islamic finance – uk tax aspects - pwc · pdf fileuk real estate insights islamic...

Islamic finance – UK tax aspectsAn extract from UK real estate insights - Issue 10, October 2008

Asset Management

UK real estate insights

Islamic finance – UK tax aspectsThe previous edition of UK realestate insights included an articleon general Shariah principles andtypical financing techniques. Thisarticle looks at the UK taxationtreatment of murabaha,diminishing musharaka and ijaraarrangements.

The tax legislation contained in FinanceAct 2005 does not make any referenceto ‘Islamic finance’. Prior to theintroduction of specific tax rules relatingto ‘alternative finance arrangements’,the tax treatment of Shariah-compliantstructures was governed by generaltaxation principles. Structuring ofShariah-compliant real estatetransactions is challenging as alltransactions must satisfy the strictShariah investment principles, e.g.financing and activities undertaken bythe tenants.

The specific direct tax rules entitled‘alternative finance returns’ and ‘profitshare returns’ are contained in FinanceAct 2005. The tax rules only apply wherecertain conditions are satisfied and cover

murabaha (including commoditymurabaha), diminishing musharaka,sukuk, mudaraba and agency-type profitshare structures. The introduction ofspecific taxation rules do not necessarilymean that the older shariah-compliantstructures cannot continue to be taxefficient as long as they comply withgeneral taxation principles. It is quitepossible shariah-compliant investorsmay continue to prefer the older shariahcompliant structures for non-tax reasons,e.g. appointment of a lessee to act asagent under an ijara lease to comply withcertain aspects of a shariah compliantijara lease.

The mudaraba and agency type profitshare structures may typically be used inthe retail banking environment and are

less likely to be used in the financingof real estate transactions; theapplication of tax rules relating to suchstructures is outside the scope of thisarticle. As far as the taxation rulesrelating to sukuk structures areconcerned, these will be considered inthe next article to be published in theUK real estate insights magazine.

Shariah compliant real estateacquisition structures

Murabaha

The use of a murabaha structure is thesimplest way of financing and acquiringreal estate. The structure involvesa bank (financial institution) acquiring theproperty and then selling it on to ashariah compliant investor on a costplus basis.

To take an example, if a property wasavailable for purchase at £100, as a firststep, the shariah-compliant investor willset up a special purpose vehicle (‘SPV’)in a tax efficient jurisdiction and inject anappropriate amount of equity into theSPV. The bank buys the property at £100and pays stamp duty land tax (‘SDLT’) and then sells the property to the SPVfor £115 on the same day under amurabaha arrangement. Given that the

22Continued

SPV

Shariahcompliantinvestor

Bank

Cash – £30

Sale of property – £115

Eq

uity – £30

Purchase ofproperty –£104

Outstanding liability – £85

Source: PricewaterhouseCoopers

total cost of acquiring the property to thebank is £104 (£100 plus £4 SDLT), theprofit margin under the murabahaarrangement over the financing periodwould be £11. On sale of the property tothe SPV, the SPV would use the cash atits disposal of say £30 (equity injection)and would recognise a liability of £85payable over the period of the murabahaarrangement.

The above financing transaction shouldfall within the ‘alternative financearrangements’ contained in Section 47Finance Act 2005 on the grounds that:

• Bank (one person) buys the assetsand then sells it on to the SPV (theother person).

• The timing of the sale is immediate;however, in the above example thesale need not be immediate providedthat the bank satisfies the definition of‘financial institution’ and the propertywas bought by it for the purpose ofentering into the murabahaarrangement

• The price paid by the SPV is greaterthan the amount paid by the bank

• Part of the sale price is deferred untila later date than the date of the saleof the property to the SPV

• The difference between the sale priceand the purchase price equates insubstance to the return on aninvestment of money at interest.The test is what actually occurs andnot that of intention or design. Giventhat there is no alternative benchmarkto ascertain returns, the mark-upfigure in substance would have regardto the return on an investment ofmoney at interest.

• The bank is a financial institution.The term is widely defined in Section46 Finance Act 2005.

In the above example, the alternativefinance return arising over the duration ofthe murabaha arrangement is £11, whichis the difference between the price paidby the bank and the price paid for thesame asset by the SPV. For UK taxpurposes the periodic payments madeunder the murabaha arrangementswould be treated as payments of interestand partial repayment of the outstandingprinciple as computed under GenerallyAccepted Accounting Practice (GAAP).This means that the SPV should obtain atax deduction for the interest expenseagainst its rental income chargeable toUK tax. Subject to arm’s lengthconsiderations, the shariah-compliant

investor could of course partly injectthe required funding into the SPV tomaximise returns. Note that the shariahcompliant investor would need to seekapproval from the shariah board on theprovision of the required funding in theform of interest-bearing loan and equity,as in our experience the views ofshariah scholars may differ on internaldebt funding.

Assuming that the shariah compliantinvestor is non-UK resident, it wouldmake sense for the investor to set up theSPV in a tax efficient jurisdiction toensure that its UK income tax exposureon the UK source rental income is limitedto 20% on its net UK rental income. As anon-UK resident investor, subject to the‘transactions in land’ anti-avoidancerules, a sale of the SPV shares by theinvestor or a sale of the property by theSPV should be exempt from a charge toUK capital gains.

