Common structuresi Investment funds
In Luxembourg, a large variety of shariah-compliant vehicles are available to asset managers and investors. The choice of investment structure depends on the investment policy, the investors targeted and the level of regulation desired. Shariah-compliant asset allocation can be achieved by setting out a strong investment strategy together with a shariah-oriented selection process. For instance, a shariah-compliant fund must follow the principles of equal treatment of shareholders and the prohibition of undue enrichment. In practice, this means that shares subscribed for by investors must be of equal value. Consequently, preference shares in an investment company (generally permitted under the Companies Act) are not allowed.ii Available structuring options
From a legal standpoint, any Luxembourg investment vehicle can be used to set up a shariah-compliant fund. Generally, a Luxembourg investment fund can take either a corporate form or a contractual form.
From a regulatory standpoint, shariah-compliant investment funds can either be structured as undertakings for collective investment in transferable securities (UCITS) governed by Part 1 of the UCI Act of 17 December 2010 or alternative investment funds (AIFs) within the meaning of Directive 2011/61/EU, as amended (the AIFMD). The main difference between the two kinds of funds is that only UCITS can be marketed on a pan-European cross-border basis to retail and professional clients under the UCITS passport, whereas AIFs can principally only be marketed to professional investors under the AIFMD passport. Certain specialised investment funds (SIFs) and investment companies in risk capital (SICARs) may not qualify as AIFs.
A SIF is a lightly regulated, operationally flexible and tax-efficient multipurpose investment fund for a pool of well-informed investors. Even though a SIF does not have to comply with specific investment restrictions, it must follow the principles of risk diversification. A SICAR is a regulated and tax-efficient structure, specifically designed for private equity and venture capital investments. In contrast to a SIF, a SICAR may concentrate its assets in one single project as long as it invests in risk capital. Investments of a SICAR must be characterised by a high risk and an intention to develop the target entities. The purpose of the SICAR may consequently be in contradiction with the prohibition of gharrar (i.e., uncertainty and speculation) in Islamic finance. A reserved alternative investment fund (RAIF) is a vehicle reserved to well-informed investors encompassing the characteristics and structuring flexibilities of SIFs or, alternatively, SICARs, without being subject to any regulatory approval or supervision by the CSSF. The supervision is, however, operated indirectly as the manager must be regulated under the AIFMD.
Another option available to shariah promoters and investors is a Part II Fund, which is a flexible but regulated vehicle open to both retail investors and professional investors. Part II Funds must invest their assets according to the principles of risk diversification but are not limited as to the type of assets into which they can invest.
UCITS are open-ended funds investing in transferable securities such as units, bonds, money-market instruments and certain types of derivatives. These funds are harmonised on an EU level and widely sold to Islamic investors. The UCITS regime lays down common requirements for the organisation, management and oversight of such funds and imposes rules relating to diversification, liquidity and use of leverage. UCITS offer, therefore, high levels of investor protection and may incorporate shariah features, such as:
- a ban on investment in any interest-bearing assets or debt instruments and cleansing of cash and dividends receipts;
- a ban on futures or forward contracts, derivatives or short sales;
- prohibition of investment related to haram activities such as gambling, alcohol and tobacco (including the advertising and marketing of these activities); and
- creation of a shariah advisory board.
For further illustration purposes, government mudarabah certificates (i.e., a non-debt-creating mode of finance issued by the sovereign state) and commodity murabahah deposit (i.e., a short-term fixed income deposit) would generally qualify as eligible investments for UCITS. However, specific consideration should be given to commodity murabahah, as the CSSF would only consider these as UCITS-eligible investments if the issuer is a credit institution that has its registered office in the EU or a non-EU state with equivalent rules.iii Real estate and private equity investments
Real estate and private equity investments are characterised by their long-term and illiquid nature. The financing aspect of these investments is challenging because shariah law prohibits the use of conventional debt structures. In Luxembourg, this challenge can, however, be overcome by using alternative shariah-compliant instruments, such as sukuk al-murabahah (i.e., sales-based financing) or sukuk al-ijarah (i.e., lease-based financing) to finance the acquisition of assets.
