’t is the season, but not the jolly one. In many European countries it is filing season. A new kid on the block causes additional headaches for European businesses, the Anti Tax Avoidance Directive, or “ATAD”.
One of the provisions of this Directive, which was implemented with effect from 2019 and therefore impacts for the first time tax reporting in 2020 covers a now relatively familiar topic in some GCC countries: substance.
Businesses in scope of the Economic Substance Regulations (“ESR”) implemented in the UAE in 2019 were recently very occupied with their ESR notifications, and potentially filings. In Bahrain the filing of the ESR report was 30 June. The ATAD is another substance tale, but with far more direct consequences.
The ATAD protects the corporate tax base in the countries of the European Union (“EU”). There are currently 27 Member States of the European Union. The UK recently left the EU.
In the ongoing focus in the EU on fighting tax avoidance, the European Commission proposed a number of anti tax avoidance measures to the Member States to protect the corporate tax base.
One of the measures is one often referred to as “CFC-rules”, or Controlled Foreign Corporation rules. Other measures included provisions to avoid hybrid mismatches, an exit tax for assets moved out of the EU, interest limitations and a General Anti Abuse Rule (“GAAR”).
The ATAD directive had to be implemented in the Member States and have effect from 1 January 2019. This year is therefore the first filing seasons where its effects are reflected in corporate tax filings.
EU CFC rules explained
CFC have the effect of re-attributing the income of a low-taxed controlled subsidiary to its parent company. The parent company adds the revenue of its subsidiary to its own taxable income.
The EU CFC rules are now harmonized between the Member States. However, even prior to the entry into force of the ATAD directive, many Member States had comparable legislation, even going back 40 years (e.g. Germany implemented them in 1972). With the EU CFC rules though, there is now a level playing field.
Subsidiaries in which a parent has a 50% interest (50% of the capital or voting rights, directly or indirectly, or the right to receive 50% of the profits), and which are only subject to low taxation, are considered CFCs.
Low taxation is defined as the actual corporate tax paid by the entity or permanent establishment and is lower than the corporate tax it would have paid had it been established in the Member State of the parent. Member States have some freedom with this provision, e.g. France says it considers a country has low taxation if its CIT rate is lower than 50% of its own rate.
The same principles apply for head offices and branches.
When a business has a CFC, the Member State can either choose to automatically integrate certain types of income (e.g. royalties, dividends, …), or only integrate non distributed income arising from non-genuine arrangements put in place for the essential purpose of obtaining a tax advantage, unless … there is substance (a “substantive economic activity”).
What is the relation with Economic Substance Requirements?
There is no direct relation with the ESR as they were recently introduced in the UAE and Bahrain for which there are notifications to be made and reports to be filed.
However, with the CFC rules ATAD focuses amongst others on the same matter, i.e. substance. Where the ESR requires some compliance and administrative work, the ATAD has a direct tax consequence.
In terms of not meeting the substance though, the consequences under the ESR are lighter. Businesses can incur a penalty. Worst case scenario, their license can be revoked. Worse actually is the notification to the tax authority of the parent, that there is no substance. When they handle Intellectual Property, there may be an automatic notification of the tax authority of the parent jurisdiction.
Insofar as the Regulatory Authorities in the UAE and Bahrain will enforce compliance with the ESR, and they will verify substance with their licensees, there may be some of these inconvenient notifications.
Notifications may trigger tax audits in the country of the parent, and may lead the tax authority to compare the input with the corporate income tax (CIT) return filed. If that Member State has implemented the CFC rules with the substance carve out, and the CIT return does not include the income of the entity, but the notification flagged it as having insufficient substance, there may be an important issue.
The current situation was reminiscent of the introduction of VAT on 1 January 2018. Everyone is an adviser, and there’s a lack of expertise. Likely around 350,000 businesses had to ask themselves the question whether they are in scope of the ESR and whether they need to file. It was a massive exercise, similar to the scale at which the Federal Tax Authority administered the registration for VAT purposes in 2017.
The ESR notification is simple, and therefore some providers offer it cheaply. However, without a proper assessment which thinks about the long term, its consequences can be grave.
Out of complacency adopting a too broad interpretation of the Relevant Activities means that when the Licensee files a notification declaring he is in scope of the ESR in the UAE, he needs to file an ESR report by the end of 2020, related to 2019.
