Corporate Tax: How to evaluate accounting profits versus taxable profits

Our first article on the corporate tax highlighted that accounting profits are different from taxable profits, and corporate tax applies to taxable profits. I emphasised that accounting profits are calculated on the accrual basis of accounting, while taxable profits are computed by using accrual and cash basis.

In other words, we can say that accounting profits are calculated based on the applicable International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP) while, taxable profits are computed based on the guidelines given in corporate tax law and related regulations.

Since the rules of computation of profits under IFRS and GAAP are different from the basis defined in the corporate tax law, so these various principles and guidelines to calculate the profits lead to the following differences in the profits:

• Permanent difference

• Temporary difference

As the name implies, permanent differences are the differences of permanent nature that have an effect in one period, and it does not have any impact on the future period/periods. The items that create permanent differences are accepted by one administration while not considered by the other. Like such items may be accepted under IFRS and GAAP and not considered by the corporate tax law and vice versa. The typical examples of such items are dividends, capital gains, fines and penalties etc.

Dividends and capital gains are the accounting income, but these are not taxable income, as mentioned in the press release issued by the UAE’s Ministry of Finance. So, the period in which dividends and/or capital gains appear in the accounting profits, for that period, accounting profits would be higher than the taxable profits.

In the same way, fines and penalties usually create permanent differences. While computing accounting profits, fines and penalties are being reported as an expense, but these are not generally being accepted by the Law as an allowable expense. Due to these different recognition principles, accounting profits of the relevant period would be lower than the taxable profits of the respective period.

Temporary differences, as the name suggests, are differences of temporary nature. This means in one period, some transactions are creating differences, and in the subsequent period/periods, these differences are being offset. The items that create temporary differences are accepted by both administrations, but the pattern of recognising them vary from one to another. Like depreciation is an accounting expense and generally allowable expenses under the corporate tax law as well, but the rate of depreciation and/or method of depreciation may vary from one administration to other administration. Usually, tax authorities follow the straight-line depreciation method, and IFRS requires the same or reducing balance method. Based on these facts, in the eyes of the tax authorities, the pattern of consuming benefits of the assets may be different from the useful life required by the IFRS, but over the period, both methods would have the same depreciation amount.

Temporary differences can further be classified into the followings:

• Deductible temporary differences

• Taxable temporary differences

If the calculation under the respective rules resulted in more taxable profits in one period, then companies would be liable to pay more tax in that period which would be adjusted in the future period/periods. In the language of a layman, I will say that this is due to the deductible temporary differences. Such differences would create deferred tax assets in the books of the company. The key examples of the items that create deductible temporary differences are deferred revenue, warranties, bad debts provisions etc.

Since advances would not be subject to corporate tax in the UAE, so deferred revenue would not create any differences but other expenses like bad debts provisions, warranties etc. will give birth to deductible temporary differences.

For example, companies creating bad debts provisions are booking it as an expense, but tax authorities are usually considering it as an expense when these debts are being written off. In the same, companies are generally creating provisions for warranties, but these are considered allowable expenses by the tax authorities when this expense will be incurred.

In the taxable temporary differences, companies are paying lesser tax in the current period, and they are liable to pay more tax in the future period/periods. Such differences that result in lessor taxable profits in the current period are called taxable temporary differences in the language of ordinary man. Taxable temporary differences result in deferred tax liability. This means a liability that has been deferred for future periods. The classic example of such instances is prepayments. As per applicable IFRS, companies are booking prepayments as an asset and amortising over the period. This means each year certain portion of the prepayments is being classified as an expense in the accounting record but, generally tax authorities allow the full amount as an expense when payments are being made.

The above understanding is based on the global practices, and the Corporate Law once introduced by the UAE government would give us comprehensive understanding about the items that would create permanent differences and temporary differences, and we will keep you updated accordingly.

Mahar Afzal is a managing partner at Kress Cooper Management Consultants. The above is not an official but a personal opinion of the writer. For any queries/clarifications, please write to him at compliance@kresscooper.com.