Islamic Finance: An Ethical Alternative

If the financial crisis highly affected the financial sector worldwide, it also highlighted an alternative financial system, mainly based on ethics and which was widely unknown to the public: Islamic Finance.

Islamic finance has developed over some decades in countries where Islam is the main religion, but has been introduced quite recently in other financial centres of the world and in particular in Europe, where the Muslim population is well represented.

As a country wide open to the world, Luxembourg has also welcomed Islamic Finance and has become in few short years the leading jurisdiction in Europe for domiciliation of investment funds and listing of Sukuk. As of today, roughly 4 Shari’a compliant investment funds have been established in Luxembourg and 17 Sukuk are currently listed on the Luxembourg Stock Exchange.

Luxembourg is currently the second largest investment funds centre in terms of assets under management (AuM) just behind the United States with €1,992 billion under management as of 10 May 2010. The worldwide recognition of Luxembourg as a place of choice for domiciliation of investment funds is particularly due to its flexible legal environment and the pragmatic approach adopted by its financial supervisory authority.

The Grand Duchy has developed a whole range of investment vehicles, most of them accommodating the requirements of Islamic Finance. Such is the case with the SICAR (Investment Company in Risk Capital), the SPF (Private Wealth Management Company), the UCITS (Undertaking for Collective Investment in Transferable Securities), the SIF (Specialised Investment Fund), the SOPARFI (holding company) or the Securitization Vehicle.

The SIF may be considered as one of the most efficient vehicles for Shari’a compliant investments as it offers a great deal of flexibility, combined with an attractive tax regime, light risk diversification rules (it should not invest more than 30 per cent of its investments in assets of the same issuer), and the absence of restriction in eligible assets or with respect to the sector in which it is investing. It may therefore be used for the creation of equity funds, money market funds, real estate funds or private equity funds but also for more specific funds such as commodities funds, shipping funds and any other exotic funds. It is therefore a vehicle suitable for both conventional and Shari’a compliant investments.

Among the numerous existing Shari’a compliant Luxembourg funds, EFH Funds SCA SICAV SIF a QIB (UK) platform set up in Luxembourg under an umbrella fund structure is Luxembourg’s first ever Sukuk fund launched in February 2009 under the name of “EFH Global Sukuk Plus Fund”. This year, two additional sub funds have been launched. One (Liquidity Fund) is dedicated to Islamic cash management and is AAf/S1+ rated by S&P and offers daily liquidity management. The second sub fund launched this month (Islamic Financial Institution Fund) is focused on the holding of participations (stocks) in fully-fledged Islamic banks.

Beyond its efficient investment vehicles, Luxembourg is also a perfect place for the listing of Sukuk, especially due to its favourable legal framework allowing the issuance by all type of entities (corporate, quasi sovereign and sovereign issuers) under various forms (Ijara Sukuk – Mudaraba Sukuk - Musharaka Sukuk). The listing on the Luxembourg Stock Exchange is also facilitated by the limited administrative burden imposed by the financial supervisory authority compared to other countries and by the recognition of trusts incorporated under common law jurisdictions (Luxembourg is party to the The Hague Convention of the Law Applicable to Trusts and on their Recognition dated 1 July 1985 in force since 1 January 1992).

Luxembourg tax law is considered as one of the most flexible and efficient in the European Union and is constantly evolving to meet the needs of foreign investors.

Within this framework, two tax circulars have been issued by the Luxembourg tax authorities in 2010, sending a strong signal to the key players of the Islamic Finance market by implementing tax measures in favour of Islamic Finance and compliant with the Shari’a principles. These two circulars provide for more security for Shari’a compliant transactions and can also be viewed as an important step towards the promotion of Luxembourg as a global hub for Islamic Finance.

The Circular n° LG-A No. 55 issued on 12 January 2010

This first circular n° LG-A No. 55 (the ‘First Circular’) aims at clarifying the tax treatment of Murabaha and Sukuk under Luxembourg tax law and first of all, provides an interpretation of the major Sharia’a principles and main Islamic Finance instruments typically used in Islamic Finance such as, Murabaha, Musharaka, Mudaraba, Ijara, Istisna and Sukuk.

Tax Treatment for the Sukuk

According to this First Circular, Sukuk are considered as debt instruments for Luxembourg direct tax purposes and therefore their Luxembourg tax treatment shall be identical to the treatment of debt in conventional finance. As a consequence, the remuneration of the Sukuk is treated as follows from a Luxembourg indirect tax law perspective:

•       Any yield payment under Sukuk is treated as tax deductible at the level of the Company having issued the Sukuk; and
•        No withholding tax applies on such yield payment under Luxembourg tax law.

Tax Treatment for Murabaha

According to the First Circular, the Murabaha is treated as a sale agreement and as such, the income of the sale should be immediately taxable for direct tax purposes.

However, the First Circular provides for an exception to the immediate income taxation by deferring the taxation over the term of the transaction subject to the following conditions being met:

1. The agreement between the parties shall clearly state that the capital provider acquires the targeted good with the objective of reselling it either immediately or within a period of time of six months time following its acquisition;
2. The predetermined mark-up, which stands for the remuneration of the capital provider for providing the funds, must be clearly specified in the agreement and expressly known and accepted by the parties involved;
3. The remuneration must be spread over the deferral period for accounting and tax purposes in the books capital provider (based on a linear-line method), regardless of when reimbursement is actually made.

The Circular n° 749 issued on 17 June 2010

The circular n°749 issued on 17 June 2010 by Luxembourg Indirect Taxes Administration authorities (the ‘Second Circular’), aims at clarifying the tax treatment of Murabaha and Ijara agreements as regards registration duties and VAT.

Registration duties (‘droits d'enregistrement’)

The Second Circular emphasises the distinction between two possible situations with respect to registration duties:

1. The disposal of shares of a company with substantial immovable property assets. In this case, the sale of shares is not subject to registration duties.

2. The sale of interest in a partnership or in an Economic Interest Group (EIG), being transparent entities for tax purposes, holding immovable property. In this situation, the sale of the interest is subject to registration duties.

The Second Circular also confirms that a purchase and resale of immovable property is subject to registration duties based on the acquisition costs and not on the resale price. The difference between the acquisition price and the resale price will be considered as interest and therefore not subject to registration duties.

However, this treatment is only applicable if the following conditions are met:

•        The purchaser has to take immediate possession of the immovable property;
•       The time period between the acquisition contract and the resale contract shall not exceed 10 days; and
•       The initial agreement (ie, acquisition agreement) has to mention that the purchase is realised under a Murabaha agreement and a copy thereof has to be attached to the notarial deed acting the transfer of the immovable property.

VAT

 As regards VAT implications, the Second Circular states that the activity carried out by a special purpose vehicle (SPV) created under Murabaha or Ijara agreements falls within the scope of VAT. However, any real estate transaction carried out under Sharia’a compliant financial instruments may benefit from a VAT exemption under article 44 §1 f) and g) of the VAT law, subject to certain conditions being met.

Conclusion

Mirroring its current position as a top financial centre for conventional finance, Luxembourg has decided to become a leader in the area of Islamic finance. Thanks to its very flexible and efficient legal and tax framework, its long standing experience and expertise in investment funds, all of which is consolidated by the political stability of the country and a multilingual highly qualified workforce, Luxembourg appears to have the means of its ambition.

Luxembourg is today the first non Muslim country to have been elected as a member of the Islamic Financial Services Board (IFSB) and also the first one to host the IFSB annual summit in 2011.The strong commitment of the Luxembourg authorities clearly leaves the door open to a promising future.