Intercompany Financing: Two Layers of Risk, One Transaction
Intercompany loans, guarantees, and cash pooling arrangements present a unique compliance challenge in Saudi Arabia: they attract scrutiny under two separate regulatory frameworks simultaneously. Transfer pricing rules determine whether the interest rate — and the terms of the financing — reflect what independent parties would have agreed. Saudi thin capitalisation rules then determine whether interest deductions are allowable at all, regardless of whether the pricing is arm’s length. Both must be assessed. Neither can be ignored.
Intercompany financing is one of the most common mechanisms through which MNE groups fund their Saudi operations. A parent loan to a Saudi subsidiary is often more flexible and faster to arrange than external bank financing. But the simplicity of the arrangement can lead to insufficient TP analysis — and ZATCA is increasingly focused on whether intercompany debt is structured and priced consistently with what an independent bank or creditor would have required.
This article covers the TP analysis for intercompany loans, the pricing methodology, the thin capitalisation overlay, guarantee fees, and cash pooling — with worked examples and a clear picture of the documentation ZATCA expects.
Intercompany Loans — Pricing the Interest Rate at Arm’s Length
The transfer pricing question for an intercompany loan is: what interest rate would an independent lender have charged to the borrowing entity, under comparable terms and credit conditions? This is determined using the CUP method — specifically, by reference to comparable independent lending rates for loans with comparable terms, currency, amount, maturity, and borrower credit risk.
The Credit Risk Analysis
Credit risk is the starting point. An independent lender assesses the borrower’s creditworthiness before setting an interest rate. The TP analysis for an intercompany loan must replicate this assessment — determining the standalone credit rating of the Saudi borrower (i.e., the rating it would have if it were an independent entity, not supported by the group). This standalone credit assessment then drives the comparable rate search.
The group’s implicit support — the fact that the parent may in practice stand behind its subsidiary’s obligations — is a separate consideration. The TP analysis may recognise some benefit from group membership when pricing the loan, but the starting point is always the borrower’s own credit profile as if it were operating independently.
Finding the Arm’s Length Rate
For SAR-denominated intercompany loans, the appropriate comparable rate reference includes Saudi interbank rates (SAIBOR), comparable bank lending rates for similar facilities, and publicly available bond yields for entities with comparable credit profiles. For USD or other currency-denominated loans to Saudi entities, the relevant reference rates are the SOFR or equivalent benchmark rates adjusted for the borrower’s credit spread.
The final rate should reflect the loan’s specific terms: amount, maturity, security (if any), covenants, and currency risk. An unsecured three-year loan carries different credit risk — and therefore a different arm’s length rate — than a secured five-year facility. These distinctions must be reflected in the analysis.
Al-Baraka Manufacturing Co. is a Riyadh-based entity 100% owned by a German parent. In January 2023, the German parent extended a SAR 50 million intercompany loan to Al-Baraka at 2% per annum — a five-year unsecured loan in SAR.
Step 1 — Credit analysis: Al-Baraka’s standalone financial profile (leverage, EBITDA coverage, asset base) is assessed. Based on financial ratios, a standalone credit rating of approximately BB (sub-investment grade) is estimated.
Step 2 — Comparable rate search: SAR-denominated loans extended by Saudi banks to BB-rated borrowers for five-year unsecured facilities in early 2023 carried rates in the range of 5.5%–7.5% (SAIBOR + credit spread). Even accounting for some group membership benefit, a rate below 4% is difficult to defend for a standalone sub-investment grade borrower.
Step 3 — The gap: The 2% rate charged appears below the arm’s length range. Al-Baraka has been under-charged for the cost of capital — the interest deduction is understated, and the German parent has under-earned on the loan. A ZATCA adjustment could increase the interest rate to the arm’s length range, increasing Al-Baraka’s interest expense (and CIT deduction) and increasing the German parent’s interest income. WHT at 5% applies on the arm’s length interest amount paid to the non-resident German parent.
Thin cap check (see below): Even if the arm’s length rate is confirmed, the deductibility of interest on a SAR 50 million loan must also pass Saudi thin capitalisation testing separately.
Thin Capitalisation — The Second Layer of Restriction
Saudi Arabia imposes thin capitalisation restrictions on interest deductions under the Income Tax Law and its Implementing Regulations. These rules operate entirely separately from the TP arm’s length analysis — and in practice, they can be the more binding restriction.
