shariah compliant ways of investing

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Chapter 20 Islamic funding structures

by Mohammed Amin and Irfan Butt,PricewaterhouseCoopers LLP

INTRODUCTION

[20.1]

This chapter covers the issues that arise when investors in UK real estate want their financialarrangements to be consistent with Shariah (Islamic law). The approach is as follows:

Summarise the basic principles of Shariah which are relevant here, without attempting acomprehensive coverage of Islamic law.

Outline the most common way for Shariah compliant investors to acquire UK real estatebefore the recent changes in UK tax law to facilitate Islamic finance. Practitioners needto be familiar with this structure as it, sometimes with variations, is still regularly used bysome Islamic advisors.

Give a high level summary of how the UK has changed its tax law to facilitate Islamicfinance.

Illustrate some of the structures which are now in use. Explain the UK tax law applicable to sukuk. While no sukuk have been issued by UK

companies at the time of writing, the changes introduced by the Finance Act 2009 (FA2009) have eliminated the impediments to the issue of sukuk to raise finance using UKreal estate as the underlying asset. Accordingly one can expect them to be used infuture, both to finance real estate acquisitions and to raise finance for other purposessecured on real estate.

BASIC INTRODUCTION TO SHARIAH

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Shariah is an Arabic word whose literal meaning is a path to water. In a business context, it can beconcisely described as Islamic law.

The sources of Shariah law[20.3]

Shariah is based upon the Quran (regarded by Muslims as the direct word of God) and the Sunnah(the words and acts of the prophet Muhammad (peace be upon him) as recorded in collections ofsayings known as Hadith. Other sources include ijma (consensus on a matter by jurists), ijtihad(interpretation) and qiyas (legal analogy). Shariah provides a framework for life as a Muslim andgoverns everything that a Muslim does, not just explicit religious activities such as prayers andfasting.

Shariah scholars and their role in Islamic finance[20.4]



Shariah scholars play an important role in Islamic finance as they are qualified to issue fatwas (legalopinions) on financing structures to confirm their compliance with Islamic law. In practice, views maydiffer amongst Shariah scholars. Typically Islamic banks and asset managers will have their ownShariah boards which will issue fatwas for products launched and offered to their clients or investors.

Relevant principles of Shariah[20.5]

The key principles of Shariah relating to business generally are: The requirement for honesty and fair trade. Faults in merchandise should be disclosed and not hidden from the customer. Avoid misrepresentations. One cannot sell something that one does not yet own. Avoid selling prohibited (haram) items.

Major prohibitions affecting financial transactions[20.6]

The major rules in Islam which bear upon financial arrangements are the prohibition of the following: Riba (generally understood to mean any interest). Gharar (excessive complexity or uncertainty in contracts). Maysir (speculation or gambling).

Riba (interest)[20.7]

Under Shariah, money is regarded as simply a means of exchange, and it stipulates that moneycannot be used to make money. That would be unfair exploitation of the borrower (who pays a fixedinterest return to the lender for the use of borrowed money whether the borrowers' business makes aprofit or not).Gharar or uncertainty

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Any agreement which has a significant element of gharar is invalid from a Shariah perspective.

Maysir or gambling

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Shariah encourages Muslims to produce returns through effort, rather than to rely on chance orspeculation. In modern day finance, Shariah scholars would regard most derivatives as prohibitedunder maysir or gharar.

Shariah-compliant business activities[20.10]



In order for investments to be fully Shariah-compliant, in addition to meeting the above key financingprinciples, the underlying assets should be involved in permissible (halal) activities. Any investmentwhere the underlying activity is not halal must be avoided. Prohibited activities will, among others,include the following:

a business carrying out conventional banking transactions involving the payment orreceipt of interest on deposits and loans;

conventional insurance and re-insurance activities; distilling, producing, selling and marketing of alcoholic drinks; gambling, including renting buildings for that purpose to a bookmaker; processing and selling pork; and businesses involved in adult entertainment, night clubs and related activities.

