Middle East sovereign wealth funds in US investments: Navigating legal, tax, and regulatory complexities

Middle East-based sovereign wealth funds (SWFs) have increasingly recognized the United States as an attractive destination for diversifying their investment portfolios. However, their pursuit of US investments is fraught with multifaceted legal, tax, and regulatory challenges.

In this comprehensive article, we delve into these challenges while exploring relevant laws and regulations.

What is a sovereign wealth fund?

Sovereign wealth funds (SWFs) are distinct from other financial institutions due to their unique characteristics, purposes, and sources of funding. Here's why and how SWFs differ from other financial institutions.

Ownership and purpose

1. Government ownership:  SWFs are typically owned and operated by governments or government entities. They are established by countries to manage and invest excess foreign exchange reserves, which often originate from commodities, trade surpluses, or other revenue sources.
2. Long-term investment:  The primary purpose of SWFs is to preserve and grow a nation's wealth for future generations. They focus on long-term investment strategies rather than short-term profit maximization.

Source of funding

1. Foreign exchange reserves:  SWFs are funded by a country's foreign exchange reserves, which may include earnings from the export of natural resources like oil, gas, or minerals. These reserves are accumulated in times of economic prosperity.
2. Contrast with banks:  Banks rely on deposits from customers and other sources for funding, operating with a primary goal of offering financial services, such as loans and savings accounts, to the public.

Investment approach

1. Diversified portfolio:  SWFs typically invest in a wide range of asset classes, including equities, fixed income, real estate, and alternative investments like private equity and infrastructure. Their goal is to achieve diversification and reduce risk.
2. Contrast with hedge funds: Hedge funds often pursue aggressive investment strategies to generate high returns for clients. They may engage in short selling, leverage, and other techniques that SWFs usually avoid.

Transparency and accountability

1. Transparency: SWFs vary in their levels of transparency, but many strive to disclose their investment strategies, governance structures, and annual reports. They aim to be accountable to their governments and citizens.
2. Regulation: In the US, financial institutions are subject to comprehensive regulatory frameworks. They must adhere to strict reporting and capital adequacy requirements imposed by agencies like the Federal Reserve and the Securities and Exchange Commission (SEC).

Economic stabilization

1. Counter-cyclical role: SWFs often play a counter-cyclical role in their home economies. During economic downturns, they can provide financial stability by injecting capital or funding critical infrastructure projects.
2. Banks and economic cycles:  US banks are primarily profit driven and may contribute to economic cycles. During economic crises, banks might reduce lending, exacerbating financial instability.

Investment size and influence

1. Size of investments: SWFs are among the largest institutional investors globally due to their substantial assets under management. They can influence financial markets and investment decisions on a significant scale.
2. Role of commercial banks: While commercial banks in the US handle large volumes of retail and corporate banking transactions, their investment influence is often more localized compared to the global reach of SWFs.

In summary, sovereign wealth funds are fundamentally different from other financial institutions, especially in the United States, due to their government ownership, long-term investment focus, unique funding sources, and strategic roles in economic stability. Their distinct characteristics and objectives make them key players in global financial markets and international investments.

Regulatory compliance in the US investment landscape

When it comes to regulatory compliance, Middle East sovereign wealth funds (SWFs) entering the US investment landscape face a multi-faceted challenge. The linchpin of this challenge is the scrutiny of the Committee on Foreign Investment in the United States (CFIUS). CFIUS operates under the Foreign Investment Risk Review Modernization Act (FIRRMA),[1] which was signed into law in 2018 to bolster national security reviews of foreign investments.

To navigate the regulatory landscape further, SWFs must also be well-versed in reporting requirements outlined in FIRRMA legislation, which expanded CFIUS jurisdiction over certain transactions and introduced mandatory declarations for specific foreign investments.

Taxation

While Middle East SWFs do not enjoy the benefits of favorable tax treaties with the United States, the US internal revenue code generally exempts foreign governments (and their sovereign wealth funds and other affiliates) from US federal income tax on certain types of income, including certain income from stocks, bonds, and other securities.  In order to take advantage of these favorable tax rules, Middle East SWFs need to meticulously plan their investment structures used for specific investment strategies. These complexities take into account ownership thresholds, entities used by the SWF and taxes on various income streams, such as dividends, interest, and capital gains. In addition, the Foreign Investment in Real Property Tax Act (FIRPTA)[2] necessitates withholding tax on the sale of US real property interests by foreign investors.

To address FIRPTA considerations, as an example, SWFs often employ blockers such as real estate investment trusts (REITs) or leveraged C-corporations to mitigate against tax liabilities and filing obligations and to maximize after tax returns.

Investment structuring

Meticulous structuring of investments is paramount for Middle East SWFs. The choice between limited liability companies (LLCs), corporations, or partnerships may significantly impact governance considerations and US federal income tax consequences.

SWFs must also consider the implications of US and global regimes and initiatives such as the Base Erosion and Anti-Abuse Tax (BEAT) and the OECD’s Pillar 2, which may affect the tax efficiency of their structures.[3]

Visas and immigration

Securing the requisite visas for SWF executives and staff is essential. The E-2 Treaty Investor Visa program, available to nationals of specific countries, facilitates entry for managing investments.

Cultural and business differences

Effectively addressing cultural disparities and divergent business practices is pivotal for Middle East SWFs in the US. Adapting communication styles, understanding local expectations, and cultivating robust relationships can enhance investment success.

Moving ahead

The pursuit of US investments by Middle East sovereign wealth funds is a strategic move by Middle Eastern countries towards diversification and global economic influence. To overcome the intricate legal, tax, and regulatory challenges, SWFs must engage proactively with regulatory bodies, craft tax-efficient investment structures, address visa requirements, and adapt to cultural nuances. The examples provided here underscore the necessity of meticulous planning, tailored to the unique goals and circumstances of Middle East SWFs.

Middle East SWFs should recognize that investment strategies are multifaceted. To navigate the complexities of the US market effectively, SWFs should seek counsel from seasoned legal and financial professionals with particular experience in US regulations and international investments. This approach will not only ensure compliance, but will help to optimize the success of their investments, ultimately contributing to their countries' economic growth and global financial influence.  At DLA Piper, we have the experience you need to effectively manage SWF investments in the US.

Find out more about the implications of the topics discussed here by contacting Dr. Ehab Elsonbaty.

^[1] Foreign Investment Risk Review Modernization Act (FIRRMA), Pub. L. No. 115-232 (2018).
^[2] Foreign Investment in Real Property Tax Act (FIRPTA), 26 U.S.C. § 1445 (1980).
^[3] Internal Revenue Code (IRC) - Sections 301, 368 (various subsections), Tax Cuts and Jobs Act (TCJA).