Saudi Arabia’s new draft tax laws

Saudi Arabia’s Zakat, Tax, and Customs Authority (ZATCA) is in the process of comprehensively reforming its income tax and zakat framework, which mainly entails the introduction of a revised Income Tax Law, aiming to replace the existing law, and a unified Zakat and Tax Procedures Law. The aim is to foster a more business-friendly environment that attracts Foreign Direct Investment (FDI), while ensuring compliance with international standards. We provide the key highlights of the draft laws below.

Key highlights of the proposed reforms

Comprehensive Tax Law Amendments: The proposed Draft Income Tax law introduces changes in partnership tax treatment, investment funds, and micro-enterprise taxpayers. It also includes detailed provisions for transfer pricing and introduces the concept of a preferential tax regime, which applies to international jurisdictions imposing an income tax rate under 15%.
Force of attraction rules: The force of attraction principle is based on the concept that when a company has a permanent establishment (PE) in a foreign country, it becomes liable to pay taxes on the income generated from its operations in that country. This rule is being updated so that it applies when a non-resident taxpayer with a PE in Saudi Arabia conducts similar activities to its PE. However, this rule can be waived if the non-resident taxpayer can demonstrate valid economic or commercial reasons for not conducting these activities through its Saudi PE.
Permanent Establishment: The concept of a Permanent Establishment (PE) has undergone revisions to specify instances that may establish a PE for a non-resident entity in Saudi Arabia. These instances include:

The presence of a management site;
Offices;
Facilities functioning as sales outlets;
The provision of services within Saudi Arabia directly by a non-resident entity or via its employees, associates, contractors, or other appointed individuals, particularly if these services extend over 30 days or more in any 12-month period.

The draft has the effect that a PE is not automatically established where a non-resident conducts business in Saudi Arabia through a broker, a general commission agent, or any other independently acting agent. However, if an agent’s business mainly represents a non-resident entity and the terms between them are not akin to those typically set between two unrelated parties, this agent may be regarded as dependent under the new law, thus establishing a PE presence.

Preferential Tax Regimes: For the first time, the Draft Income Tax Law introduces the notion of ‘preferential tax regimes’, defining these as systems that offer tax or related benefits exceeding those available under Saudi Arabia’s own laws.

Characteristics of a preferential tax regime include:

An income tax rate below 15%.
Absence of an information exchange agreement with Saudi Arabia.
Provision of tax advantages to entities without the necessity for actual economic activity or lacking substantial commercial presence.

Anti-avoidance: The Draft law also focuses on anti-avoidance, stipulating that transactions involving entities in preferential tax regimes will be subject to distinct tax treatments. This includes the rules on the deductibility of expenses, depreciation methods, withholding tax rates, and transfer pricing regulations.

Transfer pricing: Additionally, the Draft Law further specifies that expenses not adhering to the arm’s length principle, when paid to related entities or permanent establishments in these preferential tax regimes, will not be recognized for tax purposes.

Hybrid Instruments: The concept of “hybrid instruments” is now defined in the Draft law, and these instruments will not qualify for tax deductions or exemptions if their tax treatment differs in the jurisdiction of the counterparty, especially if the appropriate tax is not applied in that jurisdiction.

Additionally, tax deductions in Saudi Arabia may not apply to payments made to a non-resident entity if that entity is not recognized as a legal entity in its home jurisdiction, does not hold a similar status under the tax laws of its home country, or where payments are not subject to taxation in the entity’s home country.

Mergers and restructuring: The proposed Draft Income Tax Law stipulates that in the event of a merger or demerger, where equity, or assets and liabilities of a legal entity are transferred, the resulting profits and losses will not be included in taxable income, provided that the assets and liabilities involved are valued at their book values prior to the merger.

Participation exemption: Dividends, capital gains, and liquidation distributions from a resident’s direct investment in resident or non-resident entities may be exempt from corporate income tax, provided that the taxpayer holds at least 10% stake for a continuous 365-day period before the year of distribution. The draft law also outlines specific scenarios where this exemption does not apply.

Sale of shares in KSA company: A non-resident company may be exempt from income tax on gains from the direct or indirect disposal of shares, stocks, units, or partnership interests in a Saudi-based company, on condition that the sale is to another company within the Kingdom that belongs to the same group.

Resident Natural Persons: The new draft stipulates specific conditions under which a natural person who is resident in Saudi but does not hold Saudi nationality is considered a resident for tax purposes, such as staying in Saudi Arabia for a certain number of days within a tax year. Where such natural person is resident in the Kingdom and is involved in a commercial activity, income derived from such activity will be subject to 20% income tax.

This includes, but is not limited to:

Revenue from activities performed in or outside Saudi Arabia;
Earnings from movable or immovable property;
Profits from owning, trading, and disposing of shares or units in legal entities, including dividends and other distributions;
Income from activities conducted by a permanent establishment located outside the Kingdom.

Non-Saudi Residents: The tax base for non-Saudi residents includes income from activities within the Kingdom, minus deductible expenses. There are specific provisions for calculating the tax base for those involved in oil and hydrocarbons production.

The draft law also reaffirms that income from employment does not fall under the taxable category for non-Saudi resident individuals. This concept has already been an interpretation of the current income tax law, but has now been made clearer by the draft revision.

Withholding Tax (WHT) Rates and Categories: The law suggests various WHT rates for different categories, such as services, dividends, and rental payments, and introduces specific rates for transactions with preferential tax regimes. Payments involving debt claims, dividends, rent, services, and royalties to a Resident Person or Permanent Establishment in a preferential tax regime are subject to a 20% withholding tax.

Limitations to interest on loans: Loan charges will be deductible to the extent of 30 percent of the adjusted earnings, as per BEPS.

Way forward

For businesses operating in or planning to enter the Saudi market, these changes necessitate a proactive approach to address the following:

Review: Businesses should thoroughly analyze how these changes impact their operations, particularly in terms of residency status, taxable income, and compliance obligations. Companies should also understand their revised tax obligations early to avoid penalties for non-compliance.
Strategic Tax Planning: Consider the implications of the new tax laws on business structure, especially for partnerships and investment funds.
Monitor International Transactions: Pay special attention to transactions with entities in preferential tax regimes and adjust transfer pricing policies accordingly.
Tax incentives: Identify and leverage tax incentives to enhance sustainability and potential tax benefits.

In summary, these sweeping reforms present both challenges and opportunities for businesses. By staying informed and adapting strategies accordingly, businesses can navigate this changing landscape effectively, ensuring compliance and optimizing their tax positions in Saudi Arabia.

Authored by: Zain Satardien, Aakriti Sharma

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