Stable environment: The tax system and regulations for potential investors

Saudi Arabia is ranked third place out of all countries in the world in terms of the ease of paying taxes, a remarkable achievement for a G-20 country with an annual GDP of over $700bn. Provided that businesses make a commitment to comply with all existing regulations with due care, they can enjoy the advantages of the system. Tax regulations in the Kingdom are fairly brief and clear with regards to many items. At the same time, a number of areas remain open and subject to interpretation, and businesses should be able to take a position on unclear areas and be prepared to defend their position during tax audits. Requirements are reasonable but nonnegotiable at the same time. For example, only one corporate income tax return per year is to be filed. At the same time, no deadline extensions and no adjusted resubmissions (except to correct arithmetic error) will be allowed without penalties.

Tax legislation can be characterised as stable. Taxpayers can comfortably plan their tax affairs and budget costs for the foreseeable future – an advantage that increasingly few economies are able to offer today. Tax law was enacted in 2005, close to a decade ago, and is referred to as the New Income Tax Law. Tax rules are especially stable given that many other areas of the society and business regulation, such as foreign investment, labour and immigration, finance and securities market, have undergone increasing reform in recent years.

However, although fundamental principles, tax rates and key concepts have remained unchanged, taxpayers have been witnessing and experiencing the introduction of amendments and additions to various parts of the tax rules. The overall objective of these changes has been to clarify grey areas in the rules and close gaps to ensure that a consistent approach is applied in all similar cases.

These regulatory changes have been introduced in various stages by the Department of Zakat and Income Tax (DZIT), in the form of responses to queries posted on the frequently asked questions section of their website; decisions of appeal organs of various levels; changes to the implementation of by-laws; and finally changes to the law itself.

That said, taxpayers should see some tangible changes to rules in the near future.

In accordance with Resolution No. 1776 issued on March 19, 2014 by the Ministry of Finance, the DZIT has been tasked with developing guidelines on the application of transfer pricing (TP) rules already contained in the law. The resolution makes it clear that guidelines should be based on existing international practices. The website of the DZIT and other public sources of information reported that DZIT had been in consultations on this subject with OECD, accounting firms and other organisations that deal with taxation professionally. It is understood that the first draft of TP guidelines is already available and taxpayers should expect more scrutiny of their pricing with related parties in the near future.

Value-added tax (VAT) has been a topic of discussion in all GCC countries since 2011. Very little reliable data from public sources is available on such relevant issues as timing, rate and territory (either referring to the entirety of the GCC or otherwise, individual states). This does not mean that VAT is far in the future as issuing new laws with little or no public discussion is not uncommon in GCC. Needless to say, VAT will be a material change for businesses and consumers; it will also be a new item to administer and collect for tax authorities, and one whose complexity should not be underestimated, especially if VAT is introduced across the GCC.

Rules relating to the payment of zakat (Islamic alms) should soon be consolidated and codified in a single regulation document. Zakat is considered to be an obligatory payment decreed by Islam. Requirements were originally addressed to individuals, and it is only in more recent times that rules for corporate payers have been fully developed. In substance it applies to the part of the business that is ultimately owned by KSA/GCC nationals. Given that most large business ventures in KSA have a partner in the GCC represented by a Saudi state-owned entity or a Saudi/GCC private businessperson, most businesses are inevitably affected by zakat rules.

INTRODUCTION TO THE TAX SYSTEM: Saudi Arabia operates two parallel systems of taxation. Different tax regimes can apply to companies owned by Saudi/GCC nationals and to other companies: resident companies owned by Saudi/GCC nationals are subject to zakat payment, all other companies pay corporate income tax.

Regulations stipulate the examination of Saudi resident companies to identify their ultimate beneficiaries and owners. However, this requirement does not extend to foreign holding companies outside of GCC countries. In other words, if a Saudi company (or group) is owned by an entity outside of the GCC region, this Saudi company will normally be subject to corporate income tax, irrespective of the nationality of its ultimate beneficiaries.

