A closer look into Saudi Arabia’s proposal for a new Income Tax Law

1. Summary

In late 2023, Saudi Arabia’s Zakat, Tax and Customs Authority (“ZATCA”) opened a public consultation to replace the existing Income Tax Law (“ITL”) by a new one. The proposal, which is currently under study, aims to update the ITL, to align it with the most relevant international tax practices and to promote business through a more tax friendly environment.

In this article we delve into the new measures that the draft ITL would introduce if published as is, as well as on what it does not include and should have been considered.

2. Background

For the reader unfamiliar with the Kingdom’s tax landscape, Saudi Arabia has a particular regime regarding direct taxation. Income Tax (“IT”) coexists alongside Zakat, which is a religious levy and one of the five pillars of Islam.

Generally, the main factors in determining whether a capital company incorporated in Saudi Arabia is subject to IT and/or to Zakat are the nationality of the shareholders of such company and the share of profits attributable to them, although there are some exceptions and each case should be individually analysed. The ITL draft does not seem to change this principle. As such, the new ITL – if and once approved – should mainly affect those taxpayers who are totally or partially subject to IT. However, Zakatpayers should pay heed as well, because the ITL’s provisions on withholding tax apply to all companies in Saudi Arabia, regardless of their tax status.

The ITL was approved in 2004. Over the years it has been subject to certain partial reforms, but its backbone remained untouched. Looking at the IT’s performance lately, in the following chart we highlight the revenue collected by ZATCA from IT and how much does IT contribute in relation to total revenue, according to the data published by the Ministry of Finance. For a better reading, we distinguished between tax revenue and total revenue, given Saudi Arabia’s high reliance on oil revenue (total revenue includes tax and non-tax revenue such as oil revenue):

Year	IT revenue (SAR billion)	Total tax revenue (SAR billion)	Total revenue (tax and non-tax, SAR billion)	IT contribution to total tax revenue	IT contribution to total revenue
2019	17	220	927	7.73%	1.83%
2020	18	226	782	7.96%	2.30%
2021	18	317	965	5.68%	1.87%
2022	24	323	1,268	7.58%	1.93%
2023	38	356	1,212	10.83%	3.19%

A few considerations can be made in relation to the above chart:

• The IT’s contribution to tax revenues is small. Most of the tax revenue derives from indirect taxes such as VAT and excise tax.
• Equally, the IT’s contribution to total revenues is even smaller. This is because Saudi Arabia’s budget largely depends on oil revenue.
• As the reader may have noticed, in 2021 and 2022 there was a slight decrease in the IT’s relative contribution to total tax revenues. One potential explanation is that several companies generated tax losses during the Covid-19 pandemic in 2020, which then they carried forward to subsequent years. Under the current regime, only 25% of the current year’s tax base can be offset against previous tax losses, and the balance is carried forward until it is completely set off. It is possible that several companies did not generate sufficient taxable profits in 2021 and thus were not able to fully offset all the previous tax losses. The other potential reason is that until 2020, revenue from indirect taxes was lower, hence the IT’s relative contribution was higher. In 2020 the standard rate of VAT raised from 5% to 15%, and in addition a 5% real estate transfer tax was introduced.
• Interestingly, in recent years IT revenue has experienced a steady growth, both in absolute and relative figures, with the temporary exception of the pandemic. In fact, in 2023 rouse by more than 50% year-on-year, and it even exceeded the revenue collected from Zakat, bearing in mind that most companies in Saudi Arabia are subject to Zakat and not to IT. This is hardly surprising, given Saudi Arabia’s efforts to open its economy, the upswing in foreign direct investment, the increased number of foreign companies which establish locally, as well as ZATCA’s initiatives to cancel tax related penalties if taxpayers paid the principal of the outstanding taxes.

In summary, the IT’s contribution to total revenues has been historically modest, but it is in a sustained upward course. The Saudi Government is aware that IT is poised to play a relevant role in the coming years, in a future environment where international investment will likely burgeon. For this reason, ZATCA aim to revamp the IT regime with a law which conforms to global best practices and the enduring vision and objectives of the Kingdom, encourages foreign direct investment without impeding overall economic advancement, and fosters transparency and voluntary compliance among taxpayers.

ZATCA opened the draft ITL’s public consultation for comments between October and December 2023. The consultation drew high attention within the legal and tax community, as well as among the public – Istitlaa, the public consultation portal, published 219 comments in Arabic and 103 in English. Currently it is under study by ZATCA.

