Shariah Compliant Ways of Investing

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Chapter 20 Islamic funding structures
by Mohammed Amin and Irfan Butt,
PricewaterhouseCoopers LLP
INTRODUCTION
[20.1]
This chapter covers the issues that arise when investors in UK real estate want their financial
arrangements to be consistent with Shariah (Islamic law). The approach is as follows:
Summarise the basic principles of Shariah which are relevant here, without attempting a
comprehensive coverage of Islamic law.
Outline the most common way for Shariah compliant investors to acquire UK real estate
before the recent changes in UK tax law to facilitate Islamic finance. Practitioners need
to be familiar with this structure as it, sometimes with variations, is still regularly used by
some Islamic advisors.
Give a high level summary of how the UK has changed its tax law to facilitate Islamic
finance.
Illustrate some of the structures which are now in use.
Explain the UK tax law applicable to sukuk. While no sukuk have been issued by UK
companies at the time of writing, the changes introduced by the Finance Act 2009 (FA
2009) have eliminated the impediments to the issue of sukuk to raise finance using UK
real estate as the underlying asset. Accordingly one can expect them to be used in
future, both to finance real estate acquisitions and to raise finance for other purposes
secured on real estate.
BASIC INTRODUCTION TO SHARIAH
[20.2]
Shariah is an Arabic word whose literal meaning is a path to water. In a business context, it can be
concisely described as Islamic law.
The sources of Shariah law
[20.3]
Shariah is based upon the Quran (regarded by Muslims as the direct word of God) and the Sunnah
(the words and acts of the prophet Muhammad (peace be upon him) as recorded in collections of
sayings known as Hadith. Other sources include ijma (consensus on a matter by jurists), ijtihad
(interpretation) and qiyas (legal analogy). Shariah provides a framework for life as a Muslim and
governs everything that a Muslim does, not just explicit religious activities such as prayers and
fasting.
Shariah scholars and their role in Islamic finance
[20.4]
Shariah scholars play an important role in Islamic finance as they are qualified to issue fatwas (legal
opinions) on financing structures to confirm their compliance with Islamic law. In practice, views may
differ amongst Shariah scholars. Typically Islamic banks and asset managers will have their own
Shariah boards which will issue fatwas for products launched and offered to their clients or investors.
Relevant principles of Shariah
[20.5]
The key principles of Shariah relating to business generally are:
The requirement for honesty and fair trade.
Faults in merchandise should be disclosed and not hidden from the customer.
Avoid misrepresentations.
One cannot sell something that one does not yet own.
Avoid selling prohibited (haram) items.
Major prohibitions affecting financial transactions
[20.6]
The major rules in Islam which bear upon financial arrangements are the prohibition of the following:
Riba (generally understood to mean any interest).
Gharar (excessive complexity or uncertainty in contracts).
Maysir (speculation or gambling).
Riba (interest)
[20.7]
Under Shariah, money is regarded as simply a means of exchange, and it stipulates that money
cannot be used to make money. That would be unfair exploitation of the borrower (who pays a fixed
interest return to the lender for the use of borrowed money whether the borrowers' business makes a
profit or not).
Gharar or uncertainty
[20.8]
Any agreement which has a significant element of gharar is invalid from a Shariah perspective.
Maysir or gambling
[20.9]
Shariah encourages Muslims to produce returns through effort, rather than to rely on chance or
speculation. In modern day finance, Shariah scholars would regard most derivatives as prohibited
under maysir or gharar.
Shariah-compliant business activities
[20.10]
In order for investments to be fully Shariah-compliant, in addition to meeting the above key financing
principles, the underlying assets should be involved in permissible (halal) activities. Any investment
where the underlying activity is not halal must be avoided. Prohibited activities will, among others,
include the following:
a business carrying out conventional banking transactions involving the payment or
receipt of interest on deposits and loans;
conventional insurance and re-insurance activities;
distilling, producing, selling and marketing of alcoholic drinks;
gambling, including renting buildings for that purpose to a bookmaker;
processing and selling pork; and
businesses involved in adult entertainment, night clubs and related activities.
In practice; it may pose difficult but not insurmountable challenges to structure an investment so that
it is Shariah-compliant. For example, in the case of an investment in a retail shopping mall, it is not
uncommon to find that some of the shops are engaged in impermissible activities. This would require
some form of re-structuring to either segregate the non-permissible activities into a separate
structure or for the fund/asset manager to report the amount of income from impure sources to
investors. The investors can then donate this impure income to charity. In this way, each investor
can deal with the income in the manner that the investor considers appropriate.
THE SHARIAH COMPLIANT REAL ESTATE ACQUISITION
STRUCTURE COMMONLY USED PRIOR TO SPECIFIC UK
LEGISLATION FOR ISLAMIC FINANCE
[20.11]
Prior to the introduction of the Alternative Finance Arrangements rules in the UK, there was no
guidance available from HMRC or specific tax legislation to provide certainty of tax treatment for
Shariah-compliant transactions. Consequently, most Shariah-compliant property transactions were
either fully equity funded or took the form of a mixture of internal debt and equity or ijara (explained
below) leases. Shariah scholars often permit internal debt (debt between wholly owned entities) on
interest bearing terms, on the grounds that you are incapable of paying interest to yourself; you are
just moving money from one wholly owned entity to another.
The fully equity and mixture of internal debt and equity funded structures were simple and did not
differ from conventional structures. However, in the case of ijara lease structures, the UK tax
treatment of the underlying transactions wholly depended on the interpretation of general tax
principles due to the innovation in structuring of Shariah-compliant transactions. The structuring
complexities are the product of the need to align UK legal requirements with Shariah requirements.
The use of such structures is now less common. However, certain Shariah-compliant real estate
funds still use this route to structure their UK real estate investments, although it can be
administratively burdensome and operationally expensive. In time the other structures discussed
later in this chapter can be expected to become more prevalent.
A typical ijara lease can best be described diagrammatically as follows:
Click here to view image
The key point about this structure is that external bank finance is used, with associated interest costs.
However the company paying the interest is not owned by the Shariah compliant investor. Everything
that the investor owns is Shariah compliant.
An ijara contract is basically a leasing contract as understood by UK law which is also Shariah
compliant. However Shariah requires the lessor to retain a specified level of risk in the asset before a
UK law leasing contract can be accepted as a (Shariah compliant) ijara contract. For example a full
pay out finance lease would fail to qualify as an ijara contract. Certain other provisions commonly
found in UK lease agreements are also prohibited if the contract is to qualify as an ijara contract. For
example, the lessee cannot be charged interest on late payments; however, the lessee can be
charged a penalty for late payment which the lessor will then donate to charity.
Under the ijara lease structure, ProjectCo makes a refundable deposit to FinanceCo which in turn
borrows from a conventional bank and acquires real estate. Note that FinanceCo and ProjectCo are
not connected in any way through ownership. This type of structure enables Shariah compliant
investors to leverage their investment in the real estate as they only provide equity equivalent to the
amount of the refundable deposit. The rest of the property purchase price is funded by FinanceCo
bank borrowing.