Even though the ESR report may also not turn out to be very extensive in terms of the information to be filled out, it will be much more extensive than the notification. And even though there are penalties foreseen for not filling out the notification correctly, and for not meeting the substance requirements, this is not what businesses should worry about. It is rather the direct tax consequences in the jurisdiction of the parent.
Substance compared between CFC rules and ESR
Same cookie, different flavour. The preamble to the ATAD directive mentions a “substantive economic activity”. Member States can choose not to apply the substance rule for non EU countries and use their own rules.
The criterion is not defined in detail, but neither is it in the ESR applicable in Bahrain and the UAE. In those last two jurisdictions, when a business conducts a relevant activity, they are in scope and they need to meet a substance test. In order to pass the test, you must generally show that:
- core income generating activities are conducted
- The activities are directed and managed in the country
- There is an adequate level of FTE’s, Opex and physical assets
The entities regulating the ESR are in Bahrain and the UAE though, whereas for CFC purposes, the conversation is to be had with the tax jurisdiction of the parent.
Substance is not over
The ESR Filing is done, remains the report. It does not stop there though. The tax policy changes signal an increased attention for substance. The sometimes complicated legal framework in the GCC may therefore also have to evolve. The increased attention in the EU for low tax jurisdictions means that this filing season, the CIT return in the EU has again become a bit more complicated.
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In this article the authors discuss common structures which are set up by non-GCC businesses to invest in KSA. Sometimes these structures have as a primary or secondary objective to optimize their overall tax liability in KSA. These structures are subject to increasing risk and should be disclosed if they led to an underreporting of corporate income tax in KSA. Managing this risk and the associated exposures is now possible at reduced cost thanks to a new tax amnesty program which was recently announced by GAZT.
Tax landscape in KSA
In the Kingdom of Saudi Arabia (“KSA”), there are two types of direct taxes. The first is referred to as Zakat, which is a (quasi-) taxation on Saudi individuals and companies based on the concepts of Islamic law. The second is a traditional Corporate Income Tax (“CIT”) levied on profit.
In order to determine whether a company is subject to Zakat or CIT, the shareholding structure must be analyzed. Companies which are fully owned by KSA or GCC nationals  are subject to Zakat. Where a company is owned by both non-KSA and KSA investors , the portion of taxable income attributable to the non-KSA interest will be subject to CIT , and the proportion which relates to the interest held by the KSA or GCC national goes into the basis on which Zakat is assessed.
Zakat is assessed at 2.5%, whereas the CIT rate is 20%. However, the base for the calculation of Zakat  vastly differs from the tax base for CIT purposes . Generally, the total direct tax liability of a business in KSA is lower when it is subject to Zakat, compared to when it is subject to Corporate Income Tax. Much depends however on the profitability of a business, and its assets and liabilities.
Structures used for KSA tax optimization
In situations where it is deemed that the overall tax liability would be lower under the Zakat regime as compared with an effective taxation under the CIT regime, businesses have sometimes implemented corporate legal structures mainly aimed at circumventing applicable KSA foreign ownership restrictions to benefit from a favorable tax treatment as described above. However, such corporate structures are likely to be successfully challenged by GAZT as they do not reflect the economic reality and the spirit of the provisions set out in the KSA CIT laws and regulations.
A common example of a structure which could be used for such purposes, is to set up a foreign holding company (“HoldCo") which holds the shares of one or more companies with operations in KSA. In these structures, the majority or all of the shares in the HoldCo are (nominally) held by GCC nationals on behalf and to the account of the foreign investor, but the economic interests and other rights of the foreign investor are usually substantially protected through 'side agreements' or, more robust alternative structures whereby the GCC nationals agree, among other things, to waive all economic and legal rights to receive dividends, to exercise votes, and to receive any proceeds of the sale of the shares. The GCC nominees surrender these in favor of one or more foreign investors who are registered as legal minority shareholders, or perhaps not registered at all.
The above mentioned structure has the effect of optimizing the overall tax liability of the operational company in KSA, since it will for the most part be liable for Zakat as opposed to the generally less favorable CIT regime. However, we set out below the potential risks and issues with such structures which may be potentially challenged by GAZT.
Tax evasion or other purposes
The structure can serve different purposes, such as managing certain restricted activities in KSA. The structure, or its equivalent, has been in place for many years and only seems to have come in focus of GAZT in the last few years.
