The UK is renowned for its support of Islamic finance and has done an excellent job of marketing itself not only as a premier destination for Islamic investment but for a thriving domestic industry in a non-Muslim majority jurisdiction. But is everything as idyllic as it seems? Although the government has made much of its level-playing field for Islamic financial products and services, there remain a few areas where equality, it seems, has not yet arrived. This week, LAUREN MCAUGHTRY speaks to experts who give us an in-depth look at exactly where the problems lie — and what needs to change.
The UK has made substantial provision with regards to Islamic finance, and its position has always been clear — the authorities wish to give the sector equal treatment without any advantage or disadvantage compared to conventional products. But how successful has this been?
Specific provisions known as the ‘Alternative Finance Arrangement Rules’ were introduced in the Taxation of Chargeable Gains Act 1992 (TCGA 1992) and updated in 2009 as part of the Corporation Tax Act to address the direct tax treatment of certain forms of Shariah financing. These cover purchase and resale arrangements (Murabahah), diminishing shared ownership arrangements (Musharakah), deposit arrangements, profit share agency arrangements (Wakalah) and investment bond arrangements (Sukuk). The UK alternative finance arrangement rules are intended to allow Shariah compliant financing arrangements to be treated for UK direct tax purposes in the same way as if they were a conventional loan, with the aim of providing a level-playing field in UK direct tax terms between conventional loan finance and Shariah financing arrangements that work in an equivalent economic way, so that the alternative arrangement is treated as a loan and the alternative finance return is treated as interest, thus giving rise to a tax deduction for the ‘borrower’ as in a conventional loan, and a taxable receipt for the ‘lender’ on the same basis.
In structures where an asset is transferred, such as Murabahah or Musharakah, the alternative finance return is also in theory ignored for capital gains tax (CGT) purposes in order to ensure it is not taxed twice (first as interest and secondly as part of a gain subject to tax on chargeable gains). However, a number of UK Islamic institutions have recently raised concerns that in fact, Islamic products are still at a theoretical disadvantage when it comes to CGT treatment — and the situation needs to be urgently addressed.
“The main issue is the CGT liability on Islamic mortgage refinance. We are lobbying to try and get that clarified — the government did introduce draft legislation a few years ago, but never implemented it,” confirmed Imam Qazi, a partner and the head of Islamic finance at Foot Anstey. “At the moment, if you own a residential property and refinance it with an Islamic bank, you have to transfer the title to the bank, and because of the way that CGT currently works in the UK, when you transfer the property there is a potential liability there. HMRC [Her Majesty’s Revenue and Customs] have never charged it and I don’t think they ever will, but the legislation needs to be changed to reflect that.”
So are Islamic banks actually at a financial disadvantage at the moment? In theory, no — but in fact, practitioners have informed IFN that their clients are indeed suffering from tax burdens that they would not have been charged had they used conventional arrangements.
“HMRC’s position on Shariah compliant finance is that tax legislation should not operate any more or less favorably than it does toward conventional loan finance. However, CGT legislation could operate more harshly toward taxpayers obtaining Shariah compliant finance,” explained Dr Samir Alamad, the head of Shariah compliance and product development at Al Rayan Bank. “For example, a customer of Al Rayan Bank recently was told by HMRC that he had omitted to report a taxable disposal in his tax return. This disposal arose purely from his entering into a refinancing arrangement with Al Rayan Bank, and wouldn’t have arisen had he obtained a conventional, interest-bearing loan.”
Tax treatment of customers seeking Islamic refinancing
Let us take a look at another example.
As with conventional mortgage providers, UK Islamic banks such as Al Rayan provide finance both for customers who want to buy properties and for customers who wish to refinance existing borrowings on properties they already own, but in a Shariah compliant manner.
