What is sukuk?

In the sharia'a-compliant financial world, bonds or certificates representing an undivided interest in an underlying asset (such as land) held by the issuer, are known as sukuk. The holder of the sukuk is entitled to a share of the returns generated by the underlying asset.

For an investor, the return is (broadly) economically equivalent to that on a conventional bond. And, like conventional bonds, sukuk are transferable.

Typically, the fund raiser (original owner) sets up a new special purpose issuing entity (the issuer). The assets are sold by the original owner to the issuer. The issuer then holds such assets on trust for investors. The issuer issues sukuk (bonds) to investors. The proceeds of that bond issue are used to pay the original owner for the assets. The original owner often buys back the assets at maturity of the bond.

Government action

The UK Government has already signalled its support for the issue of sukuk and other sharia'a-compliant financial structures and instruments. The approach taken is to ensure that sukuk are taxed in the same manner as conventional bonds.

Finance Act 2007 contained provisions to treat returns to investors as if they were interest returns. This allows those payments to be tax deductible for the issuer - even though it is a profit distribution. In so doing, the provisions removed a significant disincentive (and cost) to the issue of sukuk in the United Kingdom. It also made the United Kingdom a more attractive place to issue sukuk.

Latest developments

The UK Government has now recognised further structural disincentives in the UK tax system to the issue of sukuk. The latest proposals – which were announced in yesterday's Budget and which will form part of Finance Act 2009 and are due to have effect from Royal Assent – aim to counter these disincentives to the issue of land asset-based sukuk found in stamp duty land tax, tax on capital gains and the capital allowances regime.

Stamp duty land tax (SDLT)

Multiple charges to SDLT arise on acquisitions by the issuer and holders of the sukuk and on reacquisition by the original owner. These charges would not apply to conventional bond structures and are therefore a barrier to land asset-based sukuk. So, reliefs from SDLT will be introduced to remove these charges.

Capital gains

The effect of the capital gains disposal rules represents a further fiscal barrier to sukuk. Multiple charges to capital taxes arise on the disposal of land by the original owner to the issuer, on disposal by the issuer back to the original owner and, depending on the type or structure of sukuk, for the original owner at various points in the life cycle of the sukuk. More specifically, a typical sukuk might involve a "buy and leaseback" structure (ijara'a sukuk) whereby an issuer would sell an asset to a special purpose vehicle. The issuer would then lease it back for the duration of the bond and eventually buy it back. This represents a series of taxable disposals.

Relief will be given for such capital taxes by disregarding these disposals. In effect, the original owner will be treated as if it had owned the assets throughout the life cycle of the sukuk.

Capital allowances

As ownership of the underlying land assets passes to the issuer or bond holders, the original owner is denied the benefit of capital allowances under the traditional capital allowances regime. Amendments to the capital allowances provisions will be made and these will ensure that the benefit of allowances is retained by the original owner. Again, the effect is that a fiscal barrier is removed to the development of sukuk in the United Kingdom.

Due to the original tax barriers, the United Kingdom only hosted sukuk listings but has not seen any issuances. The UK Government's willingness to make these new changes signals that the United Kingdom continues its drive to be the global hub for Islamic finance.