Up until recently, we also had no explicit formal and public standpoint from GAZT on the matter, although in informal communication and in individual files the structure was challenged. This changed recently when, on its website, GAZT has announced that manipulation of ownership of shares for the purpose of reducing the CIT or Zakat liability of the company qualifies as tax evasion . It should be noted, however, that the KSA CIT legislation does not define what exactly is to be considered as ‘manipulation’ of ownership of shares.
Based on the above interpretation by GAZT, we are of the view that the use of a side agreement or other similar agreements or structures designed to create a tax advantage by way of having a discrepancy between the legal and economic ownership (as described above) is likely to fall within the scope of tax evasion, provided that it has the effect of lowering the overall tax liability of the company in KSA.
The qualification of the so-called ‘manipulation' as tax evasion is significant, because it implies that the normal statute of limitations will be extended. Instead of five years, GAZT would have ten years to issue or amend an assessment . In addition, penalties up to 25% of the unpaid tax may be imposed by GAZT .
GAZT has an increasing numbers of tools at its disposal, both formal and informal. Historically, it relied much on informal tools and anecdotal discoveries.
The informal tools were the informal exchanges between the KSA and foreign tax authorities. Although these cannot constitute the basis for an additional assessment, they did provide valuable information. The complexity though was that data was not always available or is sometimes scattered (e.g. in the UAE between different authorities).
Double Tax Treaties generally also provide the basis for a broad exchange of information provision. KSA can therefore request information to the foreign Ministry of Finance.
For the bigger international companies, the country by country reports (CbCr) filed can be a source of information. Since these should follow the economic realities reflected in the financial statements, a 100% nominally GCC held business with a side agreement would not feature in the CbCr report of the GCC shareholders (if they need to file one).
The local country files, also compulsory in KSA, except for 100% Zakat payers, may also provide some information.
GAZT is allowed to re-characterise any transactions whose form does not reflect its factual substance and status. With some imagination, GAZT may also estimate a formal Zakat payer’s liability with respect to Corporate Tax thus shifting the burden to the tax payer to demonstrate the contrary.
Untangling structures and KSA’s Voluntary Disclosure Initiative
It is not easy to untangle such structures. It requires at a minimum a change of ownership, e.g. of the Holding company or the set up of a new company. Often the structure is amended or disclosed through informal proceedings with GAZT. Upon disclosure, GAZT will impose discretionary penalties.
GAZT has recently announced a broad-based tax amnesty program with respect to income tax, withholding tax, VAT and excise tax ("Initiative"). The Initiative is effective as from 18 March 2020 until 30 June 2020 ("Initiative Period”). Any voluntary disclosures made during the Initiative Period will not lead to any penalties being imposed by GAZT (this includes penalties for late payment, penalties for delay in submitting the tax return and penalties for making amendments to the tax return). In other words, any penalties which would otherwise be due under normal circumstances (i.e. in case of a tax audit), will be waived by GAZT, provided that the taxpayer submits a voluntary disclosure during the Initiative Period.
Taxpayers who are using (similar) tax optimization structures such as the ones that have been discussed in this article should consider making a Voluntary Disclosure to GAZT during the Initiative Period (18 March 2020 to 30 June 2020) in order to benefit from a waiver of penalties under the tax amnesty program.
With increasing detection risks and awareness at GAZT, we highly recommend to revisit the structures put in place in the past to mitigate their risks and get a tabula rasa with the KSA tax authorities.
 Citizens of the Gulf Cooperation Council ("GCC") are considered as Saudi nationals for KSA tax purposes.
 In principle there is no minimum Saudi ownership requirement, however there are restrictions with respect to certain regulated activities banking, financing, insurance or regulated investment activities.
 Article 6 (a) of the Cabinet Decision No. 278/1424 On the Approval of the Income Tax Law.
 The computation of Zakat is complicated, but it is essentially an assessment on net income or net worth. Zakat can either be calculated through the direct method (net of Zakat able assets method) or the indirect method (sources of funds method).
 Broadly speaking, CIT is assessed on net profits, i.e. taxable income minus deductible expenses (articles 8 - 21 of the Saudi Arabia Cabinet Decision No. 278/1424 On the Approval of the Income Tax Law).
 See https://gazt.gov.sa/ar/ContactUs/Pages/FraudExamples.aspx (Arabic only).
 Article 65 (b) of the Cabinet Decision No. 278/1424 On the Approval of the Income Tax Law.
 Article 77 (b) of the Cabinet Decision No. 278/1424 On the Approval of the Income Tax Law.