In our previous article, we discussed that the opening balance sheet for corporate tax purposes of a taxable person shall be the closing balance sheet prepared for financial reporting purposes under accounting standards applied in the UAE on the last day of the financial year that ends immediately before the commencement of the first tax period.
Moreover, we highlighted that the clause 2 of article 61 of the UAE Corporate Tax law (the law) requires that the opening balance for the first tax period should be based on arm’s length principles. This requirement is introduced to prevent non-arm’s length transactions, arrangements or balances that may have an impact on the taxable income of the future tax period.
To comply with the provision 61(2) of the law; taxable persons are liable to prepare the financial statements as per applicable International Financial Reporting Standards (IFRS), and carry forward the balances for tax purposes reflecting in the balance sheet of the latest financial year at the arm’s length price.
Certain balances such as cash, bank balances etc., reflecting in the balance sheet of the latest financial year, will not have any impact on the future taxable profits. We can therefore exclude these balances from our analysis.
Balances, showing in the closing balance sheet of the latest financial year, may be related to recent transactions with third parties i.e., parties that are not related parties or connected persons. These balances will already be based on arm’s length principles, and therefore, these may not require any adjustments. For example, if a company purchased machinery from a third party just before entering tax era, the value of the machinery showing in the balance sheet will almost be as per market value and may not require any major adjustment.
The taxable person can have a proper analysis of the balances related to transactions with related parties. If the sellers are based in jurisdictions where transfer pricing rules apply, we can assume that the seller has already charged an arm’s length price; and risk of non-arm’s length price are very minimal. Therefore, for the very recent transactions with such sellers, a fair market value of the asset will be showing in the balance sheet of the latest financial year.
For example, in August 2023, UAE based company, Cherry Ltd, purchased machinery from its UK based subsidiary, Berry Ltd, for Dh20 million. The machinery is still reflected in Cherry Ltd’s closing balance sheet for the financial year 2023 and will be depreciated in the future. The depreciation of the machinery will impact Cherry Ltd’s future taxable profits. Since Berry Ltd is a UK-based supplier and transfer pricing rules are applicable in the UK, for this recent transaction, we can assume that the machinery is priced at the market value.
Some balances will require adjustment to bring them at the arm’s length price. There can be various ways to bring the balances at the arm’s length price. One way to bring the balances at the arm’s length price is to use the fair market value of the assets and liabilities. Another way is to use the book value of the assets and liabilities, adjusted for any impairments or revaluations that have occurred since the date of acquisition. Finally, it is also possible to use a combination of these two methods.
The method that is used will depend on the specific circumstances of the taxable person. For example, if the taxable person has recently acquired an asset, it may be more appropriate to use the fair market value of the asset. On the other hand, if the taxable person has held an asset for a long time, it may be more appropriate to use the book value of the asset, adjusted for any impairments or revaluations.
For example, before their first tax period, S LLC acquired a financial asset from a company, W LLC. S LLC records the financial asset on a historical cost basis at Dh70,000 in its financial statements. At the beginning of its first tax period in June 2023, an independent expert valued the financial asset at Dh100,000. So, the opening balance of the asset used at the beginning of the first tax period should be Dh100,000 instead of Dh70,000, given in the books.
Let’s consider another example. P Ltd purchased a land and building from its related party for Dh15 million in 2010. The building was revalued at Dh20 million in 2018. The written down value shown in the closing balance sheet of the latest financial year 2023 is Dh17 million. However, the value of the property has increased, and the fair value of the building is now Dh19 million. Therefore, the opening balance of this building for the first tax period will be Dh19 million.
No matter which method is used, it is important to ensure that the opening balances are brought in at arm’s length. This means that the balances should be based on the prices that would have been charged or paid by independent parties in a similar transaction. This will help to ensure that the company’s taxable profits are accurately reflected and that the company is not subject to any additional or short tax liability in the future.
Where many transactions have been made with the same related party; nature, and timing of the transactions is same, the taxable person can make a cluster of transactions and adjust their opening balance through a single adjustment, instead of ascertaining the fair market value of each transaction separately.
The taxable persons should prepare their financial statements as per IFRS for the financial year immediately ending before the commencement of their first tax period; and have proper analysis of the balances showing in the related balance sheet to bring it at the fair market value.
Mahar Afzal is a managing partner at Kress Cooper Management Consultants. The above is not an official opinion of the Khaleej Times but an opinion of the writer and it should not be considered a formal advice. For any queries/clarifications, please write to the writer at [email protected]