Benjamin R. Newland and Nabil A. Issa
King & Spalding LLP, Dubai, UAE
Saudi Arabia has enormous oil reserves, the largest economy in the Arabian Gulf region, a young population, steadily increasing GDP, and ambitious growth plans. An increasing number of US companies are doing business in the country, and the US is the largest source of foreign direct investment. Because of its immense wealth, Saudi Arabia is a country that is impossible to ignore.
For those who venture to the Gulf country, however, the picture on the ground is mixed. In spite of widely-touted "ease of doing business" rankings, which show Saudi Arabia bubbling up to just below Norway, Canada, and Australia, the Saudi business environment is opaque and the legal system is still in an early development stage, with laws and regulations being less-than-uniform in application and subject to unpublished policy changes by the government agencies charged with administering them.
Because of this, many US companies choose to enter the country through a joint venture with a well-known local firm. A joint venture is often seen as the fastest and most predictable way of penetrating the market, with the US partner's technical expertise leveraging off the Saudi partner's connections and local know-how. Below are 10 tips that are useful to bear in mind when establishing such a Saudi joint venture.
1. Use a limited liability company for (relative) speed and flexibility. A limited liability company (LLC) is by far the most common choice for Saudi Arabian joint ventures. The only other option, practically speaking, is a joint stock company (JSC), but a JSC must have at least five shareholders, comes with higher minimum-capitalization requirements and is more difficult and time-consuming to establish. An LLC needs only two "shareholders," and in general can get by with lower capitalization. Formation requires at least six weeks once all documents are assembled, but that is a considerable improvement on the six months or more usually required for a JSC. The Articles of Association used to establish the LLC must closely track the standard form Articles published by the Ministry of Commerce & Industry (MoCI), but customization is permitted on some points, including on voting thresholds and board composition. Unlike in the US, however, LLC interests may not carry different voting or economic rights, or be issued in different classes or series.
2. As much as possible, capitalize the joint venture with debt. At a certain point in the formation of a joint venture, the partners will discuss the amount of funding that the joint venture operations will require. For US parties it is natural to think of contributing a proportionate share of the total funding amount as equity capital in the new company. In Saudi Arabia, however, this would be a mistake. Beyond the minimum statutorily-required share capital – the amount of which varies according the nature of business being conducted, but which starts at US$135,000 – it is advisable to fund the company's capital needs through shareholder loans. The reason? A company must maintain 50% of its paid-in share capital in a special reserve account, and must set aside 10% of annual profits until the reserve account is fully funded. For companies with high paid-in share capital this creates a "trapped cash" problem. To avoid this, companies set their share capitalization at the lowest permissible level and then fund further capital needs through shareholder loans.
3. Realize that your tax position will be different from that of your Saudi partner. In Saudi Arabia, all investors are not created equal. While the Saudi Department of Zakat and Income Taxation (DZIT) will assess on a Saudi-national shareholder only zakat (which is, essentially, an Islamic tax on wealth) at a rate of 2.5%, DZIT will tax the net income of the joint venture attributable to a foreign shareholder at 20%. Further, a foreign shareholder (but not a Saudi national) is subject to 5% withholding tax on any company dividends or distributions. Capital gains and royalty payments are also subject to disparate treatment. Tax treaties can be used to reduce some of these foreign-shareholder assessments, and there are currently tax credits available for participants in various industries and for activity in certain parts of the country that may mitigate some of the tax burden. The simplest mitigation measure, however, may be to structure operations in such a way that expenses are brought forward to reduce taxable income, with profit-taking coming later in the life of the venture.
4. Do not rely on a buy-sell provision to create a joint venture exit. One common provision in US joint ventures for dealing with "deadlock" in decision-making, or with serious disputes between joint venture partners, is a buy-sell mechanic, where one party names a price at which a joint venture interest could be bought or sold. The other party may then either buy from or sell to the first party at the named price, meaning that either way one party is removed from the joint venture. Another common provision is the dilutive issuance of shares: if one partner refuses to contribute equity capital as needed, the other partner can contribute, thereby diluting the interest of the first and possibly removing some voting rights or board representation in the process. In practical terms, neither of these options is available in Saudi Arabia, where any change in shareholding must be consented to by all existing shareholders, all of whom must appear in front of a notary public to sign amended Articles of Incorporation that specify the new shareholding.
5. Set arbitration in Dubai or Bahrain. Not infrequently, a Saudi joint venture partner will agree to arbitration in London to settle joint venture disputes, and may even agree that English law will govern the shareholders' agreement. A foreign shareholder may initially feel elated at this "win," but the victory is illusory. We are not aware of any arbitral awards rendered outside of the Gulf Cooperation Council countries being enforced in Saudi Arabia. Instead, such awards are re-litigated on the merits in Saudi courts, where the local judges will apply Saudi law, regardless of what is stated in the contract. If arbitration is chosen as a dispute resolution mechanism, seat the arbitration in Bahrain or Dubai. There are some indications that, based on the 1983 Riyadh Arab Agreement for Judicial Cooperation, relating to enforcement of Gulf-states judicial awards, a Saudi court may enforce an arbitral award rendered in these jurisdictions without re-litigation on the merits, provided that such award is not contrary to Islamic law.
