A United Arab Emirates asset manager is offering international investors access to Saudi Aramco's IPO via a dedicated protected cell, illustrating a little-known route for foreigners to invest in Saudi Arabia via funds domiciled in the Gulf Cooperation Council.

Dalma Capital Management Ltd.'s segregated investment vehicle sits under an umbrella company domiciled in the Dubai International Financial Centre and provides foreign investors with the opportunity to invest in Aramco's IPO. "[The fund] invests exclusively in Aramco and provides investors 'delta one' access to Aramco shares," said Zachary Cefaratti, CEO of Dalma Capital.

While these finds are not publicly available to retail investors, the vehicle can provide qualifying investors an alternative to accessing equities listed on the Saudi stock exchange, or Tadawul. It has benefits over participatory notes or swaps that add counterparty risk, can be inefficient and limit access to IPOs, Cefaratti said.

Dalma Capital has in total three Saudi equity funds, including the Aramco protected cell, all of which admit foreign investors, but have a majority of GCC-citizen unit holders, which is a requirement for a fund to be considered local.

"The [protected cell] was established in response to demand, and was very positive. Had we established it sooner and anticipated demand, we believe demand would have been even better," said Cefaratti, who has a positive outlook on Aramco stock, describing it as "a dividend haven, with the cushion of a bond on the downside and the potential for appreciation on the upside."

In Saudi Arabia, foreign investors have been using private funds registered with the Capital Market Authority to access assets including real estate and private equity for around a decade, said Nabil Issa, a lawyer with King & Spalding, an international law firm active in Saudi Arabia. The firm is also listed as the legal adviser to Dalma Capital's Aramco protected cell.

Investments into these funds, including real estate and private equity, do not require approval from the Saudi Arabian General Investment Authority, said Issa, which is usually required for foreign direct investment.

Some foreign investors used private funds to take positions in Saudi Arabian equities ahead of the emerging market MSCI and FTSE index upgrades, said James Stull, a lawyer with King & Spalding. "We saw not only Saudi funds, we saw a number of managers setting up funds at [the Dubai International Financial Centre], at Abu Dhabi Global Market and elsewhere in the GCC."

Data from the CMA shows that the number of equities-focused private funds grew to 126 in the third quarter of 2019 from 103 in the third quarter of 2017.

Tax benefits

Investing via a GCC-domiciled fund can also have tax advantages when compared with direct investment or investing through qualified foreign investors.

A fund or umbrella that is majority owned by GCC nationals, and is in the DIFC or other GCC jurisdictions, qualifies for reduced withholdings taxes, said Cefaratti.

Dalma Capital's Aramco cell "qualifies as a domestic investor providing direct access to the Saudi cash equity market and exempting it from the withholdings tax applicable to foreign investors," he said.

Qualified foreign investor funds are subject to higher withholdings taxes on dividends, he said.

In Saudi Arabia, CMA funds are currently not subject to zakat, or tax, at the fund level, while Saudi companies owned by a CMA fund are generally subject to zakat at 2.5% only, irrespective of non-GCC foreign unit holders in the fund, said one tax expert, who declined to be named. By comparison, a Saudi company that is directly or indirectly owned by non-GCC investors is subject to 20% corporate tax on the profits attributable to the ultimate non-GCC shareholders, he said.

This could give foreign investment via a local fund a significant tax advantage, however it remains unclear whether this is a deliberate policy from the General Authority for Zakat and Tax, or GAZT, or a loophole, the expert said.

"The current tax treatment of CMA funds and Saudi portfolio companies owned by CMA funds is not considered formal policy and the GAZT can change their approach at any point in the future, including on a retroactive basis," said the expert. "[W]e are awaiting guidance from the GAZT on the registration of CMA funds for tax purposes."

Direct market access for non-GCC investors to equities listed on the Tadawul is restricted to qualified foreign investors. To qualify, a company must meet certain requirements such as AUM of at least $500 million.

Nevertheless, qualified foreign investor authorization still gives significant advantages. As an investor, a qualified foreign investor can have more control over their investment strategy than they would as minority unit holders in a fund, while as an asset manager their funds can be marketed and sold entirely to international investors without needing a majority of — or even any — local investors, said Issa.

Restricted assets; management fees

Investing via a GCC domestic fund structure does not allow foreigners to invest in restricted investments, such as real estate in the holy cities of Mecca and Medina, stocks in companies that have activities in these or other restricted stocks, said Issa.

Typically the CMA relies on authorized brokers to ensure that rules are met, including that a majority of unit holders are GCC citizens, he said.

Dalma Capital's Aramco protected cell fund advertises a management fee of 1.25% per annum and a subscription fee of up to 2%, with the latter fully rebated if investors remain invested for two years, said Cefarrati.

Currently the protected cell has less than 50% non-GCC domestic investors. "If foreign unit holders were to surpass domestic unit holders, we would need to register the scheme under the qualified foreign investor program and would likely spin out foreign unit holders into a separate investment vehicle," said Cefaratti, confirming that Dalma meets the $500 million AUM threshold.