Tax Alert: A closer look at the proposed Income Tax Law

In its efforts to achieve the goals set by Vision 2030, Saudi Arabia's economy is going through a remarkable transformation, with an increased focus on industry diversification and modernization efforts. As a result, the country is witnessing a notable increase in foreign investment, bolstering its financial stability and global presence.

As the country focuses on attracting foreign investments and welcoming multinational companies to Saudi Arabia, the Zakat, Tax and Customs Authority (ZATCA) released the draft Income Tax Law soliciting public feedback. The proposed amendments in the Income Tax Law aim to encompass the international best practices and are summarized in this Tax Alert. The deadline for submitting comments on the draft Income Tax Law is 25 December 2023.

The definitions under Article 1 have been revised to include new definitions as well as revise certain terms to provide additional clarifications including but not limited to the following:

The scope of “royalties” has been widened to not only include the exploitation of natural or mineral resources but also the exploitation of intellectual rights.

“Activity” has been redefined to include an ongoing activity and/or a series of activities carried out to generate profits.

“Partnerships” have been redefined to include general partnership, a limited partnership, and any other form of partnership, other than the established forms of companies formed under the company law.

“Person” have been redefined to include, inter alia, endowments, investment funds, and any form of partnership.

“Payments” have been defined anew to include, inter alia, in-kind considerations paid or payable, including settlements, set-offs, and book adjustments.

“Islamic financial instruments” have been defined to include any contracts, arrangements, or financial rights that are compliant with the Shari’ah law.

The Draft Income Tax Law proposes that in the absence of the definition of a specific term, the following hierarchy is to be followed to ascertain the meaning:

• The Regulations;
• Zakat and tax procedure law;
• Other tax and Zakat laws in force in Saudi Arabia;
• Other regulations in force in Saudi Arabia, provided that such definitions do not contradict the provisions of the Income Tax Law;
• International agreements; and
• Accounting standards adopted by the Saudi Arabian Organization for Certified Public Accountants (SOCPA), provided that such definitions do not contradict the provisions of the Income Tax Law.

The definition for a legal person to be a “resident” for corporate income tax purposes has been expanded to include, inter alia, governmental departments formed in Saudi Arabia including ministries, public institutions, general authorities, and related entities.

As for natural persons, the “minimum presence test” for a natural person to be a resident of Saudi Arabia for corporate income tax purposes has been redefined as follows:

• A person domiciled in Saudi Arabia;
• A person holding a statutory residence permit in Saudi Arabia and is present in Saudi Arabia for 30 days or more, continuous or in the aggregate, within 365 days starting from the first day of residence for the relevant tax year;
• A person residing in Saudi Arabia for 183 days or more, continuous or in the aggregate, during a tax year;
• A person residing in Saudi Arabia for less than 90 days, continuous or in the aggregate, during a tax year and resided in Saudi Arabia for 270 days or more, continuous or in the aggregate, within the preceding three tax years.

The underlying notion of the force of attraction rule envisages that when an enterprise is said to have a permanent establishment in another country, it exposes itself to being taxed on the income earned by it from carrying out activities in that other country.

The force of attraction rules are being revised to allow for them to get invoked if the non-resident taxpayer who has a PE in Saudi Arabia is engaged in similar activities as of its PE unless the non-resident taxpayer could prove that there is economic or commercial justifications for not executing the similar activities through its PE in Saudi Arabia.

As per the current Income Tax Law, capital gains arising from the in-direct (offshore) disposal of a company that derives its value mainly from immovable properties located in Saudi Arabiaare considered as sourced from Saudi Arabia.

However, as per the proposed Income Tax Law the company being disposed of, directly or indirectly, should be deriving 50 percent or more of its value from immovable property at any time during the 365 days period preceding the disposal.

The income of a non-resident legal entity earned through the indirect sale of partnership, shares, interest, or units is considered Saudi-source income if 50 percent or more of its value originates from non-traded assets in Saudi Arabia at any time within the 365 days prior to the disposal. This also applies in case of a partnership, in a resident legal entity.

The Draft Income Tax Law outlines the scope of related persons as follows:

• Natural persons who are relatives through marriage or otherwise relatives up to the fourth degree, or partners in a partnership.
• A natural person is considered related to a legal person if, alone or with related parties, they control 50 percent or more of the voting rights, income, or capital of a partnership, or if they benefit from agencies administering property held in a trust, fund, or similar arrangements. Further, a related person status will be established if a person or related party holds an interest in another legal entity and controls 50 percent or more of its voting rights, income, or capital, or if they participate in the management, control, or capital.
• For legal entities, common control, effective control over business decisions, or mutual effective control between related parties establishes their related status.