In practice; it may pose difficult but not insurmountable challenges to structure an investment so thatit is Shariah-compliant. For example, in the case of an investment in a retail shopping mall, it is notuncommon to find that some of the shops are engaged in impermissible activities. This would requiresome form of re-structuring to either segregate the non-permissible activities into a separatestructure or for the fund/asset manager to report the amount of income from impure sources toinvestors. The investors can then donate this impure income to charity. In this way, each investorcan deal with the income in the manner that the investor considers appropriate.

THE SHARIAH COMPLIANT REAL ESTATE ACQUISITIONSTRUCTURE COMMONLY USED PRIOR TO SPECIFIC UKLEGISLATION FOR ISLAMIC FINANCE

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Prior to the introduction of the Alternative Finance Arrangements rules in the UK, there was noguidance available from HMRC or specific tax legislation to provide certainty of tax treatment forShariah-compliant transactions. Consequently, most Shariah-compliant property transactions wereeither fully equity funded or took the form of a mixture of internal debt and equity or ijara (explainedbelow) leases. Shariah scholars often permit internal debt (debt between wholly owned entities) oninterest bearing terms, on the grounds that you are incapable of paying interest to yourself; you arejust moving money from one wholly owned entity to another.The fully equity and mixture of internal debt and equity funded structures were simple and did notdiffer from conventional structures. However, in the case of ijara lease structures, the UK taxtreatment of the underlying transactions wholly depended on the interpretation of general taxprinciples due to the innovation in structuring of Shariah-compliant transactions. The structuringcomplexities are the product of the need to align UK legal requirements with Shariah requirements.The use of such structures is now less common. However, certain Shariah-compliant real estatefunds still use this route to structure their UK real estate investments, although it can beadministratively burdensome and operationally expensive. In time the other structures discussedlater in this chapter can be expected to become more prevalent.A typical ijara lease can best be described diagrammatically as follows:Click here to view image

The key point about this structure is that external bank finance is used, with associated interest costs.However the company paying the interest is not owned by the Shariah compliant investor. Everythingthat the investor owns is Shariah compliant.An ijara contract is basically a leasing contract as understood by UK law which is also Shariah



compliant. However Shariah requires the lessor to retain a specified level of risk in the asset before aUK law leasing contract can be accepted as a (Shariah compliant) ijara contract. For example a fullpay out finance lease would fail to qualify as an ijara contract. Certain other provisions commonlyfound in UK lease agreements are also prohibited if the contract is to qualify as an ijara contract. Forexample, the lessee cannot be charged interest on late payments; however, the lessee can becharged a penalty for late payment which the lessor will then donate to charity.Under the ijara lease structure, ProjectCo makes a refundable deposit to FinanceCo which in turnborrows from a conventional bank and acquires real estate. Note that FinanceCo and ProjectCo arenot connected in any way through ownership. This type of structure enables Shariah compliantinvestors to leverage their investment in the real estate as they only provide equity equivalent to theamount of the refundable deposit. The rest of the property purchase price is funded by FinanceCobank borrowing.Following acquisition, FinanceCo grants an ijara lease to ProjectCo in return for rental paymentswhich typically equate to the interest and capital payments under the bank facility owed byFinanceCo. ProjectCo receives rental income from the underlying occupational lease and anybalance left after settlement of its obligations under the ijara lease, other expenses and taxes is thenpaid to the Shariah-compliant investor.Additional legal agreements may also need to be entered into by ProjectCo and FinanceCo totransfer certain obligations to ProjectCo such as the responsibility to maintain, repair and insure theproperty. (To be Shariah compliant, the ijara lease will leave repair obligations with the lessor,FinanceCo, but it is usually regarded as permissible for other side agreements to transfer theseobligations to ProjectCo.) FinanceCo and ProjectCo also enter into put and call options to ensureProjectCo retains the benefit of any increase in the value of real estate through the exercise of thecall option and FinanceCo has a put option to require ProjectCo to purchase the property so that itcan be assured of being able to repay the bank borrowing.In the absence of any specific tax legislation, the tax treatment of the above structure was primarilygoverned by general tax principles, ProjectCo would register under the non-resident landlord scheme(assuming it to be a non-resident company which is the norm) and would obtain a tax deduction forrental payments to FinanceCo as an expense in arriving at the UK property business profits. The UKtransfer pricing rules should not apply as the parties to the ijara transaction are not connected in anyway. As far as the entitlement to capital allowances is concerned, the allowances typically remainwith FinanceCo unless further structuring is undertaken to ensure that the entitlement to claim capitalallowances transfers to ProjectCo. If FinanceCo is only receiving rent from ProjectCo equal toFinanceCo's interest expense (for example if the bank loan is non-amortising) then its net taxableincome would be zero so any capital allowances received by FinanceCo would be wasted.In practice, this structure also creates complex SDLT and VAT issues. It has always beenproblematical to decide whether certain SDLT reliefs would apply to some of the transactions formingpart of an ijara lease arrangement between FinanceCo and ProjectCo. Furthermore, an exit is alsovery complex as a sale to a conventional investor would invariably require pre-sale restructuring toprovide a simple entity to sell. If the structure is not collapsed carefully, unexpected taxconsequences can arise. Also, the use of multiple entities and an external charity or service providermakes this structure more expensive to administer.As indicated above, although this structure is still encountered regularly in practice, it is essentiallyobsolete following the changes made to UK tax law in recent years to facilitate Islamic finance.