Following acquisition, FinanceCo grants an ijara lease to ProjectCo in return for rental payments
which typically equate to the interest and capital payments under the bank facility owed by
FinanceCo. ProjectCo receives rental income from the underlying occupational lease and any
balance left after settlement of its obligations under the ijara lease, other expenses and taxes is then
paid to the Shariah-compliant investor.
Additional legal agreements may also need to be entered into by ProjectCo and FinanceCo to
transfer certain obligations to ProjectCo such as the responsibility to maintain, repair and insure the
property. (To be Shariah compliant, the ijara lease will leave repair obligations with the lessor,
FinanceCo, but it is usually regarded as permissible for other side agreements to transfer these
obligations to ProjectCo.) FinanceCo and ProjectCo also enter into put and call options to ensure
ProjectCo retains the benefit of any increase in the value of real estate through the exercise of the
call option and FinanceCo has a put option to require ProjectCo to purchase the property so that it
can be assured of being able to repay the bank borrowing.
In the absence of any specific tax legislation, the tax treatment of the above structure was primarily
governed by general tax principles, ProjectCo would register under the non-resident landlord scheme
(assuming it to be a non-resident company which is the norm) and would obtain a tax deduction for
rental payments to FinanceCo as an expense in arriving at the UK property business profits. The UK
transfer pricing rules should not apply as the parties to the ijara transaction are not connected in any
way. As far as the entitlement to capital allowances is concerned, the allowances typically remain
with FinanceCo unless further structuring is undertaken to ensure that the entitlement to claim capital
allowances transfers to ProjectCo. If FinanceCo is only receiving rent from ProjectCo equal to
FinanceCo's interest expense (for example if the bank loan is non-amortising) then its net taxable
income would be zero so any capital allowances received by FinanceCo would be wasted.
In practice, this structure also creates complex SDLT and VAT issues. It has always been
problematical to decide whether certain SDLT reliefs would apply to some of the transactions forming
part of an ijara lease arrangement between FinanceCo and ProjectCo. Furthermore, an exit is also
very complex as a sale to a conventional investor would invariably require pre-sale restructuring to
provide a simple entity to sell. If the structure is not collapsed carefully, unexpected tax
consequences can arise. Also, the use of multiple entities and an external charity or service provider
makes this structure more expensive to administer.
As indicated above, although this structure is still encountered regularly in practice, it is essentially
obsolete following the changes made to UK tax law in recent years to facilitate Islamic finance.
OVERVIEW OF THE NEW UK TAX LAW FOR ISLAMIC FINANCE
[20.12]
The UK is a pioneer among Western countries in adapting its tax system to facilitate Islamic finance.
It is helpful to understand the approach the UK has taken, before going on to consider how the new
UK tax laws can be applied to real estate transactions.
The UK started adapting its tax law in FA 2003 when it legislated to abolish the double charge to
SDLT arising on Shariah compliant mortgage transactions. These typically involved the bank
purchasing all or part of a property and re-selling it to the customer, either immediately or in stages.
This meant two occasions of charge to SDLT, whereas a conventional mortgage only involves one
occasion of charge.
However, the most fundamental changes were introduced in 2005, specifically to enable the
operation of Islamic banks in the UK. The reason why tax law changes were needed is most easily
understood by considering the following commodity murabaha (purchase and resale) transaction. The
purpose of this transaction is to allow the Bank to provide 100 of finance to the Customer, for two
years, to earn a finance charge, in economic terms, of 10.
Example 1
Under UK tax law prior to the reform, Customer was probably not entitled to a tax deduction.
Customer has purchased an amount of copper at a price of 110 payable in two years time, and sold
that copper for 100 with the price being payable immediately. Accordingly, Customer has suffered a
loss of 10. It was not clear that this loss was tax deductible.
Unless Customer could argue under UK tax law that it was trading in copper, it would not be entitled
to deduct the 10 loss against its other income. Furthermore, even if Customer was a company that
regularly traded in copper, this transaction does not look like a normal trading transaction since
Customer knew that it would suffer a 10 loss when it commenced the transaction.
Accordingly, under pre-reform UK tax law, Customer would probably not obtain tax relief for its 10
cost, even though in economic terms it is clearly a finance cost. Accordingly legislation was needed
to ensure that obtaining finance through commodity murabaha transactions qualified for tax relief.
Strategic design considerations
[20.13]
The tax law changes were introduced by FA 2005, with subsequent expansion of the range of
transactions covered in FA 2006 and FA 2007. A review of the legislation enables one to reverse
engineer the design considerations that underlie it, in particular the following:
tax law must apply equally to all taxpayers;
tax law changes should not impact upon transactions not intended to be covered;
legislation should not be longer than is necessary;
addressing specific obstacles to Islamic finance.
Tax law should apply equally to all taxpayers
[20.14]
Strictly speaking, the UK has not enacted any Islamic finance legislation. A search of FA 2005 will
fail to find words such as Islamic, Shariah, murabaha or any other term used specifically in Islamic
finance. The reason is that the tax treatment of a transaction cannot be allowed to depend upon
whether it is Shariah compliant. As well as introducing significant uncertainty into the UK tax system,
introducing Shariah considerations would create a situation where all taxpayers were not receiving
identical tax treatment.
Instead, the UK identified certain types of transaction widely used in Islamic finance, and ensured
that those types of transaction received appropriate tax treatment. This is illustrated by FA 2005, s 47
Alternative finance arrangements: purchase and resale.
Reading s 47, it is clear that it was designed to set out tax rules for murabaha transactions. However,
it nowhere uses those terms and nothing in s 47 limits its application to Islamic finance. If a
transaction falls within s 47, the tax treatment follows automatically, regardless of whether the
transaction is (or was intended to be) Shariah compliant.
The following table sets out the key concepts that have been created in UK tax law, and the Islamic
finance structures that they correspond to.
Tax law Islamic finance
Purchase and resale FA 2005, s 47 Murabaha
Deposit FA 2005, s 49 Mudaraba
Profit share agency FA 2005, s 49A Wakala
Diminishing shared ownership FA 2005, s 47A Diminishing musharaka
Alternative finance investment bond FA 2005, s 48A Sukuk
Tax law changes should not impact upon transactions not intended to be
covered
[20.15]
Commercial sales of goods often involve a credit period for the customer. It would unduly complicate
UK tax law if every sale of goods with deferred payment required identification of the price that would
have prevailed if no credit were given, and then giving separate tax treatment for the implied cost of
the credit. Consider for example a food manufacturer selling hundreds of thousands of tins of food to
retailers with 30 days credit allowed for the payment of each sales invoice.
FA 2005, s 47 limits its impact by requiring the involvement of a financial institution in subs 47(3).
This ensures that only transactions where finance is provided by or to a financial institution fall within
the new rules. Accordingly, the food manufacturer and its customers should not be impacted by these
new rules. (One drawback of this approach is that it is currently impossible for two non-financial
companies to transact Islamic finance with each other and receive the tax treatment given by the
new legislation.)
