• Service: Tax, Global Indirect Tax, Mergers & Acquisitions, Global Transfer Pricing Services, Global Compliance Management Services, International Tax
  • Date: 11/23/2012

Investments in infrastructure - due diligence blueprint 

With their rapidly expanding economies and populations, the infrastructures of many Middle Eastern countries are under increasing strain. To sustain this pace of growth, infrastructure projects to build or expand power, utilities and transportation networks are critical. These improvements come with tremendous costs, and governments in the region are seeking to raise funds and access skills and know- how through partnerships with foreign private investors. In the Middle East and North Africa regions alone, one source estimates total infrastructure spending at more than USD1 trillion over a decade.1

Given these opportunities, foreign investors taking part in infrastructure development can earn substantial returns. But with lifecycles that run from 15–20 years or more, these projects require extended commitments. From a tax, legal, business and political perspective, foreign investors need to do their homework and understand the long-term implications of their investments.

Foreign ownership restrictions

Many Middle Eastern countries impose varying restrictions on the extent of foreign ownership of local businesses. Some countries impose no restrictions whatsoever while others may require certain projects to be undertaken in partnership with the government and/or domestic entities. These restrictions can change over an investment’s lifetime. Understanding the country’s privatization policies is important.

For example, in Oman, foreign companies can own 100 percent of a property for an initial period, but after 4 years, the investor is required to list and sell shares of the project company to the public. While the investor will have to give up ownership, the listing may help them improve overall returns by opening opportunities to earn premiums on the listed shares. The implications of such restrictions should be taken into account as part of investor’s strategic plan.

Concentration of ownership rules

Before bidding on any projects, determine whether the host country imposes any rules to restrict the concentration of ownership of certain industries. If you succeed in securing three or four major government infrastructure contracts in certain countries, you may be barred from bidding on new, possibly more lucrative projects – unless you give up control over current ones. These rules should be examined in the context of all upcoming projects in the country so you can keep your best investment choices open.

For example, in Oman, the electricity market share restrictions set by the Electricity Regulator limit the share of any licensee to no more than 25 percent of total domestic production capacity of licensed facilities generating electricity delivered into the grid.

Sole ownership or collaboration?

Where the choice is available, due diligence investigations should assess whether the investment would be best made through a wholly owned enterprise or through a form of business collaboration. With a consortium, you relinquish a share of ownership and control. In return, you and your partners may be better positioned to bid for and execute the project based on your combined technical, marketing and financing strengths.

Formal or flexible arrangement?

If a form of collaboration is the optimal choice, you must then assess whether to incorporate a formal joint venture or enter into a more flexible arrangement. Either way, the terms of the arrangement need to be carefully considered and clearly specified in the related legal agreements.

Choice of partner

When assessing potential business partners, usual due diligence involving the candidate’s capabilities, reputation and financial strength are key. With long-term infrastructure projects, prospective partners should be vetted from a competitive standpoint as well. Your partner in bidding on one project could end up bidding against you on the next.

While your own due diligence may give you insights into your potential partners, the same process could create privacy or conflict of interest problems down the road. During this exploratory phase, foreign investors should enter into binding confidentiality agreements to protect themselves accordingly.

Political stability and foreign investment protection

While the political situation appears to be calming across the region in general, pockets of conflict persist and the emergence of new conflicts is distinctly possible. Given the extended term of infrastructure projects, potential investors should assess the levels of geopolitical risk against their company’s risk tolerance and appetite. They should also look into what forms of foreign investment safeguards are available, either in domestic law or through bilateral investment protection agreements.

Holding company structure

From a tax standpoint, foreign investors should consider the optimal ownership structure based on the interests of each partner and shareholder. In certain situations, for example, where ownership of two projects is involved, a question arises as to whether the holding company should be established inside or outside of the country in which the project occurs. For example, the United Arab Emirates and Bahrain do not impose taxes and could be favorably considered for an overseas holding company structure.

However, if there is a requirement in the project country for the project company to sell shares to the public during the project’s lifecycle, it would be necessary to re-incorporate in the project country prior to the sale of shares to the public. The costs and challenges associated with reincorporation should be compared with the tax advantages of incorporating overseas. Further, consideration should be given to the structure of companies to be formed for operations and maintenance (O&M) and management of the project company. The holding company’s location and structure should be decided before bidding on a project. Consideration should also be given to the country’s network of tax treaties.