The choice of tax system depends only on the ownership structure of the taxpayer. Therefore, no other factors, such as the type of activity, the industry of operation, or geographical location, among other factors, have any impact on the outcome.

“Mixed companies”, referring to companies that are jointly owned by Saudi or GCC nationals and foreign individuals or entities, are subject to both zakat and corporate income tax, applied to respective shares of shareholders in the business.

Foreign companies that have established themselves on a permanent basis within the Kingdom are subject to corporate income tax via self-assessment in a manner similar to how Saudi companies are assessed. However, foreign companies that earn income from Saudi sources without creating a permanent establishment within the Kingdom are instead subject to taxation by way of withholding.

All corporate employers are liable for their share of social insurance contribution.

There are no other corporate taxes in KSA.

The DZIT is the government body responsible for implementing policies, collecting dues and ensuring compliance of zakat regulations.

The General Organisation for Social Insurance (GOSI) has similar responsibilities with respect to the payment of social taxes.

OVERVIEW OF CORPORATE INCOME TAX: Corporate income tax rules are governed by the Income Tax Law, which came into force in 2004. The law is supplemented by implementing regulations or bylaws. In addition, the Ministry of Finance issues resolutions concerning tax and zakat, and the DZIT regularly issues circulars and responses to frequently asked questions containing its interpretation/position on various parts of the tax system.

Tax administration and enforcement practices in KSA can be characterised as mix of both substance and form. Tax authorities may (and often do) scrutinise transactions to understand their substance and may challenge taxpayers if they view transactions as driven by concerns of taxation. At the same time, documentation (such as contracts and invoices) supporting transactions have to be in place and accurately reflect taxpayer’s intent and substance of its transaction. Authorities may choose to base their judgement and conclusion solely on the provisions of documentation. For example, the extended description of activities in a cross-border service contract may be sufficient to claim the creation of permanent establishment, even if the in-country component of the service has not been delivered.

INTERNATIONAL AGREEMENTS: Provisions of international agreements to which the Kingdom is a party tend to prevail over the provisions of domestic tax legislation. However, the law makes an exception to anti-avoidance rules contained in Article 63 of the law (see further discussion in DTTs below).

TAX ACCOUNTING: The tax system is mainly based on financial accounting and reporting standards, which should be based on Saudi Generally Accepted Accounting Principles (GAAP), issued by the Saudi Organisation of Certified Public Accountants. Tax law sets its own rules with respect to some specific areas, e.g. depreciation method, accounting for long-term contracts, etc.

The Saudi riyal is the official currency used for tax accounting purposes. The tax year is run according to the Hijri calendar year. While another calendar tax year, for example the Gregorian, may be used, it will be subject to certain restrictions.

Books must be maintained within the country and be kept in the Arabic language.

PERSONS SUBJECT TO TAX: Under the law, the following persons are defined as subject to tax in KSA:

• A resident capital company in respect of the shares of non-KSA/GCC nationals;

• A resident non-GCC individual who conducts business in KSA;

• A non-resident who conducts business in KSA through a permanent establishment (PE);

• A non-resident with other taxable income from sources within KSA.

TAX RESIDENTS: A natural person is resident in KSA if one of the following conditions is met:

• He/she has a permanent place of residence in KSA and resides in the Kingdom for at least 30 days in a tax year; or

• He/she resides in KSA for at least 183 days in a tax year without having a permanent place of residence. A company is considered to be resident in KSA if one of the following conditions is met:

• It is formed in accordance with the KSA Companies Law; or

• Its central management is located in KSA.

TAXABLE INCOME & TAX BASE: Generally, taxable income is gross income. This includes all revenues, profits or gains of any type and of any form of payment resulting from carrying out an activity, including capital gains and any incidental revenues less exempted income.