Financial institution is defined in FA 2005, s 46(2):
The definition of a bank is itself quite complex, and the diagram below illustrates what does or does
not (marked X) qualify as a bank:
Tracing through the definitions establishes that they cover all banks licensed in the European
Economic Area (provided they have exercised their passporting rights to take deposits in the UK)
and also persons licensed to take deposits in other countries, which is the key practical definition of a
bank. However, many other bodies engaged in financial activities, such as hedge funds, fall outside
these definitions.
Legislation should not be longer than is necessary
[20.16]
FA 2005, s 47 demonstrates how complex it can be to legislate for an apparently straightforward
transaction. Drafting the new legislation would have been very arduous if it was then necessary to
legislate specifically for all the tax consequences flowing from the transaction structures used in
Islamic finance.
The legislation avoids this burden by assimilating the tax consequences of Islamic finance
transactions into the existing tax legislation. For example, where a company undertakes a murabaha
transaction, the tax consequences are governed by FA 2005, s 50(1):
(1) Where a company is a party to arrangements falling within section 47, Chapter 2 of Part 4
of FA 1996 (loan relationships) has effect in relation to the arrangements as if
(a) the arrangements were a loan relationship to which the company is a party,
(b) any amount which is the purchase price for the purposes of section 47(1)(b) were the
amount of a loan made (as the case requires) to the company by, or by the company
to, the other party to the arrangements, and
(c) alternative finance return payable to or by the company under the arrangements were
interest payable under that loan relationship.
FA 1996 which governs loan relationships contains a very extensive and complex set of provisions
which apply to companies engaging in the lending or borrowing of money and paying interest or other
finance costs. FA 2005, s 50 (1) is not saying that s 47 involves the making of a loan; instead it taxes
the company as if a loan had been made and as if the alternative finance return (the profit or loss
under the murabaha transaction) were interest.
Addressing specific obstacles to Islamic finance
[20.17]
Tax legislation in the UK has grown steadily since income tax became a permanent feature of the tax
system in 1842, and was of course developed long before Islamic finance was contemplated in the
UK. Not surprisingly, it happened to contain specific provisions which would impact upon Islamic
transactions, even though the equivalent conventional transaction was not affected. These were
addressed by specific legislation.
For example, the UK has long had a provision in ICTA 1988, s 209(2)(e)(iii) to counter companies
disguising equity finance in the form of debt, in order to obtain tax relief for payments that are
economically equivalent to dividends to risk bearing shareholders:
(2) In the Corporation Tax Acts "distribution", in relation to any company, means
(e) any interest or other distribution out of assets of the company in respect of securities of
the company (except so much, if any, of any such distribution as represents the
principal thereby secured and except so much of any distribution as falls within
paragraph (d) above), where the securities are
(iii) securities under which the consideration given by the company for the use of
the principal secured is to any extent dependent on the results of the company's
business or any part of it.
This provision would preclude Islamic banks offering investment accounts to their customers, since
the profit share paid to the customer would be treated as a distribution. This means that the payment
would not be tax deductible for the bank.
This problem is addressed specifically by FA 2005, s 54:
Profit share return [defined in FA 2005 section 49 in a form that corresponds to profit share
return on investment account deposits of Islamic banks] is not to be treated by virtue of section
209(2)(e)(iii) of ICTA as being a distribution for the purposes of the Corporation Tax Acts.
BASIC METHODS OF ISLAMIC FINANCE FOR REAL ESTATE
RELATED TRANSACTIONS
[20.18]
The most common forms of real estate Islamic financing methods used within the Islamic finance
industry are:
Murabaha
[20.19]
Murabaha is a financing technique which is typically used to provide acquisition finance. The provider
of finance, which is typically an Islamic bank, buys an asset from a supplier and sells it on to its
customer at a disclosed premium. The customer pays the bank the purchase price either in
instalments over an agreed period of time or as a single bullet payment on a fixed future date. The
amount of premium is generally set by the bank by reference to market interest rates, as there is no
comparable Shariah compliant benchmark. The fact that the premium or mark up is being
benchmarked against prevailing interest rates should not lead to the financing arrangement being
regarded as non-Shariah compliant.
A diagrammatic description of a murabaha structure is shown overleaf.
A murabaha financing can be arranged for acquisitions of a variety of assets, including real estate.
The premium is fixed at the point when the bank sells the asset to the customer. For example, the
bank may purchase a building for 100,000 and sell it to the customer for a price of 206,767.40
payable over 25 years in 300 fixed monthly instalments of 689.22. Mathematically, this is equivalent
to the bank lending money for 25 years at a fixed rate of interest of 7% per annum, compounded
monthly. As banks usually fund their activities by taking floating rate deposits, such a contract would
create considerable interest rate risk for the bank unless it can hedge the risk.
FA 2005, s 47 should apply to this transaction. Accordingly, the customer would treat each monthly
payment as comprising part capital and part alternative finance return, deductible against the rental
income if the building is let.
Mudharabah
[20.20]
Mudharabah is a type of partnership contract between two parties where one party, ie the provider of
finance (rab al mal), provides capital while the other party (the mudarib) which is typically a bank in
this context provides expertise, knowledge and manages the partnership. The profits are shared as
per the agreed profit sharing ratio but in the event of a loss, Shariah requires that the rab al mal fully
absorbs the loss. This form of arrangement is very common in Islamic banking as Islamic banks
usually use mudharabah contracts with customers who deposit their money in the bank in the
expectation of a return. The bank may utilise the funds at its disposal and enter into a mudharabah
contract with customers to whom it provides finance by providing the required capital (acting itself as
a rab al mal) for a project in the expectation of a return. This is sometimes known as a two tier
mudharabah since there are two mudharabah contracts interposed between the underlying project
and the person providing funds to the bank.
Although mudharabah is most commonly used in the Islamic banking sector, its use is not limited to
banks. In practice, it can be used for the management of assets such as real estate by an asset
manager and also for the provision of expertise to a venture by a person in return for a fee and a
profit share.
A mudharabah arrangement is shown below:
However, the special tax rules in FA 2005, s 49 apply only where funds are provided to a financial
institution. Other mudharabah contracts, whether they entail a bank providing finance to a customer
or two parties neither of whom is a financial institution, must be analysed from first principles. In most
cases they are likely to constitute a partnership for UK tax purposes.
Musharaka
[20.21]
This is similar to a conventional partnership or joint venture. Under a musharaka contract, both
parties provide capital, and profits are shared according to a pre-agreed profit share ratio whereas
Shariah requires that any losses are shared according to the amount of capital contributed by each
partner. Musharaka contracts are often used in long-term investment projects, property development
and investment activities and the partnership continues until the project is finished. Each partner
leaves its share in the capital in the business until the end of the project.
A diagram of a musharaka arrangement is shown below:
Diminishing musharaka
[20.22]
Diminishing musharaka is a popular tool for banks particularly in the property sector. This method
involves a slight variation of the musharaka method in that the joint ownership of an asset or project
is divided into slices to be transferred for a fixed price during a fixed period of time from the bank to
the eventual owner. However, the eventual owner has the full right of occupation. Since the eventual
owner does not own part of the property occupied (because it is owned by the bank) it pays rent to
the bank on that part. This type of arrangement is most commonly used in the UK for
Shariah-compliant mortgages for residential properties. The rent can be reset regularly based on
prevailing interest rates. Accordingly, in economic terms this is equivalent to a floating rate lending
transaction, in comparison to the fixed rate murabaha transaction.
