Moving Money Across Borders: Why Dividends, Loans And Fees Carry Legal Costs And Risks For Investors

An overseas company can have money in the bank and still be unable to send it to its owner. Its cash balance may exceed the profits that company law allows it to distribute. Even when such a transfer is permitted, with-holding tax, exchange controls or a challenge to the commercial basis of the payment might affect its value and timing.

 

Investors should understand the potential complexities associated with the route: a shareholder loan, subscription and management fee provide potentially different entitlements and obligations, despite identical payer and recipient. Funding choices made early on may affect the ability to extract the return later. The analysis should address the company's jurisdiction, the relevant status of the investor and actual purpose of the payment, rather than its description on the form. A convenient label cannot reconcile diverse arrangements.

 

Dividends are Constrained by Company Law and the Company's Position

 

Dividend capacity depends on the applicable company law rules and the company's finances. In Britain, section 830 Companies Act generally restricts distributions to realised profits after realised losses. A year's profit may therefore have been offset by losses previously incurred. Borrowing in itself does not create distributable profits: the relevant accounts need to be examined (including the required corporate approvals and the company's constitution) before the investor assumes the right to the balance.

 

Investment Funding Affects the Basis for Exit

 

Capital injections need to be documented in light of their final use. Subscription of shares creates an equity participation: it does not create a right upon the investor upon similar terms to a loan. Paying to reduce the shareholder loan or capital on the books can require a formal statutory reduction or other lawful mechanism to allow a repayment in certain jurisdictions. In Britain, by way of example, provision exists for a private company limited by shares to make a capital reduction on a special resolution and solvency statement, and court confirmation is available. The appropriate records of ownership, filing and any foreign investment approvals should be established when the money comes in.

 

A loan from a shareholder is potentially repayable but the agreement needs to address the currency in which, when and how the loan is to be serviced. The Organisation for Economic Co-operation and Development (OECD) guidance considers whether the advance has the characteristics of economically debt: the price (interest on the loan) is relevant but whether the borrower could service similar debt outside the relationship is also relevant. Depending on the domestic law, there are cases where purported debt might be found to be equity and restrictions on interest deductions even if the loan is considered to exist. An arm's-length rate alone does not necessarily determine interest deductibility: principal and interest also need to be treated separately for tax on the repayment.

 

Management Fees Demand Evidence of Services Rendered to Justify the Charge

 

Management fees bring a contrary consideration: the services rendered and those which attracted the charge. The UAE Federal Tax Authority's guidance on transfers pricing requires consideration of whether the services would provide an economic or commercial benefit that an independent business would purchase or perform itself. Costs incurred solely as a result of the parent owning the subsidiary do not support charging the subsidiary. Evidence of the performance, the beneficiaries and distribution of the cost matters as well as an annual invoice for management.

 

Royalties and Fees Need Scrutiny of the Licence and Basis of the Charge

 

In like vein, agreement on the basis on which a royalty charge is made needs to consider the entitlement and the consideration: ownership of a particular trade mark, intellectual property or other right belonging to a group company does not imply entitlement to all the revenue from its use except on agreement. The nature of functions performed, assets and risks at each entity are relevant facts. Agreements should reflect the commercial basis. Shifting a percentage of revenue offshore as royalty leaves the evaluation of the royalty vulnerable if the charge cannot be sustained. Similarly fees: the basis of the cost, what the paying entity has received in exchange, should be identified to support a claim that the sum represents compensation for a service.

 

Withholding Tax Can Affect the Return on Payment Outside the Jurisdiction

 

Depending upon the applicable domestic law, the category of payment (dividend, interest, royalty, service payment) can affect whether and to what extent the payer owes withholding tax. Classification is relevant in that different treatments might be available. Agreement to the category of the payment (and whether the sum is gross or if the payer should top-up to meet a specified net amount) should be clarified as part of the contract negotiations. That classification determines who bears the unexpected withholding tax.

 

A tax treaty may reduce the charge but entitlement depends on its wording and the recipient circumstances (residence, beneficial ownership of the sum received and any anti-abuse provisions). Residency, beneficial ownership and circumstances of the income must also be considered in any evaluation. An intermediary inserted to claim treaty benefits can potentially fail each test. The procedure is also relevant: Britain’s tax authority, HM Revenue & Customs (HMRC) guidance makes it clear that the relief from UK withholding tax is not automatic and distinguishes between the availability of relief at payment, and the relief for repayment of an over-withheld sum. The required certification and procedure should be established before assuming applicable relief.

 

For UAE investors, the destination of the currency is important: the UAE currently applies a 0% withholding tax rate to certain UAE sourced income paid to non-residents. This does not determine the tax which the income may incur upon leaving another jurisdiction. The receipt of a dividend, royalty or interest in the UAE bank account does not mean that the foreign withholding tax charge is eliminated. A UAE credit for foreign tax paid is limited to the UAE corporate tax due on the income. Unused credit cannot be carried forward, back or refunded. If the income is exempt in the UAE, foreign withholding charges remain a cost with no UAE credit.

 

Exchange Controls May Apply Upon the Exit of the Investment

 

Foreign exchange considerations can implicate legal aspects. India's Foreign Exchange Management Act differentiates between current account payments (interest on a loan and investment income) and capital account (transactions in connection with cross-border borrowing and lending by a corporate). An option available in relation to dividends cannot therefore be assumed to apply to an equity subscription or the return of the loan principal. Classification of the transaction as current account or capital account is not sufficient: not all current account payments are free, and not every capital account payment requires individual central bank clearance. The category of investment might matter on its exit. The Reserve Bank of India (RBI) rules relate the ordinary route for remittance of securities sale proceeds to repatriation status: the applicable pricing and taxation for the currency is therefore implicated. The records created on entrance to the investment can therefore affect its return years later. Agreements should provide for the currency of the payment and the sharing of costs and exposure to currency conversion: a favourable quotation cannot remedy a prohibition on making the underlying payment.

 

Banking Checks Cover More Than the Payer's Name

 

Bank scrutiny extends beyond account numbers. The Financial Action Task Force (FATF) standards require identification of the customer and of the beneficial owner and a review of the transactions in light of the customer's business and risk profile: local law dictates the duties imposed on banks. They may seek the loan agreement, dividend resolution or service contract supporting the payment. Establishing the source of funds is a question of what that particular lump of money represents. Source of wealth examinations address how the investor accumulated its assets. The extent of the checks is determined by the requirements (and the risk): banking enquiries into the owners of a company are not the same as a beneficial ownership of income for treaties which can concern the company receiving the payment. Completion of the one is not conclusive of the other.

 

Intermediary (correspondent) banks processing the transfer can ask further questions or sanctions. Any change to the beneficiary or an ownership trail unidentifiable or a discrepancy in the description of the invoice versus the payment can prompt further information to be provided. Processing of the payment does not validate that the payment is a lawful or properly taxed distribution. Each request exists within its own legal framework.

 

For an investor in funding choices internationally, the constructive exercise is to determine the return: what, how and with what documentation the payment will be made? Clarifying those questions makes the prospective return credible. Having allowed profits to accumulate abroad, restructuring the funding basis or reconstructing missing documentation may prove more complex than the initial payment.

 

Dr. Sunil Ambalavelil is the Global Executive Chairman of Kaden Boriss, an international law firm specialising in franchise and business agreements. A seasoned legal adviser, he has advised and supported the international growth of numerous global brands, helping them navigate the legal complexities of cross-border expansion.
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