3. The proposed changes

The amount and depth of the changes proposed would be unprecedented in the Kingdom. Some changes would reduce taxation and favour investment, whereas other changes aim at tackling harmful practices and tax avoidance. Below is an overview of the main reforms that would be introduced, if approved:

• Expanding the cases where a natural person becomes a tax resident. In addition to the existing criteria of tax residence, the ITL would include two additional criteria: being domiciled in Saudi Arabia or having an intermittent-but-recurrent qualified presence in Saudi Arabia for the last 3 years.
• Expanding the source of income rules. The ITL would expand the source of income rules, to include capital gains generated on the indirect transfer of shares/interests in Saudi companies whose value is predominantly composed of Saudi assets or Saudi real estate.
• A 30-days-within-12-months services permanent establishment. The ITL would introduce for the first time at the domestic law level a new category of services permanent establishment, and the time threshold for such services permanent establishment to be created would only be 30 days within 12 months. Currently the ITL does not explicitly include a services permanent establishment clause, however in practice ZATCA apply it based on the interpretation of double tax treaties.
• Preferential tax regimes list. The ITL would introduce the concept of preferential tax regimes, commonly known as a tax blacklist, for the first time in the Kingdom. Foreign countries may qualify as a preferential tax regime for Saudi tax purposes if they meet any of the conditions set out in the ITL. ZATCA’s board of directors would issue the list of countries having preferential tax regimes, in coordination with the Ministry of Foreign Affairs. It is unclear at this stage whether foreign countries that meet any of the conditions under the ITL should automatically be treated as tax preferential regimes, or only those which are explicitly included in ZATCA’s list would be so considered. Further, the compatibility of this list with existing international treaties will need further consideration, especially in relation to Gulf Cooperation Council countries.
• Tax defensive mechanisms in respect of transactions conducted with persons located in countries with preferential tax regimes. The ITL would include reactive measures relating to tax preferential regimes. Transactions that taxpayers in Saudi conduct with parties located in countries which are considered a preferential tax regime would result in negative tax consequences. Depending on the type of transaction, these measures may include the limitation of the tax deductibility of expenses, the limitation of participation exemption benefits, the limitation on the depreciation of assets, or increased withholding tax.
• Tax deductions in case of reinvestment of certain capital gains, in case of expenses incurred on research and development activities, as well as on green investments. The ITL would include innovative incentives such as a deduction when a capital gain is generated and a reserve is created to reinvest in another asset, tax deductions regarding expenses related to qualifying research and development activities, as well as tax incentives in relation to qualifying green investments.
• Tax measures regarding hybrid mismatches on financial instruments. In line with international practices, the ITL would disallow the tax deductibility or exemption of certain financial instruments between related persons if there is a hybrid mismatch.
• Allowing double tax credits in respect of taxes paid abroad, subject to conditions. The ITL would now clearly regulate the deduction of income taxes paid outside of Saudi Arabia. In general terms and subject to further regulation, income taxes paid abroad will be deductible from the payable IT, with the following limit: the lower of the IT that would be payable in Saudi Arabia on the same income, or the total IT due as per the submitted IT return.
• A general thin capitalisation rule, in line with most countries. Net financial expenses would be deductible in the tax year in which they are incurred, with the limit of 30% of the adjusted profits. The current ITL draft does not include any exceptions which may be found in other countries, such as a minimum tax-deductible amount in any event, special provisions for companies recently incorporated or that engage in long-term projects, etc. The IT regulations may provide further clarity.
• Clarifying the taxation of non-Saudi natural persons who reside in the Kingdom and carry out an economic activity. The ITL seeks to clarify the taxation of those non-Saudi natural persons who are tax resident in Saudi Arabia and carry out an economic activity. Salaries and similar income earned in the context of an employment relationship would continue to be not subject to IT, under easy-to-meet conditions.
• A participation exemption regime for domestic and foreign dividends, capital gains and liquidation proceeds, subject to conditions. Currently the ITL includes a limited participation exemption in respect of dividend income. The new ITL would expand and improve the participation exemption regime. The ITL’s aim is to make Saudi Arabia a favourable jurisdiction where foreign groups may set up a holding company, from which they may hold interests in other entities which are in Saudi Arabia or abroad.
• An exit tax. The ITL would include an exit tax for those companies that relocate their tax residence abroad. The exit tax would also apply to natural persons who relocate abroad, but only to those that carry out an economic activity.
• Changing the tax treatment of partnerships. Unlike the existing regime, the new ITL would treat partnerships as opaque for tax purposes, meaning that IT would be imposed on the partnership itself and not on its partners.
• Tax relief for M&A and intra-group transactions. The ITL would afford tax favourable treatment to intragroup reorganisations, including certain share transfers, mergers, de-mergers and conversions of partnerships, subject to conditions. The existing ITL includes certain tax relief for intragroup reorganisations, however ZATCA currently hold a narrow interpretation, especially in respect of cross-border transactions. Therefore, the new ITL would incentivise these transactions.
• Revamping the withholding tax regime. The withholding tax regime would be significantly reworked, where some provisions would be better than the existing regime and some provisions would make it less favourable. Critically, payments made to non-resident persons who are in a tax preferential regime will be subject to increased withholding tax. 