The law provides that income from the following specific types of activities/sources is considered taxable in KSA:

• Use of licence in KSA for industrial or intellectual properties; this category of income also covers software licences;

• Activities within KSA;

• Immovable property located in KSA, including gains from the disposal of an interest in such immovable properties;

• Disposal of shares in a resident company or a resident partnership;

• Lease of movable properties used in KSA;

• Dividends, management fees or director’s fees paid by a resident company;

• Services rendered by a resident company or permanent establishment to the company’s head office or to an affiliated company;

• Payments made by a resident for services performed in whole or in part in KSA;

• Income of a Saudi PE. Taxpayers are required to prepare financial statements under Saudi GAAP and are expected to have them audited. Net income according to those financial statements, as adjusted for tax purposes, is the base subject to corporate income tax.

TAX RATES: The standard corporate income tax is charged at a flat 20% rate.

The special 30% rate applies to the income of taxpayers engaged in “natural gas investment activity”. Another special 85% rate applies to income from production of hydrocarbons.

There are also a number of withholding tax rates applicable to income from sources in KSA discussed further in this article.

CARRY-FORWARD OF LOSS: Losses of tax may be carried forward indefinitely until they are fully utilised. Deduction of tax losses is limited and should not exceed 25% of the tax base in a particular year.

In the event of a change in control of 50% or more in the shares or voting rights of a taxpayer, all carried forward losses will forfeit.

Loss carry-backs are not allowed.

THIN CAPITALISATION: There is no special legislation governing thin capitalisation for tax purposes.

A Saudi entity may deduct interest payments to affiliates, but not to the head office, provided that the amount of debt and the interest rate are kept at arm’s length and that the interest deductibility formula is met (as explained below). A Saudi entity may be financed with minimum capital, and there is no limit to the amount of debt that may be used.

The deduction of interest expense is limited to the lower of the actual expense or interest income as well as 50% of taxable income before interest income and interest expense.

Additionally, in accordance with the Companies Regulations, if the total accumulated losses of a company exceed 50% of its share capital, a meeting of the company’s shareholders’ must be called to determine whether or not to continue the business. The subsequent resolution must be then published in the Official Gazette.

PERMANENT ESTABLISHMENT: Saudi tax law defines a PE as “a permanent place of the non-resident’s activity through which it carries out business, in full or in part, including business carried out through its agent”.

Therefore, the following constitutes a PE:

• Construction sites, assembly facilities and the exercise of those supervisory activities connected therewith;

• Installations, sites used for surveying natural resources, drilling equipment, ships used for surveying for natural resources as well as the exercise of supervisory activities connected therewith;

• A fixed base where a non-resident natural person carries out business;

• A branch of a non-resident company licensed to carry out business in the Kingdom;

• Holding interest (share) in a resident partnership within the Kingdom. It should be noted that there is no minimum period of time required to establish a PE. As a result, technically speaking even a one-day supervision of a construction site or an assembly facility is sufficient in order to create a PE. In practice, the DZIT has accepted certain activities lasting up to three months as not creating a PE; there are cases when the DZIT accepted even a period of six months.

Article 4 of the by-laws specifies that dependant agent is someone who has any of the following authorities:

• Negotiate on behalf of the principal;

• Conclude contracts on behalf of the principal;

• Has a stock of goods, owned by the principal, on hand in KSA to supply customers on behalf of the principal;

• Insurance/reinsurance agent (even if the agent does not possess powers for negotiations). Deduction of certain inter-company transactions is limited for PEs. After-tax profit of PEs is subject to additional 5% upon repatriation. The law states that this tax applies upon actual or deemed repatriation.

WITHHOLDING TAX: Income of non-residents from KSA sources is subject to withholding tax (WHT) if they do not have a PE in the country. A KSA person or PE of a non-resident (tax agents) making a qualifying payment to a non-resident is responsible for withholding the applicable tax.

The following are the various types of income and applicable WHT rates:

• Management fees: 20%;

• Royalties, licence fees, related party (including technical and consulting services, and telecommunications services) payments: 15%;

• Technical and consulting services: 5%;

• Payments for rent, air tickets, telecommunications: 5%;

• Payments of loan charges and dividends: 5%;

• Insurance payments: 5%; and

• Other services and payments: 15%. The law specifically assigns responsibility for withholding to tax agents. The law has moreover imposed penalties on tax agents in the event of a failure to withhold, pay or report to the DZIT.