With respect to leverage, under shariah law, debt financing and the payment of interest are proscribed (riba). In practice, however, it is usually accepted that a shariah-compliant fund may engage in leverage through the use of shariah-compliant financing instruments. Conventional loans or interest-bearing instruments are not permitted. It is also conceivable to open investment to additional equity-based investors using a musharakah contract whereby each investor has management rights in proportion with its investment in the fund. Shariah-compliant property investments can also be achieved by using a mudarabah or an ijarah contract. The mudarabah contract is similar to the relationship between a Luxembourg general partner (i.e., fund manager) and the limited partners (i.e., investors). By contrast, an ijarah contract is a lease contract for a specified asset or the usufruct of a specified asset. The rules governing ijarah may be considered similar to those governing conventional leases, subject to limitations provided for by the shariah law.iv Capital marketsBenefits of the Luxembourg securitisation regime
Many issuances of sukuk in Luxembourg have been structured using a Luxembourg securitisation undertaking subject to the Securitisation Act. The securitisation undertaking may be set up in the form of a company or a securitisation fund managed by a Luxembourg management company. Securitisation funds do not have legal personality; they are constituted by one or more co-ownerships of assets or fiduciary estates, which provide a closer connection between the investors and the underlying assets – a considerable advantage from the point of view of shariah law. While the vast majority of securitisation undertakings are unregulated, a securitisation undertaking that offers securities to the public more than three times per year has to apply for a licence from the CSSF to qualify as a regulated securitisation vehicle for the purposes of the Securitisation Act.
A securitisation undertaking's primary activity must be to engage in securitisations, defined by the Securitisation Act as transactions whereby a securitisation undertaking:
- acquires or assumes, directly or through another undertaking, risks; and
- to finance the acquisition or assumption of those risks, issues securities whose value or yield depends on those risks. Risks to be securitised may be related to all kinds of assets, including claims, receivable or equity interests, with no requirement of risk diversification.
Unlike funds, securitisation undertakings must not actively manage securitised assets. The Securitisation Act allows a securitisation undertaking to set up multiple compartments by a simple decision of its board of directors. Each compartment forms a distinct and independent part of the securitisation undertaking's assets and is segregated from its other compartments and general estate. One or more securitisations can be carried out independently out of each individual compartment, which significantly reduces transaction costs as one vehicle can be used for an unlimited number of distinct transactions. For instance, it would be possible for one securitisation undertaking to create several compartments, some of which would be dedicated to shariah-compliant transactions, while the other compartments could be used for issuing conventional securities. Investors (irrespective of whether they hold equity or debt securities) will only have recourse to the assets comprised in the compartment to which the securities they hold have been allocated.
A securitisation vehicle is considered insolvency remote – a feature much valued by rating agencies. The main characteristics of Luxembourg's sophisticated securitisation regime – the ring-fencing of compartment assets, priority of payments, limited recourse, prohibition of seizure of assets and non-petition for bankruptcy – are protected not only by contractual arrangements, but are also expressly recognised by the Securitisation Act. Legal proceedings initiated against a securitisation undertaking in breach of those provisions will, in principle, be declared inadmissible by a Luxembourg court.
It should also be mentioned that a securitisation undertaking issuing exclusively debt instruments (and sukuk is regarded as such from a Luxembourg law perspective) will be able to rely on an exemption from the scope of the AIFM Act. Other exemptions from the AIFM Act may also be available.Raising finance in a shariah-compliant manner
One of the popular Islamic finance structures that have been put in place in Luxembourg using a securitisation vehicle is murabahah. A pioneering transaction, which combined a reducing revolving convertible murabahah with a note issuance, involved a Luxembourg securitisation company that acted both as the issuer of conventional bonds and as the lender under the murabahah facility. The issuer used the proceeds of the bonds to purchase certain commodities, which it subsequently sold, on deferred payment terms, to an Islamic investment bank for a sale price equal to the acquisition cost plus profit. The cash payments of the deferred sale price were used by the issuer to meet its obligations towards the bond investors. Additionally, the bondholders had the option to convert the cash distributions due to them under the bonds into shares of the lender under the murabahah contract (which constituted the securitised asset for the purpose of the bond issue).