A diagrammatic description of a diminishing musharaka arrangement is shown below:
Ijara
[20.23]
As discussed above ijara is a form of leasing. In practice, ijara is similar to a conventional lease
where a lessor (typically an Islamic bank) purchases an asset and then leases it to a lessee for a
specific rental income. The bank retains the legal title to the asset during the term of the ijara
contract, whereas the lessee has the use of the asset during that term. In the case of a simple ijara
contract, the lessee returns the asset to the bank at the end of the ijara contract.
In practice, most ijara contracts provide for a formal purchase feature whereby the lessee promises
to buy the asset at the end of the ijara contract period at a pre-agreed price. Often, the final purchase
price is a token sum. This type of ijara contract is called as ijara-wa-iktana.
Ijara contracts are a familiar feature of Shariah-compliant real estate transactions. However, in
practice, the use of ijara contracts to provide asset finance is not limited to real estate and with the
exception of certain consumables, (eg money, food or fuel) such contracts are used commonly for all
types of permissible asset finance transactions.
No special tax law was required for ijara transactions as the main UK tax rules for leasing of
equipment or real estate are applicable.
A diagrammatic description of a typical ijara contract arrangement is shown below:
Istisna
[20.24]
Istisna is a form of project or contract finance which takes the form of the sale of an asset before it
comes into existence. This type of financing arrangement is specifically permitted under Shariah
despite the fact that at the time the parties enter into the agreement, the contract lacks one of the
three main elements (contracting parties, subject-matter and offer and acceptance) of a valid
contract under Shariah, ie non-existence of the subject-matter. The use of istisna is most prevalent in
the manufacturing, processing and construction sectors. In practice, on delivery of the finished asset,
an Islamic bank may sell the asset back to its client under a murabaha or ijara contract, or enter into
a parallel istisna and sell the asset to a third party purchaser at a premium, which could in fact be
under a murabaha or enter into an ijara structure. Under an istisna contract, payments may be made
in a lump sum in advance or progressively in accordance with the development phase. The delivery
date and price is agreed at the outset with the final settlement takes place on delivery of the
completed product.
A simple diagrammatic description of istisna and parallel istisna is as shown overleaf.
Sukuk
[20.25]
Islamic bonds are known as sukuk (the plural term of sakk which means certificate). Sukuk are
investment certificates linked to underlying assets and which represent an undivided ownership
interest in those assets. The investment returns on sukuk are based on the performance of the
underlying assets and each holder is entitled to a proportionate share of the profit or loss generated
by the underlying asset.
In practice, sukuk may take different forms depending on the nature of the contract under which the
asset is used to generate income. For example, if the asset is rented out under an ijara contract, one
would refer to an ijara sukuk. Sukuk are usually issued by a special purpose company (SPV). The
SPV is typically established by the originator (ie the entity looking to raise funds). Depending on the
nature of the underlying asset or project, the originator will sell the asset or enter into a mudharabah
or musharaka arrangement with the issuer (the SPV). The SPV will hold the underlying asset in trust
for the benefit of the sukuk holders. The SPV is typically bankruptcy remote which means that in the
event of bankruptcy of the issuer, the creditors of the issuer cannot have any claim over the assets
held in the SPV.
A simple diagrammatic description of an ijara sukuk structure is as shown opposite.
APPLICATION OF UK TAX RULES TO SHARIAH-COMPLIANT REAL
ESTATE ACQUISITION STRUCTURES
[20.26]
As a result of the UK tax law changes introduced in FA 2005 and subsequent Finance Acts, many of
the preferred Shariah compliant structures discussed above can now be used for UK real estate
transactions. Note that a Shariah compliant estate acquisition does not simply involve looking at the
yield and credit rating of the tenant. The due diligence exercise would need to look at the activities
carried on at the premises by the tenant to ascertain whether it is carrying on prohibited activities,
before a decision is made to progress to the legal due diligence stage. In addition, some form of
post-acquisition re-structuring exercise may also be needed to segregate certain segments of the
investments into prohibited and non-prohibited income streams.
Property Murabaha
Direct tax treatment of murabaha transactions
[20.27]
The use of a murabaha structure is the simplest way of financing and acquiring real estate. The
structure involves a bank (financial institution) acquiring the property and then selling it on to a
Shariah-compliant investor on a cost plus basis.
Example 2
For example, if a property was available for purchase at 100, as a first step, the Shariah-compliant
investor will set up an acquisition company (usually non-UK resident) and inject an appropriate
amount of equity into the Acquisition Company eg 30. The bank buys the property at 100, pays any
SDLT arising on the acquisition and then sells the property to Acquisition Company for 115 on the
same day under a murabaha arrangement. Given that the total cost of acquiring the property to the
bank is 104 (100 plus 4 SDLT), the profit to the bank (corresponding to its financing income)
under the murabaha arrangement over the financing period would be 11. On sale of the property to
Acquisition Company, it would use the cash at its disposal of say 30 (equity injection) and would
recognise a liability of 85 payable over the period of the murabaha arrangement.
In order for the above transaction to fall within the alternative finance arrangement rules contained in
FA 2005, s 47 the following requirements must be satisfied:
a person (X) purchases an asset and sells it either immediately or, in the case of a
financial institution, it purchases the asset for the purpose of entering into the
arrangement with another person (Y);
the amount payable by Y for the asset is greater than the amount paid by X;
all or part of the price is required to be paid until a date later than that of the sale; and
the difference in the sale price and the purchase price equates in substance to the return
on an investment of money at interest.
In addition, it also important that the murabaha financing arrangement is at arm's length otherwise
the borrower will not be entitled to any tax deduction in respect of the deemed interest: FA 2005, s
52.
It is imperative that one of the parties to the transaction must be a financial institution as defined
above; otherwise the transaction would not fall within the alternative finance arrangements rules.
In the above example, assuming that the Bank satisfies the definition contained in ICTA 1988, s
840A, and acquires the real estate for the purpose of entering into the alternative finance
arrangement (not holding the property as trading stock or currently being occupied by the Bank) and
the other conditions outlined above were satisfied, the transaction should fall within the alternative
finance arrangements rules. This would result in the mark up between the sale price and the
purchase price being treated as interest for the lender as well as the borrower.
The deemed interest expense should be tax deductible for the borrower in the normal way against its
UK source rental income. The base cost for capital gains tax purposes would be the purchase price
excluding the mark up (deemed interest) plus any other incidental costs wholly and exclusively
incurred by the borrowers for the acquisition of real estate.
The inclusion of a murabaha type transaction in the legislation now enables onshore and offshore
investors to undertake UK real estate investments in a simpler way than the traditional ijara type
structuring outlined at the beginning of the chapter.