OVERVIEW OF THE NEW UK TAX LAW FOR ISLAMIC FINANCE

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The UK is a pioneer among Western countries in adapting its tax system to facilitate Islamic finance.It is helpful to understand the approach the UK has taken, before going on to consider how the newUK tax laws can be applied to real estate transactions.



The UK started adapting its tax law in FA 2003 when it legislated to abolish the double charge toSDLT arising on Shariah compliant mortgage transactions. These typically involved the bankpurchasing all or part of a property and re-selling it to the customer, either immediately or in stages.This meant two occasions of charge to SDLT, whereas a conventional mortgage only involves oneoccasion of charge.However, the most fundamental changes were introduced in 2005, specifically to enable theoperation of Islamic banks in the UK. The reason why tax law changes were needed is most easilyunderstood by considering the following commodity murabaha (purchase and resale) transaction. Thepurpose of this transaction is to allow the Bank to provide 100 of finance to the Customer, for twoyears, to earn a finance charge, in economic terms, of 10.

Example 1Click here to view image

Under UK tax law prior to the reform, Customer was probably not entitled to a tax deduction.Customer has purchased an amount of copper at a price of 110 payable in two years time, and soldthat copper for 100 with the price being payable immediately. Accordingly, Customer has suffered aloss of 10. It was not clear that this loss was tax deductible.Unless Customer could argue under UK tax law that it was trading in copper, it would not be entitledto deduct the 10 loss against its other income. Furthermore, even if Customer was a company thatregularly traded in copper, this transaction does not look like a normal trading transaction sinceCustomer knew that it would suffer a 10 loss when it commenced the transaction.Accordingly, under pre-reform UK tax law, Customer would probably not obtain tax relief for its 10cost, even though in economic terms it is clearly a finance cost. Accordingly legislation was neededto ensure that obtaining finance through commodity murabaha transactions qualified for tax relief.

Strategic design considerations[20.13]

The tax law changes were introduced by FA 2005, with subsequent expansion of the range oftransactions covered in FA 2006 and FA 2007. A review of the legislation enables one to reverseengineer the design considerations that underlie it, in particular the following:

tax law must apply equally to all taxpayers; tax law changes should not impact upon transactions not intended to be covered; legislation should not be longer than is necessary; addressing specific obstacles to Islamic finance.