6. Use SAGIA to sponsor a US national as General Manager for the joint venture. Foreign shareholders often wish to appoint their own trusted executives to serve as general manager of the joint venture, rather than have a Saudi partner fill this sensitive and important position. A general manager, like any other Saudi company employee, must hold a valid Saudi work visa (or iqama) that is "sponsored" by the manager's employer. Because the appointment of the general manager must occur as a part of company formation, however, in practical terms the first general manager must be either a Saudi Arabian national or a foreign national who already has an iqama. Until recently, foreign parties finessed this by "seconding" their intended general manager to a company owned by the Saudi partner, with the existing company providing the necessary iqama, so that once the joint venture company was formed the general manager could immediately move his employment to that company. The Ministry of Labor has put a stop to this practice by forbidding foreign employees to change employers in the first two years after entering Saudi Arabia. Saudi partners may suggest that they simply appoint their own employee as general manager, but that is a decision that can be difficult to reverse. Fortunately the Saudi Arabian General Investment Authority (SAGIA) has established an alternative sponsorship process that enables foreign nationals to serve as a company's general manager without already having an iqama from a Saudi company. As a result, the US partner in a joint venture is still able to appoint the initial general manager.
7. Pick your joint venture purpose carefully. The description of the company's purpose or objectives in the Articles of Incorporation is very important. Unlike in the US, the company may not simply conduct "all lawful business;" rather, the purpose must be described with specificity in the Articles and the company's activities will be restricted to carrying out the stated purpose. MoCI, SAGIA and other government ministries involved in company formation will closely scrutinize the stated purpose of a company, as capitalization requirements, licensing requirements and regulatory restrictions all flow from that.
When considering the possible purpose of the joint venture, keep in mind that some business sectors and activities remain closed to foreign investment or to foreign-owned companies. These sectors are officially listed on the so-called "negative list" maintained and published by SAGIA. Since Saudi Arabia's accession to the World Trade Agreement in December 2005, the government has gradually opened up the economy to foreign investment, and the number of sectors on the negative list has been decreasing. Today, for example, a US or other foreign enterprise may own up to 100% of a company involved in manufacturing or oil-field services. It is also true, however, that even some of the officially "open" sectors remain closed to foreign investment. The pharmaceutical and clinical healthcare sectors, for example, are ostensibly open, but in practice the Ministry of Health will not license a foreign participant.
8. Allow more time for paperwork. In the US, it is now possible to establish a company without ever leaving one's office, as everything can be done electronically through scanned signature pages and with corporate service companies. Saudi Arabia, however, is still a paper-based system, and paperwork is serious business. Companies own, and regularly use, corporate stamps and seals. Most important documents must be witnessed – by two adult Muslim males, no less – and executed in front of a notary public, and notaries wield extraordinary power to approve or disapprove of documents and even transactions. In forming the joint venture company, it is important to be aware that the authorizing resolutions for a foreign shareholder, along with the foreign shareholder's constitutional documents and passport copies of authorized signatories, will need to be notarized, legalized and authenticated up through the Saudi Arabian embassy in the shareholder's home country before they can be submitted to MoCI to commence company formation. The process of authentication itself can take six weeks, which can push the overall time for LLC formation to three months.
9. Do not count on a shareholders' agreement to guarantee shareholder rights. Joint venture partners often choose to supplement the brief Articles of Incorporation with a "shareholders' agreement," which may be entered into before company formation, that sets out approval rights, board composition, competition restrictions, management arrangements and dispute resolution mechanisms, among other things. It is important to note, however, that courts in Saudi Arabia rarely, if ever, grant specific performance or injunctive relief – which is to say that they will not make anyone do anything or refrain from doing anything. This, in turn, means that an agreement to contribute capital in accordance with a schedule, to sell shares upon certain triggering events or to vote in favor of particular projects will likely not be enforceable. A Saudi court might award money damages in certain circumstances, but that will of course depend on a showing of actual harm. In this light, note that Saudi judges are trained only in Shari'ah law, and should not be expected to bring sophisticated commercial analysis to bear on joint venture problems. Further, be aware that provisions in a shareholders agreement that are not Shari'ah-compliant or, that are inconsistent with the registered Articles of Incorporation, will not be enforced at all in Saudi Arabia.
10. Front-load discussion of US-law compliance. Several recent aggressive prosecutions under the US Foreign Corrupt Practices Act (FCPA) have highlighted the importance of FCPA compliance for US companies doing business abroad. Equal attention needs to be paid to the rules on detection and prosecution of money-laundering and financing of terrorism promulgated under the Patriot Act, US export control regulations and lists of "restricted persons" or "specially designated nationals" maintained by the US Office of Foreign Assets Control and other agencies. These issues are sensitive ones in Saudi Arabia and the Gulf-states generally, and compliance obligations are best raised with a Saudi partner early in joint venture discussions. Saudi parties will often suggest that the joint venture comply instead with local law (e.g., Saudi anti-corruption laws) or with rules and restrictions promulgated by international organizations such as the United Nations. These measures are good, but are generally insufficient for a US business, and it is best to set expectations at the outset, when momentum to reach agreement is high and both parties are flush with good will.
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As the tips above illustrate, there are many unique challenges associated with conducting business and forming joint ventures in Saudi Arabia. Partnering with a local can make life easier in many respects – there is a widespread belief that the right Saudi joint venture partner can open doors when tendering for projects, for example – but it is important to find a guide with "boots on the ground" when entering into this territory. The right legal and tax consultants, with recent experience in Saudi Arabia, will be able to tell you not just the laws on the books but also the ways in which those laws are interpreted and administered in practice.
About the authors
Benjamin R. Newland is a partner in King & Spalding's Dubai office. He regularly advises US companies on joint ventures, cross-border M&A, and other Middle East investment matters.
Nabil A. Issa is a partner in King & Spalding's Dubai and affiliated Riyadh offices, and has been based in the Middle East for the last 10 years. His practice focuses on Shari'ah-compliant transactions and structuring foreign investment in the Middle East.
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