Setting up and operating a joint venture

Structure

Are there any particular drivers in your jurisdiction that will determine how a joint venture is structured?

As in other jurisdictions, the duration and complexity of the projects or operations for which joint ventures are created will have a significant impact on their structure. Unincorporated joint ventures are typically used for short-term engagements owing to the fact that unincorporated joint ventures can be dissolved rather easily. For long-term engagements, the closer relationship between the parties and independent management and operational structure established by an equity joint venture may be more appropriate.

In addition, certain particularities specific to Saudi Arabian law require consideration when structuring a joint venture. For instance, because of the primacy of Islamic law, Saudi Arabian entities may not procure conventional interest-bearing loans, unless specific authorisation to do so has been given by their shareholders. Such authorisation could be included in the company’s constitutive agreements. Furthermore, owing to the poor protection of intellectual property under Saudi Arabian law, this aspect should be addressed when structuring a joint venture. Intellectual property rights should not be transferred to a local Saudi Arabian entity. Necessary intellectual property should be made available to the local entity through licensing agreements. In addition, since enforcement of claims is still rather time-consuming and costly in Saudi Arabia, it may be advisable to manage the profits generated by the joint venture entity to secure shareholder interests in the commercial venture.

Tax considerations

When establishing a joint venture, what tax considerations arise for the joint venture parties and the joint venture entity? How can tax charges be lawfully mitigated?

Under Saudi Arabian law, Saudi Arabian nationals (and citizens of other Gulf Cooperation Council (GCC) countries, who are considered Saudi Arabian nationals within the meaning of Saudi Arabian tax law) are not subject to income tax. Consequently, profits generated by a corporate entity will be subject to income tax only where and as far as such profits are apportioned to shares held by, or the beneficial owners of which, are foreigners. Asymmetric distributions of profits and losses will be considered when assessing the corporate income tax load. Thus, where in a joint venture entity Saudi Arabian nationals hold 50 per cent of the shares and the profits are distributed 80/20 to the benefit of the foreign shareholders, 80 per cent of the profits will be subject to corporate income tax. Corporate income tax is charged at a flat rate of 20 per cent of the annual net profits of the entity. An additional 5 per cent withholding tax is levied where funds are transferred abroad.

Foreign interests in unincorporated joint ventures may also be subject to Saudi Arabian corporate income tax where a permanent establishment of the foreign partner is generated in Saudi Arabia through the unincorporated joint venture. In this case, profits generated through this permanent establishment will be taxable in the Kingdom. Where a foreign business without a permanent establishment in Saudi Arabia receives income from a Saudi Arabian tax resident for work executed in Saudi Arabia, the Saudi Arabian customer is required to withhold 15 per cent of all payments as withholding tax.

While not subject to corporate income tax, interests of Saudi Arabian nationals in a corporate entity are not tax-free, and are subject to the zakat. While traditionally a mandatory charitable contribution, zakat in present-day Saudi Arabia is collected as a tax at a flat rate of 2.5 per cent. Unlike corporate income tax, which is calculated based on the net profits of an entity, the tax basis for zakat is the net worth of the company and thus more comparable to a wealth tax than an income tax. Withholding tax is not charged if profits allocated to Saudi Arabian shareholders are transferred abroad. Finally, the tax year for zakat is the Islamic calendar year, while Saudi Arabian income tax is assessed based on the Gregorian calendar. Hence, the application of corporate income tax and zakat in mixed Saudi Arabian- and foreign-held equity joint ventures requires somewhat more dedicated tax planning and management.

Effective from 1 January 2018, Saudi Arabia introduced value added tax (VAT) at a standard rate of 5 per cent. Specific products and services, as well as certain transactions, are zero-rated or VAT exempted. The new VAT needs to be considered when assessing the viability of a venture in the Saudi Arabian market.

Asset contribution restriction

Are there any restrictions on the contribution of assets to a joint venture entity?

While capital contributions to corporate entities are much more common, there are, in principle, no restrictions on the contribution of assets to a joint venture entity. Still, some restrictions apply due to foreign ownership restrictions. For instance, foreigners may only own real estate in Saudi Arabia if the value of their real estate investment exceeds 30 million riyal or such real estate is acquired for use in their professional endeavors, ie, business premises, workers’ accommodation or warehouses.

Interaction between constitution and agreement

What is the interaction between the constitution of the joint venture entity and the agreement between the joint venture parties?

The constitutive agreement of a corporate entity established in Saudi Arabia - typically referred to as the articles or memorandum of association - have to be legalised by a notary public in the Kingdom and filed with the competent authorities. From a legal point of view, the parties are free to define the terms of these articles or memoranda as they see fit, provided that they meet the requirements of Saudi Arabian law, first and foremost those of Royal Decree M/3 of 28/1/1437H governing commercial companies. The Saudi Arabian authorities tend to reject articles that deviate substantially from the standard articles typically utilised without legal grounds. Furthermore, the official articles cannot be made subject to foreign law or include an arbitration clause. Therefore, a separate joint venture agreement is typically concluded that governs the internal relationship among the joint venture parties.

