the sub-lease, not the item of property, plant or equipment that it leases from the head lessor. (IFRS 16.B58)
At the commencement date of the sub-lease, if the intermediate lessor cannot readily determine the rate implicit in the sub-lease, then it uses the discount rate that it uses for the head lease to account for the sub-lease, adjusted for any initial direct costs associated with the sub-lease. (IFRS 16.68)
However, if the head lease is a short-term lease for which the company, as a lessee, has elected the short-term lease exemption, then as an intermediate lessor the company classifies the sub-lease as an operating lease. (IFRS 16.B58)
When the leased property meets the definition of investment property, see Investment property.
Case – Sub-lease classified as a finance lease with reference to the right-of-use asset in the head lease
Head lease: Intermediate landlord L enters into a five-year lease for 5,000m2 of office space (the head lease) with Company M (the head landlord).
Sub-lease: At the beginning of Year 3, L sub-leases the 5,000m2 of office space for the remaining three years of the head lease to Sub-tenant N.
L classifies the sub-lease with reference to the right-of-use asset arising from the head lease. Because the sub-lease is for the whole of the remaining term of the head lease – i.e. the sub-lease is for the major part of the useful life of the right-of-use asset – L classifies it as a finance lease.
At the commencement date of the sub-lease, L:
During the term of the sub-lease, L recognises both interest income on the sublease and interest expense on the head lease.
Food for thought – Does entering into a sub-lease with a longer term than the remaining head lease term trigger a remeasurement of the head lease?
Yes. Two parties may enter into a sub-lease in which the non-cancellable period of the sub-lease or the sub-lease term – i.e. including one or more optional periods – exceeds the lease term for the head lease. Because the act of entering into the sub-lease is a significant event within the intermediate lessor’s control, it reassesses the head lease term. This results in the term of the head lease being equal to or longer than the term of the sub-lease. If this represents a change in the term of the head lease, then this will trigger a remeasurement of the intermediate lessor’s liability under the head lease.
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