The sale of the property by the bank tothe SPV should not be subject to acharge to SDLT as the relevant relievingprovisions contained in Section 73Finance Act 2003 should prevent adouble charge to SDLT on the sale of theproperty by the bank to the SPV.


Islamic finance – UK tax aspects

23Continued



Commodity Murabaha

Under the current lending environmentand falling property prices, a bank maynot be prepared to purchase real estateand to have an exposure to a fall in theproperty price. As an alternative to aMurabaha, in practice, a shariah-compliant investor may instead use whatis known as a ‘commodity murabaha’.This form of financing is becoming verypopular with Islamic as well asconventional banks on the basis that it isthe customer rather than the bank whichbears any risk in the event of a fall in thecommodity price.

A diagrammatic description of acommodity murabaha structure is asshown above.

Under a commodity murabaha, a bankwill buy a commodity (e.g. copper) atspot price from a trader and sell it on toits customer at a mark-up under amurabaha. The customer will take thedelivery and sell the commodity toanother trader at spot price. In practice,both transactions will typically take placeon the same day, normally withinminutes of each other, and the bankshould not be exposed to any price risk.

For UK tax purposes, the differencebetween the spot price and the cost plusprice is treated as interest provided thatcertain conditions in relation to thecommodity murabaha arrangements asoutlined in Section 47 Finance Act 2005are met. Note that without theintroduction of the ‘alternative financearrangements’ legislation in Finance Act2005, no relief would have been possiblefor the SPV to claim a tax deduction forthe financing costs equivalent to theamount of mark up.

24

SPV Commoditybroker B

Commoditybroker A


Bank

Purchase of commodity at spot price

Sale of commodityat cost plus

Sale of commodity at spot price

Continued


Diminishing Musharaka

This type of property acquisition methodhas been typically used in the UK byshariah-compliant investors to acquireresidential properties; however, thismethod can equally be used by shariah-compliant investors to acquire otherforms of property.

Under a diminishing musharakaarrangement, an investor and a bankenters into a partnership whereby aninvestor contributes’ a certain proportionof funds to the partnership (typically aform of required deposit) and the bankthen injects the remaining balance.The funds are then used to acquire theproperty jointly by the investor and thebank. The investor has exclusive right tooccupy or otherwise use the asset and is

exclusively entitled to any income, profitor gain arising from that asset.

The investor makes periodic paymentsto the bank and increases its beneficialinterest in the property over the termsof the musharaka arrangement. The totalpayment exceeding over the amountinitially contributed to the musharakaarrangement is treated as interest fortax purposes.

The Finance Act 2003 provides relivingprovisions to ensure that any increasein the underlying property interest byan investor during the terms of adiminishing musharaka arrangement isnot subject to an SDLT charge. Note thatthe SDLT rules are complex and theirapplication would need to be consideredon a case-by-case basis.



25

Islamic Bank

Periodic payments

25% units 75% units

£75,000£25,000

Unilateral promise to buy remaining units

Client

Continued




Simple Ijara Lease

Under a simple ijara lease structure,conventional finance is typically obtainedthrough a parallel structure. The parallelstructure comprises a charitable trustand a finance company (‘FinanceCo’).The shariah-compliant investor sets up aspecial purpose vehicle (‘ProjectCo’) andinjects its share of the required fundingin the form of equity and financingcertificate representing shareholderloans.

A simple diagrammtic descriptionof a simple ijara lease structure isshown above.

ProjectCo makes a refundable deposit toFinanceCo, which in turn borrows from aconventional bank and acquires realestate. Following acquisition, FinanceCogrants an ijara lease to ProjectCo inreturn for rental payments, whichtypically equates to interest andamortisation payable under the bankfacility by FinanceCo. ProjectCo receivesrental income, the underlyingoccupational lease and any balance leftafter settlement of its obligations underthe ijara lease; other expenses and taxesare then paid to the shariah-compliant

investor representing a return on itsinvestment. FinanceCo and ProjectCoalso enter into put and call options toensure that any appreciation in the valueof real estate economically accrues toProjectCo.

The tax treatment of this structure isgoverned by general taxation principlesand the interest element included withinthe ijara lease payments should be tax-deductible against the UK source rentalincome. The SDLT and VAT tax treatmentis complex and will need to beconsidered carefully on a case-by-casebasis. In addition, certain variations tothe structure may be required wheresubstantial capital allowances arein point.

Conclusion

The introduction of the taxation rulesin Finance Act 2005 has broadened thestructuring alternatives available toshariah compliant investors forinvestments in real estate. The taxrules permit the use of less complexalternative acquisition structures such asmurabaha, commodity murabaha anddiminishing musharaka as opposed tothe most complex acquisition structuresinvolving the use of ijara leasearrangement. The introduction of thespecific tax rules is a welcomedevelopment for shariah compliantinvestors as this would also have aknock on effect on the maintenancecosts of such structures.

Irfan Butt is a senior manager in tax,specialising in real estate funds. He isalso an Islamic Finance Practitioner,having undertaken the Islamic FinanceQualification offered by Securities andInvestment Institute (UK) in collaborationwith Ecole Superieur des Affair, Beirut,Lebanon.

Sulay Sinha has also recently joined theteam as a senior manager. Prior tomoving to the UK eighteen months ago,he worked for a major financial holdingcompany in the Middle-East.

26

Finance Co Project Co

Occupationallease


BankBank loan

Put option

Ijara lease

Refundable deposit

Call optionE

quity/finance certificates

CharitableTrust


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