Shariah Tax Planning in the UK

By Riyazi Farook, Islamic Finance New, 26th January 2007 (Vol. 4, Issue 4)

In the UK, a 40% inheritance tax (IHT) is imposed on certain assets in excess of £285,000 (US$564,860) of a deceased person’s estate for the tax year 2006/2007. This individual allowance, which is revised annually, is known as the nil rate band (NRB). There are ways to substantially reduce or even eliminate any IHT liability, if arranged prior to death. ReliefsWhilst there are many exemptions and reliefs available, the following provides a summary of the most relevant principles.

Gifts

Gifts of any value made by the deceased to the surviving spouse, before or on death, are exempt from IHT. However, these gifts may be liable to IHT on the death of the surviving spouse. English law does not recognize the Islamic Nikkah (solemnization) ceremony if undertaken in the UK, with the exception that the ceremony is used to obtain a civil marriage certificate. If the surviving spouse is not UK domiciled, the inter-spouse exemption is limited to £55,000 (US$109,023). A popular use of this exemption is to ensure that on death all assets in excess of the NRB are passed to the surviving spouse. Gifts of any value made to a registered UK charity are exempt from inheritance tax (IHT).

Lifetime transfers

Gifts of any value are deemed to be exempt from IHT if made seven or more years prior to death. Otherwise, IHT is payable in full on gifts made less than three years prior to death, and on a sliding scale if made between three and seven years prior to death. Gifts in which the donor retains some beneficial interest, such as a house in which the donor continues to reside rent-free, are considered to be “gifts with reservation” and are liable to full IHT.

Business property relief

The transfer of shares owned for two or more years by the deceased in an ongoing business concern is exempt from IHT. This is crucial for business owners, as the vast majority of trading companies and partnerships qualify for this relief. Investment companies or properties – both commercial and residential – generating rental income normally do not qualify for business property relief.

Annual exemption

A single gift of £3,000 (US$5,947) per annum can be made which is exempt from IHT. Any unused annual exemption can be carried forward one tax year, enabling a maximum of £6,000 (US$11,894) to be gifted.

Deeds of variation

The beneficiaries of an estate are able to retrospectively revise a will after death, usually for religious, family or tax reasons. In order for a deed of variation to be accepted by the Inland Revenue, all beneficiaries must be over 18 and sane, and give their written consent within two years of death. Deeds of variations are typically very costly and time-consuming.

Advanced inheritance tax planning

Where a client’s assets are considerable, the above rules will need to be augmented to ensure tax is mitigated. Listed below are some of the more popular advanced techniques which typically apply to those whose assets are valued in excess of £1 million (US$1.966 million). Quite often these methods involve some form of capital gains tax (CGT) planning. The following are merely simplified solutions – more complex solutions need to be discussed with professional tax planners.

DT and IIP

Assets can be transferred into a discretionary trust (DT) on death. A DT also allows assets up to the NRB (£285,000 (US$564,860)) to be exempt from paying inheritance tax. Anything over this amount owned by the deceased is placed into another type of trust called an interest in possession (IIP) trust, which also allows for tax mitigation. Technically the assets in the IIP trust are held for the benefit of the spouse, although the trustees will only give the spouse what is due to her under Shariah rules. Consequently, once the trustees distribute the assets from the IIP, a potentially exempt transfer lasting for seven years is created on the spouse. The DT can also be used to reduce the assets of someone who pro-actively wishes to reduce the value of their estate during their lifetime. Typically, in this scenario one is discouraged from making gifts, as gifts made to any person apart from the spouse will automatically trigger a CGT charge. The value of a DT is that the CGT charge can be deferred by placing assets into the trust.

