What are economic substance regulations?

As KSA is boldly moving towards its goal of vision 2030, it’s reshaping its economy to be less dependent on oil. The purpose of this evolution is to push regulatory transparency, and one of its fundamental aspects is Economic Substance Regulations (ESRs). Developed to match the global tax standards set by OECD and the EU, KSA’s ESR regulations make certain that companies operating in the Kingdom must prove real economic activity from local offices and skilled employees to smart decision making and profit generating functions.

If you are planning to operate your business in Saudi Arabia or if you are already doing so, its mandatory to be fully aware of how these regulations impacts your company. This guide will unpack all the details that you need to know regarding ESR’s in 2025, why they exist, which firms are affected and how to report accurately to stay fully compliant on the ever-changing KSA regulatory environment.

What Are Economic Substance Regulations?

Economic Substance Regulations are the legal set of rules defined to curb tax mishandling and avoidance and to ensure that profits are taxed precisely where substantive economic activities generating those profits are conducted. These regulations are presented to stop companies, mainly multinational firms, from illegally shifting profits to countries with low- or no-income tax (without having any actual business operations). These regulations have become a part of many jurisdictions today, specifically where there is minimum or low corporate tax to prevent harmful tax practices.

In KSA specifically, ESR demands the entities operating specific activities in the region to maintain a specific level of operations and presence within the Kingdom. The goal behind it is that businesses must not just operate on paper; they should have an actual workforce, real physical offices, and ongoing business operations. By assuring the real operational substance, ESR disincentivizes the use of shell companies and fake arrangements that move profits from high-tax jurisdictions to lower-tax ones without economic justification. Companies are required to present evidence that the profits align with the actual value of creation.

Objectives of ESR Implementation in Saudi Arabia

The major objectives of Implementing the Economic Substance Regulations in KSA are:

• Compliance with International Standards: to keep KSA regulatory framework in line with OCED’s BEPS action 5 and EU tax requirements
• Attracting Legal Investments: focusing on having investors with real businesses operations in KSA not just using the country for its low tax facilities
• Promoting Transparency: creating clear and fair tax regime that reduces the chances of shifting profits
• Avoiding EU Block listing: Making certain that Saudi Arabia remains away from EU list of jurisdictions with no corporation for tax purposes
• Economic Growth: encouraging the larger objectives of Vision 200 by maintaining real, productive activity in advanced sectors
• Fostering Local Employment: ESRs emphasizes on creating jo opportunities for local talents which promote the knowledge economy

Legal Framework and Authority

The ESRs enforcement is looked after by Zakat, tax and custom authority (ZATCA) which is competent enough to oversee the implementation of ESRs in Saudi Arabia. This legislation was created to keep the KSA’s legal framework in line with global standards, including transfer pricing and corporate tax. ZATCA has also presented guidance documents to encourage businesses to understand whether they fall under the category of ESRs and how to proactively comply with it. An annual compliance assessment is done, and in case of failure to meet the criteria, businesses have to bear severe consequences and penalties. ZATCA is mainly responsible for evaluating ESR reports, issuing compliance ratings, conducting audits, and applying fines when required. The authority also assists in online platforms for ESR notifications and reporting to further ease the process.

Which Entities Are Subject to ESR?

Economic substance regulations are generally applied to businesses who take part in certain relevant activities. Which include:

• Holding Company Business
• Distribution and Service Center Business
• Headquarter Business
• Shipping Business
• Intellectual Property Business
• Leasing and Financing Business
• Banking Business
• Insurance Business
• Investment Fund Management Business

Businesses taking part in any of these activities and generating income in KSA must know whether they meet the compliance criteria of ESR. These companies may be LLC, foreign company’s branch office or legal forms operating under Saudi Jurisdiction.

Understanding Core Income-Generating Activities (CIGAs)

Each business activity is linked with a set of Core Income Generating Activities (CIGAs) that must be done in KSA. Some of its key examples are:

• Holding Company: Maintaining the equity investments, receiving dividends and making thoughtful decisions
• Leasing and Finance: Organizing of loans, credit analysis, assessment of risks and managing of lease agreements
• Distribution and Service Provider: Purchasing and storage of goods, managing of inventory, fulfilment and fulfilment of orders
• IP business: Research and development, making intangible assets, management of brand and licensing agreements

These CIGAs are specifically designed to focus on relevant activity and serve as legal benchmarks for ZATCA while analyzing whether and entity has satisfied the economic substance test or not.

The Economic Substance Test

For complete compliance with ESR business must fully clear the economic substance test, which is done based on three key requirements:

1. Must be managed and directed in KSA, including all the board meetings, additionally all the decisions and policies must be documented locally, and local managers must take part in decision making
2. CIGA should also be conducted in KSA, companies must perform income generating activities within countries with full proof of each operations including records and employee’s data.
3. Companies must have an adequacy of Resources, with full-time employees with desired skills, physical offices and assets.

Apart from that, companies that outsource specific functions must make sure that the service provider should also be in KSA and should fulfil the needs of relevant CIGAs to a satisfactory standard.

Penalties for Non-Compliance

Many times, businesses fail to comply with economic substance regulations due to overlooking minor areas like CIGA Misalignment, cost burden, improper documentation, outsourcing risks, and complex cross-border structures. These leads to hefty fines and penalties such as:

• Financial Penalties for up to SAR 400,000 as per the depth of legal violation
• Loss of favorable tax treatment for non-compliance
• Risk of damage in reputation and credibility among investors
• Suspension of license in case of multiple violation

These penalties vary depending on the nature of breach; therefore, it is essential to avoid any misconduct, report accurately, and maintain records.

Best Practices for ESR Compliance

For successful compliance and to avoid legal hurdles and penalties, businesses must:

• Conduct self-assessment on day to day basic to find out if their operations fits ESR exposure
• Prioritize ESR responsibility by either hiring a compliance officer or team manager to look after Economic Substance Regulations.
• Maintain a thorough record of board meetings, employment contracts, rental documents, and financial data to present them Infront of authorities on demand
• Always be ready for ZATCA audits by accessing records on routine basis
• Engage professional advisors or regulatory accounting experts for better planning and reporting
• Utilize the latest tools and software to stay compliant by automating tracking, document storage, and reminders for deadlines.

The Role of SS&CO in Supporting Compliance

SSCOKSA offers a wide range of Economic Substance Regulations services through a team of regulatory accounting professionals. We assist businesses in:

• Assessing the applicability of Economic Substance Regulations
• Keeping a track of income and activities
• Filing and preparation of ESR reports and notification
• Keeping the ESR aligned with transfer pricing and VAT regulations

To aid businesses stay ahead of regulatory changes and to stay away from penalties that leads to reputational and capital damage, SS&CO with its deep regulatory understanding of local and global ESR practices becomes a strategic partner of any business in need. Our services help businesses build a sustainable business away from all regulatory hurdles with a competitive presence in the Kingdom.