Which agreement will take precedence is not explicitly governed by Saudi Arabian law. However, Saudi Arabian authorities have frequently taken the position that the provisions of a company’s articles will take precedence over those of a joint venture agreement if the provisions of the two agreements conflict. Therefore, the joint venture agreement should be carefully drafted to expend on rudimentary provisions of the articles or govern matters not contemplated in the articles.

Party interaction

How may the joint venture parties interact with the joint venture entity? Are there any restrictions?

The joint venture parties typically assert control of the joint venture entity through an ordinary or extraordinary general assembly. At least one ordinary general assembly must be held each year. An extraordinary general assembly will have to be held in certain instances; for example, if the company is over-indebted. Under Saudi Arabian law, a company is deemed to be over-indebted where its liabilities and obligations exceed its assets plus half of its share capital. The Saudi Arabian authorities will not consider positive future developments of the entity’s business when determining whether it is over-indebted. If a company is over-indebted, an extraordinary general assembly has to be convened, during which the shareholders shall resolve either to liquidate the company or inject additional capital into the company.

Restrictions for sharing information between the shareholders and a joint venture entity only apply in specific constellations. While such restrictions are very rare for limited liability companies, certain information-sharing restrictions apply where a joint venture entity is incorporated as a joint stock company. Furthermore, restrictions may be imposed on the joint venture by agreement between its shareholders - for example, to shield certain interactions between one of the shareholders and the joint venture entity from the other shareholders - or with third parties, for example, in transactions where a customer of the joint venture entity seeks to limit the disclosure of confidential information.

Exercising control

How may the joint venture parties exercise control over the joint venture entity’s decision-making?

The primary mechanism for shareholders to exercise control over a joint venture entity is asserting control over the entity’s management. Under Saudi Arabian law, the management of limited liability companies is vested in individual general managers, while joint stock companies are managed by a board of directors. To expend its control over a joint venture entity, a shareholder can procure the right to appoint the general managers of a limited liability company or the majority of the directors of a joint stock company. Similarly, to secure its position, minority shareholders can demand the right to determine at least one director or manager. Furthermore, shareholders may wish to establish a supervisory board to oversee local management.

Regulations pertaining to management can also be utilised to limit the independence of the joint venture entity by including restrictions on management authorities. These restrictions will not be binding in respect to third parties, unless the restrictions are explicitly communicated to such third parties, for example, by disclosing managers’ powers of attorney to third parties. Hence, restrictions on management authorities will typically only have legally binding effect internally between the management and the company or its shareholders. Typical restrictions imposed on local management are limiting their authority to conclude transactions that exceed a specific value or have significant implications for the joint venture. Local management can be compelled either to act jointly to conclude such transactions or to procure the consent of the shareholders or a supervisory board to do so.

An important tool for minority shareholders to secure their interest in a joint venture is voting in the general assembly. For instance, minority shareholders can increase their impact on a joint venture or prevent marginalisation by procuring veto rights for decisions with a substantial impact on the joint venture, such as the incorporation of subsidiaries, amendments to the entity’s business objectives and its liquidation. Where parties to a joint venture cannot agree to include veto rights, majority requirements for decisions on fundamental aspects of the joint venture may be raised to allow a group of minority shareholders to successfully oppose such decisions.

Governance issues

What are the most common governance issues that arise in connection with joint ventures? How are these dealt with?

Governance and compliance standards in Saudi Arabia are comparatively rudimentary. Aside from entities subject to the supervision of the CMA, which are subject to the corporate governance regulations issued by the CMA, corporate entities are subject only to a basic set of corporate governance rules arising out of statutory Saudi Arabian law. Foreign and group governance regulations of joint venture partners may be imposed on a joint venture by agreement.

While compliance standards are still lacking in Saudi Arabia, the government has taken steps to increase compliance throughout all economic sectors. These include stricter measures against bribery, increased worker protection - such as explicitly outlawing placement fees - and the introduction of fair market practices. Furthermore, foreign investors will typically be bound by domestic compliance standards imposed in their home jurisdiction. Because of inexperience with compliance standards, local staff will require increased training on applicable compliance standards and procedures, and additional supervision may be necessary.

Nominee directors

With an incorporated joint venture, what controls exist in your jurisdiction in relation to nominee directors? How should a nominee director balance the potentially conflicting interests of the joint venture company and the appointing shareholder?