Declaration of trust

Ownership of an asset to be deemed as shared by a group of individuals, rather than just the legal owner (or indeed just one individual other than the legal owner) is allowed under declaration of trust. This is crucial for married couples, as it allows both NRBs to be applied to the value of the family home if it was initially purchased in a single name. For example if the husband initially purchased a house now valued at £500,000 (US$991,082), this would exceed his NRB by some £215,000 (US$426,171). By completing a deed of trust (DoT) on this property, and allowing half the property to be owned by his wife, the two sets of NRB can be offset against the value of the property. These would be worth £570,000 (US$1.12 million), which is greater than the value of the property at £500,000 (US$991,082), thereby eliminating any tax charge.

Offshore planning

Principally, offshore planning is the ability to hold assets in an environment where they are exempt from both inheritance and CGT, and relies on one obtaining a non-domicile status. This strategy is for the very wealthy whose assets exceed the £5 million (US$9.91 million) mark.

Conversion to tenants in common

Couples who own their family home as joint tenants would have the house automatically passed to the surviving spouse in the event of one partner’s death, regardless of any provisions made in the will. This situation does not conform to Shariah law and would likely lead to a tax charge when the surviving partner eventually dies. A couple owning a £500,000 (US$991,082) home as joint tenants would have the house passed to the wife upon the husband’s death, making her the sole owner. A tax charge would arise on her death. Owning a home jointly as tenants in common allows for the half owned by one partner to be included as an asset in their will on death, instead of passing to the surviving spouse. This arrangement not only allows Shariah law to be applied to the half owned by the deceased, but also avoids a tax charge on the death of the surviving partner, as their share is now worth £250,000 (US$495,509), which is less than the NRB.

The Importance of Inheritance in Islam

Many can speculate as to why Islam has placed such an emphasis on the laws of inheritance and making a will. One could argue that it prevents family conflict on death, or that it represents a means via which needy relatives can benefit from a wealthy family member. The Muslim law of inheritance has been praised all over the world, including from western quarters, for its refined and elaborate set of rules on the transference of property.

The Hadith states: “A man may do good deeds for seventy years but if he acts unjustly when he leaves his last testament, the wickedness of his deed will be sealed upon him, and he will enter the Fire. If [on the other hand], a man acts wickedly for seventy years but is just in his last will and testament, the goodness of his deed will be sealed upon him, and he will enter the Garden.” (Ahmad and Ibn Majah).

With such compelling instructions in the Shariah, one would expect every adult Muslim to give priority to making a will. Unfortunately this priority has to a large extent been neglected. Muslims who reside in the UK are hit by a double whammy because of their apathy. UK tax authorities have imposed a whopping 40% tax on assets over a certain threshold held upon death. For the tax year 2006/2007, this amounts to £285,000 (US$564,860). In addition, English law dictates the “law of intestacy” on a person who passes away without a valid will in place. This effectively distributes their assets in a pre-determined, un-Islamic fashion, to the heirs. Invariably this predetermined distribution will not be tax-efficient and often will be contrary to both the wishes of the family of the deceased and contrary to Shariah. (There are also practical considerations concerning the Islamic rites of burial such as janazah (funeral prayer), ghusl (ritual washing), kafn (burial shroud), dafn (burial not cremation) along with any wasiyyah (bequests) such as avoiding post mortem, and also fidya (compensation for missed fasts/prayers, etc) to consider.) The preparation of a valid will is not just an obligation for Muslims, but is also vital to mitigate tax, protect one’s assets, to ensure one’s wishes are followed after death and to ensure potential family disputes are minimized.

Shariah law is very clear on debt settlement and the subsequent distribution of wealth. Only after fully settling the deceased’s debts and burial costs can his wealth be distributed. Shariah allows the deceased to bequeath up to a third of his estate to anyone other than a recipient entitled to a share from the remaining two-thirds.

Heirs to the estate

After the distribution of up to a third of one’s assets, heirs to a Muslim’s estate as defined in Shariah are the fixed share inheritors (wife or husband) and the residuary inheritors (usually sons and daughters), whose exact percentage of inheritance is not fixed.

Shariah inheritance law is not recognized by UK law and so Muslims should prepare their wills, incorporating trusts into which all their assets are placed automatically on death.

