Following recent adjustments to real estate valuations and exchange rate fluctuations, Middle Eastern investors have shown an increasing appetite for investment in European real estate, with a particular emphasis on the United Kingdom. Asset management industry players, both onshore and offshore, frequently visit the Middle East to raise funds for investment in the UK. This quarter we discuss the tax treatment of investments in UK property through Ijara structures and the benefits from the new double taxation treaty entered into between the UK and Saudi Arabia (the Treaty) on Saudi Arabian backed UK real estate investments.

The Treaty

The Treaty was signed on 31 October 2007. The Treaty came into effect on 1 January 2010 in Saudi Arabia and on 1 January 2009 in the UK. Of particular interest to the Saudi Arabian financial community is that the treaty will come into effect in the UK for the purpose of corporation tax on 1 April 2010 and for income tax and capital gains tax on 6 April 2010.

UK real estate tax structuring

The main UK taxes which need to be considered when investing in UK land and buildings are as follows:

  • tax on rent;
  • UK withholding tax on interest (or deemed interest) on any borrowings; and
  • Stamp Duty Land Tax (SDLT).

Until 2003 it was generally inefficient to use Islamic finance to acquire real property in the UK, mainly due to the multiple charges to SDLT. However, the gradual introduction of tax relieving provisions aimed at typical Islamic financing techniques has removed most of the obstacles and, with careful planning, there should be no UK tax reason why such finance (either on Ijara-based structure or a Murabahah) should not be used. The Treaty makes further inroads in levelling the playing field with conventional finance, particularly in relation to withholding taxes on Ijara-based financings.

For the purpose of UK taxation legislation, and for the purpose of this note, “deemed interest” refers to profit and other charges and payments which, when levied in relation to an Islamic finance transaction, have the same or similar economic effect to interest payments under conventional finance.

Ijara based structures

UK tax legislation now contains two sets of provisions which provide tax relief for Ijara-based transactions.

First, relief is available from multiple SDLT charges. Providing that certain qualifying criteria are met, a single SDLT charge will be levied on the acquisition from the financing bank, and relief will be granted from other SDLT charges which would have arisen as the Ijara transaction is completed. As long as the entity providing finance is a bank or a wholly owned subsidiary of a bank, it is relatively straightforward to satisfy the tests which qualify a purchaser for this relief.

Secondly, relief is available from withholding tax charges on interest (or deemed interest) in some circumstances. The starting position is that there will be a withholding tax charge on UK source interest (actual or deemed interest) unless the lender is (a) a UK Bank or a UK Branch of a non-UK Bank, (b) a UK resident company (a bank or a wholly-owned subsidiary thereof), or (c) resident in a jurisdiction which has a treaty with the UK which provides for no withholding tax. The treaty route will only be effective for deemed interest payments, if there is a specific provision in the relevant treaty. Importantly, the Treaty with Saudi Arabia is clear on this point. As a result, there is potentially no withholding tax on deemed interest payments where the lender is a Saudi Arabian based financial institution.

In summary, an Ijara-based structure as referred to above will normally qualify for the SDLT exemption and it will, from April 2010, also mean that there are no UK withholding taxes on deemed interest payments provided that the lender is a financial institution which is resident in Saudi Arabia.

Commodity Murabahah

It has to be said that many scholars are of the opinion that the use of commodity Murabahah to finance land acquisitions is not generally acceptable from a Shari’ah point of view. However, where there are good commercial reasons for such a structure, including the fact that tax would make the more acceptable alternatives prohibitively expensive, it is now relatively common for such financing methods to be approved. Certainly, a number of UK mainstream banks are providing property finance by way of commodity Murabahah.

While we have not examined commodity Murabahah structures in detail in this briefing, if chosen, such structures are SDLT efficient and can now also enjoy relief from withholding taxes if structured carefully.