Under Article 16 of the Income Tax Implementing Regulations, interest paid to a related party (directly or indirectly) is deductible only where the total debt from related parties does not exceed a debt-to-equity ratio of 3:1. Where the related-party debt exceeds three times the entity’s equity, the interest attributable to the excess debt is disallowed.
It is entirely possible — and common — for both the TP arm’s length analysis and the thin capitalisation restriction to apply to the same intercompany loan simultaneously. The TP analysis determines the correct arm’s length interest rate on the full loan amount. The thin capitalisation rules then determine how much of the total interest (at that arm’s length rate) is actually deductible. The more restrictive result applies. Finance teams must run both calculations — not one or the other.
Al-Baraka Manufacturing Co. (from the earlier example) has equity of SAR 15 million and related-party debt of SAR 50 million. The arm’s length interest rate has been confirmed at 6% per annum. Annual interest charge: SAR 50M × 6% = SAR 3 million.
Thin capitalisation test: Maximum permitted related-party debt = SAR 15M × 3 = SAR 45 million. Excess debt = SAR 50M − SAR 45M = SAR 5 million. Disallowed interest = (SAR 5M / SAR 50M) × SAR 3M = SAR 300,000.
Net deductible interest: SAR 3M − SAR 300,000 = SAR 2.7 million.
The TP analysis confirmed the arm’s length rate. The thin cap rule then restricts the deduction. Both calculations are necessary. Note: the thin cap restriction does not affect the WHT base — WHT applies to the full interest paid to the non-resident lender (SAR 3 million at 5% = SAR 150,000), regardless of how much is deductible for CIT purposes.
Guarantee Fees and Cash Pooling Arrangements
Intercompany Guarantees
Where a parent company guarantees a Saudi subsidiary’s bank borrowing — allowing the subsidiary to access financing at a lower rate than it could obtain independently — the guarantee has economic value. Under the arm’s length principle, that guarantee should be compensated: the Saudi subsidiary should pay a guarantee fee to the parent that reflects the benefit received.
The arm’s length guarantee fee is typically assessed as the difference between the interest rate the subsidiary would have paid without the guarantee (based on its standalone credit profile) and the rate it actually pays with the guarantee in place. This “yield approach” is the most commonly used method.
ZATCA’s TP Guidelines recognise that financing guarantees are covered transactions under the Bylaws. The documentation for a guarantee fee arrangement must address: the standalone credit profile of the beneficiary, the market rate it would have paid without the guarantee, the rate it actually pays with the guarantee, and the resulting guarantee benefit — which determines the arm’s length fee.
Cash Pooling
Cash pooling — where a group treasury entity sweeps and notionally consolidates balances across multiple group entities — is a common treasury management tool. Each Saudi entity participating in a cash pool has either a notional deposit or loan balance with the pool leader. Each balance should earn or pay an arm’s length return.
For Saudi entities, the key TP questions are: what interest rate does the Saudi entity earn on its pool deposit (or pay on its pool borrowing), and does that rate reflect what independent parties would have agreed? The arm’s length rate should reflect the terms of the pool — the notional balance, the currency, the overnight or short-term nature of the arrangement, and any offset benefits. ZATCA has also noted that cash pooling arrangements may, depending on their structure, create effective control relationships — which themselves are relevant for the related-party definition analysis.
Documentation Requirements for Intercompany Financing
The Local File for intercompany financing transactions must be particularly thorough. ZATCA will expect:
| Documentation Element | What ZATCA Expects |
|---|---|
| Loan agreement | Written intercompany loan agreement specifying principal, interest rate, maturity, repayment schedule, currency, security (if any), and covenants |
| Credit analysis | Assessment of the Saudi borrower’s standalone credit profile — financial ratios, industry context, and the implied credit rating used in the rate analysis |
| Comparable rate analysis | Evidence of comparable independent lending rates for comparable borrowers — bank rates, bond yields, or SAIBOR-based benchmarks with credit spreads |
| Thin capitalisation calculation | The 3:1 debt-to-equity test applied to the entity’s financial statements; calculation of the disallowed interest portion |
| WHT documentation | Evidence of WHT withheld and remitted on interest payments to non-resident lenders; treaty relief documentation if applicable |
| Treasury policy | Where the loan forms part of a broader group treasury or cash pooling policy, the Master File should describe that policy and how individual loans are priced within it |
Common Compliance Failures in Intercompany Financing
- Zero-interest or below-market intercompany loans. Loans between related parties at zero interest — or at a nominal rate with no economic justification — are a clear TP exposure. ZATCA can impute an arm’s length interest rate on any related-party loan, creating interest income for the lender (the parent) and an interest deduction for the Saudi borrower that differs from what was actually paid.