Foreign currency issues

GCC countries do not impose any foreign currency restrictions. This opens opportunities for investors to review exchange rates, fluctuations and potential currencies for operations in order to optimize foreign currency management. Investors also need to consider the tax treatment of forward covers taken to hedge foreign currency exposures.

In a significant recent development, Egypt now requires Central Bank approval for large transfers of funds outside Egypt.

Financing the project

Consideration needs to be given to the extent of external financing, including equity bridge loans, that would be available at various stages of the project and the debt equity restrictions which may exist in a country’s tax laws; further, the implications and timing for conversion of shareholder loans into equity needs to be considered. For example, Saudi Arabia imposes a withholding tax on interest payments. Further, in order for the project company to deduct interest cost (which is already subject to withholding tax), such interest cannot exceed 50 percent of the taxable profits (excluding interest income and interest expense).

In Oman, newly issued Executive Regulations to the Tax Law require that the debt-to-equity ratio not to exceed 2:1 before a deduction can be claimed regarding interest on loans from related parties. In Egypt, the required debt-to-equity ratio is 4:1. Interest deduction is limited to an interest rate that does not exceed twice the discount rate as determined by the Central Bank of Egypt. A withholding tax of 20 percent applies to interest paid to overseas parties by resident companies. However, interest on loans having a term of 3 or more years entered into by private sector companies is exempt from withholding tax.

Tax and transfer pricing issues

Many of the MESA tax issues discussed throughout this publication are relevant for investments in infrastructure in the region. For long-term infrastructure projects, the bigger challenge is consistency of tax treatment throughout the life of the project. These issues should be considered at both the shareholder and company level. Foreign investors should pay special attention to tax issues arising from:

  • transfer pricing rules and documentation requirements
  • thin capitalization rules
  • differences in accounting and tax treatment of certain items (e.g. depreciation)
  • acceptability for tax purposes of certain accounting treatments prescribed by International Financial Reporting Standards (IFRS), for example, in respect of service concession arrangements and arrangements in the nature of lease
  • tax implications of returns to founder shareholders in terms of project development fee, technical services fee and management fees
  • tax implications of engineering, procurement and construction (EPC) contracts
  • value added tax (VAT) obligations and the implications of government contracts on potential VAT recoveries
  • new VAT laws which may be introduced in the GCC
  • the availability of tax incentives, holidays and exemptions and flexible tariff agreements
  • the ability to carry forward tax losses incurred during the tax exempt period to the post exemption period
  • withholding tax requirements.

Consideration should also be given to recouping costs incurred on failed bids from successful projects, for example, by way of a ‘project development fee’ to the founding shareholders. Keep in mind, however, that such fees may create tax issues in terms of creating a taxable presence and/or potential withholding tax obligations. For example as Kuwait follows source-based taxation principles, any development fee paid to developers could become taxable in Kuwait.

Planning your exit strategy

Even though your participation in the project could last for decades, you should take time to assess potential exit strategies, including capital gains tax implications. Saudi Arabia, for example, exempts from tax capital gains arising from sales of listed shares. As part of the exit review, you should factor in winding-up costs, including the costs of environmental clean-up and decommissioning of plant and equipment. If your exit route involves going public for part of the holdings, you will need to consider listing requirements, corporate governance rules, and the composition of boards and audit committees.

In Egypt, capital gains arising from the sale of shares are not subject to tax as long as the seller (i.e. the ‘foreign shareholder’) is non-resident for tax purposes.

Financial modeling

Such large projects require an elaborate financial model to be developed, incorporating the returns and cash flows during the project period and reflecting the various risks identified above. Independently verifying the integrity of the model is important as this would become the basis for the submission of the bid, negotiations with the customer, and agreeing terms with financial institutions willing to finance the project.

The big picture – risk versus reward

As a final step in this due diligence exercise, the founding partners should take a step back and carefully assess the effort and above-noted risks involved in making the bid against the potential returns.

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1Source: “Infrastructure and Employment Creation in the Middle East and South Africa”, MENA Knowledge and Learning Quick Notes Series No. 54 (World Bank, January 2012).


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