The UK has published legislation which should enable Shari’ah compliant securitisations to take place in the UK.
shari’ah-compliant securitisation – tax aspects
Shari’ah-compliant financing techniques in the UK have been developing apace in recent years. The UK has recently passed (in the Finance Act 2007) legislation which aims to overcome the significant difficulties which have to date prevented Shari’ah compliant securitisations from taking place in the UK.
To date, the area in which growth has been greatest is that of home finance for individuals. Aided substantially by the removal of the double stamp duty land tax (SDLT) charge that would otherwise arise in a Shari’ah-compliant home finance structure, one market research company estimates that the market for Shari’ah compliant home finance is set to grow by up to 47 per cent per annum1. A niche area, yes, but one with a lot of potential.
The potential for the Shari’ah property finance market has traditionally been limited by the banks’ ability to make funds available to consumers. One way in which conventional banks free up capital, so that they can write new lending business, is to securitise existing loans. Prior to the introduction of the new rules, tax considerations have made such a securitisation uneconomic. This now looks set to change.
The market for Shari’ah-compliant products
Although there is a substantial and maturing market in the Middle East for Shari’ah-compliant products, there is also a sizeable market in the UK and Europe. A section of the potential market is devout enough only to consider investing in “pure” Shari’ah-compliant products, or, if none is available, not investing in financing at all. In the area of home finance, this may mean saving to purchase a home, or renting, rather than taking traditional financing.
However, there is a wider potential market that would prefer to take Shari’ah compliant finance, if available, although that group may also take traditional finance if the Shari’ah alternative is more expensive or otherwise less competitive. In tapping this potential market in the home finance area, the abolition of the double charge to SDLT was extremely important, because it removed the main additional cost of Shari’ah-compliant home finance compared with the traditional mortgage.
In order for a Shari’ah compliant securitisation to be implemented, the tax treatment needs to be no worse than its traditional counterpart. This is what the new legislation sets out to do.
Structuring considerations in Shari’ah-compliant finance
It is reasonably well known that the charging of interest, or riba, is strictly prohibited under Shari’ah law. However, the guidance is wider than a prohibition on a charge which would be understood to be interest by any other name. For a transaction to be riba-free, a product or service must be delivered by the institution, and money itself cannot constitute a product. Hence, Shari’ah financings tend to focus on the financing of assets, or seek to use assets to replicate traditional loan finance. Profit cannot be assured, and therefore an Islamic financial institution must assume at least some commercial or financial risk on a transaction. Inherent in this is the need to transfer to the financier rights and obligations consistent with some element of property ownership. Synthetic transactions are not possible: to finance an asset, some recognisable interest in that asset – whether this be a form of beneficial or legal ownership – must pass to the financier.
The Shari’ah-compliant home finance structure
The way in which many home finance products have been structured involves a combination of Shari’ah products – an Ijara lease, together with a diminishing Musharakah contract. The Islamic finance institution purchases the home which is to be financed, and then leases it under the Ijara lease to the customer on terms that rent is paid. The term of the Ijara lease would equate to the term of a residential mortgage. The rent would equate to the interest paid on a traditional mortgage, and may be reviewed and varied from time to time.
Musharakah is a form of equity financing, under which both the customer and the Islamic finance institution put up part of the equity. The customer’s proportion of the financing would equate to the deposit paid under a traditional mortgage, and the Islamic finance institution’s to the principal element of the mortgage finance. The proportions of the customer’s and institution’s investment will be agreed at the outset.
Under a diminishing Musharakah contract the customer makes periodic payments to the institution. As payments are made, his beneficial interest in the property increases. The payments made equate to the repayments of principal under a repayment mortgage. Over the term of the financing, the entire beneficial interest in the property passes to the customer. Hence the need for the exemptions under sections 71A to 73 Finance Act 2003 from SDLT – there have been three land transactions, the sale of the property to the institution, the lease from the institutions to the customer, and the (gradual) on-sale from the institution to the customer.
The structuring of Islamic bonds (Sukuk)
A conventional, plain vanilla bond or note is a simple debt, and the noteholder’s return for providing capital to the note issuer takes the form of interest. An Islamic bond, or Sukuk, obviously cannot bear interest. In order for a Sukuk to be Shari’ah-compliant, the Sukuk holder must have a proprietary interest in the assets which are being financed. The Sukuk holder’s return on his subscription proceeds is income generated by the assets which he, through holding the Sukuk, has proportional ownership of. There are a number of ways of structuring Sukuk, the most common of which may be described as trust or partnership structures. Typically, a bankruptcy remote issuer would acquire property, which will be held on trust for the Sukuk holders. The Sukuk, or trust certificates, are issued by the issuer to the Sukuk holders, who thereby acquire a proprietary interest in the assets of the issuer. The nature of this proprietary interest will depend on the view taken by the Scholars (specialist in Islamic jurisprudence, who issue the ruling or fatva confirming the compliance of the products with Shari’ah law) but it is understood that the minimum ownership requirement for the Sukuk holder is an entitlement to income generated by the assets. The issuer, acting as trustee, collects such income and distributes it to the Sukuk holders in accordance with their proportional interest in the assets.