For UK tax purposes the periodic payments made under the murabaha arrangements would be
treated as payments of interest and partial repayment of the outstanding principal as computed under
generally accepted accounting practice. This means that the Acquisition Company should obtain a
tax deduction for the interest expense against its rental income chargeable to UK tax. Subject to
arm's length considerations, the Shariah-compliant investor could of course partly inject the required
funding into the SPV as internal debt to maximise its tax deductions. Note that the Shariah-compliant
investor would need to seek approval from the Shariah board on the provision of the required funding
in the form of internal interest bearing loan and equity, as the views of Shariah scholars on internal
debt funding vary.
Assuming that the Shariah-compliant investor is non-UK resident, it would be preferable to set up the
Acquisition Company offshore to ensure that its UK income tax exposure on the UK source rental
income is limited to 20% of its net UK rental income. As a non-UK resident investor, (subject to the
transactions in land anti-avoidance rules in ITA 2007, s 752 et seq), a sale the Acquisition Company
shares by the investor or a sale of the property by the Acquisition Company should both be exempt
from a charge to UK capital gains tax.
SDLT treatment of murabaha transactions
[20.28]
The sale of the property by the bank to the Acquisition Company should not be subject to a charge to
SDLT due to the relevant relieving provisions contained in FA 2003, s 73. The SDLT rules
specifically provide relief for a murabaha type real estate transaction to ensure that there is no
double charge to SDLT on the sale of real estate at a mark up by a financial institution to a property
investor.
The relief is available under FA 2003, s 73 provided that the following conditions are satisfied:
a person enters into an arrangement with a financial institution; and
under that arrangement the financial institution acquires a major interest in land (the
first transaction);
it then sells the property to the person (the second transaction); and
the person grants the financial institution a legal mortgage over the interest.
As the first transaction is between the Bank and the seller which is not the person disposing of the
property to the Bank, the first transaction would not be exempt from a charge to SDLT. However, the
second transaction would be exempt from SDLT provided that the financial institution pays SDLT on
the chargeable consideration (which it does in the first transaction) and that consideration is not less
than the market value. Note that the legislation provides SDLT relief on the first transaction if the
financial institution acquires the property from same person to whom it sells the property under the
arrangement (ie purchase and sell back) or where the property was acquired by another financial
institution under other arrangements included under FA 2003, s 71A (sale and leaseback) and s 72A
(diminishing musharaka).
VAT treatment of murabaha transactions
[20.29]
The VAT treatment of Shariah-compliant real estate transactions is set out in HMRC's VAT
Information Sheet 11/06. The Information Sheet covers various structures including, but not limited
to, real estate. Assuming that a property transaction qualifies as a transfer of a going concern
(TOGC) for VAT purposes, the onward sale of the property with mark up would involve two supplies
being made by the bank to the purchaser ie property and the facility to defer payment. The mark up
element of the transaction will be treated as consideration for the facility to defer payment and will be
exempt under VATA 1994, Sch 9, Group 5, item 3, whereas the property transaction should qualify
as a TOGC.
Obtaining finance by commodity murabaha transactions
[20.30]
Instead of buying the property and reselling it, the bank may instead provide finance to the customer
by engaging in commodity murabaha transactions as outlined above.
Direct tax treatment of commodity murabaha transactions
[20.31]
The use of commodity murabaha has gone through significant growth in recent years. As with the
murabaha property financing method, the provider of finance does not need to be an Islamic financial
institution; most conventional banks are able to provide finance through commodity murabaha
transactions.
The use of commodity murabaha as a financing method has received a lot of attention from Shariah
scholars recently. Views differ among scholars on its use due to the back to back nature of the
transaction, albeit the transactions do involve a real underlying asset. This financing arrangement is
more attractive and flexible than murabaha financing as it typically gives the bank a floating rate
asset rather than a fixed rate asset by regularly rolling over the commodity contracts.
Under a commodity murabaha, a bank will buy a commodity (eg copper) at spot price from a trader
and sell it on to its customer at a mark up under a murabaha. The customer will take the delivery and
sell the commodity to another trader at spot price. In practice, both transactions will typically take
place on the same day, normally within minutes of each other, and neither the bank nor the customer
should not be exposed to any price risk. The term of the transaction is usually relatively short, eg
three months, with the transactions being rolled over at prevailing benchmark interest rates under a
commodity murabaha facility agreement that may have a tenor of several years.
For UK tax purposes, the difference between the spot price and the cost plus price is treated as
interest provided that certain conditions in relation to the commodity murabaha arrangements as
outlined in FA 2005, s 47 are met. Note that without the introduction of the alternative finance
arrangements legislation in FA 2005, it would not have been possible for the Acquisition Company to
claim a tax deduction for the financing costs equivalent to the amount of mark up.
The above arrangement falls within the provisions of FA 2005, s 47 as one of the parties to the
arrangements is a financial institution, and the bank re-sells the commodity as soon as it buys it.
Assuming that the other condition regarding the difference in the sale and purchase prices equating
in substance to the return on an investment of money at interest is also met, the borrower, ie
Acquisition Company should be entitled to fully deduct the deemed interest cost over the term of the
arrangement.
SDLT treatment of commodity murabaha transactions
[20.32]
The acquisition of property from the third party vendor will be subject to SDLT at the appropriate rate,
as with any other property acquisition. The commodity transactions themselves have no SDLT
consequences.
VAT treatment of commodity murabaha transactions
[20.33]
Assuming that the property is tenanted and the vendor has opted to tax, the transfer of the property
should be treated as a TOGC for VAT purposes and hence outside the scope of VAT.
As far as the commodity transactions are concerned, the VAT treatment commodities as set out in
Notice 701/9 Derivatives and Terminal Markets will apply. The profit element arising to the bank on
the commodity murabaha transactions will be treated as consideration for the facility to defer
payment and will be exempt under VATA 1994, Sch 9, Group 5, item 3.
The VAT treatment of the underlying commodities will depend on their nature. If the transactions
happen to be subject to VAT but take place in the same VAT return period, this should not give rise
any cash flow issue as VAT input and VAT output will amount to the same amount. However, in
practice this is not likely to be feasible as typically there will be a series of commodity transactions
being rolled over. Instead, the parties normally ensure that the commodities are not subject to VAT
due to being stored in a bonded warehouse.
Diminishing Musharaka
[20.34]
As explained above, diminishing musharaka is preferred to murabaha as a form of property financing
since it gives the bank a floating rate asset instead of a fixed rate asset.
Direct tax treatment of diminishing musharaka transactions
[20.35]
Diminishing musharaka transactions are typically undertaken by individuals to purchase residential
properties. However, it is also possible to acquire commercial properties through the diminishing
musharaka financing method. In practice, there is some evidence of property investors undertaking
property investment transactions through a diminishing musharaka type of funding, but they are less
common than with residential properties.
A diminishing musharaka arrangement will fall within the alternative finance arrangements provided
that it satisfies the following requirements included under FA 2003, s 47A:
a financial institution acquires a beneficial interest in an asset, and
another person (the eventual owner) also acquires a beneficial interest in the asset; and
the eventual owner makes payments to the financial institution equal in aggregate to the
consideration paid for the acquisition of its beneficial interest; and
the eventual owner is to acquire the financial institution's beneficial interest (whether or
not in stages) as a result of those payments, and
the eventual owner makes other payment to the financial institution under a lease or
otherwise for the use of the asset; and
the eventual owner has the exclusive right to occupy or use of the asset; and
the eventual owner is entitled to any income, profit or gain arising from the asset.