- No credit analysis to support the interest rate. Simply stating that the rate was set at “market rates” without demonstrating what market rates for comparable borrowers actually were is not adequate documentation. The credit analysis underpins the entire rate justification — without it, the benchmark search has no foundation.
- Forgetting thin capitalisation when modelling TP positions. Finance teams focused on establishing the arm’s length interest rate sometimes overlook the thin capitalisation constraint entirely. Both must be assessed. A Saudi entity that is correctly priced under TP but exceeds the 3:1 ratio faces disallowed interest deductions regardless.
- Not withholding on interest payments. Interest paid to non-resident related parties is subject to Saudi WHT at 5%. Treaty relief may reduce this, but the default domestic rate applies unless proper treaty procedures are followed. Under-withholding on intercompany interest is a common compliance gap.
- Not documenting the cash pool structure. Cash pooling creates a large number of individual lending and borrowing balances. Each position needs to be documented and priced. A single-page treasury policy that does not address individual entity balances, credit risk assessment, or rate setting is not adequate TP documentation for a cash pool arrangement.
Frequently Asked Questions
Can a Saudi company borrow from its parent at zero interest?
Under Saudi TP rules, a zero-interest intercompany loan is generally not arm’s length — an independent lender would charge interest reflecting the credit risk, maturity, and market conditions. ZATCA can impute an arm’s length interest rate on the loan, creating interest income for the parent and an interest deduction for the Saudi entity that must be reported. The zero-rate position may be defensible only in exceptional circumstances with specific substantiation — confirm with a qualified TP advisor.
What is the Saudi thin capitalisation ratio?
Under Article 16 of the Income Tax Implementing Regulations, the permitted ratio of related-party debt to equity is 3:1. Interest paid on related-party debt that exceeds three times the entity’s equity is disallowed as a deduction for CIT purposes. The test applies to the entity’s financial position at year end and is based on the total of all related-party debt — not individual loans in isolation.
Does WHT apply to intercompany interest payments?
Yes. Interest paid by a Saudi entity to a non-resident related party is subject to Saudi WHT at 5%. This applies to the actual interest paid — including interest at an arm’s length rate. Treaty relief may reduce the rate where a qualifying treaty is in force between Saudi Arabia and the lender’s jurisdiction, and where the treaty’s procedures are correctly followed. WHT applies regardless of the thin capitalisation treatment — even disallowed interest is still subject to WHT if it is actually paid.
How is the arm’s length interest rate determined for a SAR-denominated intercompany loan?
The arm’s length rate for a SAR loan is determined by reference to comparable independent lending rates for borrowers with a similar credit profile, for comparable loan terms (amount, maturity, security). Relevant reference points include SAIBOR-based rates plus a credit spread reflecting the borrower’s standalone credit quality, and available Saudi bank lending rate data for comparable facilities. The credit analysis identifying the standalone credit rating is the foundation of this exercise.
- The arm’s length interest rate on an intercompany loan is determined by reference to what an independent lender would have charged for a comparable loan — based on the borrower’s standalone credit profile, the loan terms, the currency, and prevailing market rates. CUP is the primary method.
- Thin capitalisation restrictions apply separately and additionally. Related-party debt exceeding a 3:1 debt-to-equity ratio results in disallowed interest deductions under Article 16 of the Income Tax Implementing Regulations. Both the TP analysis and the thin cap test must be completed on every intercompany loan.
- WHT at 5% applies to interest paid to non-resident related parties. Treaty relief may be available but must be properly claimed. WHT is not affected by thin capitalisation disallowance — it applies to the actual interest paid.
- Guarantee fees and cash pooling balances are also controlled transactions. Each must be priced at arm’s length and documented. A zero-fee guarantee arrangement or undocumented cash pool position is a TP exposure.
- Documentation for intercompany financing must include the loan agreement, credit analysis, comparable rate evidence, thin capitalisation calculation, and WHT records. An intercompany loan without a written agreement and credit analysis is not defensible on ZATCA audit.