4. What is missing?

So far, we discussed what changes the proposed ITL may bring about. However, the draft does not address certain topics, such as the following:

• The OECD’s Pillar One and Two. Saudi Arabia is among the 137 countries that on 8 October 2021 agreed to the OECD-brokered statement under which a two-pillar solution should be implemented to solve the tax challenges arising from the digitalisation of the economy. Pillar One would affect large multinationals with global revenue exceeding EUR 20 billion and profitability above 10%, whereas Pillar Two would affect multinationals with revenue exceeding EUR 750 million. Countries are not required to implement the two pillars in their domestic laws, but if they choose to do so, they must do so in accordance with the OECD design and they must respect that other countries implement them. Saudi Arabia has made no official announcements regarding Pillar One or Pillar Two to date. In the Gulf region, only Qatar and the UAE have announced or implemented Pillar Two related measures.
• Special Economic Zones (“SEZ”). On 13 April 2023, the Government of Saudi Arabia announced the launch of four new SEZs across the Kingdom, located in King Abdullah Economic City (KAEC), Jazan, Ras Al Khair and Riyadh’s Cloud Computing in King Abdulaziz City for Science and Technology. These SEZs, along with the Special Integrated Logistics Zone at King Khalid International Airport, are expected to offer competitive incentives, including but not limited to 5% IT rate for up to 20 years; 0% withholding tax on repatriation of profits from SEZ into foreign countries; customs duties deferral for goods inside SEZ; and VAT exemptions for goods traded within or between SEZs.

The IT Law draft, however, seems to anticipate some or all the above measures. The draft includes one article which states that ZATCA’s board of directors or the competent authority may issue a decision whereby special tax provisions or treatments shall apply to specific activities or locations in the Kingdom, and that such special treatments shall be issued by way of separate regulations. Therefore, we expect separate tax legislation to be issued in the coming months.

Lastly, regarding the tax incentives for Regional Headquarters (“RHQ”), during the summer of 2023 ZATCA issued another public consultation which proposed to exempt RHQs from IT. Such measure was not finally implemented in the IT Law. However, on 16 February 2024, the RHQ Tax Rules were officially published in the Saudi gazette. The RHQ Tax Rules create two tax incentives: a zero percent (0%) rate of IT for qualifying RHQs, and a zero percentage (0%) withholding tax on certain payments made by qualifying RHQs, provided that they meet certain requirements. These tax incentives are welcome and should incentivise multinational groups to set up their RHQ in Saudi Arabia, although there are some practical nuances that will need further clarification and practice. We published a separate article commenting on the RHQ Tax Rules in our website.

5. Concluding remarks

The key takeaway is that Saudi Arabia is embracing some of the tax ideas in the most advanced jurisdictions in the world. The proposed ITL would include several favourable tax provisions that can be found in tax-friendly jurisdictions. Saudi Arabia is decisively stepping to the global fore, and it is taking positive steps. After all, the design of the income tax system is another tool – and a critical one – through which countries compete against each other.

Notwithstanding, we expect the IT Law and the IT Regulations to provide further detail on several points. In addition, the IT will add new concepts and complexity, hence ZATCA’s and the Tax Committee’s interpretation will also be paramount.

Lastly, the ITL does not regulate critical aspects such as the OECD’s Pillar One and Two and SEZs. We expect separate tax legislation to be issued in due course.

6. How we can help

Our Saudi tax team is expert on income tax issues and drafting legislation. They have been working on the existing IT legislation for years, advising clients and representing them in tax disputes before the Tax Committees. They are aware of ZATCA and the Tax Committee’s interpretation in practice.

By combining previous knowledge and experience on tax advisory and litigation matters in Saudi Arabia, we are in a unique position to anticipate what will likely be the future interpretation of the proposed measures and to provide in-advance tax planning accordingly, so that clients can stay ahead of the game.