Legal Briefing

The butterfly effect: changes to UAE’s company law and Dubai’s free zones

The In-House Lawyer Logo

UAE | 01 December 2010

With in excess of 30 free zones Dubai has developed an extremely successful free zone industry, with many of Dubai’s free zones held up internationally as examples of how such trading zones should operate.

Generally speaking, free zones are established as transit points through which goods can be transported and stored prior to distribution, avoiding the imposition of the customs duties and charges that would apply if goods were brought directly into a mainland jurisdiction. Therefore, they are often aimed specifically at export-oriented industries.

There can be little doubt that, to date, Dubai’s free zones have enjoyed prodigious success. Jebel Ali Free Zone (Jafza), one of Dubai’s longest-standing free zones, is recognised as a market leader and contributes in a substantial manner to the nation’s gross domestic product. Currently, in excess of 6,500 companies are based in Jafza.

The reasons behind the success of Dubai’s free zones are complex and must be considered in light of the broader commercial landscape. The attractiveness and success of Dubai’s free zones can not simply be attributed to sector specificity, well-planned infrastructures or exemptions from customs duties.

A closer look reveals additional factors at play, principally the opportunity to establish a corporate entity in the UAE in which 100% ownership is afforded to investors.

In addition to the retention of majority ownership, Dubai free zones afford foreign investors establishing therein the opportunity to avail of UAE residency visas for employees and shareholders, thus allowing them to reside in Dubai.

From a legal perspective, however, free zones are treated as if they are offshore locations, and free zone authorities are entitled to create their own governing regulations, including the ability to offer corporate entities with characteristics unavailable under current UAE commercial legislation. For example, many free zones offer the opportunity to found a free zone establishment with one shareholder and with the benefit of limited liability, an entity that does not exist in mainland UAE.

Dubai’s economy is suffering. The global economic crisis has had a profound effect. An economy that was, until recently, one of the fastest growing in the world experienced negative growth in 2009 of between -1.3% and -4%, depending on the source.

Levels of foreign direct investment (FDI) have fallen sharply, and the government is currently working towards implementing extensive initiatives and reforms to increase the attractiveness of the emirate to foreign investors.

Long-stated as an impediment to attracting FDI are the current restrictions placed on foreign ownership of UAE-based corporate entities. Currently, amendments to Federal Law No 8 of 1984 (the Companies Law) are in the final stages of review and are awaiting approval before the UAE’s National Federal Counsel.

Article 22 of the Companies Law deals with foreign ownership restrictions for corporate entities established in the UAE. All corporate entities established in the UAE must have a local UAE shareholder. Foreign investors are not entitled to hold more than 49% of the share capital of a UAE-based corporate entity.

For many potential foreign investors considering the UAE this represents an unacceptable loss of control, and many have started to look to other Gulf Co-operation Council (GCC) states as alternatives.

Other GCC states have taken steps to liberalise their commercial market places, offering foreign investors majority or total corporate ownership in many sectors. Bahrain, Saudi Arabia, Kuwait and Qatar have all taken strides in this direction, with proven results. Bahrain, for example, allows 100% foreign ownership in all but a few sectors. According to the Heritage Foundation and the Wall Street Journal 2010 Index of Economic Freedom, Bahrain has the world’s 13th most freely accessible economy, ranking ahead of many western nations, including the Netherlands and Luxembourg. Saudi Arabia, which allows full foreign ownership in many sectors, has been widely liberalised with the exception of oil and gas concerns, and FDI amounted to circa $35bn in 2009, according to figures published by the United Nations Conference on Trade and Development.

The UAE on the other hand has fared less well: from 2007 to 2009, FDI has fallen from $14.2bn to $4bn.

These figures are evidence of the pressing need for the UAE to relax foreign ownership restrictions. The pending introduction of a new Companies Law will almost certainly deal with this issue.

Benefits

The amended legislation will undoubtedly serve to benefit mainland Dubai’s economy. However, the direct benefits to Dubai’s many free zones are not so clear.

Under the current regulatory framework for all of Dubai’s free zones, no entity established therein can carry on business directly in the UAE. Essentially this means that a free zone entity may carry on business with parties located inside its free zone, with parties located in other free zones or with parties located outside the UAE.

