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Deferred tax may arise after effective date of tax law

The contrasting methodologies give rise to variations in profits

Accounting profits are determined in accordance with either the International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP), whereas taxable profits are computed based on the provisions outlined in the corporate tax law. The contrasting methodologies used to calculate profits under IFRS/GAAP and tax laws give rise to variations in profits, leading to distinctions such as permanent and temporary differences.

Permanent differences, as suggested by their name, are discrepancies of a lasting nature that affect a single period without influencing future periods. These disparities arise from items that are recognised by one authority but disregarded by another. Such items may be acknowledged under IFRS and GAAP but overlooked by tax laws, and vice versa. Common examples of such items include dividends, capital gains, fines, and penalties, among others. Like dividends and capital gains are the accounting income, but these are not taxable income. In the same way, fines and penalties are allowed as business expense, but these are not allowed as tax expense. Due to these principles, for one period accounting profits will be different from the taxable profits.

Temporary differences, as their name suggests, are discrepancies of a temporary nature where certain transactions create variations in one period that are subsequently reconciled in the following period(s). These disparities stem from items acknowledged by both regulatory bodies, albeit with differing recognition patterns. For instance, depreciation, recognized as an accounting expense and generally permissible under tax laws, may vary in terms of depreciation rate or method between administrations. While tax authorities typically employ the straight-line depreciation method, IFRS may mandate the use of the same or reducing balance method. Consequently, the timing of asset benefit consumption recognized by tax authorities may differ from the useful life stipulated by IFRS; however, both methods ultimately result in the same total depreciation amount over time. Such differences are called temporary differences, which can further be classified as deductible temporary differences and taxable temporary differences.

Deferred tax means the tax that has been deferred which will be settled at some future date. It arises solely from temporary differences, whereas permanent differences affect only a single period without any future implications. The deferred tax can be classified into deferred tax assets and deferred tax liability.

When calculations based on the relevant guidelines yield higher taxable profits in a one period and lower taxable profits in the subsequent tax period(s), companies are obligated to pay a greater amount of tax during the current period, with adjustments made in subsequent periods. This situation arises from deductible temporary differences, leading to the creation of deferred tax assets in the company’s financial records. Common examples of items that give rise to deductible temporary differences include deferred revenue, warranties, and provisions for bad debts.

Expenses such as bad debt provisions and warranties give rise to deductible temporary differences. For instance, companies record bad debt provisions as accounting expense, whereas tax authorities typically recognise them as expense when the debts are written off. Similarly, companies commonly set aside provisions for warranties, which tax authorities consider allowable expenses when the expenses associated with warranties are realised.

Taxable temporary differences occur when companies pay less tax in the current period, leading to a higher tax obligation in future periods. In simple terms, these differences, which decrease taxable profits in the current period, are known as taxable temporary differences. They result in the recognition of deferred tax liabilities, representing tax liabilities postponed to future periods. A typical example of such scenarios is prepayments. Under applicable IFRS, companies record prepayments as assets and amortise them over time. This results in a portion of the prepayments being recognised as an expense each year in the financial records, whereas tax authorities typically allow the full prepayment amount as an expense when the payments are made.

In the UAE, corporate tax is effective from June 01, 2023. While closing the books for the financial year ending after the effective date of the law, the businesses are liable to book the deferred tax asset or deferred tax liability based on the taxable temporary differences. Where companies have already closed the books and got the financial statements audited without considering the impact of deferred tax, they need to adjust the books and revise the financial statements.

Mahar Afzal is a managing partner at Kress Cooper Management Consultants. The above is not an official of Khaleej Times but an opinion of the writer. For any clarification, please feel free to contact him at mahar@kresscooper.com