The new UK tax law on sukuk

Mohammed Amin MA FCA AMCT CTA (Fellow), tax partner at PricewaterhouseCoopers LLP and head of the firm's Islamic finance practice in the UK, explores the new UK tax law on sukuk. This article is based on the presentation given by the author at IIBI's monthly lecture in London, July 2007.

Diagram 1 illustrates an ijara sukuk. The owner has a building and decides to raise money using that building. It sets up a special purpose vehicle (SPV) and sells the building to that SPV, and then rents it back. The SPV pays for that building by issuing sukuk. Those sukuk are not a debt owed by the SPV; instead they are a direct legal claim on a proportionate share of the building and of the rent it generates.

Diagram 2 illustrates a mudarabah sukuk, based upon an actual example. XYZ trading company has a collection of business assets and wants to raise $500 million to use in its business. It sets up an SPV, here XYZ Sukuk Ltd, which raises $500 million to buy the assets. That $500 million comes from the investors as payment for sukuk certificates. Next the assets, which are now owned by XYZ Sukuk Ltd on trust for the investors, are contributed to a mudarabah whereby 99 per cent of the profits of the mudarabah will go to the trust for payments to investors subject to a maximum limit, in this case of six per cent, i.e. six per cent of $500 million = $30 million p.a. Again, the investors are not receiving interest but a share
of the business profits.

Before this year's tax law, what happened if a sukuk was issued? The basic problem was that tax costs arose in the issuing SPV company. The SPV is receiving something that is clearly taxable income. However the payments that the SPV makes to the investors do not give rise to any tax relief. Those payments to the investors are not interest; they are simply paying on to the investor the fractional entitlement to the rent or the fractional entitlement to the income of the mudarabah. There is no reason why the SPV should get tax relief for those payments under basic UK tax law. So tax arises in the SPV.

Even if the sukuk-issuing SPV tried to argue that this payment to the investors should really be treated like interest, it still wouldn't get tax relief. There is a very specific provision in our tax code, in the Income and Corporation Taxes Act (ICTA) 1988 section 209(2) (e) (iii). If you issue securities, in other words debt instruments, under which the interest payable on those securities is dependent upon the results of the company's business, then that interest doesn't get tax relief. Instead it is treated as a distribution, like a dividend. It is not a tax-deductible expense.

We now have some new legislation in the Finance Act (FA) 2007. However, if you search FA 2007 for the word 'sukuk', you will not find it. The rules for sukuk introduced in 2007 follow the same overall approach as the 2005 rules for murabaha transactions or mudarabah transactions. HM Treasury simply created a definition, a new concept in UK tax law; something called an 'alternative finance investment bond' (AFIB). If the definition is met, certain tax consequences follow.

The definition of an AFIB

The legislation requires one or more persons to pay money to a bond issuer. The bond issuer is going to acquire some assets which will generate income or gains.

There has to be a fixed period of time when the arrangements will end. A sukuk that is perpetual won't qualify. As part of the legal agreements, the issuer has to undertake that at the end of the sukuk it will dispose of any bond assets that are left.

The issuer will also make other payments to the investors, which are called additional payments. In diagram 1, the additional payments come from the rent and in diagram 2 from the business profits.

The additional payment must not exceed a reasonable commercial return on a loan equal to the amount of the capital. One of the things that the UK Government was most concerned about was ensuring that it did not give a tax deduction for payments on sukuk instruments which had equity characteristics, i.e. which were equivalent to ordinary shares. The law does not stipulate what is a reasonable commercial return; that would depend upon the facts and circumstances.

The bond issuer is going to manage the bond assets. In other words, the bond assets are not managed by the investors. Of course, the bond issuer can delegate management. In diagram 2, once the bond assets have been contributed to the mudarabah, XYZ Trading Company as the mudarib is going to manage that mudarabah.

The sukuk, the bond, has to be transferable. This doesn't mean it has to be physically transferred. The sukuk could be issued and the same people may hold it for its entire five- or ten-year life, which is actually very common with sukuk. There is relatively little secondary trading in practice, but the critical thing is that they have to be transferable.

The AFIB has to be listed on a recognised stock exchange. There is a provision in the Income Tax Act 2007 section 1005 which details what a recognised stock exchange is and there is a provision in the legislation to recognise a stock exchange purely for the purpose of the AFIB rules. As well as a long list of fully recognised stock exchanges, HM Revenue & Customs (HMRC) lists seven exchanges which are recognised only for the purposes of the AFIB rules. (See www.hmrc.gov.uk/fid/rse.htm)

Diagram 1 Ijara sukuk

If issuing a sukuk from the UK, it is important to make sure that it is listed on a fully recognised stock exchange within the Income Tax Act 2007 definition to avoid paying withholding tax. If a sukuk is listed on a fully recognised stock exchange, then the consequence of the 2007 rules is that it is treated for tax purposes as if it were a debt instrument and the exemption for listed eurobonds should apply. Interest on listed eurobonds can be paid without withholding tax.

If a UK-based sukuk is created and listed on a stock exchange which is only recognised for the purpose of the AFIB rules and not recognised for any other purposes, then the eurobond exemption would not apply. The eurobond exemption looks specifically at stock exchange designations under Income Tax 2007, not at the extension for sukuk. Finally, there is an accounting test. If the issuer were to prepare accounts under International Financial Reporting Standards (IFRS), the sukuk would be treated as a financial liability.

