Common structuresi Home and other retail finance
Retail Islamic finance has been well established in the US since the OCC approved the ijarah structure for home lending in 1997 because it is 'functionally equivalent' to conventional secured real estate lending. Similarly in 1999, the OCC approved the use of the murabahah structure for home financial products as it was deemed to be functionally equivalent to conventional real estate mortgage transactions, or inventory or equipment lien agreements.
The OCC opined that under such structures a bank's ownership of property is only for 'a moment in time' because of the simultaneous nature of purchase and sale transactions. Therefore, Islamic contracts, the OCC concluded, avoid the type of risk that existing restrictions aimed to limit. In terms of accounting, the bank records the loan as an asset on its balance sheet. The borrower is required to maintain the property and pay all expenses. If the borrower defaults, the bank may sell the underlying property to recover the amount owed, as in a mortgage transaction.
Musharakah is also used for home financing in the US. It is a rent-to-own financed sale of property, where the bank first purchases the property and the customer pays the bank over time the full price plus a cost. With each rent payment, the customer earns a portion of the property's ownership. Under this equity-based structure (also called 'diminishing musharakah'), when the customer sells or disposes of the property, losses are shared between the customer and the bank as co-owners based on their percentages of ownership. The bank's return is taxable income to the bank and deductible by the borrower.ii Insurance
Deposit insurance, which banks use for stability, is inconsistent with shariah because a bank having insurance alters the risk-sharing structure required under shariah. Therefore, shariah, a cooperative form of reimbursement that comes from a fund to which entities contribute regularly, does not work in the US. Reinsurance is necessary in the US because of high minimum capital requirements, but there are not many retakaful services. Although structuring a product around this impediment in the US is technically possible, it has been a strong enough practical impediment to prevent further growth of the Islamic insurance market. Another serious obstacle to the successful introduction of takaful and retakaful in the US is the Establishment Clause of the First Amendment to the US Constitution. Establishment Clause challenges are analysed under a three-part test to establish that there is a secular purpose, religion is neither advanced nor inhibited, and it does not foster excessive government intervention.
Each state has its own licensing requirements for insurance companies operating in the state, which generally prohibit the proliferation of takaful. To be licensed, an insurance company must prove its experience, management capability and sound finances. It must also justify its premium rates and meet or exceed the solvency requirements. Even after it becomes licensed, an insurance company is often limited in choosing the types and concentrations of fixed-income investments that it must make with its reserves. Moreover, if the insurer becomes insolvent, an emergency loan must be taken out of the shareholders' fund to help meet obligations arising out of the insolvency. This could be a problem in takaful insurance, because capital requirements imposed upon the insurance companies may not accurately reflect the separation between the fund for policyholders and that for shareholders. Nonetheless, some takaful are subject to a lesser degree of oversight from the state insurance regulators.
Despite the difficulties associated with takaful, American International Group Inc (AIG) first started to offer Islamic homeowner takaful insurance in the US in 2008. Currently, AIG's underwriting subsidiaries, Risk Specialist Companies Inc and Lexington Insurance Company, issue takaful. Zayan Finance, a New York-based Islamic financial services firm, is the exclusive broker that offers takaful in many states. AIG also maintains a shariah board made up of Islamic scholars who have given legitimacy to the takaful alternative to conventional insurance in the US market.iii Real estate investment
Islamic finance has widely used real estate as a basis for shariah-compliant financial structures. Prime or trophy assets (e.g., hotels or large office headquarter buildings) have been its focus. Thanks to rental guarantees, stable demand and rising rental payments, dorms and other student accommodation have also effectively attracted Islamic funds. Further developments may be achieved by expansion of the scope of social infrastructure to include education, healthcare and social housing sectors. Since 2010, however, Islamic funds and banks that offer mezzanine finance have proliferated. Here, a conventional senior bank provides a loan with interest, the investors provide the equity and the mezzanine financing is placed in a shariah-compliant way. The senior conventional bank and the shariah-compliant mezzanine lender enter into an intercreditor agreement governing the way in which each of their loans is treated while conforming to the mezzanine lender's Islamic sensibilities.
Murabahah is the most popular type of structure used for real estate investment in the US. A typical murabahah structure contains an unconditional contract of sale with a cost price, markup and payment date predefined. The profit from the marked-up sales price is paid in instalments. One of the largest examples of recent real estate investments done under murabahah is the US$219 million syndicated construction loan for 45 Park Place, a luxury condominium tower in Manhattan, New York. It was led by Malaysia's Maybank and Kuwait's Warba Bank; Italy's Intesa Sanpaolo and MASIC, the investment arm of Saudi Arabia's Al Subeaei family, also participated.