Luxembourg issuers, some of them ordinary companies as opposed to securitisation undertakings, are regularly used to issue sukuk, the proceeds of which may be invested, directly or indirectly, in assets such as real estate or aircraft. A stream of rental income generated by those underlying assets is then distributed to investors via payments under the sukuk. Notably, Luxembourg has played host to a joint venture formed among prominent Islamic and conventional financial actors who invested, through a mixture of equity and sukuk, in a Luxembourg special purpose vehicle (LeaseCo) to acquire a string of retail properties leased to tenants. In return for the right to control the target properties and receive rents, LeaseCo paid the issue proceeds of the sukuk to a Luxembourg joint venture vehicle (PropCo), thereby enabling it to purchase the shares of the company whose subsidiary owned the relevant properties. Any rewards associated with the ownership of the properties were to be extracted by the joint venture members via payments made by LeaseCo in respect of the sukuk.
Another example of the successful application of Luxembourg law in the implementation of Islamic financial transactions is the issue of sukuk using a two-tier securitisation structure by an international Islamic organisation. This type of set-up is expressly permitted under the Securitisation Act and involves two securitisation undertakings: an issuing vehicle and an acquisition vehicle. In the case at hand, the issuing vehicle issues, on an ongoing basis, trust certificates and contributes the proceeds to the acquisition vehicle in exchange for the undivided beneficial ownership interest in shariah-compliant assets purchased by the acquisition vehicle using the contribution from the issuing vehicle. Those assets are held by the acquisition vehicle for the benefit of the issuing vehicle under an English law trust. The issuing vehicle, for its part, holds the undivided ownership interest on trust for the holders of the trust certificates as well as acting as their agent (wakeel). Through its undivided beneficial ownership, the issuing vehicle is entitled to receive profits and redemption amounts generated by the underlying assets and uses the sums so received to honour its obligations under the trust certificates.
One of the prominent issuers of sukuk is the Luxembourg state itself, which, in 2014, became the first eurozone country to issue sovereign sukuk. For the purpose of the transaction, Luxembourg arranged for the setting up, and became the sole shareholder, of Luxembourg Treasury Securities SA, a special purpose vehicle that has acted as the formal issuer of the instruments. The Luxembourg sukuk, which is of the al-ijarah type, is backed by three administrative buildings that have been purchased by the issuer from the Luxembourg State using the issue proceeds of the sukuk. The buildings will be transferred back to the Luxembourg State for a pre-agreed purchase price when the sukuk matures. The Luxembourg sukuk have been admitted to trading on the Euro MTF market of the Luxembourg Stock Exchange.
Whereas there is no specific framework regulating Islamic finance transactions in Luxembourg from a legal perspective, there are two circulars issued by the directors of the direct tax administration and the indirect tax administration regarding the Luxembourg direct and indirect tax treatment of murabahah transactions and sukuk.i Direct taxationMurabahah transactions
For the purposes of the following paragraphs a murabahah transaction is to be understood as an agreement transaction consisting of two consecutive sales of a certain asset whereby, at the first stage, a party (the financier) purchases an asset from a third party upon the request of its counterparty (the purchaser) and then, at the second stage, resells the asset to the purchaser at a marked-up price, payable by the purchaser on a deferred basis.
From a Luxembourg general tax perspective, the 'capital gain' generated at the hands of the Luxembourg financier upon the mere execution of the second sale and purchase agreement between the financier, as seller, and the purchaser, would, in principle, be fully taxable at a current combined rate of 24.94 per cent (corporate income tax, increased by the solidarity surcharge, and municipal business tax for companies established in Luxembourg City) for 2019.