Further, the definition of effective control and persons under common control has been widened enough to harmonize the concept with the transfer pricing methodology. 

The Draft Income Tax Law has proposed the following enhancements to the transfer pricing regulations:

• The definition of related persons to be aligned with Saudi Arabia's transfer pricing regulations.
• Incorporating detailed rules on corresponding tax adjustments for transfer pricing purposes.

The definition of a Permanent Establishment (PE) has been amended to clarify that following could trigger a PE for a non-resident:

• A place of management;
• Offices;
• Premises used as a sale outlet; and
• Performance of services in Saudi Arabia by a non-resident person himself or through its employees, affiliates, contractors, or other persons engaged for such purpose, if the services continue for a period of 30 days or more within any 12 months;

The Draft Income Tax Law states that a PE will not be constituted in Saudi Arabia merely because a non-resident carries on an activity in Saudi Arabia through a broker, general commission agent, or any other agent of an independent status, provided that such person is acting in the ordinary course of its business.  Further, the Draft Income Tax Law proposes that, if the business of an agent (connected with the non-resident) is conducted wholly or principally on behalf of the non-resident person and commercial or financial conditions are made or imposed between the agent and the non-resident that differ from those generally agreed between two independent persons, the agent will not be considered as an independent agent.

The concept of preferential tax regimes has been introduced for the first time in the Draft Income Tax Law  As per Article 1 of the Draft Income Tax Law, the term “preferential tax regimes” includes regimes that grant tax or non-tax benefits that go beyond the benefits granted by KSA under its domestic laws.

Under a preferential tax regime, these benefits, whether temporary or permanent, are either offered throughout a jurisdiction or only in specific parts and are available to all taxpayers or some taxpayers only.

As proposed by the Income Tax Law, a preferential tax regime is a regime where:

• The applicable income tax rate is less than 15 percent;
• An information exchange agreement by such a jurisdiction has not been entered into with Saudi Arabia; and
• Tax benefits are accorded to persons without being required to carry out economic activities, or to those who lack commercial substance.  

As per Article 10 of the Income Tax Law (anti-avoidance measures), transactions with entities operating in preferential tax regimes are subject to a special tax treatment with respect to the deductibility of expenses, depreciation, withholding tax rates, and transfer pricing.

Furthermore, Article 18 of the proposed Income Tax Law states that expenses, not in conformation with the arm’s length principle, paid to related persons or permanent establishments based in preferential tax regimes will be disallowed.

Hybrid instruments have been defined to include any such instrument that is defined differently by two tax jurisdictions i.e., an instrument defined as a “debt instrument” by one jurisdiction and an “equity instrument” by the other jurisdiction. These instruments will not be entitled to a tax deduction or exemption in Saudi Arabia if their tax treatment differs from the jurisdiction where the other party resides, and the appropriate tax is not imposed in that jurisdiction.

Moreover, payments to a non-resident legal person will not be deductible from the tax base if the non-resident legal person is not treated as a legal person or does not have an equivalent status under the applicable tax law in its country of residence or if such payments are not taxable in its country of residence. 

As per Article 11, the following items of income have been proposed to be exempted:

• Income derived by a non-resident capital company from direct or indirect disposal of shares in a resident company, but only in cases where the disposal is made to a resident company within the same group; and
• Dividends, income from debt claims, and capital gains (from the disposal of shares or stocks) derived by the government of another country, its authorities, or its wholly owned entities, whether directly or indirectly from sources in Saudi Arabia, subject to reciprocity.

Dividends, capital gains, and distributions upon liquidation, emanating from a resident person’s direct ownership in shares of a resident or a non-resident legal person, have been proposed to be exempted, depending upon the fulfillment of the following criteria:

• The shareholding percentage is 10 percent or more in the investee;
• The ownership percentage of 10 percent or more is continued to be held for a consecutive period of 365 days (including the day on which the distribution took place) preceding the year of distribution;

The proposed Income Tax Law has further delineated certain instances where the participation exemption will not be applicable. 

The following expenses have been proposed to be treated as deductible expenses:

• Real estate transaction tax (RETT), resulting from the sale of real estate, paid by a taxpayer; and
• Non-recoverable input value-added tax.

As per the proposed interest limitation rules, net loan charges will be deductible to the extent of 30 percent of the adjusted earnings.