One advantage of murabahah is that it may not require credit support. Here, the bank pays the seller for the property for immediate sale to the buyer for the cost plus a profit pursuant to a murabahah agreement. A murabahah transaction has also been used to refinance a conventional loan to allow the borrower to withdraw cash to pay off interest-bearing obligations, subject to the advice of shariah scholars. For US tax purposes, the profit piece of the purchase price in a murabahah transaction is deemed to be interest, such that it is taxable to the IFI and deductible by the customer.
An ijarah is a lease structure used in acquiring real estate as well as in other acquisition finance contexts (e.g., aircraft, ship or project finance). Under ijarah, a bank purchases a property and places the ownership over the property in a holding subsidiary and then leases it to the buyer for its use pursuant to the ijarah lease. Typically, title to the property is only transferred to the borrower after full payment of the cost of the property. The customer pays rent to the bank, which consists of, among other things, the purchase price and the profit. Unlike in a conventional finance lease transaction, the bank, acting as an owner and a lessor, has obligations to insure and undertake major maintenance of the leased asset. These obligations may, however, be contracted out to the borrower, who acts as a lessee. The lessee is responsible only for payment of the rent while the lessee continues to use the asset, so the ijarah structure cannot become effective before completion of the leased facility construction. Unlike in conventional leases, under an ijarah, if there is a total destruction or condemnation such that the property cannot be used for its intended purpose, the rent payment will cease. The lease-to-purchase model (i.e., ijarah wa iqtina) is also frequently used in real estate investment in the US. Under the laws of most states, the transaction can be simplified by having the client immediately take title to the property at the initial purchase.iv Investment funds
A mudarabah agreement is formed between two partners, with one contributing capital to invest in some form of commercial enterprise, while the other provides the expertise and management experience. The capital contributor is known as the rab-al-mal and the managing partner is known as the mudarib. This type of structure is typically used for funded participating arrangements and establishment of an investment fund. The rab-al-mal and the mudarib share the profit generated from the investment in accordance with pre-agreed profit sharing ratios. However, any loss of capital is assumed by the rab-al-mal.v Other areas
There have been two major sukuk issuances in the US: the East Cameron gas sukuk, the first sukuk al-musharakah in the US, which was backed by oil and gas assets, and the General Electric sukuk al-ijarah, which was backed by aircraft leases. The East Cameron sukuk has gone into bankruptcy, but the General Electric sukuk is performing well. Both Illinois and New York have begun efforts to enact legislation to recognise sukuk.
For commodity trading, tawarruq is used, which essentially is a reverse murabahah. Under this structure, a bank buys freely tradable commodities such as platinum and copper (other than gold and silver, since they are considered currency) at market value for spot delivery and spot payment, and then immediately sells them, at an agreed price that contains the profit, to the customer on a spot delivery and deferred payment basis. The customer immediately sells the commodities at market value to a third party for spot delivery and spot payment. The end result is that the customer has received a cash amount and has a deferred payment obligation for the purchase price to the bank. Under the tawarruq structure, the profit piece of the purchase price also takes into account the bank's commodity risk and third-party supplier risk, in addition to the creditworthiness risk of the customer.vi Combining conventional and shariah-compliant financing capital stack
A shariah-compliant lender may participate in a capital stack structure in a transaction that uses both shariah and conventional financing by delineating the assets and the cash flows in the transaction.
In certain circumstances, shariah-compliant and conventional lenders may enter into a formal intercreditor agreement that sets out the priority of payments and the ranking of security. This is most likely to occur when the structural subordination is not possible and the borrower under both the conventional and shariah-compliant finance is the same entity. The intercreditor agreement between shariah-compliant and conventional lenders is likely to address many similar matters covered in such an agreement between solely conventional lenders. Matters that could be addressed may include:
- allocation of the borrower's operating income;
- allocation of proceeds following acceleration on default;
- disputes and governing law; and
- what the different lenders can and cannot do in respect of their facilities.
Islamic finance raises many US taxation issues, including strong tax incentives for debt over equity, the tax treatment of sales and additional layers of transactions in certain instruments. In addition, differences in the tax treatment of Islamic and conventional finance could cause cross-border spillovers and encourage international tax arbitrage. For instance, the Internal Revenue Service has yet to issue official guidance on tax deductibility of the payments made under ijarah and mudarabah structures and on partial treatment of such payments as interest. Real estate transfer taxes and mechanic's liens present another challenge because the shariah-compliant financing structures often require multiple transfers of the property with heavy fees incurred by parties with each transfer (e.g., property being purchased by the bank first and then transferred to the borrower). The state of New York has abolished these fees for transactions executed under ijarah and mudarabah structures, but many other states do still charge.