It is interesting to note that the legislation permits only the eventual owner to share in any upside in
the value of the asset. However, the financial institution is permitted to share any loss arising from
the fall in value of the underlying asset.
There is no restriction on the eventual owner granting a lease to a person (other than the financial
institution or person controlled by the financial institution) provided that the grant is not required by
the financial institution or under an arrangement to which the financial institution is a party. The
arrangement is specifically prevented from being treated as a partnership for UK tax purposes.
The legislation treats the financing element of the payments, (other than the payments which the
eventual owner makes to the financial institution as consideration for the acquisition of its beneficial
interest) as deemed interest and in the case of a person carrying on a property business, subject to
arm's length provisions, it should be entitled to claim a tax deduction for the deemed interest
expense against the rental income. As stated above, although this type of financing is most common
in the residential sector, there is no reason why it cannot be undertaken for commercial property
transactions.
SDLT treatment of diminishing musharaka transactions
[20.36]
The initial acquisition of a property under a diminishing musharaka will be subject to the normal
SDLT charge at the appropriate rate. FA 2003, s 72A specifically exempts subsequent transactions
from a charge to SDLT whenever the eventual owner increases its interest in the underlying property.
In order for the subsequent transactions in the changes in the ownership percentage to be exempt
from a charge to SDLT, the following conditions must be satisfied:
the financial institution and the person must have a major interest in land as owners in
common (the first transaction);
the financial institution and the person enter into an agreement under which the person
has a right to occupy the property exclusively (the second transaction); and
a further agreement is entered into between the parties under which the person has the
right to require the financial institution to transfer to the person in one or a series of
transactions the entire interest (further transaction).
Assuming that the property is acquired from a third party, as stated above, the first transaction will
remain subject to SDLT; however, the second transaction will not be subject to any SDLT charge to
the extent that the SDLT charge on the first transaction has been paid. The further transactions will
also be exempt from a charge to SDLT provided that:
conditions relating to the first transaction are satisfied (in this case payment of SDLT);
and
at all times between the first transaction and the further transaction(s), the interest is
held by the financial institution and the person as owners in common and the land
occupied by the person.
A simple diagrammatic description of the transactions is as shown below:
VAT treatment of diminishing musharaka transactions
[20.37]
The VAT treatment of a diminishing musharaka transaction will depend on whether the underlying
property is a residential or commercial property. Residential property will give rise to an exempt
supply. The treatment of commercial property will depend on its status for VAT purposes.
The main supplies under a diminishing musharaka transaction are (i) the gradual sale of the
equitable interest and (ii) a lease of property. As such, the VAT treatment of supplies made under this
form of arrangement will follow the normal rules for property transactions.
Ijara lease
[20.38]
An ijara lease transaction may take place in the following ways:
a person sells real estate to a financial institution and leases back the property from the
financial institution (sale and leaseback transaction) with or without the option for the
person to buy the asset back at the end of the lease term; or
a financial institution buys real estate and leases it to a person with or without the option
for the person to buy the asset at the end of the lease term.
Direct tax treatment of ijara lease transactions
[20.39]
There are no specific tax rules dealing in the alternative finance arrangements rules to deal with
direct tax aspects of ijara type transactions. The general tax rules will be followed to determine the
disposal of asset for capital gains tax purposes and likewise deductibility of rental payments under an
ijara lease.
SDLT treatment of ijara lease transactions
[20.40]
An ijara based sale and leaseback transaction can best be explained diagrammatically as follows:
FA 2003, s 71A provides specific relief from SDLT provided that the arrangement complies with the
following conditions:
the financial institution purchases a major interest in land or an undivided share of a
major interest in land (the first transaction) here from the customer;
where the interest purchased is an undivided share, the major interest is held in trust for
the financial institution and the customer as beneficial tenants in common;
the financial institution grants a lease to the customer (the second transaction); and
the financial institution and the customer enter into an agreement under which the
customer has a right to require the financial institution to transfer to the customer in one
or a series of transactions the whole interest under the first transaction (the further
transaction).
The first transaction is exempt from SDLT if the seller is the customer as in the above example. The
second transaction relating to the grant of a lease is also exempt from SDLT. The further transaction
is also exempt from SDLT provided that:
the requirements of the first and second transactions are complied with; and
at all times between the second transaction and the further transaction the interest
purchased by the financial institution is held by the financial institution so far as not
transferred by a previous further transaction; and
the lease or sub-lease granted under the second transaction is held by the customer.
Note that the provisions of FA 2003, s 71A do not apply to land in Scotland which is covered by FA
2003, s 72A which provides the same SDLT treatment.
VAT Treatment of ijara lease transactions
[20.41]
The VAT treatment of an ijara lease transaction where the title to the asset is not expected to pass to
the customer to buy the property back at the end of the lease term will follow the normal rules for
property outlined in Notice 708 Buildings and construction, Notice 742 Land and Property and Notice
742A Opting to tax land and buildings.
Where the title of the property is expected to pass to the customer at the end of the lease term, the
normal rules for property will apply for the sale of the property as set out in Notice 708 Buildings and
construction, Notice 742 Land and Property and Notice 742A Opting to tax land buildings. Any
additional charge payable above the price of the property will be treated as consideration for a
deferred payment facility and thus exempt under VATA 1994, Sch 9, Group 5, item 3.
Sukuk
[20.42]
As mentioned above sukuk are the Islamic equivalent of bonds. Until the global financial crisis this
asset class was growing very rapidly. Sukuk issuance fell in 2008 but as capital markets have started
to unfreeze, there has been an increase in sukuk issues.
Direct tax treatment of sukuk
[20.43]
FA 2003, s 48A sets out the rules for alternative finance investment bonds (AFIBs) which correspond
to sukuk. The provisions were introduced in FA 2007 and treat AFIBs as equivalent to debt securities
for UK tax purposes. Any profit return derived from the underlying asset and payable to AFIB holders
is treated as deemed interest and should be tax deductible against the income of the AFIB issuing
entity.
In order for a particular sukuk issuance to fall within the AFIB rules contained in FA 2003, s 48A, the
following requirements must be met:
a bond-holder pays a sum of money to a bond issuer;
the arrangement identifies assets, or class of assets (the bond assets) which the
bond-issuer will acquire for the purpose of directly or indirectly generating income or
gain;
the arrangement specifies a period at the end of which it ceases to have effect (the
bond term);
the bond-issuer undertakes to dispose of at the end of the bond term any bond assets
which are still in the issuer's possession and to make a repayment of the capital (the
redemption payment) to the bond-holder during or at the end of the bond-term (whether
or not in instalments), and pays to the bond-holder other payments (additional
payment) during or at the end of the bond term;
the amount of the additional payments does not exceed an amount which would be a
reasonable commercial return on a loan of the capital;
the bond issuer undertakes to arrange for the management of the bond assets with a
view to generating income sufficient to pay the redemption payment and additional
payments;
the bond-holder is able to transfer the rights under the arrangements to another person;
the bonds are a listed security on a recognised stock exchange within the meaning of
ITA 2007, s 1005), and
the arrangement is wholly or partly treated in accordance with international accounting
standards as financial liability of the bond-issuer.