This requirement is in place to prohibit circumvention of the current 51% to 49% foreign ownership restrictions as mentioned above. To allow a free zone company to carry on business directly in the UAE would be in direct contravention of the existing federal legislation.

The only legal alternative for free zone companies wishing to carry on business in the UAE is to appoint a mainland UAE agent or to establish a mainland branch of the free zone company. In both cases, the local UAE agent must be a UAE national or a company wholly owned by UAE nationals. Both options present practical difficulties and additional expense for free zone entities wishing to enter the UAE marketplace.

A branch company or local agent may carry out services or sell goods on behalf of the free zone company. This can be a costly and, particularly in the case of service providers where human capital is involved, an impractical and difficult model to operate.

The attractiveness of this option would diminish markedly if alternative solutions were to present themselves. A change in the relative ownership requirements for foreign investors in mainland Dubai corporate entities would most certainly offer such an option.

It remains to be seen whether 100% foreign ownership will be introduced. It may only be applicable to limited economic activities and will almost certainly not affect strategic sectors such as the oil and gas industry. It is more likely that a compromise will be reached; with foreign investors receiving in excess of 49% but less than 100% in the non-core sectors.

For many foreign investors a majority stake in a mainland Dubai entity offering the possibility of carrying on business throughout the GCC including the UAE, and with the benefit of operating from mainland Dubai as opposed to a particular free zone, would present a commercially viable and attractive alternative.

This will place Dubai’s free zones at a competitive disadvantage and will present them with serious challenges in attracting new investment, as well as difficulties retaining existing clients.

In an effort to remain competitive, many of Dubai’s free zones have introduced wide-ranging reforms to attract further foreign investment. Measures taken include sweeping cuts in set-up costs, comprehensive reviews of regulatory framework and increased spending on infrastructure. This will certainly stand them well in light of potential future challenges.

A continued effort by free zone authorities to implement change has led to clear results. Evidence of the continued commercial success of Dubai’s free zones is borne out by available data. Dubai Silicon Oasis, Dubai’s answer to California’s Silicon Valley, is a good case in point. Published results show that in the first half of 2010 profits grew by 131% while revenues were up 148%, as compared with the same period in 2009.

Dubai Airport Free Zone was recently ranked second in fDI Magazine’s ‘Global Free Zones of the Future’ survey. Three other Dubai free zones (Dubai Knowledge Village, DuBiotech and Dubai Media City) were also ranked in the top ten. In addition, published figures available for Dubai Airport Free Zone show that revenues for 2009 were up 30% over 2008 levels.

Whether such impressive growth levels can be maintained is doubtful if legislative amendments to foreign corporate ownership restrictions are introduced.

Dubai’s free zones currently represent an attractive alternative for many foreign investors seeking to establish a base in the UAE. The effect a liberalisation of foreign ownership requirements is likely to have on Dubai’s free zones will ultimately depend on the appetite of existing companies and new investors to deal directly into the UAE, and the levels to which foreign corporate ownership is liberalised.

Their ability to offer specialised, industry specific benefits to clients that outweigh the positive aspects of having a mainland Dubai base, with full or majority control and the ability to carry on business directly in the UAE, will also be a key determinant.

A liberalisation of foreign ownership requirements will present opportunities for companies currently operating from free zones and utilising agency relationships or branch companies to carry out business in the UAE. Companies currently based in Dubai free zones, using the free zone as a distribution point for the region and wishing to benefit from customs exemptions offered, will most likely remain with the free zones.

Changes to foreign ownership requirements are most likely to affect those free zones not adjacent to transportation hubs and those where investors have settled primarily to gain access to the UAE while retaining a majority ownership interest in their commercial venture.

Comment

With the pending introduction of a revised Companies Law, this is an issue that will need to be given serious consideration if all of Dubai’s free zones are to remain viable.

The proposed amendments to the Companies Law will have far-reaching and mainly positive effects on many aspects of commercial life in the UAE. It is imperative that law makers consider the wider consequences that such amendments will engender. This is an issue that will need to be dealt with sooner rather than later; failure to do so will result in seriously adverse consequences for many of Dubai’s free zones.

By Mark Gilligan, associate, Habib Al Mulla & Co.

E-mail: mark.gilligan@habibalmulla.com.