For corporate taxpayers in Saudi Arabia, deducting interest expenses for tax purposes is subject to specific Zakat, Tax and Customs Authority (ZATCA) rules. This guide explains the limitations, calculation methods, and compliance requirements under the Saudi Formula Test, ensuring you maximize allowable deductions without triggering penalties.
📌 Understanding Interest Expense Deduction in Saudi Arabia
Interest expense deduction is a common tax consideration for businesses with borrowings. However, in Saudi Arabia, the deduction is subject to special rules to prevent excessive interest deductions that could erode the tax base, especially in cross-border transactions with related parties.
The primary limitation tool is the Saudi Formula Test, which sets a cap on the amount of interest expenses that can be deducted from taxable income.
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✅ What is the Saudi Formula Test?
The Saudi Formula Test limits interest deductions to a percentage of the company’s equity and related-party debt structure. The goal is to ensure financing arrangements are aligned with real business needs and not solely for tax benefits.
Under this rule:
- Interest expenses on related-party loans are deductible only up to the amount allowed by the formula.
- The formula considers the ratio of total debt to equity, adjusted for specific tax and Zakat requirements.
- Excess interest above the limit is disallowed for tax purposes.
💰 The Saudi Formula Calculation
The basic formula can be summarized as:
Allowable Interest = (Adjusted Equity × Prescribed Percentage) + Other Permitted Interest
Key factors include:
- Adjusted Equity: Share capital plus retained earnings, minus certain disallowed assets.
- Prescribed Percentage: Set by ZATCA guidelines, often aligned with international thin capitalization norms.
- Debt-to-Equity Ratio: Higher ratios may result in greater interest disallowance.
📄 Documentation Requirements
To support interest deductions under the Saudi Formula Test, taxpayers must maintain:
- Loan agreements with clear commercial terms.
- Proof of actual interest payments (bank statements, payment vouchers).
- Evidence that loans were used for business purposes, not personal or non-business activities.
- Calculations demonstrating compliance with the Saudi Formula Test limits.
⚠️ Common Mistakes Leading to Disallowance
- Incorrectly classifying shareholder withdrawals as loans.
- Failing to adjust equity for non-deductible assets.
- Not applying the Saudi Formula Test to related-party interest expenses.
- Using unsubstantiated interest rates that exceed market norms.
💡 Best Practices for Compliance
- Engage tax advisors to perform annual Saudi Formula Test calculations.
- Ensure all financing arrangements with related parties are at arm’s length.
- Regularly review your debt-to-equity ratio to avoid unexpected disallowances.
- Maintain clear, complete, and accessible loan documentation for ZATCA audits.
🏁 Conclusion
The interest expense deduction rules in Saudi Arabia, particularly the Saudi Formula Test, are designed to promote responsible corporate financing and prevent tax base erosion. By understanding the formula, keeping precise records, and adhering to ZATCA guidelines, businesses can optimize their financing strategies while remaining compliant.