However, Circular LG-A No. 55 issued by the director of the Luxembourg direct tax administration on 12 January 2010 (the Direct Tax Circular) provides for deferred taxation of the capital gain on a straight-line basis over the full payment deferral period under the murabahah agreement (which usually corresponds with the duration of the murabahah agreement), notwithstanding any reimbursements made during this period.
From an economic perspective, the Direct Tax Circular compares the capital gain generated in the hands of the Luxembourg financier to the remuneration for giving the purchaser the possibility of deferred payment (i.e., it is treated for Luxembourg tax purposes as ordinary interest income, which would have been earned by the Luxembourg financier under conventional financing). It should be noted that the deferred taxation is available only for remuneration earned by the financier for giving the possibility of deferred payment to the purchaser and not, for example, any intermediation fee that the financier may receive.
The treatment of the capital gain realised by the financier as interest income under the Direct Tax Circular is subject to the following conditions, which must be met by the murabahah transaction:
- the murabahah agreement must clearly state that the financier is acquiring the asset for immediate resale to the purchaser (within a maximum of six months);
- the murabahah agreement must clearly define the various elements constituting the financier's profit:
- the remuneration for deferred payment;
- the intermediation fee; and
- the exact acquisition price of the asset to be paid by the financier and subsequently by the purchaser;
- the murabahah agreement must provide for a clear and explicit acknowledgment and acceptance by all parties of the financier's profit;
- the murabahah agreement must explicitly define the financier's profit as being the consideration for the service provided to the purchaser, being the possibility of deferred payment given to the purchaser; and
- from an accounting and tax perspective, the financier's profit must be booked in the same way. In other words, the pure profit (i.e., the remuneration for the possibility of deferred payment) must be spread over the deferred payment period stipulated in the murabahah agreement, regardless of the actual dates of repayment.
If the purchaser is a Luxembourg tax resident, any payments remunerating the financier for giving the purchaser the possibility of deferred payment under the murabahah agreement should, in principle, be exempt from Luxembourg withholding tax and should also be deductible for tax purposes, subject to the interest deduction limitation rules that apply depending on the assets held and income received by the purchaser (not applicable to purchasers qualifying as financial undertakings such as, inter alia, UCITS, AIFs or 'securitisation special purpose entities' (SSPEs) within the meaning of Regulation (EU) 2017/2402), and unless they relate to items of income that are exempt in Luxembourg (e.g., foreign real estate) and provided that the above conditions are met.Sukuk
Pursuant to the Direct Tax Circular, sukuk may be considered a conventional debt instrument (i.e., as a bond (its return, or interest, being dependent on the performance of the underlying asset)). Any profit distributions made under the sukuk to its holders are, in principle, deductible in the hands of the issuer (subject to the interest deduction limitation rules that apply depending on the assets held and income received by the issuer (not applicable to issuers qualifying as financial undertakings such as, inter alia, UCITS, AIFs or SSPEs)) and such distributions are not subject to Luxembourg withholding tax.ii Indirect taxationRegistration dutiesMurabahah
Depending on the underlying asset of a murabahah agreement, Luxembourg registration duties could be due, in principle, on each sale and purchase of the said asset (e.g., Luxembourg situs real estate).
Pursuant to Circular No. 749 issued by the director of the Luxembourg indirect tax administration on 17 June 2010 (the Indirect Tax Circular), the registration duties payable in Luxembourg on a murabahah agreement concerning real estate located in Luxembourg City are limited to 2.8 per cent under the condition that:
- both notarial deeds (documenting the purchase and the resale) are registered with the indirect tax authorities at the same time; and
- the financier explicitly declares in the first notarial deed (documenting the purchase) that the real estate asset will be subsequently resold.
