Saudi Arabian banks have started publishing their full financials for 2017, and news reports over the past week have focused on bank disclosures related to the additional zakat liability required by the General Authority of Zakat and Tax (GAZT) for years going back to 2002. We highlight that this has been a pending issue between banks and GAZT for many years now. Saudi Arabian banks file their zakat returns with GAZT, and based on these, the Authority has made additional demands of zakat from banks, based on its own assessment. The difference in zakat assessment between banks and GAZT is related primarily to the disallowance of certain long-term investments and addition of certain long-term financing to the zakat base. The GAZT assessment of zakat is being challenged by banks, and the appeal proceedings are underway at various levels of the available appellate forums. While banks are confident about their position in this issue, if they lose their appeal, there will be a substantial one-time impact on their book value. Tax and zakat for KSA banks are routed through shareholders’ equity, so we do not expect an impact on their income statements. Certain banks have already set aside provisions for the additional zakat demanded by GAZT.
 
Zakat is an Islamic tax paid by Saudi Arabian companies on behalf of their Saudi Arabian national shareholders. It is based on the net book value (tax base), and the official zakat rate is 2.5%. Foreign shareholders of KSA banks do not pay zakat but pay a 20% income tax. Zakat and income tax are now accrued on a quarterly basis by banks and are charged to retained earnings in accordance with SAMA guidance. Banks pay cash dividends net of zakat to Saudi Arabian shareholders and net of income tax to international shareholders. 
 
Impact on banks: The pending issue of additional zakat liability engulfs the whole banking sector. That said, we believe once a final verdict on this issue is reached (expected sometime this year), it will help lift an overhang that has been lingering over Saudi Arabian banks for many years now. 
 
Investment perspective: We note that, despite the potential one-time impact, KSA banks are generally well-positioned to absorb the impact of zakat. Within our coverage, we highlight Al Rajhi, our top pick in KSA, which had a T1 ratio of 22.2% (made up entirely of core capital) at end of 4Q17. Similarly, Samba (Tier 1: 19.2% as of 3Q17) and SABB (Tier 1: 18.4% as of 3Q17) are also well-positioned to absorb this impact, in our view. 
 
Al-Rajhi Bank: SAR73.46 as of 26 Feb. 2018, Rating: Buy, TP: SAR80.00/share, MCap: USD31,833mn, RJHI AB/1120.SE

Samba Financial Group: SAR25.32 as of 26 Feb. 2018, Rating: Neutral, TP: SAR26.00/share, MCap: USD13,504mn, SAMBA AB/1090.SE

Saudi British Bank: SAR29.01 as of 26 Feb. 2018, Rating: Neutral, TP: SAR30.00/share, MCap: USD11,604mn, SABB AB/1060.SE