The newly proposed interest limitation rules appear to be in line with the recommendations made in Action 3 of BEPS 1.0.

Tax depreciation will now be calculated using the straight-line method based on the rates prescribed under the by-laws, replacing the currently applicable declining balance method

Article 27 of the proposed Income Tax Law postulates that if a gain is derived from the disposal of a tangible or an intangible asset, a legal person can opt to form a reinvestment reserve to the extent of the gain derived from the disposal, provided that the purpose of the reserve is to reinvest in another similar depreciable tangible or intangible asset. The reinvestment for the purposes of this article is required to be made within two years of the disposal. 

The Draft Income Tax Law proposes that upon transfer of equity in a legal person or its assets and liabilities as part of a merger/demerger arrangement, the profits and losses generated from such a merger/demerger shall not form part of the taxable income, provided that the assets and liabilities are recognized at their book values before the merger/demerger.

Operating tax losses can be carried forward and offset against taxable profits in subsequent year. It appears that the current restriction on adjusting taxable losses up to 25 percent of the taxable profit is omitted, however, the implementing regulations will specify the governing criteria for this provision.

As per the provisions of Article 40 of the Draft Income Tax Law, tax credits for the foreign tax paid against the corporate income tax due on the same taxable income in Saudi Arabia can be claimed subject to certain conditions.

Tax incentives have been introduced by the Draft Income Tax Law for the first time according to the provisions embodied in Article 42, subject to the conditions prescribed under the by-laws.

According to the provisions of article 44, the taxable income of a resident non-Saudi natural person includes, without limitation, the following if it is related to that person’s activity carried out on an independent and regular basis. Most notably:

• Income generated from an activity carried out or practiced in or outside the Kingdom;
• Income generated from movable or immovable assets;
• Income generated from holding, trading and disposing of Interest or units in legal Persons and dividends, as well as other distributions; and
• Income generated from an Activity by its Permanent Establishment based outside the Kingdom.

It has been reiterated that income generated from employment is not taxable in the hands of non-Saudi resident natural persons, subject to the provisions stated under the by-laws.

Article 31 of the Draft Income Tax Law prescribes that a legal person shall be deemed to have disposed of/liquidated all their assets and liabilities upon ceasing their activities in Saudi Arabia. As such, the resultant profits will contribute to the tax base of the legal person and will be subject to corporate income tax at 20 percent. The implementing regulations to this effect are to be issued.

Micro-enterprises have been entitled to calculate their tax base on a cash basis if this method is being used for accounting purposes, or their tax base will be calculated on an estimated basis if the micro-enterprise fails to prepare financial statements or to keep books and records. Permanent establishments will not be considered micro-enterprises.

The mechanism for tax base calculation is to be specified in the implementing regulations.

As per Article 50, the following payments have been subjected to a withholding tax of 5 percent:

• Debt claims between related companies, including bonds and sukuk;
• Dividends;
• Rent;

Royalty shall be subject to withholding tax of 15 percent.  Whereas, payments for services have been made subject to withholding tax at 10 percent.

The article has not differentiated between the nature or type of the services, which may indicate that all the services, of whatever nature, shall be subject to a flat withholding tax rate.

Article 50 further proposes that:

• Utilization of profits to increase the equity of a person shall be considered as dividends;
• The following payments will be subject to withholding tax at 20 percent in case the beneficial owner is a resident person or permanent establishment situated in a jurisdiction where a preferential tax regime is applicable:
  • Debt claims between related companies, including bonds and sukuk;
  • Dividends;
  • Rent;
  • Services; and
  • Royalty;

• For the sake of imposing withholding taxes, profits of non-residents generated through a permanent establishment in the Saudi Arabia shall be deemed to be distributed within 120 days from the year-end and accordingly will be subject to withholding tax under the category “dividends”.
• Certain payments, inter alia, have been proposed not subject to withholding tax:
  • Compensation for work, including salaries, benefits, and bonuses paid by an employer to an individual under an employment or contractual relationship. Bonuses received by board members or directors are considered remuneration.
  • Payments to entities, organizations, partnerships, or non-resident institutions, classified as transparent according to the rules in their tax jurisdiction to the extent that they are attributable to the resident person’s interest in KSA, and
  • Payments by a natural person in consideration for services utilized for personal use and not relating to any commercial activity.

In closing, we recommend taxpayers take advantage to provide their insightful feedback on the proposed Income Tax Law through the Public Consultation Platform before the due date of 25 December 2023.

For detailed discussions to know the impact of the proposed Income Tax Law on your business, kindly contact our Tax team.