Legal and tax concerns

The laws of intestacy apply when a person dies without leaving a will. Essentially, the first £125,000 (US$247,750) plus chattels are given to the wife, and half of the remainder of the estate is placed in a trust giving the wife a right to income for life. On the wife’s death, the assets pass to any children above 18 years of age. Otherwise, the remaining half is held in a trust until they come of age. Evidently, this approach does not conform to the Shariah, as the assets would be trapped under the trust for an uncertain amount of time, often involving the Court of Protection’s consent when administering the child’s assets. This rule also applies in the event of a dispute between inheritors, possibly leading to a court battle. Mutual agreement between all heirs to share the assets could avoid such a distressing situation. However, there is no certainty of this, particularly in cases involving a considerable amount of assets.

Once death occurs, all authorities (such as banks and investment companies) will freeze the deceased’s assets until a probate certificate is received by them. Accounts held jointly escape this freeze and the surviving partner can continue using the account after the other partner passes away.

The presence of a will enables the named executors to obtain a probate certificate. Without a will, the spouse and children would need to get letters of administration. With the certificate of probate, the executors are authorized to manage the assets of the deceased with a view to transferring them to the ownership of the rightful heirs.

The process of probate can be completed within a few months if the assets of the deceased are less than £150,000 (US$297,270) and if there are no inheritance tax concerns. Otherwise, it can take years to conclude. A probate certificate will only be issued once the inheritance tax liability is paid. There are ways to resolve this situation and manage the probate process efficiently from an Islamic as well as a legal perspective.

Conclusion

It is clearly very important for a Muslim to plan his financial affairs adequately prior to death. The Shariah strongly supports this view. For Muslims owning substantial wealth, the Islamic philosophy, however, must be accompanied by sophisticated trust-based tax planning in line with UK taxation laws. Failure to achieve this may render the entire Islamic planning void, and result in a 40% tax charge. It is recommended that Muslims utilize trust-based will solutions. These are legally valid, thereby avoiding the laws of intestacy. Furthermore, by placing assets on death into trust, the trustees are able to ensure an Islamic distribution occurs. Finally, certain types of trust are effective at mitigating inheritance tax as well as providing asset protection. Careful drafting of one’s will, including the right type of Shariah compliant tax effective trusts, along with choosing honest trustees, will allow the preparation of a legally valid, tax efficient and Shariah compliant will.

Case study

What follows is a clear illustration of the case, based on a real life case study, where the estate value exceeds £575,000 (US$1.13 million) but not £1.5 million (US$2.97 million).

Sufiyan is married to Ameena and they have a son and two daughters. Sufiyan has an estate worth £950,000 (US$1.88 million), excluding business property worth £1 million (US$1.98 million), from his IT firm which he founded and still owns. In addition, Ameena owns assets worth £285,000 (US$564,860). Sufiyan’s personal pension fund totals £200,000 (US$396,478). The question then arises on the potential IHT liability: how it can be reduced and how should these estates be distributed in an Islamic way through their wills?

The potential liability amounts to £266,000 (US$527,275) (40% tax applied to the difference between Sufiyan’s estate less the NRB). To reduce the tax liability, a will in accordance with the Shariah and inserted with two key trusts needs to be created. The trusts are the DT, as defined earlier, into which assets equivalent to the NRB will pass on death (referred to as a NRB discretionary trust). In addition, an interest in possession trust (IIP), which has a life tenancy for the living spouse, is set up. A life tenancy is simply the right to income for life. As the wife holds a life tenancy in the IIP, all transfers to the IIP are free of IHT on death. A transfer to an IIP is essentially the same as an inter-spouse exemption for taxation purposes. Naturally then, the balance above the NRB on the first death will be passed into the IIP to avoid any taxation.