Traditional residential mortgage backed securities (RMBS) securitisation
As with all securitisation, residential mortgage-backed deals have to be structured so as to ensure that minimal tax is paid by the securitisation vehicle, as any tax paid is an absolute cost in the structure. Transfer taxes which arise when mortgages are transferred from the originating bank to the bankruptcy-remote securitisation vehicle, ideally have to be structured round, or, if this is impossible, paid or reserved for. The imposition of withholding taxes on payments from the obligors to the securitisation vehicle also has to be avoided as this, at best, would otherwise result in a cash flow disadvantage for the vehicle. Commercially, it is also imperative that there is no withholding tax imposed on the payment of interest to bondholders.
A structure for a traditional UK RMBS transaction may commonly be as follows
On this tried and tested structure, there would be no stamp duty or SDLT to pay on the sale of the mortgages, the obligors would not be obliged to withhold tax on interest paid on the mortgages as the Issuer SPV is UK tax resident (section 930 Income Tax Act 2007 (ITA)) and there is no withholding on interest payments on the bonds as they would be structured so as to be quoted Eurobonds (section 882 ITA).
The Issuer SPV in a traditional securitisation should be taxed (under the new specialised regime for securitisation companies) on any profit it retains, which should be a minimal amount. Vehicles used in Shari’ah compliant securitisations are specifically excluded from the new securitisation regime. Nevertheless, the proposed changes to the UK tax rules (which are described in more detail later in this article) should result in them being taxed in an equivalent fashion to a traditional Issuer SPV.
Replicating the traditional structure – SDLT
The Shari’ah-compliant residential mortgage gives the financial institution a real property interest in the home which is being financed. It is necessary, in order for the Sukuk issued by the issuer to be Shari’ah-compliant, and also in order for the financial institution to remove the home financings from its balance sheet, that the interest in the property be transferred to the issuer.
Before the enactment of the Finance Act 2007, the existing SDLT exemption for Islamic mortgages extended relief only so far as to ensure that the original transaction between customer and financial institution results in only one charge to SDLT. The new legislation provides that a sale or assignment of an Islamic mortgage by a financial institution will benefit from relief from SDLT under any of sections 71A to 73 Finance Act 2003.
Replicating the traditional structure – treatment of the sukuk holder
The payments made by the customer to a financial institution under an Islamic mortgage, structured as a diminishing Musharakah contract coupled with an Ijara lease, other than an amount paid for the customer’s gradual acquisition of the beneficial interest in the property, will be treated as an “alternative finance return” for tax purposes. This alternative finance return is treated in the same way as interest (on a loan relationship where the recipient is a company), and that the amount paid by the financial institution for the acquisition of the property to be financed is to be treated as the capital element of a loan.
However, before the Finance Act 2007 these rules only applied to the tax treatment of a financial institution (broadly, a bank or building society, or a subsidiary of a bank or building society). This meant that there were a number of concerns – most significantly withholding tax – where an Islamic mortgage is transferred to a Sukuk holder. Section 53 Finance Act 2007 provides that the payments made by a customer to a Sukuk issuer, other than the amounts paid for the customer’s gradual acquisition of the beneficial interest in the property, will be treated as an alternative finance return, with the result that they will be taxed in the same way as interest. This puts the withholding tax position on a level footing with that of a traditional RMBS securitisation.
Replicating the traditional structure – treatment of the issuer
In order for a Sukuk issuer to be able to compete on a level playing field with a traditional RMBS issuer, it is necessary to ensure that it suffers minimal tax liabilities. Prior to the introduction of the new legislation, it was necessary to ensure that the trust created by the issue of the Sukuk was a bare trust, so that the Sukuk holders were taxed directly on their income under the Islamic mortgages, and the issuer was not left with liabilities to income tax, capital gains or inheritance tax. The new legislation will result in the Sukuk issuer being taxed on the income it receives from customers of the Islamic mortgages but also receiving a deduction for the payments it makes to the Sukuk holders. The net effect of this should be minimal tax leakage.
The UK tax authorities have been working for some time with the Islamic finance industry (with significant input from Norton Rose) to produce these changes. The new legislation means that the three great hurdles – SDLT on the transfer of Islamic mortgages to an issuer, withholding tax and the tax treatment of the issuer – have been put on the same footing as traditional securitisations. This makes the prospect of a Shari’ah compliant securitisation a real possibility, together with further growth in the Shari’ah compliant home financing market.