However, the law states further that the “beneficiary” remains liable in case tax is not withheld and the DZIT may recover the tax from the “beneficiary or its agent or sponsor”.

Tax agents should report to the DZIT on their tax withholding and pay the withheld tax to DZIT within the first 10 days following the month of payment or withholding.

Similar to income tax, tax agents should submit their annual report on WHT within 120 days of the end of the tax year.

Full or partial relief may be obtained by applying and enforcing bilateral tax treaties.

DOUBLE TAX TREATIES: Around 30 Saudi double tax treaties (DTTs) are in force and the tendency is to continue signing double tax avoidance agreements to promote foreign investment, allowing for a more competitive and internationally accepted taxation regime in the Kingdom. Saudi DTTs generally follow the model treaty laid down by the OECD.

Benefits of these tax treaties vary among countries and specific items of income; some treaties provide a reduced rate, or exemptions from WHT on royalties, dividends and interest, while others provide limited relief from capital gains tax.

REFUNDS OR AUTOMATIC APPLICATION: Until recently, WHT had to be deducted on all qualifying payments. However, in 2013 new circulars were issued that allow automatic application of DTTs without going through the refund process, although choice of refund method is still available.

CAPITAL GAINS: No special tax treatment exists for capital gains, and so they are added to total taxable income of KSA taxpayers.

Capital gains received by non-residents from the disposal of shares in KSA resident companies are subject to tax at a rate of 20%.

TAX COMPLIANCE: Taxpayers are required by the law to file one tax return per year.

Tax returns with a taxable income exceeding SR1m ($266,600) before deductions should be certified by a KSA certified public accountant.

RETURNS FOR CORPORATE INCOME TAX: Returns for corporate income tax should be filed within 120 days following the end of the tax year.

Taxpayers should be aware of a fairly large amount of preparatory paperwork that should be ready to file together with the tax return.

These include, without limitation, an audited financial statements, a breakdown of all purchases, a GOSI certificate, an annual WHT form, a breakdown of repair and maintenance costs, and details of changes in shareholding (including copies of sale-purchase agreements and an updated commercial registration and licence).

The resulting tax liability should be settled by the filing deadline, i.e. 120 days after the end of tax year.

Taxpayers should make three advance payments during tax year unless it is the first tax payment or the amount of advance payment calculated as per the rules is less than SR500,000 ($133,300).

PENALTIES & FINES: Non-registration of a taxable entity, late filings and late payment of taxes due are potentially subject to penalties.

Delay in payment triggers a penalty at 1% of the unpaid taxes for each 30 days of delay.

Failure to file the income tax return by the deadline could potentially attract the greater of:

• 1% of the gross revenue up to SR20,000 ($5330); or otherwise

• Between 5% to 25% of the underpaid tax. There are no late filing penalties for the late submission of withholding tax returns. However, delay in payment of withholding tax is subject to a penalty of 1% of unpaid tax for every 30 days of delay. The penalty is however not cumulative, so one should expect to pay 1% for each month of delay.

In addition to the above penalties, a taxpayer may also be subject to a fine of 25% on the difference of tax paid and tax due where that difference is a result of fraud or false information provided by the taxpayer or its certified accountant.

OVERVIEW OF THE ZAKAT REGIME: The legal basis of the existing system for zakat in Saudi Arabia originates in religious requirements. These mandate the sharing of excess wealth and the reporting of growth of certain, specific types of wealth.

In accordance with these religious stipulations, zakat is regarded as a reponsibility incumbent upon the individual.

Therefore, the application of zakat on corporates is regarded as a way for the government to help individuals fulfil their obligation.

However, similar to income tax, authorities do not enforce the rules to ensure compliance by individuals. In practice, only corporate zakat payers have a responsibility to meet requirements before the DZIT.

CODIFICATION OF ZAKAT RULES: Rules pertaining to zakat remain largely uncodified, although there are by-laws issued by the DZIT that cover procedural matters. Zakat is mainly governed by fatwas, pronouncements by religious authorities.

RATE OF ZAKAT: The liability for zakat can be calculated by applying the standard rate of 2.5% to the zakat base.

