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Legislative and regulatory framework

i Legislative and regulatory regime

Islamic finance has been developing rapidly in the UK for over a decade and the government has taken a leading role in legislating for its development and promotion. The UK hosted the first stand-alone Islamic financial institution in the EU and, according to the latest Islamic Finance Country Index (2018), the UK is ranked 17th of 48 countries in terms of its overall Islamic finance offering. This puts it in first place in Europe and in first place among non-Muslim-majority nations. The UK has a strong and proud tradition of openness and flexibility, which, combined with London's position as a leading international financial centre and the UK's significant Muslim population (just over 5 per cent of the UK population according to the 2011 census), provides a strong foundation for growth. As a result of its standing, London has long been perceived as the Western hub for Islamic finance.

Rather than regulating Islamic finance products with separate legislation, the UK's approach has been to adapt pre-existing legislation and regulations governing conventional financial instruments to cater for the structures commonly used in Islamic finance. In so doing, the UK's approach has 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, as early as 2003, the government introduced special exemptions to stamp duty land tax to relieve the unintended double taxation charge that arose as a result of structures used by Islamic mortgages and was also quick to remedy the adverse tax treatment of sukuk to place them on a level playing field with conventional debt instruments. This approach leaves the application of Islamic principles as a matter of conscience for the parties concerned, reflecting both the lack of a single codified body of Islamic law and the fact that there are differences of opinion among scholars as to how Islamic principles should be applied to modern-day financial instruments. As discussed in more detail below, the English courts have taken an approach consistent with this in considering only English law (to the extent that this is the governing law of the relevant contracts) when ruling on disputes involving Islamic finance transactions.

The primary legislation that governs Islamic finance in the UK is set out in the Finance Act 2005 as amended by the Finance Act 2007. The Finance Act 2005 characterises Islamic finance transactions as 'alternative finance arrangements' and takes a relatively straightforward approach to folding Islamic finance instruments into the conventional legislative environment. For example, anything described in an Islamic finance instrument as 'profit' will be treated in the same manner as the provisions of previous Finance Acts that deal with 'interest'; this is particularly important when considering the tax treatment of Islamic finance instruments. Further, given that the Finance Act 2005 was generally aimed at bank financing with a specific focus on consumer financing, particularly Islamic mortgages, the Finance Act 2007 expanded the scope of the Finance Act 2005 to include sukuk (defined as alternative finance investment bonds (Section 53, Finance Act 2007)) with the intention to pave the way for the inaugural sukuk issuance by the UK government (discussed in more detail below) by responding to the anomaly created by previously not providing for tax deductibility of profit distributions under a sukuk, making it a more expensive way to raise finance when compared to a conventional bond with tax-deductible interest payments.

Prior to the introduction of the Finance Act 2007, an issue that arose in connection with a potential sukuk issuance by a UK issuer was whether, for the purposes of the Financial Services and Markets Act 2000 (FSMA), a sukuk would be considered to be the equivalent of a conventional bond or of a collective investment scheme (CIS). The issue arose because sukuk contemplate the investment by the issuer of the issue proceeds received from sukuk holders in certain assets – these are all features of a CIS. Market practitioners had long taken the view that a sukuk should be treated in the same manner as a conventional bond (with the investment in the assets being in satisfaction of shariah (not investor) requirements), but for such treatment to be given in the UK, an assessment would have to be made by the regulator in respect of each individual case – this was clearly not a practical solution. The Financial Services and Markets Act 2000 (Regulated Activities) (Amendment) Order 2010 (the 2010 Order) introduced a number of amendments to clear up this issue and to confirm that sukuk should be regulated in the same manner as conventional bonds. The 2010 Order amended the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 to specifically state that alternative finance investment bonds are to be categorised as 'specified investments' in the same manner as financial instruments that create or acknowledge indebtedness. The 2010 Order also amended the Schedule to the Financial Services and Markets Act 2000 (Collective Investment Schemes) Order 2001 to specifically exclude alternative finance investment bonds from the definition of CIS and introduced a new Section 77A, which created a definition of alternative finance investment bonds. This definition is consistent with that set out in the Finance Act 2007.

Notably, the 2010 Order made a number of consequential amendments to other legislation and regulations, including the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001, the Financial Services and Markets Act 2000 (Carrying on Regulated Activities by Way of Business) Order 2001 and the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005. These amendments extend the scope of those regulations to include alternative finance investment bonds. The amendments illustrate a consistent approach taken by successive UK governments in treating Islamic finance as a subset of the universe of conventional financial instruments. This approach indicates that the Islamic finance industry will be held to the same standards as the conventional finance industry in the UK and contracting parties should expect to be subject to the same levels of scrutiny from the English regulators and courts as their conventional peers.

ii Regulatory and supervisory authorities

The two principal authorities charged with the oversight of Islamic finance institutions (to the extent that such institutions perform 'regulated activities') are the Financial Conduct Authority (FCA) and the Prudential Regulatory Authority (PRA). The FCA is the conduct regulator with supervisory responsibility for Islamic finance in the UK, and all Islamic banks in the UK are required to be authorised and licensed by the FCA. The PRA holds responsibility for the prudential regulation of banks, building societies, credit unions, insurers and major investment firms – including Islamic banks in the UK. The FCA and the PRA each hold Islamic banks and financial institutions to the same standards of regulation as conventional banks, and Islamic banks in the UK are considered to be 'financial institutions' for the purposes of the FSMA. Islamic banks are subject to sanctions and fines in the same manner as conventional banks. The FCA's and the PRA's approach to regulation can be summed up as 'no obstacles, but no special favours'.

Unlike certain other regulatory authorities, such as Malaysia's, the FCA does not have shariah scholars who review the shariah compliance of a product offered by an Islamic finance institution. Consistent with the UK approach of treating Islamic finance institutions in the same way as conventional firms, the Islamic finance institution would require authorisation to carry on regulated activities and obtain the necessary permissions from the FCA in the ordinary way. However, an Islamic finance institution may have to provide additional information to the FCA in certain circumstances, such as the role, if any, that its shariah board performs in relation to operational and financial matters. In addition, UK regulatory bodies have stated that they intend to work with international industry bodies, such as the International Organization of Securities Commissions, which have their own Islamic finance initiatives. The UK's Financial Services Authority (which was the sole UK regulator prior to its split into the FCA and the PRA) also supported moves to develop common shariah standards by organisations such as the Islamic Financial Services Board and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). While neither of these standards have been formally adopted in the UK (and therefore do not have any binding legal effect), they are certainly useful in identifying best practice.

Finally, it is worth noting that financial transactions entered into with an individual and not otherwise subject to regulation under FSMA may be subject to regulation under the Consumer Credit Act (CCA) 1974, unless that agreement is entered into wholly or predominantly for business purposes, or one of the other exemptions under the CCA 2006 applies.