The legislation does not explicitly define what is meant by a reasonable commercial return on a loan
of the capital. In practice, the issuer should consider market returns on debt securities having a
similar duration and credit rating to ensure that the return does not exceed the level of a reasonable
commercial return on a loan of the capital. In addition, payments which equate in substance to
discount are taxed in a similar way to discounts on conventional bonds under FA 2005, s 51A.
The bond-issuer can acquire the bond assets before or after the issuance of the sukuk. Given that
funds are needed for the bond-issuer to acquire the bond-asset, in practice, the acquisition will
typically take place after cash has been raised through the issuance of sukuk. The legislation does
not limit the bond-assets to any specific asset class. There is also no restriction on the nature of the
additional payments which can be fixed or variable, and can be determined wholly or partly with
reference to the value of income arising from the bond-asset or determined on some different basis.
In addition, the additional payment may be paid by the issuer or by transfer of shares or other
securities by the issuer. Therefore it is possible to issue exchangeable or convertible AFIBs.
It should be noted that the legislation specifically provides in FA 2005, s 54 an override of the
provisions contained in ICTA 1988, s 209(2)(e)(iii), so that redemption payments and additional
payments falling within the provisions of FA 2005, s 48A are not treated as distributions which would
not be tax deductible.
Where the above requirements are met, the additional payments payable by the issuer to the
bond-holders are treated as alternative finance returns: FA 2005, s 48B. For UK tax purposes, the
bond-holder is:
not treated as having an interest in the bond-assets even though it may have an
undivided interest in the bond-asset from a Shariah or UK legal perspective; and
any income arising to the issuer will belong solely to the issuer and no bond-holder is
entitled to claim capital allowances in respect of the bond-asset other than the issuer.
AFIBs are treated as a qualifying corporate bond (QCB) within the provisions of TCGA
1992, s 117 if:
the capital is expressed in sterling;
the arrangements do not include provision for the redemption payment to be in
a currency other than sterling;
the right to the redemption payment cannot be converted directly or indirectly
into an entitlement of securities apart from other arrangements falling within FA
2007, s 48A; and
the additional payments are not determined wholly or partly by reference to the
value of the bond assets.
No withholding tax should arise on the alternative finance return payments if the AFIBs are listed on
a stock exchange which is recognised for all tax purposes under ITA 2007, s 1005 as the AFIBs
should then qualify as eurobonds under ITA 2007, s 882. However, there is a trap to be avoided. FA
2005, s 48A(3) enables a stock exchange to be designated solely for the purposes of FA 2005, s 48A,
and some exchanges have been so designated. AFIBs listed only on such exchanges will not qualify
as eurobonds, and withholding tax would be due on additional payments if the issuer is UK resident.
There are specific provisions in FA 2005, s 48B which ensure that the arrangements are not treated
as a unit trust scheme for TCGA 1992 purposes, or a unit trust scheme for income tax purposes or an
offshore fund for purposes of the offshore fund rules or a relevant holding for the purposes of FA
1996, Sch 10 (loan relationships collective investment schemes).
On a disposal of AFIBs, any gains will generally be taxed under the loan relationships rules for
corporate holders. They will be exempt from capital gains tax for non-corporate holders provided that
they meet the above requirements to be treated as QCBs which are outside the scope of a charge to
capital gains tax.
SDLT treatment of AFIBs
[20.44]
For transfers executed on or after 21 July 2008, AFIBs may fall within the meaning of loan capital
exemption from stamp duty. The relevant legislation is included under FA 2008, s 154 which treats
AFIBs as loan capital and returns thereon as interest, for the purposes of the loan capital exemption.
In addition, for instruments executed on or after 21 July 2008, the loan capital exemption is not
denied solely because interest on the bond is dependent on the results ie the interest ceases or
reduces only if (or to the extent that) the issuer, after meeting, or providing for, other obligations
specified in the capital market arrangement concerned, has insufficient funds available from that
capital market arrangement to pay all or part of the interest: FA 2008, s 101.
VAT treatment of sukuk
[20.45]
There are no special VAT rules for sukuk related transactions and the VAT treatment of costs
associated with the issuance should follow the normal VAT rules.
CHANGES TO AFIB RULES FOR PROPERTY RELATED SALE AND
LEASEBACK TRANSACTIONS FA 2009
[20.46]
Although the AFIB rules were enacted by FA 2007, no UK issues took place as the legislation in FA
2005, s 48A did not address the tax treatment of transactions in the underlying asset. For example,
the sale of UK real estate to a sukuk issuing SPV and its later repurchase would entail a total SDLT
charge of 8%.
Outline of changes
[20.47]
FA 2009 introduced various changes to the AFIB legislation. They cover capital gains tax, capital
allowances and SDLT.
A typical diagrammatic description of an ijara sukuk structure is shown below to illustrate the
changes.
Provided certain qualifying conditions are satisfied, any capital gain arising on the transfer of real
estate by the Originator (P) with a view to entering into an alternative finance arrangement involving
issuance of AFIBs by an SPV is ignored for capital gains tax purposes. In addition, the transfer of the
real estate does not result in the SPV being treated as having incurred capital expenditure for capital
allowances and, therefore, the capital allowances will continue to be claimed by the originator. The
sale from P to Q and the eventual sale back from Q to P are both exempt from SDLT.
SDLT relief is not available if control of the bond asset is acquired by a bond holder or a group of
connected bond holders. Control arises if bond holders have the right of management and control of
the bond asset and a single bond holder or a connected group of bond holders acquires sufficient
rights to enable it or them to exercise the right of management and control of the bond asset to the
exclusion of others. Whether or not a person is connected with another will be determined under
ICTA 1988, s 839. In view of the listed nature of AFIBs, where ownership can change and be hard to
identify, this requirement can create uncertainty. Unless procedures are put in place to protect
against the risk of such control being acquired, it could cause the transaction transferring the land
from P to Q to be subject to SDLT.
One way to deal with the above issue would be for the AFIB documentation to limit any management
and control rights under all circumstance to the administrator or trustees of the arrangement.
Certain exclusions are provided within the rules to ensure innocent failures are not caught under the
provisions above. The first case is where at the time the rights were acquired by the bond holder (or
all of the connected bond holders), they did not know and had no reason to suspect the existence of
the right to management and control and as soon as reasonably practicable after that event, the bond
holder transfers sufficient AFIBs so that management and control is no longer possible. The second
case is where the bond holder underwrites a public offer of AFIBs and does not exercise the
management and control right.
Conditions to qualify for these reliefs
[20.48]
In order for the transfer of land to be treated as an arrangement falling within the alternative finance
arrangements involving the issuance of AFIBs, the following conditions contained in FA 2009, Sch
61, para 5 must be satisfied:
(A) P transfers a qualifying interest in land to Q (the first transaction) and enters into an
agreement with Q to purchase the asset back at the end of the bond term.
