UAE Corporate Tax – Year 1 transition isn’t quite plug and play last year’s accounts

The UAE corporate tax regime works off financial statements prepared in accordance with IFRS. This accounting driven approach makes pragmatic sense given the regulatory requirement for UAE incorporated or registered entities to file audited financial statements annually. However, as taxpayers sift through each Ministerial or Cabinet decision, the divergence between tax and accounting treatment appears to be growing.

Not quite plug and play

The consultation document expressed the possibility of a relatively smooth entry into the corporate tax regime by not requiring business to restate their balance sheet on transition into the first assessment year by relying on the closing balance sheet from the preceding period as the opening position. However, when the enacted legislation came through, the transitional provisions raised some concerns as to whether this was likely to happen.

Article 61 sets out the transitional rules. Its stated 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. However, this balance sheet may be subject to conditions or adjustments to be prescribed and it 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.

The legislation generated a certain amount of anxiety amongst taxpayers as 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. It then started to dawn on most taxpayers that the tax accounting transition into the first assessment year was not going to a simple case of picking up and plugging in existing financial statements. Corporate tax specific financial statements are required.

Quasi Market Value Step Up on Transition - Ministerial Decision No.120 of 2023

In my previous note I made some observations around some potential situations where on balance sheet asset values may be understated and that taxpayers may feel compelled to restate their financial statements. The MoF and FTA have via the aforementioned Ministerial Decision, provided a fairly elegant solution to this potential issue.

Briefly, the decision sets out a series of transitional adjustments which taxpayers may elect to apply in relation to immovable property, intangible assets, financial assets and liabilities measured on a historical cost basis in their financial statements. Taxpayers can choose to make an irrevocable election to exclude from taxable income, the portion of the gain which arises in the period prior to the start of the first tax period in relation to immovable property or intangible assets. A similar election is also available in quantifying gains or losses in relation to financial assets and liabilities.

For practical purposes, this is a quasi market value restatement at the start of the first tax period without actually restating financial statement asset values. Some taxpayers may be disappointed that this does not translate into say, increased depreciation or capital allowance relief in the assessment year preceding actual disposal of the asset and there is potentially no transition relief if the asset is never sold. However, it does mean that financial statements do not need to be restated for these asset classes and there will be no profit adverse hit from say, higher depreciation charges. That said, valuations will need to be sought and meticulous records will need to be maintained.

For some taxpayers, this may not be enough, in which case a revaluation and restatement of the balance sheet may still be pursued. However, it remains to be seen if the FTA takes issue with this and chooses to invoke the anti abuse rule. Also, there will be many questions as everyone delves into what precisely market value, original cost and net book value translates into for their particular circumstances.

Tax Groups – Corporate Tax Specific Accounts Required

?Chapter 12 of the tax legislation allows 95% commonly owned company groups to form a single tax group for corporate tax purposes. In the case of an inbound investor or a domestic group, the top most entity in the UAE should be the parent of the group with all qualifying 95% or more subsidiaries down this vertical chain of entities as group 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. Short version, existing financial statements may not be fit for purpose, requiring substantial adjustment to achieve the desired outcome.

Article 3 of Ministerial Decision No.114 of 2023 explicitly sets out that tax groups need to prepare a standalone set of financial statements. These financial statements are to be prepared by aggregating the stand alone financial statements of the parent company and each subsidiary that is a member of the tax group, eliminating intra group transactions as required under Clause (1) of Article 42 of the law. Some groups may be fortunate in that these financials are identical to those they currently prepare to have audited and file with the regulatory authorities. However, for everyone else, you might want to get started configuring your ERP to churn out a corporate tax specific set of consolidated financial statements for your tax group.

Tax Groups – Aggregation approach implies no acquisition accounting underlying asset value restatement

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.

Given that Ministerial Decision No.114 of 2023 explicitly prescribes an aggregation approach, this implies that acquisition accounting is inapplicable. Consequently, there will be no restatement of underlying asset values of subsidiary members. What this means is that acquisition premiums paid on share acquisitions may not translate into depreciation or capital allowance relief. Also, there could be some quirky outcomes on asset disposal. At this stage, the regime does appear to have been built with an inside outside cost base mismatch for share deals involving tax groups.

Other observations

There are many other accounting driven quirks which do appear in terms of depreciation, treatment of unrealised gains and losses, deduction availability etc. Too many to discuss in this note, something to cover in another.