Tax law should apply equally to all taxpayers[20.14]

Strictly speaking, the UK has not enacted any Islamic finance legislation. A search of FA 2005 willfail to find words such as Islamic, Shariah, murabaha or any other term used specifically in Islamicfinance. The reason is that the tax treatment of a transaction cannot be allowed to depend uponwhether it is Shariah compliant. As well as introducing significant uncertainty into the UK tax system,introducing Shariah considerations would create a situation where all taxpayers were not receivingidentical tax treatment.Instead, the UK identified certain types of transaction widely used in Islamic finance, and ensured



that those types of transaction received appropriate tax treatment. This is illustrated by FA 2005, s 47Alternative finance arrangements: purchase and resale.

Reading s 47, it is clear that it was designed to set out tax rules for murabaha transactions. However,it nowhere uses those terms and nothing in s 47 limits its application to Islamic finance. If atransaction falls within s 47, the tax treatment follows automatically, regardless of whether thetransaction is (or was intended to be) Shariah compliant.The following table sets out the key concepts that have been created in UK tax law, and the Islamicfinance structures that they correspond to.

Tax law Islamic finance

Purchase and resale FA 2005, s 47 Murabaha

Deposit FA 2005, s 49 Mudaraba

Profit share agency FA 2005, s 49A Wakala

Diminishing shared ownership FA 2005, s 47A Diminishing musharaka

Alternative finance investment bond FA 2005, s 48A Sukuk

Tax law changes should not impact upon transactions not intended to becovered[20.15]

Commercial sales of goods often involve a credit period for the customer. It would unduly complicateUK tax law if every sale of goods with deferred payment required identification of the price that wouldhave prevailed if no credit were given, and then giving separate tax treatment for the implied cost ofthe credit. Consider for example a food manufacturer selling hundreds of thousands of tins of food toretailers with 30 days credit allowed for the payment of each sales invoice.FA 2005, s 47 limits its impact by requiring the involvement of a financial institution in subs 47(3).This ensures that only transactions where finance is provided by or to a financial institution fall withinthe new rules. Accordingly, the food manufacturer and its customers should not be impacted by thesenew rules. (One drawback of this approach is that it is currently impossible for two non-financialcompanies to transact Islamic finance with each other and receive the tax treatment given by thenew legislation.)Financial institution is defined in FA 2005, s 46(2):Click here to view image

The definition of a bank is itself quite complex, and the diagram below illustrates what does or doesnot (marked X) qualify as a bank:Click here to view image

Tracing through the definitions establishes that they cover all banks licensed in the EuropeanEconomic Area (provided they have exercised their passporting rights to take deposits in the UK)and also persons licensed to take deposits in other countries, which is the key practical definition of abank. However, many other bodies engaged in financial activities, such as hedge funds, fall outsidethese definitions.

Legislation should not be longer than is necessary[20.16]



FA 2005, s 47 demonstrates how complex it can be to legislate for an apparently straightforwardtransaction. Drafting the new legislation would have been very arduous if it was then necessary tolegislate specifically for all the tax consequences flowing from the transaction structures used inIslamic finance.The legislation avoids this burden by assimilating the tax consequences of Islamic financetransactions into the existing tax legislation. For example, where a company undertakes a murabahatransaction, the tax consequences are governed by FA 2005, s 50(1):(1) Where a company is a party to arrangements falling within section 47, Chapter 2 of Part 4of FA 1996 (loan relationships) has effect in relation to the arrangements as if

(a) the arrangements were a loan relationship to which the company is a party,(b) any amount which is the purchase price for the purposes of section 47(1)(b) were the

amount of a loan made (as the case requires) to the company by, or by the companyto, the other party to the arrangements, and

(c) alternative finance return payable to or by the company under the arrangements wereinterest payable under that loan relationship.