(B) Q issues AFIBs and holds the land as a bond asset.
(C) Q and P enter into a leaseback agreement.
(D) Q before the end of 120 days from the date of Condition A transaction registers a
satisfactory legal charge in favour of HMRC and provides evidence thereof to HMRC.
The legal charge:
must be a first charge or a security which ranks first;
must be imposed on or granted over the interest transferred; and
must be equivalent to the SDLT amount which would have been payable at the
time of Condition A plus interest and penalties.
(E) The total payments of capital made to Q before termination are not less than 60% of the
value of the land at the time of Condition A. This 60% refers to the amount of money
raised from investors by issuing AFIBs, not to capital payments made when
re-purchasing the land from Q. It can be thought of as requiring a minimum loan to
value ratio.
(F) Q holds the interest in land as a bond asset until termination of the bond.
(G) Q transfers the interest in land to P within 30 days following the interest in land ceasing
to be held as a bond asset and this does not take place later than 10 years after
Condition A having been met (the second transaction).
These conditions should be manageable for P and Q in most cases.
Capital gains tax relief
[20.49]
The first transaction, ie the transfer of land by P to Q will not be treated as a chargeable disposal by
P nor an acquisition of land by Q for capital gains tax purposes provided that each of conditions A to
C is met before the end of the 30-day period from the effective date, ie the date of the transfer of
land by P to Q. If condition C is met by virtue of Q and P having entered into a leaseback agreement,
the granting of the lease or sub-lease by Q to P will also not be treated for the purposes of TCGA
1992 as an acquisition by P or a disposal by Q of a chargeable asset.
Capital gains tax relief is also available if certain other conditions relating to asset substitution are
also met when an interest in land is replaced with another interest in land.
Note that no capital gains tax relief is available if:
the interest in land is transferred by Q to P without conditions E (not less than 60%
capital payment) and F (bond asset requirement) having been met;
the period mentioned in Condition G expires, or
if it becomes apparent that Conditions E to G cannot or will not be met, or
Condition D is not met (registration of legal charge in favour of HMRC).
The second transaction will not result in a disposal or acquisition of asset by Q and P if each of
conditions A to C and E to G is met and condition D is also met in the case of UK land. If certain
conditions relating to substitution of land are satisfied, relief should also be available for replacement
of interest of land with another interest in land.
SDLT relief
[20.50]
Relief from SDLT from the first transaction will be available to Q if each of the conditions A to C
above is met before the end of 30 days of the effective date of the first transaction, no charge to
SDLT will arise on the first transaction.
The SDLT relief will be withdrawn if:
the interest in land is transferred by Q to P without conditions E and F having been met;
the period mentioned in Condition G expires, or
if it becomes apparent that Conditions E to G cannot or will not be met, or
Condition D is not met.
The SDLT charge will be based on the market value of the land at the time of the first transaction. In
addition, penalties and interest will also be payable after the end of the 30-day period from the
effective date of the first transaction. Q will also need to deliver a further SDLT return within 30 days
to HMRC and include a self-assessment of the amount chargeable.
Relief from SDLT on the second transaction will be available if each of the conditions A to G above is
met and the provisions of FA 2003, Pt 4 relating to the first transaction are also complied with. Q
must provide evidence to HMRC of each of the conditions A to C and E to G being met to ensure
that the land ceases to be subject to SDLT charge.
Subject to further conditions being met, SDLT relief should also be available in the case of
replacement of interest in land with another interest in land.
Capital allowances
[20.51]
For capital allowances, Q will not to be regarded as having incurred any capital expenditure for
capital allowances purposes on the acquisition of interest in land nor is to be regarded as becoming
the owner of the asset provided that:
each of the conditions A to C is met before the end of 30 days of the first transaction;
and
the asset is the subject matter of the first transaction constituting plant and machinery or
industrial buildings.
For capital allowance purposes, loss or destruction of the asset will be treated as a disposal by P in
the period in which it occurs provided:
the asset is part of the subject matter of the first transaction and constitutes plant and
machinery; and
while the asset is held as a bond asset, the person in possession loses the asset and the
loss is permanent or the asset ceases to exist, eg destruction, dismantling or otherwise.
The disposal value for P is as per CAA 2001, s 61(2) if an amount is received by P and in any other
case, the market value at the time of the event.
Note that Q is treated as becoming the owner of the asset if the asset is part of the subject matter of
the first transaction and constitutes plant and machinery or industrial building and Q ceases to hold
the asset as a bond asset (during or after the expiry term) but does not transfer the asset to P. In
such a case, Q ceasing to hold the asset is treated as a disposal event for P in the period in which it
takes place and for IBAs (Industrial Buildings Allowances) purposes the balancing event takes place
in the same chargeable period. The disposal value for P for plant and machinery purposes is the
market value of the asset at the time of the transfer, and for IBAs purposes, P is treated as receiving,
as the proceeds of the balancing event, the market value of the asset at the time of the transfer.
In the event of Q transferring asset to a third person, the transfer is also treated as a disposal by P in
the chargeable period in which it takes place. The disposal value for P for plant and machinery
purposes is the market value of the asset at the time of the transfer by P to Q, and for IBAs
purposes, the market value of the asset at the time of the transfer by P to Q.
Substitution of assets
[20.52]
Under the rules, provided that certain additional conditions are satisfied, it is possible for substitution
of assets to take place under an AFIB arrangement without any adverse tax implications.
In order for the reliefs to continue to apply to substituted assets, it is important that:
conditions A to G are met in relation to an interest in land;
Q ceases to hold the original land as a bond asset (transfers it to P) before the
termination of the arrangement;
P and Q enter into a further arrangement relating to another land (replacement land);
the value of the replacement land at the time of transfer is = to the original land at the
time of the first transaction;
condition F does not need to be met provided that A, B, C, F and G are met;
condition D will need to be satisfied in relation to the replacement land;
if the replacement land is not in the UK the original land ceases to be subject to the
charge; and
HMRC notify Land Registry of the discharge and must do so within 30 days from the
date Q provides the evidence.
The inclusion of this facility within the legislation is a step in the right direction to ensure for the
substitution of assets to take place which is a common feature of sukuk.
Anti-avoidance
[20.53]
The legislation also introduces an anti-avoidance measure to prevent avoidance of tax. No SDLT and
capital gains tax relief is available if the arrangements not effected for genuine commercial reasons
or form part of arrangements of which of the main purpose, or one of the main purposes, avoidance
of tax. There is no formal advance clearance process available for taxpayers to seek advance
clearance for particular types of transactions from HMRC so that the arrangements fall within the
AFIBs rules.
Conclusion
[20.54]
The FA 2009 changes mean that the UK now has a workable regime for the issue of sukuk. We may
expect to see sukuk being issued in future as a means for Shariah compliant investors to leverage
their investment in real estate.
There should also be scope for conventional real estate investors to leverage by issuing sukuk in
certain cases where the underlying property is used for permissible purposes. Until the global
financial crisis there was significant investor demand for sukuk, and this source of capital may be
expected to return to the markets as capital markets normalise.

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Tolley's Tax-Link 21/02/2011 13:59:22 (Page 1)

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