UAE Corporate Tax – Which set of financial statements in transition?

The new corporate tax regime works off financial statements prepared for financial reporting purposes in accordance with accounting standards. This design feature makes pragmatic sense since UAE incorporated or registered entities file audited financial statements annually. However, as pointed out in my February 2023 note on operating leases, accounting treatment can diverge materially from the underlying arrangement. This note sets out some other observed quirks encountered by businesses trying to navigate the transition into the new corporate tax regime.

You start off where you last left things or do you?

Item 10.17 of the consultation document expressed the intention to ease entry into the corporate tax regime by not requiring business to restate their balance sheet upon entry. This was to be achieved by allowing business to rely on the closing balance sheet from the preceding period as their opening position. This was a noble and aspirational goal to make the transition as fuss free as possible. However, the enacted legislation places some hurdles for business to navigate through in transition.

Article 61 contains the transitional rules for the new corporate tax regime. Its purpose is to set the corporate tax opening balance sheet for the first assessment year to be the closing balance sheet prepared for financial reporting purposes under accounting standards from the preceding financial year. This balance sheet may be subject to conditions or adjustments to be prescribed. Also, the balance sheet needs to be prepared in compliance with the arm’s length principle prescribed by Article 34 as well as the general anti abuse rule as set out in Article 50.

Accounting standard classification, treatment, value quantification and disclosure of related party transactions can diverge quite substantially from the arm’s length principle as well as the actual terms and amounts which the parties undertook to transact. On this basis, the tax accounting transition into the new corporate tax regime is unlikely to be as easy as picking up and running with financial statements prepared, audited and lodged with authorities, especially if there are any related party transactions.

Figuring out the tax base??

Article 20 in the legislation states that taxable income of each taxable person is to be determined based on adequate, standalone, accounting standard compliant financial statements prepared for financial reporting purposes, using adjusted accounting income. The provision then goes on to set out options for the treatment of unrealised gains and losses as well as defining the capital vs revenue distinction. However, there are no other provisions which prescribe how taxpayers are to determine the tax base of assets for the purpose of say, quantifying depreciation or gains and losses, other than the transitional rules in Article 61.

Relying on financial statements to say, set a depreciation base is less than straight forward. In most tax systems, depreciation bases are typically driven off the actual acquisition cost. Financial reporting broadly adopts a similar approach under IAS16, in that initial measurement relies on a cost based approach. However, it is important to also be aware that revaluations and impairments to fair value also occur under accounting standards. The book value of assets may have been impaired below current fair value due to the Covid 19 pandemic and the uncertainty created by the conflict in Ukraine. Consequently, failing to revalue and restate previously impaired asset values in the accounts as part of the transition into the first assessment year could potentially result in permanent loss of depreciation base. However, this revaluation needs to be supportable (e.g. this reflects genuine fair value recovery) as the general anti abuse rules will need to be factored in. ?

Another potential quirk arises in quantifying the depreciable base if the financial statements used are translated from a foreign functional currency into a presentation currency pursuant to IAS21. Foreign exchange fluctuations can distort the cost of assets and thus the depreciable base, depending on whether the conversion rate originates from the transaction date, accounting standards or the applicable exchange rate pursuant to Article 43 of the tax legislation. There is more likely to be a material difference where the currencies involved are not fixed or pegged.

Accounting standards can, in some circumstances, separate a financial arrangement into equity and debt components. Whilst the tax legislation is silent on debt vs equity classification, it is not uncommon to see different classification for tax purposes, if for instance, a business was required to apply arm’s length principles for transfer pricing purposes due to tax treaty override. Additionally, there is the question of differences in measurement approaches under accounting standards vis-à-vis the arm’s length principle. Consequently, taxpayers are likely to seek clarification on how to proceed with quantifying gains or losses arising from these types of instruments.

Tax Groups – Existing Consolidated Accounts or Consolidate Stand Alone Accounts?

Chapter 12 of the tax legislation allows for 95% commonly owned company groups to form a single tax group for corporate tax purposes. These rules suggest that if an inbound corporate group into the UAE is to form a tax group is to be formed, the top most entity in the UAE as the parent of the group with all qualifying 95% or more subsidiaries down this vertical chain of entities as potential members.

Article 42 requires the tax group to prepare consolidated financial statements in accordance with accounting standards applied in the UAE. It is important to note that the requirement to prepare consolidated financial statements under IFRS 10 is driven by the accounting standard (IFRS 10) definition of control and is thus triggered at a much lower level of ownership than for tax purposes. Consequently, the composition of the group in the consolidated financial statements are likely to be different for accounting vis-à-vis tax purposes and this is before throwing in other complications such as free zone entities.

This also raises the question of whether a specific set of consolidated financial statements is required for UAE corporate tax purposes and how these are to be prepared. Taxpayers would value guidance on whether tax groups can fulfil their Article 42 obligations by adjusting existing consolidated accounts (if these already exist) to exclude non qualifying entities or by consolidating the stand alone accounts of the qualifying entities.

It remains to be seen if a single group can be formed if there are multiple entry points into the UAE or if each vertical chain must form its own tax group. The former approach is not uncommon in other jurisdictions. For instance, the Netherlands fiscal unity system allows sister companies to form a group if they are 95% commonly owned by a non Dutch resident holding company. It is noted that the loss transfer rules in Article 38 appear to allow for loss transfers across 75% commonly owned sister companies. I mention this as tax specific consolidated financials would be required as this grouping would likely exist only for corporate tax purposes and not financial reporting purposes under accounting standards.

Tax Groups – Which set of financials determines underlying asset value?

Underlying asset values are often substantially different in the consolidated group financial statements vis-à-vis the individual entities. Typically, consolidated financial statements restate the underlying assets and liabilities of its subsidiaries whilst subsidiary financial statements remain unchanged. Further variations can arise depending on how the UAE applies accounting standards (e.g. IFRS 3) with respect to business combinations.

In some circumstances, consolidated financials may not restate the underlying assets to fair value, thus failing to recognise the acquisition premium paid. For instance, this can occur when a consolidated group is already in existence, for accounting purposes, and the parent increases its ownership interest in the subsidiary from 60% to 95% in a creeping acquisition or as a result of a reorganisation. This is referred to as a common control transaction whereby the underlying assets are recorded in the consolidated financial statements using the predecessor value method, ignoring any further acquisition premium paid to increase ownership from 60% to 95%.

Now imagine if this increase in ownership occurs just prior to the formation of a tax group as it transitions into the first assessment year of the corporate tax regime. If consolidated financial statements are to be prepared for the tax group in accordance with accounting standards pursuant to Article 42, this implies that the common control rules could apply to depress asset values. This then raises the question of whether such an approach complies with the arm’s length principle as required by the transitional rules in Article 61, especially if the acquisition premium paid reflects consideration paid to third parties in a bona fide market transaction.

These quirks are being highlighted as there is no guidance on how to set the tax cost base of depreciable assets, especially for tax groups. Some jurisdictions, such as Australia require the cost base of the underlying assets to be reset whereas other jurisdictions such as the Netherlands allow for depreciation of goodwill.

Final Observations

The quirks observed in this note only scratch the surface in terms of the many tax accounting considerations requiring attention. Not only do the newly established tax functions have to navigate the legislation and prepare themselves for the transition into the new corporate tax regime, it appears that the finance functions have their hands full with a very substantial technical accounting exercise to generate a corporate tax specific set of financial statements.?