Conclusion

Adequate planning of one’s financial affairs is crucial for Muslims, as laid out in Shariah law. Those who own substantial wealth not only need to properly follow through with rules set out under the Shariah (see below), but must also acknowledge the importance of trust-based tax planning, in line with UK taxation laws. Failure to observe these laws would cause a hefty tax charge of 40% to the heirs. Islamic tax planning utilizing trust-based will solutions is legally binding and avoids the laws of intestacy. Placing assets into a trust also ensures that the trustee can distribute the wealth according to Shariah principles. Moreover, certain types of trust are also effective at mitigating IHT and providing asset protection.

First UK Islamic business banking account- Riyazi Farook
http://www.youtube.com/riyazi


Lloyds TSB is to offer the UK's first business account by a High Street bank that complies with Islamic law.

The Way Forward to Islamic Banking in India

By Riyazi Farook Islamic Finance News, 5th January 2007.

Islamic banking is the fastest growing concept the world over but has not caught on in India. There are currently a handful of foreign banks operating in the country which are offering Islamic banking products. These include Lloyds TSB, Citibank, Grindlays, Standard Chartered, HSBC and ABN AMRO, which are already operating interest free banking in several west Asian countries, Europe and the US. There are a few home-grown banks like ICICI and Kotak Mahindra which offer Islamic banking products as Indian banks become increasingly aware of the Islamic banking concept and confi dent of the huge potential market in India.

The resilience of the Islamic banking industry already seen in many parts of the world could progress further with the distinctive advantages which India can offer. A population of over 1.3 billion is certainly a massive market to tap. India has the capability to offer huge manpower and natural resources. Opportunities which India can offer are in the areas of technical and managerial talent, with the added benefi t of international experience, given the underlying strength of its economy in which the country has emerged as one of the fastest growing economies in the world.

At this juncture, Islamic banking in India is limited to the co-operative sector scattered in various states all over the country. Islamic banks in operation number less than 15, with deposits of about US$150 million. In reality, they are just non-banking fi nance companies (NBFCs) which function on the basis of profi t and loss. These so-called Islamic banks cater to the needs of their locality except for a few that operate across districts or states. As their sources of funds are limited and their existence is small scaled, they miss out on any economies of scale.

Islamic banks in India provide housing loans on the basis of coownership, venture fi nance on Mudarabah or profi t-sharing and Musharakah or equity participation and consumers’ loans. Some banks fi nance transport also on the Murabahah or mark up basis through hire purchase.

As for investments, the Islamic banks put their funds in government securities, small savings schemes or mutual funds and to a smaller extent, investment in shares of companies or the stock market. Conventional banks are showing preference to undertake this form of interest-free banking. However, the absence of a legal Islamic banking framework is making it diffi cult for scheduled commercial banks to manage this form of banking or even adopt the Islamic banking system in a small way. Islamic banks in India are not under the control of its banking regulations but are licensed under the Non Banking Finance Companies Reserve Bank Directives 1997 RBI (Amendment) Act 1997, operating on profi t and loss (Mudarabah) under Islamic principles. RBI has also introduced a compulsory registration system.

Even if banks are allowed to set up windows that offer Islamic banking services, they need to maintain cash reserves and a Statutory Liquidity Ratio (SLR) which involves interest. ettlement and clearing facilities are not available from these banks, therefore their inability to issue cheques.

There is an urgent underlying need to regulate the fi nancial institutions in India given such an immense market among Muslims. A regulated Islamic banking industry would offer the masses an avenue to channel their money into the formal banking system, be it conventional or Islamic.

Muslims in India have undoubtedly regarded religion as the biggest hurdle for them to deposit their money in the bank or to obtain funding for developing their businesses or ventures. A huge proportion of this population even avoids serving in fi nancial institutions. The nonparticipation of Muslims in India’s formal banking institutions has not only weighed down their economic prospects but also prevented a huge sum of money belonging to the Muslim community to participate in the national development. Islamic banking can certainly revolutionize the micro-fi nance sector in the country and become an advantage for the debt-ridden farmers in areas like Maharashtra.

The Indian fi nance ministry has advised the Reserve Bank of India (RBI) to draw a roadmap for Islamic banking in the country. This is a step in the right direction to tap both the local market as well as major fi nancial players from the middle-east.

