Out-Law / Your Daily Need-To-Know

Tax treatment of Shari'a finance

Out-Law Guide | 03 Aug 2011 | 11:47 am | 6 min. read

This guide was last updated in May 2014.

Shari'a – broadly meaning 'the way' – is the body of Islamic law, religion and ethics which governs the conduct of many of the world's Muslims. This guide looks at the tax treatment of Shari'a compliant finance.

What is Shari'a finance?

Shari'a finance – sometimes called Islamic finance or, in the tax legislation, alternative finance – means financial products which adhere to the principles of Shari'a so that they can be made available to customers who wish to be Shari'a-compliant. Shari'a-compliant financial transactions are often structured in a very different way to conventional Western products, in order to comply with the principles.

One general rule in Shari'a is that one party should not unfairly exploit, or become unjustly enriched at the expense of, another. Some of the key Shari'a principles which impact on finance transactions include the prohibition of the following:

  • riba – this is usually translated as 'interest', although strictly it has a much wider meaning. Shari'a regards the charging of interest on financial transactions as a form of exploitation, in that reward is earned without effort or risk;
  • gharar – excessive uncertainty. There is a very high standard regarding certainty in all contractual matters from the outset of an agreement, including price and subject matter;
  • maisir – speculation. Shari'a-compliant financial products should not profit from pure chance, as opposed to ordinary commercial risks such as risks of ownership;
  • gimar – gambling. This is considered similar to maisir and is prohibited for the same reason;
  • ihtikar – hoarding or price manipulation. Since money is treated as a means of exchange only and not an end in itself, Shari'a encourages people to put their money to work for the benefit of the community;
  • haram – an object or purpose which is haram is one that is unethical or unlawful. The subject of an investment cannot be a business dealing with something prohibited by Shari'a; including pork products, alcohol, armaments or casino equipment.

Tax legislation has developed in order to ensure that the UK tax treatment of Shari'a-compliant financial products is the same as the tax treatment applicable to their Western counterparts.

There are many different kinds of Shari'a-compliant structures. This guide focuses on four of them: ijara (lease), murabaha (sale on deferred payment terms), mudarabah (pooled finance for a share in profit) and sukuk (the Islamic equivalent of bonds). We will explain how these key structures work, and how they are dealt with for UK direct tax purposes.

Ijara

Some Shari'a-compliant structures fit quite well within existing UK law and use concepts that will already be very familiar to Western businesses. One structure of this type is ijara.

Ijara is a type of lease structure. Under ijara, a financial institution purchases an asset and leases it to its customer. The customer makes rental payments to the financial institution and these payments represent an agreed profit element.

The rental payments will be calculated to produce a return which may be linked to a benchmark point of reference, and the overall economic effect is similar to a finance lease or hire-purchase agreement. The main difference between ijara and a conventional Western product is that Shari'a requires the financial institution to technically retain a degree of commercial risk throughout the hire period that would normally be taken on by the person leasing the asset - for example, by taking responsibility for insurance. In practice, the financial institution may be able to minimise these risks.

Unlike the other products described below, ijara is not the subject of any special rules except in relation to VAT and stamp duty land tax (SDLT). While the tax treatment of ijara is not necessarily straightforward, the issues raised should be no different from those raised in non-Islamic asset financing.

Murabaha

Murabaha is commonly used in trade or home finance. The financial institution will acquire an asset, hold it (often only briefly, but it is important that the institution takes a degree of commercial risk in the asset) and then sell it to the customer, usually on deferred purchase terms, for a set price which will include an agreed uplift. It is a form of cost-plus financing, as the deferred sale price which the financial institution receives is the cost price of the asset plus a premium – calculated by reference to a benchmark point of reference - paid in instalments.

The term is also used to describe a transaction equivalent to a short-term deposit between banks. One bank will buy and then sell a commodity to another financial institution on deferred payment terms at an increased price.

The UK tax rules are designed to ensure that the direct tax treatment of murabaha is equivalent to paying or receiving interest on a loan, but these rules only apply if the difference between the purchase price and the resale price 'equates, in substance, to the return on an investment of money at interest'. This is an objective test. Assuming the rules do apply to treat the payments or receipts as interest on a loan, it is necessary to calculate the 'alternative finance return' - the difference between the original price paid for the asset by the financial institution and the resale price paid for the asset by the customer. The payment of this return will then be characterised as interest, and the arrangement is treated as a loan for tax purposes.

Importantly, the alternative finance return is ignored when calculating the financial institution's capital gain. The institution would ordinarily be liable for capital gains tax as it has technically acquired a capital asset and disposed of it at a profit.

Mudarabah

Mudarabah is often used when a number of investors wish to pool their resources under the management of a third party who will invest the resulting fund in Shari'a-compliant products. It is a versatile structure that can be used to structure funds, syndicate other Islamic finance products or provide a form of Shari'a-compliant deposit account. The percentage of the profits and losses from the investment which will belong to the investors, and to the fund manager as its fee, will be specified from the outset.

As with murabaha, the aim of the UK tax legislation is to tax the Shari'a product in the same way as similar Western products. Therefore, if the product is structured in such a way as to generate an alternative finance return which is the equivalent of interest (using the same objective test as for murabaha), then that return will usually be taxed as interest if the third party who manages the fund is a financial institution.

Sukuk

Sukuk are a type of asset-backed certificate representing an ownership share in the underlying asset or business held by the issuer. They are often described as 'Islamic bonds', although commercially and legally they are quite different. A holder of sukuk is entitled to a proportionate share of the return on the underlying assets. The holder does not have an equity interest in the issuer itself, but is not legally a loan creditor either. There are many different kinds of sukuk used alongside other Islamic finance products and each arrangement must be analysed on its own terms from both a tax and a Shari'a compliance perspective.

The taxation of sukuk can be very complicated. Holders of sukuk that are the equivalent of debt will be treated like a Western bondholder, provided that certain conditions are met. Some of the key conditions are:

  • the return generated on sukuk cannot exceed a reasonable commercial return on an equivalent loan;
  • the sukuk must be listed on a recognised stock exchange;
  • the issuer is required to account for the sukuk as a financial liability under International Accounting Standards (IAS), or would be required to do so if it applied IAS.

If all of these conditions are met then the sukuk holder will not be treated as having any interest in the underlying asset, the issuer will not be treated as a trustee of those assets and the suku will be recharacterised as a security of the issuer in the same way as a conventional bond. Returns paid out on the sukuk will be treated as interest paid by the issuer to the sukuk holders, and will be deductible or taxable accordingly.

Final point

It is important to note that the 'alternative finance' provisions enacted to date are not Shari'a specific. The provisions deal with only a small fraction of Shari'a-compliant transactions, so it should not be assumed that all Shari'a transactions fall somewhere within them – ijara, for example, is not dealt with in the existing rules. Similarly transactions which do not involve Islamic financial products can fall within the ambit of the alternative finance arrangements regime, so a product may be caught by the rules accidentally.