After all the strict definitions there are a few relaxations:

• The issuing entity can acquire the bond assets either before or after the sukuk itself is issued.


• Bond assets can be any kind of property and can be secondary rights in property. For example, it could be that instead of owning a building the asset could be a lease over a building.


• A declaration of trust is permitted but not mandatory.


• Bond holders may be given the right to terminate early.


• The additional payment, the economic return to the bond holder, can be either fixed or variable. However, if the payments are not fixed then the test of whether they represent only an amount equivalent to a normal commercial return on the capital is made by looking at the maximum amount of the additional payments. To ensure that the additional payments cannot exceed a reasonable commercial return, it may be worth including a numerical cap in the documentation, as in diagram 2.


• Finally, the redemption payment can be satisfied by the issue or transfer of shares. This caters for convertible or exchangeable sukuk, corresponding to convertible or exchangeable bonds.

Tax consequences of qualifying as an AFIB

From the issuing company's perspective, the AFIB is treated as a loan relationship. In other words, it is treated as if it were debt and all the tax rules for corporate debt apply to the AFIB. The Government is not saying that this is a debt instrument or that the issuer is paying interest, it is merely saying that it is going to apply the same tax law that would have applied if there had been a debt instrument.

Diagram 1 Mudarabah sukuk

The additional payments are treated as if they were interest for tax purposes. This potentially makes them tax-deductible, and there is an express override of section 209 (2) (e) (iii). The issuer is taxed as if it beneficially owned the assets, which means that it is entitled to any capital allowances (tax depreciation) the assets qualify for.

To a limited extent the issuer is treated as a financial institution. The existing tax law for Islamic finance in FA 2005 and FA 2006 applies only if one party to the transaction is a financial institution, broadly speaking a bank, a building society, a wholly owned subsidiary of a bank or building society, or an overseas recognised deposit taker. The issuer of an alternative finance investment bond is treated as a financial institution but only for two specific categories of asset. These are purchase and resale assets, in other words assets which are used in a murabaha transaction, and diminishing shared ownership assets.

The reason for these two choices is that when drafting this legislation HM Treasury primarily saw sukuk as an equivalent to conventional securitisation. Conventional banks lend conventional mortgages and often securitise them. Islamic banks typically provide mortgages by purchase and resale of property or proportional ownership of property. Accordingly, the AFIB rules enable Islamic banks to securitise their Islamic mortgages.

Taxation of buyers and sellers of AFIBs

Buyers and sellers of sukuk are legally buying and selling a fractional ownership interest in assets. Before FA 2007, this gave rise to many technical questions. Was the purchase and sale of the assets subject to stamp duty; was it subject to capital gains tax or income tax; and was it subject to VAT or stamp duty land tax? If a sukuk paid rental income, was that rental income taxed in the UK if you were non-resident? Most of these questions are actually unresolved because sukuk were quite unfamiliar in a UK tax context.

The situation now is that for both corporate and individual investors, sukuk are treated exactly as equivalent conventional debt would be treated for tax purposes, both for the taxation of income payments and for the taxation of gains or losses from buying and selling sukuk.

Areas where further change is needed

In diagram 1, the first thing the owner does is to sell the buildings to the SPV. That sale is a taxable sale. If the building has gone up in value, the company will pay tax on the gain. If the company had issued a conventional eurobond it would not have sold the building or transferred the building anywhere and therefore it would not have paid tax.

There needs to be some mechanism designed to stop tax arising on the gain when the building is sold, perhaps by deferring it as long as the building eventually reverts to the entity which sold it to the SPV.

Similarly, that sale of the building will give rise to stamp duty land tax. Again, that is an extra cost which does not arise if a conventional debt instrument is issued. The sale may also give rise to value added tax consequences. These are areas where the law needs to go further to put sukuk issuers into an equivalent position to conventional bond issuers.

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.

The Taxation of Islamic Finance in Major Western Countries

Introduction

For several decades, Islamic finance has been growing rapidly in the Muslim world, particularly in the Middle East and Malaysia. In view of the importance of the major western financial centres such as London, New York, Frankfurt and Tokyo, Islamic banks headquartered in Islamic countries find that they need to have operations in these western financial centres. More recently, as the Muslim populations of western countries have increased, they have a desire to access Islamic financial services themselves.

Accordingly, both foreign banks from the Muslim world and more recently indigenous Islamic banks find themselves needing to operate within western countries. However, the taxation systems of western countries have developed over centuries in a conventional financial environment and often fail to accommodate the type of transactions undertaken in Islamic finance.

Until recently, it has been necessary for Islamic financiers to undertake careful and specific tax planning when implementing Islamic financial arrangements in western countries to ensure that they are not disadvantaged from a taxation viewpoint. More recently, the United Kingdom (UK) in particular has been changing its tax law to accommodate Islamic finance.

This article reviews some of the key changes made by the UK and also contains a brief overview of some other western countries.

Key transactions
For simplicity, this article concentrates on three specific structures which are often used in Islamic finance transactions. These are:
· Commodity murabaha, also known as tawarruq · Diminishing musharaka
· Sukuk

The full article can be downloaded here, by permission of the Union of Arab Banks

Download Pdf (215KB) : The Taxation of Islamic Finance in Major Western Countries

"Introduction and overview of conventional finance and its taxation" - Mohammed Amin



Source: Mohammed Amin-the Finance and Treasury blog