All directors and managers are under a fiduciary duty to act in the best interests of their company. While the company is solvent, the best interests of the company equate to the interests of the company’s shareholders as a whole. Should the company become insolvent, these interests will rank behind the interests of creditors. A director finding him or herself in a position of conflict of interest does not automatically breach this duty. However, the director must resolve the conflict by exercising his or her discretion in the best interests of the company. Thus, a nominated director may to a certain degree work to favour the interests of a specific shareholder. Ultimately, however, every director is bound to work in favour of the joint venture entity. Violations of a director’s fiduciary duties may be sanctioned with substantial penalties and may expose the director to liability claims from the company and its shareholders.

Competition law

What competition law considerations are engaged by the formation and operation of the joint venture? Is approval needed?

Joint venture formation - regardless of whether an unincorporated or an equity joint venture is formed - is caught by the Saudi Arabian competition regime. Where the envisaged joint venture’s turnover would exceed the thresholds determined by the Saudi Arabian competition regulations, the proposed joint venture must be notified to the competition authorities, which will determine whether to grant approval for the transaction. The Saudi Arabian competition authorities to date have dealt with few merger control procedures and are thus comparatively inexperienced. Notification of a transaction that may require merger control approval, therefore, should be accompanied with substantial documentation on the relevant transaction and its possible impact and benefits for the Saudi Arabian market. Close cooperation with the competent authorities is essential to ensure the swift and professional resolution of a request for notification.

Provision of services

What are the key considerations in your jurisdiction in structuring the provision of services to the joint venture entity by joint venture parties?

The joint venture parties are free to conclude agreements for services or licence agreements with the joint venture. No specific restrictions apply under Saudi Arabian law. However, such agreements shall be priced at arm’s length and must comply with the provisions of the transfer pricing bylaws issued by the General Authority of Zakat and Tax in January 2019. Furthermore, intergroup contracts may also be restricted by agreement between the joint venture parties in the joint venture agreement.

Employment rights

What impact do statutory employment rights have in joint ventures?

Saudi Arabian residency regulations impose some restrictions on employment of expatriates. While employers are generally free to recruit expatriates, the Saudi Arabian government has in recent years taken measures to reduce the Kingdom’s reliance on a foreign workforce and made it more difficult for expatriates to obtain residency and work permits. Furthermore, since unincorporated joint ventures do not have a legal personality under Saudi Arabian law, they cannot sponsor foreign employees. Thus, where expatriates are to be employed for work executed through an unincorporated joint venture, these persons will have to be employed by one of the joint venture partners or a third-party manpower supplier.

In addition, Saudi Arabia has been running a programme to increase employment of Saudi Arabian nationals in the private sector (the Saudisation programme). Under this programme, private-sector businesses are ranked according to the percentage of Saudi Arabian nationals employed by them. A low ranking may result in discrimination of the business in respect to government services and in public tenders, while a high ranking may provide benefits. The thresholds applied in the ranking process depend on the size of the relevant enterprise as well as the industry in which it is engaged.

Aside from these regulations seeking to manage domestic and foreign employment, Saudi Arabian labour regulations are comparatively balanced. Royal Decree M/51 of 23/8/1426H on employment in the private sector was molded after the model labour law of the International Labour Organization. Collective labour rights, however, are comparatively little developed in Saudi Arabia. Thus, collective bargaining and collective action such as strikes have less of an impact in Saudi Arabia.

Intellectual property rights

How are intellectual property rights generally dealt with on the creation, operation and termination of a joint venture in your jurisdiction?

Protection of intellectual property under Saudi Arabian law is lacking. With the exception of universally known brands such as Coca-Cola and Apple, infringements of intellectual property rights including brands or trade secrets are extremely difficult to prevent or sanction in Saudi Arabia, if the relevant intellectual property rights are not registered domestically in Saudi Arabia. Moreover, the Saudi Arabian authorities have in the past found that joint venture parties have the right to continue to use intellectual property rights registered by a joint venture entity in Saudi Arabia after the joint venture has been terminated. Therefore, to protect their intellectual property rights adequately, joint venture partners should refrain from transferring intellectual property rights to joint venture entities or registering them in Saudi Arabia through joint ventures. They should rather register intellectual property through an entity they control and allow the joint venture to use the intellectual property through licensing agreements.

Additionally, parties may choose to include provisions in joint venture agreements or a separate agreement that would assign the right to intellectual property generated by the joint venture to a specific joint venture party. To be valid and enforceable under Saudi Arabian law, the party acquiring intellectual property would, however, have to be compelled to compensate the joint venture or the joint venture partners for the transfer of ownership of intellectual property. Such consideration may be a payment or a contribution in kind, for example, secondment of R&D staff or the provision of research facilities to the joint venture.

Finally, joint venture parties should at the time of incorporation take steps to regulate the treatment of intellectual property as of the joint venture being dissolved or a party exiting the joint venture. They should include in the joint venture agreement provisions that determine which parties have the right to use intellectual property after the joint venture is dissolved, whether the joint venture shall refrain from using certain intellectual property or trade names upon one party leaving the joint venture and how violations shall be treated. These provisions will typically be found in the joint venture agreement.