PERSONS SUBJECT TO ZAKAT: These persons are: • Saudi individuals or nationals of GCC states who conduct business in the Kingdom of Saudi Arabia.

• Saudi resident companies of all types owned by KSA/Saudi nationals, including shares of KSA/GCC nationals in mixed companies.

ZAKAT BASE: Zakat base will be higher if net adjusted profit (determined in a similar manner to income tax base) or “net worth”, determined as follows: Capital (held for a duration of at least one year), the balances of all provisions and reserves carried for the duration of at least one year, retained earnings, adjusted net profit for the current year ( determined in a similar fashion to the corporate income tax base, albeit with certain peculiarities).

These peculiarities include fewer non-deductibles, the absence of any limitation on the deduction of interest (the straight-line method of depreciation is allowed), loans (which are raised to finance long-term assets or any loan balance held for the duration of at least one year), the credit account of owners and partners (that are treated similarly to equity accounts), and subsidies (which are treated as ordinary income) are added.

The net book value of fixed assets, pre-establishment expenses, losses carried over, capital assets/construction in progress, investments (except for short-term investments that are held for sale), and land are deducted.

Payers of zakat are advised to carefully review all relevant rules and fatwas before taking any position on any particular issue.

GOSI SYSTEM: Social taxes as well as the activities of GOSI are governed by the Social Insurance Law. The Social Insurance Law is supplemented by the implementation of various regulations.

Employers should contribute to monthly GOSI occupational hazard insurance at the rate of 2% of the employee’s (foreign and Saudi nationals) salaries (i.e. the GOSI base), provided that they are under the sponsorship of the reporting entity.

The GOSI base generally consists of a monthly base salary and the cash housing allowance of an employee.

However, if housing is provided in kind, the amount to be included for GOSI purposes is computed as two months of the basic annual salary.

There is also a mandatory contribution to annuities insurance, calculated as follows:

• 9%: an employer’s contribution on a Saudi employee income (the rate will increase to 10% in September 2014);

• 9%: Saudi employees’ contribution (the rate will increase to 10% during in September 2014). Saudi employees’ contribution is calculated, withheld from salary and paid to GOSI by employer.

In addition to this, it should be noted that the minimum monthly earnings used to calculate contributions are SR1500 ($400), and maximum monthly earnings used to calculate contributions are SR45,000 ($12,000).

CUSTOMS DUTIES: The Cooperation Council for the Arab States of the Gulf, also referred to as the GCC, established a common external tariff of 5% for most imported goods. There are no other duties or taxes for products going to Saudi Arabia.

Saudi law continues to maintain a strict prohibition on the import of various specified items into the Kingdom, namely the following products: weapons, alcohol, narcotics, pork, pornographic materials, distillery equipment and certain sculptures.

OTHER TAXES: There is no form of stamp duty, transfer pricing, excise, sales, turnover, production, real estate, property or other material taxes that currently apply to businesses in KSA.

TAX STATUS OF INDIVIDUALS IN THE KINGDOM: undefined Regulations governing both tax law and zakat payments mention individuals as payers of their respective payments.

INCOME TAX: A number of articles of tax law contain references to individuals. As indicated above, persons subject to tax include:

• A resident non-GCC individual who conducts business in KSA;

• A non-resident with other taxable income from sources within the KSA. Tax residents include:

• Someone who has a permanent place of residence in the KSA and resides in the KSA for at least 30 days in a tax year; or

• Someone who resides in the KSA for at least 183 days in a tax year without having a permanent place of residence. Furthermore, the definition of “activity” in the law, from which income is subject to tax in the Kingdom, is fairly broad and also contains types of activity that would be undertaken only by individuals.

An activity is a commercial activity in all its forms, or any vocational, professional or other similar activity undertaken for the sake of profit.

However, in practice the law has never been interpreted and enforced to charge income tax to individuals in KSA. Irrespective of duration of stay and status of residence to date employment income of individuals has remained free from taxation in KSA.

That said, tax agents will deduct tax from on income subject to WHT even if it is paid to individuals.