The amounts on which registration duties are calculated are limited solely to the acquisition price paid by the financier on the first sale. The profit of the financier, which is considered interest, is thus not subject to registration duties in Luxembourg under the following conditions:
- the purchaser must take possession of the real estate asset immediately after the second sale and purchase agreement;
- no more than 10 days must separate the first sale and purchase agreement from the second; and
- the first sale and purchase agreement must contain a clause stating that the transaction is being carried out as a murabahah agreement, a copy of which must be annexed to the notarial deed relating to the first sale and purchase agreement.
The issue of sukuk should, in principle, not give rise to any registration duties in Luxembourg, provided that the terms and conditions of the sukuk are not physically attached to a public deed or to any other document subject to mandatory registration in Luxembourg. If the proceeds derived from the issue of sukuk are used for instance to purchase Luxembourg situs real estate, registration duties would, in principle, be due with respect to the purchase agreement relating to the real estate properties.Value added tax
The Indirect Tax Circular states that financiers created for the purpose of a murabahah transaction are treated under Luxembourg value added tax (VAT) law as taxable persons.iii Taxation of shariah-compliant funds
Shariah-compliant funds structured as UCITS, Part II Funds, SIFs and certain types of RAIFs (SIF-type) are exempt from any Luxembourg income, withholding, capital gains or net wealth tax. They are, however, subject to an annual subscription tax ranging between 0.01 and 0.05 per cent, calculated and payable quarterly on their aggregate net assets as valued at the end of the relevant quarter. Certain exemptions and reductions can apply.
SICARs and certain types of RAIFs (RAIFs carrying out risk capital investments and opting for a special tax regime identical to the regime applicable to SICARs) may be incorporated in the form of a fiscally opaque vehicle or as a tax transparent vehicle. If set up as tax-opaque vehicles, these are considered fully taxable companies (i.e., subject to corporate income tax, municipal business tax and the solidarity surcharge), but benefit from an exemption on any income derived from transferable securities connected with investments in risk-bearing capital or for cash held for the purpose of a future investment. These types of funds may, however, be subject to the minimum net wealth tax regime.
Further, with respect to VAT, pursuant to Circular No. 723 of 29 December 2006, undertakings for collective investment are, in principle, considered VAT-taxable persons. Thus, Luxembourg VAT may be applicable under the reverse charge mechanism whereby a fund domiciled in Luxembourg receives taxable services from suppliers located in other EU Member States, unless a specific VAT exemption may be secured (such as fees on the negotiation of securities, for example). A fund would, in principle, have no right to deduct input VAT as it should normally carry out activities that are exempt from VAT only.iv Taxation of securitisation undertakings
Securitisation undertakings subject to the Securitisation Act benefit from a favourable tax regime. If set up as a company, they are, in principle, fully taxable companies, subject to corporation tax at a current combined rate of 24.94 per cent (corporate income tax, increased by the solidarity surcharge, and municipal business tax for securitisation undertakings established in Luxembourg City) in 2019. However, the Securitisation Act states that the obligations assumed by securitisation undertakings towards their investors (including shareholders) and any creditors are to be considered tax deductible expenses. In other words, securitisation undertakings should be able to deduct any payments due or made to any investors, or creditors, from their taxable profits, subject to the interest deduction limitation rules that apply depending on the assets held and income received by the securitisation undertaking (not applicable to securitisation undertakings qualifying as SSPEs).
Securitisation undertakings are exempt from net wealth tax, except for the minimum net wealth tax.
Further, there is no Luxembourg withholding tax on payments of interest or on profit distributions made by the securitisation undertaking to its investors.
With respect to VAT, securitisation undertakings are considered VAT-taxable persons if they are deemed to be carrying out an economic activity. If a securitisation undertaking qualifies as a VAT-taxable person, Luxembourg VAT may be applicable under the reverse charge mechanism if a securitisation undertaking domiciled in Luxembourg receives taxable services from suppliers located in other EU Member States. A securitisation undertaking would, in principle, have no right to deduct input VAT as it solely carries out activities that are exempt from VAT.