In a refinancing, the most common Shariah compliant structure that might be used is a diminishing Musharakah with Ijarah. A diminishing Musharakah is almost always used where the property value is relatively modest (say, up to GBP2.5 million (US$3.29 million). Diminishing Musharakah internal refinance involves the customer selling a proportion of the beneficial interest in the property that he owns to the financial institution involved.
How does this work?
The Islamic bank agrees to buy a proportion of the beneficial interest in the property. Such a proportion matches the amount the bank is providing as finance relative to the current value of the property. The bank contracts to sell the beneficial interest back to the customer in tranches over time. The bank will also take the legal ownership of the property.
In its capacity as the legal owner, holding on trust for itself and the customer as ‘co-owners’, the bank will immediately grant a lease to the customer. It is this that ensures that the customer’s right to possession of the property is never affected. In the form of diminishing Musharakah financing that Al Rayan Bank offers, for example, the customer pays the bank exactly the same amount as Al Rayan Bank paid to acquire the beneficial interest. Alongside the capital payments, the customer pays rent under the lease. It is the rental payments that represent the bank’s margin — the equivalent of the interest a bank would charge in a conventional lending. Other providers of Shariah compliant finance might also make a gain on the sale of the property back to the customer.
Provisions of TCGA 1992 relating to diminishing Musharakah
The special provisions relating to ‘Alternative Finance Arrangements’ in Section 151H-151X of the TCGA 1992 focus on the ‘alternative finance return’ that a financial institution makes. The provisions ensure that return, which is equivalent to interest, is left out of any calculation of the bank’s chargeable gain.
“So far, if the principal private residence exemption does not apply (in the case of buy-to-let and commercial property finance offered by Islamic banks on diminishing Musharakah with Ijarah or Ijarah structures), there is nothing in [the] TCGA 1992 which provides any sort of relief for the financial institution’s customer from the capital gain that he might make on the initial transfer of their property to the financial institution as part of that finance transaction,” explained Dr Samir.
“In my discussions with HMG [Her Majesty’s Government] officials, I’ve also highlighted that there is no real disposal of the property by the customer from a tax perspective. At the same time as selling the beneficial interest to the financial institution, the customer and the financial institution enter into an unconditional contract for the customer to re-acquire the property in tranches. So, for CGT purposes, the customer re-acquires the beneficial interest immediately after selling it — which is called from a Shariah perspective Bai Al Tawliyah where the sale would be for the same amount paid, ie at cost price.
“This is akin to a repo of securities, for which the transferor of the securities has the protection in law. So far as I am aware from my various discussions with HMT and HMRC over the years, there is no equivalent protection for sales and repurchases of anything other than securities,” Dr Samir added.
Capital gains concerns
This means, in essence, that current capital gain tax legislation offers no protection to customers of Islamic banks in the UK in this situation. Clearly, this is a matter of urgent concern, especially as in the wider UK Islamic finance market currently, the diminishing Musharakah is the most used structure.
However, there is good news on the horizon.
“As a result of constructive dialogue with the government, it was acknowledged that HMRC inadvertently omitted to properly consider Islamic finance transactions in the latest proposed draft legislation and [has been] directed by ministers to find a solution,” revealed Dr Samir to IFN. “HMRC will also introduce an amendment, which for the purposes of the second home Stamp Duty Land Tax (SDLT) regime, will look through the bank’s ownership and will instead assess whether a surcharge is payable based on the Islamic bank’s client’s existing property ownership.
“I am currently advising and working with the government on these issues for swift and interim solutions or amendments to the tax laws, while at the same time pushing for a wider framework to ‘future-proof’ product innovation in the Islamic banking and finance industry in the UK. My aim is to work closely with HMG to create a framework for the Islamic finance market in the UK that outlines all possible structures of its products to be approved from a tax perspective, and the various policy implications. This would help product innovation and minimize any potential future challenges.”
It is not just Islamic institutions that have thrown their weight behind this plea. In March 2018, the Chartered Institute of Taxation also submitted a request to the UK government to align the tax treatment of Islamic finance and conventional finance.