Subsequent to this advice, RBI has taken the initiative to explore the feasibility of Islamic banking. A committee comprising senior bankers from the State Bank of India and other government and foreign banks and headed by Anand Sinha, chief general manager in charge of banking operations and development have tabled a feasibility study along with their recommendations. The fi ndings have yet to be made public.

Other initiatives towards Islamic banking in the country have been sporadic in the form of press briefi ngs, literature circulation and seminars. A recent move to get the government’s involvement in Islamic banking was the presentation to the fi nance ministry and RBI by Jamaat-e-Islami Hind (JIH), on the need to amend the RBI Act and launch Islamic banking in India. (JIH is one of the leading Muslim organizations based in Delhi).

A Bahrain-based private equity fund, with an amount of US$1 billion has expressed an interest to start an India-specifi c fund. Also fi rms like Abu Dhabi Investment, Qatar Investment Authority and Islamic Bank Finance House are looking at investing in India. This will all lead to the speeding up of the development process for the country as a whole.

Regulatory issues need to be put in place before Islamic banking can be introduced in India and its benefi ts can be enjoyed to the fullest.

Islamic Banking and Finance in Sri Lanka: A Paradigm of Success

By Riyazi Farook


Sri Lanka’s modern financial sector has undergone significant reforms since the early 1990s, notably to reduce the government’s role as a direct financial provider. A wide range of institutions offer financial services, including public and private banks, development finance institutions, merchant banks, investment banks, specialized financial institutions, microfinance institutions, leasing companies and insurance companies.

There is also a burgeoning stock exchange. The government is taking steps to strengthen the institutional and regulatory framework for financial services. A remarkable recent evolution is the reform and reorganization of the Central Bank of Sri Lanka (CBSL).

The monetary unit in Sri Lanka is the rupee (LKR), which consists of 100 cents (US$1 approx LKR 110). In addition to being the island’s monetary authority and the sole bank of issue, CBSL acts as financial adviser to the government.

Currently, more than 15 foreign banks have set up branches in the island nation. What is more significant is that some of these branches have been established for more than 100 years. Sri Lanka also has more than 10 local banks, including two that are state-owned (Bank of Ceylon and People’s Bank).

Sri Lanka is one of the few non-Islamic countries to have legislation for the Islamic banking sector. Following amendments to the Banking Act No 30 of 1988 in March 2005, there is now adequate flexibility for conventional banks to establish Islamic banking windows and launch Islamic financial products. However, efforts in strategic marketing communication to promote and raise awareness of these products are still in the infancy stage.

CBSL has already authorized Islamic banking to be carried out in licensed commercial banks as a regulated and legal activity. However, CBSL is studying the Islamic banking concepts and once the requirements are legislated in the Banking Act, Sri Lanka would have increasing opportunity to establish a full-fledged bank. Meanwhile, senior Muslim ministers are also backing an initiative to allow full-fledged Islamic banks to operate in the country.

Sri Lankan Muslims have long awaited the entry of a full-fledged Islamic financial institution that can provide them the opportunity to invest or deposit their money in a Shariah compliant manner. Islamic microfinance institutions in the rural areas are also keen to capitalize on this need, but most are offering limited service in small communities with a high density of Muslims.

The country has the potential to become an Islamic banking hub for the South Asian region. Nevertheless, only if CBSL expresses its interest and development initiatives does Sri Lanka stand a chance of competing and establishing itself in the market. Therefore, government organizations, monetary authorities and the private sector must work with Islamic banking institutions to achieve this objective.

In light of this, it is high time that Sri Lanka came up with a strategic framework on the Islamic financial sector in order to address the needs of all segments of the community. There are specialized local and overseas institutions and professionals, some of whom are experts in Islamic banking; others may have good managerial skills to contribute to the promotion of Islamic banking and its concepts. Therefore, it is paramount to include such specialists in a discussion on building a conceptual framework for Islamic banking and finance in Sri Lanka.

