Kuwait has long been a trading post, a hub where the markets of modern Iraq, Iran, Saudi Arabia and other territories could easily be accessed by Arabian Gulf transportation. The renowned Greek ruins on the Kuwaiti Island of Faylaka suggest that it was an active hub for trading between the Mediterranean and Eastern worlds more than 2,000 years ago.

Local Kuwaiti goods were largely limited to sponges and pearls until the early 1900s. The granting of a major oil concession in 1934 to the joint venture between the predecessors of British Petroleum and Chevron, and the discovery of oil in 1938, led to the export of Kuwaiti oil after World War II and the resulting sea change in the Kuwaiti economy over the next half-century.

Even before its independence from Britain in 1961, Kuwait never fancied itself as the Gulf region's manufacturing centre and, in any event, its laws failed to create a commercial environment considered friendly to foreign investors.

The imposing Saudi Arabian economy over the border combined with the dominant impact of oil exports on the local economy from the 1950s onward did little to move the Kuwaitis from a mercantile commercial model to a broader-based model. That said, the benefits of oil were apparent everywhere, with Kuwait boasting some of the best infrastructure in the region, including excellent hospitals and schools. Its civil code-based courts were considered state of the art for the region, largely populated by Egyptian lawyers with good training from leading universities there.

Regional conflicts

In 1980, however, a shift began. For nearly the whole of the 1980s, the Iran-Iraq war handicapped the Kuwaiti economy, while the Iraqi invasion of Kuwait in 1990 had brought the country to its knees. Ironically, the once-valuable geographic position between Iraq and Iran became Kuwait's national curse, one that is evident even today.

In certain respects, Kuwait never fully recovered from the Iraqi invasion. In the 1990s, Saudi Arabia continued to dominate the Gulf region economically and politically, although the emergence of Dubai as the region's economic leader was the central story of the last decade. Regional political, economic and legal developments of the Gulf Cooperation Council (GCC) are now clearly driven by Saudi Arabia and the United Arab Emirates (UAE), with Kuwait playing a minor part in the process.

While the region has been transformed, Kuwait has been in near political, economic and legal stasis for nearly 15 years. For our purposes, the paucity of reforms to diversify the Kuwaiti economy and reduce legal impediments to foreign investment have played no small part in Kuwait's relative decline. However, with the UAE and Saudi Arabia acting as clear symbols of success, driven in part by investment by foreign investors, Kuwait appears to be making its long-awaited changes.

Impediments to foreign investment

Historically, most prospective non-GCC foreign investors have pointed to two major legal impediments to their entry into the Kuwait market: (a) laws limiting non-GCC foreign ownership of Kuwaiti companies to 49%, and (b) a regressive tax code that is enforced only against non-GCC entities and a staggering top rate of tax on the Kuwait-source income of such companies of 55%. The Kuwaitis have finally taken steps to reduce or eliminate these impediments.

Alleviating concerns relating to mandatory local control was the impetus behind one of Kuwait's most recent attempts at attracting foreign investment – the passage of Law No. 8 of 2001 (the Foreign Investment Law) and the related formation of Kuwait Government body managing foreign investment, the Kuwait Foreign Investment Bureau (KFIB). The law allows for up to 100% foreign ownership of Kuwaiti companies, as well as significant tax holidays.

Historically, non-GCC foreign investors have used practical mechanisms to maintain de facto control over joint venture companies in which they own only 49% as a matter of public record. For example, management of the day-to-day affairs of the company is often transferred to the foreign investor's secondee general manager and voting proxies have essentially given control of corporate policy matters to the foreign party.

The response to the passage of the foreign investment law by non-GCC foreign investors was relief, as they have never felt entirely comfortable with these control mechanisms. Their sense of relief soon became genuine concern when it took nearly two years for the implementing of regulations for the foreign investment law to become effective. Concern quickly turned to disappointment as it became clear that the foreign investment law appeared to be mainly for the purposes of appeasing Western powers in World Trade Organisation and related negotiations.