“There is not yet a completely level playing field between the taxation of conventional finance and Islamic finance,” said the text of the document, which has been viewed by IFN.
“The submission aims to raise awareness of the lack of tax relief available for CGT for transactions structured under diminishing Musharakah agreements. The submission draws upon the tax treatment of Sukuk in the UK as [a] precedent to suggest changes. Current legislation allows Sukuk transactions to take place without any SDLT, CGT or capital allowance implications. The submission aims to align this with the tax treatment of diminishing Musharakah agreements. Currently, legislation has only provided for express SDLT reliefs for diminishing Musharakah transactions,” explained Imam.
“The UK’s approach has always been to ensure a level-playing field for Islamic finance products and conventional instruments, and so the UK has proactively monitored and responded to any unequal treatment between the two by introducing remedial legislation and regulations. For example, the government was quick to remedy the adverse tax treatment of Sukuk to place them on a level-playing field with conventional debt instruments. Another example is where the HM Treasury abolished the double stamp duty land tax charge on Shariah compliant mortgages. It is our opinion that the UK legislators will continue to strive for equal tax treatment of conventional instruments and Islamic finance products. The lack of CGT relief for diminishing Musharakah transactions seems more an oversight than a full thought-out decision. It may only be a matter of time before current legislation is amended to provide further express reliefs and clarity. The submission will of course help to pave the way for such progress,” Imam added.
This all sounds very promising. But are there any barriers to this progress? Dr Samir warns that change may not come as soon as the industry would like.
“There is still a certain lack of understanding of the various product structures of Islamic finance by the relevant authorities, which they need to appreciate fully to be able to help us in addressing those issues. This takes time,” he told IFN. “This could create a grey area for some products offered by Islamic banks in the UK until a clear legislative guidance or an interim guidance in the form of a technical note is provided by the government.”
Change might take time, but IFN is pleased to be able to reveal that good news is indeed on the horizon.
“We are indeed taking steps to address this issue,” said a HM Treasury spokesperson in response to our query on the 2nd July. “An amendment to the Financial Services and Markets Act was passed in the House of Lords last week.
This will now be debated in the House of Commons later this week.” The draft order was initially laid in front of the House of Lords on the 9th May, and seeks to update and amend further the UK’s treatment of Islamic finance.
“The UK has … sought to establish itself as a leading western center for Islamic finance,” said Minister of State at the Department for International Development Lord Michael Bates. “The government is committed to ensuring this continues to be the case. We have a situation where differing treatment in regulation and taxation is afforded to alternative finance investment bonds compared to their conventional counterparts. This is unintended from a policy perspective and the government wants to act quickly to address this gap to protect the competitiveness of the UK markets.”
The order does not only address the taxation issue from a CGT perspective, but also covers a hitherto unacknowledged Sukuk hiccup. “The order tracks an amendment made by the Finance Act 2018 which came into force on the 1st April 2018. This left a gap in the treatment of alternative finance investment bonds in financial services regulation. We intend to close that gap as quickly as possible in the interests of certainty, clarity and consistency,” explained Lord Bates. “[It] ensures that there is an alignment of the tax and regulatory treatment of alternative finance investment bonds to provide certainty, clarity and consistency for issuers of these instruments in UK markets. The order adds two types of financial trading venue — [the] so called multilateral trading facilities and organized trading facilities — to the list of permitted venues for alternative finance investment bonds.”
A positive prospect
The UK remains a staunchly positive example of how a non-Muslim jurisdiction can encourage and support a vibrant and robust Islamic finance industry. However, the aforementioned examples serve as an equally poignant reminder that nobody is perfect, and even in the most forward-thinking of jurisdictions, there are always improvements that can be made. We look forward to hearing how the UK government addresses the current concerns, and we will keep our readers informed of any and all developments as and when they occur. Watch this space.
IFN – Islamic Finance News