Players in Islamic finance

The market value of the Islamic banking sector in Sri Lanka is estimated at LKR 70 billion to LKR 100 billion (US$634 million to US$907 million). Islamic financial services providers currently active there include Amana Investments Limited, Ceylinco Islamic Investment Corporation (CIIC), Muslim Commercial Bank (MCB), National Asset Management Limited (NAMAL), First Global Investments Group and ABC Investments.

Amana Investments, established in 1997, leads the country’s Islamic financial services market. Its subsidiary Amana Takaful Ltd (ATL) began operations in June 1999 and is acknowledged as the market leader for Takaful services (commonly perceived as the Islamic alternative to conventional insurance). ATL was listed on the Colombo Stock Exchange in late 2006.

CIIC made its entry in 2003 and is fully backed by Ceylinco Insurance, one of the leading conventional insurance providers in Sri Lanka. CIIC offers both selected Shariah compliant and Takaful products.

New kid on the block MCB — owned by MCB Pakistan — commenced operations early this year. It offers both Islamic and conventional financial products.

NAMAL is the first fund management company in Sri Lanka licensed to manage unit trusts. Together with Amana Capital (a subsidiary of Amana Investments), it launched the NAMAL Amana Equity Fund early this month. The objective of the equity fund is to achieve significant growth over the medium to long term by primarily investing in equity securities that are Shariah compliant.

First Global Group is a public limited finance investment company that deals with Shariah compliant investments and financing products and services. Domestically, it is the first institution to promote training and career development programs related to Islamic banking and finance.

Finally, there’s ABC Investments, a relatively new Islamic investment group that claims to have strong funding backing from different countries. It has a memorandum of understanding with the Central Bank of Sudan in which the latter’s experts will provide assistance on training and development to ABC — especially in its Takaful segment — and will be working closely with leading Islamic financial countries for the funding in Takaful as they plan to start off with general insurance.

Barriers in Takaful industry

The Takaful concept is steadily gaining acceptance in Sri Lanka, where there are now 13 licensed insurance companies. Takaful was introduced in 2002 with the entry of ATL, which recently created history in Sri Lanka and the Islamic financial services industry worldwide when it was ranked 203rd in the world’s first comprehensive “Top 500 Islamic Financial Institutions” published by The Banker, the global finance magazine of the Financial Times Group, in its November issue. ATL accounted for US$5.55 million worth of Shariah compliant assets.

A second Takaful operator, Ceylinco Takaful Limited, made its debut in mid-2006. Sri Lanka Insurance Corporation Limited — the republic’s largest and strongest composite insurance provider with LKR 50 billion worth of assets under management — has also announced its intended foray into Takaful. Two of the country’s largest insurance operators (Ceylinco Life and Sri Lanka Insurance Corporation) also plan to offer Takaful products.

The Sri Lankan market, including that for Takaful, faces several challenges, however. One is the current legal environment, which is deemed unfavorable to Takaful operations. Other hurdles are reluctance on the part of regulators to introduce the necessary changes in law to encourage the development of Takaful, a lack of investment opportunities that are Shariah compliant and acceptable to the insurance regulators, a high capital requirement, severe competition, consumer resistance to a new form of insurance based on religious principles and the fact that Muslims represent only about 9% of Sri Lanka’s population.

Overcoming these barriers is more crucial for the Takaful industry in Sri Lanka. Its operators should make a concerted effort to convince insurance regulators to accept the salient features of Takaful and treat it as a new business model. They could also form strategic alliances to promote their products.

Human resource needs

Sri Lanka should aim to produce highly skilled practitioners and professionals as well as specialists and researchers to develop human capital needs for its Islamic banking and financial services industry, both at local and international level. Shariah scholars are scarce but they are highly critical to the success of the republic’s Islamic banking industry and its growth.

International Center for Education in Islamic Finance recently established the faculty of Islamic banking and finance, the first in Sri Lanka. It is hoped that the faculty will fulfill the need to produce a pool of Islamic professionals for the fast-growing global Islamic banking and financial services industry.