Among the many problems with the foreign investment law is that complete and thorough applications which are filed in a timely fashion are, as a practical matter, not acted upon for months or even years. Moreover, while the records of the KFIB are not public, it is understood that no more than a dozen licenses have been granted under the foreign investment (FI) law since 2001.

Four of those dozen FI licences were granted to non-GCC foreign banks to operate in Kuwait. While a good symbolic move towards liberalisation, those non-GCC foreign banks are allowed to open only a single office in Kuwait. The effect is that those banks are unable to provide retail or even small commercial banking services from their single branches. Most other licences were apparently granted to pre-existing, Kuwaiti Government-sponsored or encouraged projects driven by political considerations (e.g. the Equate petrochemical project) or granted on the basis that the non-GCC foreign investor could maintain 50% of the ownership of the Kuwaiti company rather than merely 49%. In short, non-GCC foreign investors in Kuwait continued to be denied, on whole, the right to control the joint venture companies that they form in Kuwait.

It is also apparent that preferential treatment afforded to the nationals and companies of the GCC through the GCC economic treaty has encouraged their involvement in the Kuwaiti economy, but that has been at the expense of non-GCC involvement in the local economy.

Notwithstanding this uneven history, the KFIB appears to be taking steps to increase the pace of review of FI licence applications. The granting of a number of additional non-GCC foreign bank licences appears imminent. In addition, it is understood that a no less than two dozen FI licence application files have been reopened for consideration.

The reason for this shift is likely to be found in the changes to the Kuwait tax regime discussed below. It is understood that the reticence of the KFIB to grant licences has had less to do with allowing foreign control over local enterprises, and more to do with the fact that applicants for FI licences also apply for tax holidays under the foreign investment law. Due to the draconian nature of the Kuwait tax regime, the grant of an FI licence with a tax holiday would give one non-GCC foreign investor a significant advantage over existing joint ventures, which do not have such a tax holiday. In effect, inaction by the KFIB over the last five years has simply ensured that few, if any, local joint venture companies enjoyed the benefits contemplated under the FI law – the playing field has been level, but in a fashion that made Kuwait unattractive to virtually all non-GCC investors.

Income and capital gains tax

On 8 February, 2008, the Amir signed Law No. 2 of 2008, which includes a number of fundamental amendments to Decree No. 3 of 1955 (the tax code). The amendments abolish the current tax regime that results in profits of non-GCC foreign companies being taxed up to a rate of 55% and replaces it with a flat tax rate of 15%.

Many view this as the first serious step towards market liberalisation in Kuwait since its independence in 1961. In addition to lowering the income tax rates on non-GCC foreign companies, it is hoped that the new tax regime will allow the KFIB to take a more liberal approach to granting FI licences, ultimately providing non-GCC foreign FI licence applicants greater likelihood of obtaining legally recognised control of their joint ventures.

The new flat tax rate applies to net income earned on the following:

- contracts that have been executed fully or partially in Kuwait;

- the sale, lease, or exploitation of any trademark, patent, or copyright;

- commissions;

- profits generated from commercial or industrial business;

- the exchange of assets;

- the sale or purchase of real estate; and

- the rental of property and the providing of services.

Capital gains earned through trading shares on the Kuwait Stock Exchange (the KSE), whether directly or through mutual funds, are not taxable under the new tax regime. The new law also provides that losses incurred by non-GCC foreign companies can be set off against past profits for a period of up to two years.

Few doubt that there is a shift underway with respect to non-GCC foreign investment in Kuwait. Many feel that the KSE will be the first beneficiary of this shift. The KSE has a local and relatively stable history and has proven to be an economic engine for many companies. Publicly-traded local companies such as the National Bank of Kuwait, National Industries Group, Agility and Zain are widely respected in the region and transparency, with respect to the tax treatment of non-GCC foreign shareholders in such public companies, is expected to bolster interest in the KSE. Other expected early beneficiaries are international service companies, particularly in the areas of leisure, health care and education, and manufacturing companies in infrastructure and certain consumer goods. Regardless of who benefits from the recent changes in Kuwait law, there is spirit of optimism locally that has not been experienced since well before the Iraqi invasion.

David Pfeiffer is a partner at Bryan Cave in Kuwait.