FA 1996 which governs loan relationships contains a very extensive and complex set of provisionswhich apply to companies engaging in the lending or borrowing of money and paying interest or otherfinance costs. FA 2005, s 50 (1) is not saying that s 47 involves the making of a loan; instead it taxesthe company as if a loan had been made and as if the alternative finance return (the profit or lossunder the murabaha transaction) were interest.Addressing specific obstacles to Islamic finance[20.17]

Tax legislation in the UK has grown steadily since income tax became a permanent feature of the taxsystem in 1842, and was of course developed long before Islamic finance was contemplated in theUK. Not surprisingly, it happened to contain specific provisions which would impact upon Islamictransactions, even though the equivalent conventional transaction was not affected. These wereaddressed by specific legislation.For example, the UK has long had a provision in ICTA 1988, s 209(2)(e)(iii) to counter companiesdisguising equity finance in the form of debt, in order to obtain tax relief for payments that areeconomically equivalent to dividends to risk bearing shareholders:(2) In the Corporation Tax Acts "distribution", in relation to any company, means

(e) any interest or other distribution out of assets of the company in respect of securities ofthe company (except so much, if any, of any such distribution as represents theprincipal thereby secured and except so much of any distribution as falls withinparagraph (d) above), where the securities are (iii) securities under which the consideration given by the company for the use ofthe principal secured is to any extent dependent on the results of the company'sbusiness or any part of it.

This provision would preclude Islamic banks offering investment accounts to their customers, sincethe profit share paid to the customer would be treated as a distribution. This means that the paymentwould not be tax deductible for the bank.This problem is addressed specifically by FA 2005, s 54:Profit share return [defined in FA 2005 section 49 in a form that corresponds to profit sharereturn on investment account deposits of Islamic banks] is not to be treated by virtue of section209(2)(e)(iii) of ICTA as being a distribution for the purposes of the Corporation Tax Acts.



BASIC METHODS OF ISLAMIC FINANCE FOR REAL ESTATERELATED TRANSACTIONS

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The most common forms of real estate Islamic financing methods used within the Islamic financeindustry are:

Murabaha[20.19]

Murabaha is a financing technique which is typically used to provide acquisition finance. The providerof finance, which is typically an Islamic bank, buys an asset from a supplier and sells it on to itscustomer at a disclosed premium. The customer pays the bank the purchase price either ininstalments over an agreed period of time or as a single bullet payment on a fixed future date. Theamount of premium is generally set by the bank by reference to market interest rates, as there is nocomparable Shariah compliant benchmark. The fact that the premium or mark up is beingbenchmarked against prevailing interest rates should not lead to the financing arrangement beingregarded as non-Shariah compliant.A diagrammatic description of a murabaha structure is shown overleaf.Click here to view image

A murabaha financing can be arranged for acquisitions of a variety of assets, including real estate.The premium is fixed at the point when the bank sells the asset to the customer. For example, thebank may purchase a building for 100,000 and sell it to the customer for a price of 206,767.40payable over 25 years in 300 fixed monthly instalments of 689.22. Mathematically, this is equivalentto the bank lending money for 25 years at a fixed rate of interest of 7% per annum, compoundedmonthly. As banks usually fund their activities by taking floating rate deposits, such a contract wouldcreate considerable interest rate risk for the bank unless it can hedge the risk.FA 2005, s 47 should apply to this transaction. Accordingly, the customer would treat each monthlypayment as comprising part capital and part alternative finance return, deductible against the rentalincome if the building is let.

Mudharabah[20.20]

Mudharabah is a type of partnership contract between two parties where one party, ie the provider offinance (rab al mal), provides capital while the other party (the mudarib) which is typically a bank inthis context provides expertise, knowledge and manages the partnership. The profits are shared asper the agreed profit sharing ratio but in the event of a loss, Shariah requires that the rab al mal fullyabsorbs the loss. This form of arrangement is very common in Islamic banking as Islamic banksusually use mudharabah contracts with customers who deposit their money in the bank in theexpectation of a return. The bank may utilise the funds at its disposal and enter into a mudharabahcontract with customers to whom it provides finance by providing the required capital (acting itself asa rab al mal) for a project in the expectation of a return. This is sometimes known as a two tiermudharabah since there are two mudharabah contracts interposed between the underlying projectand the person providing funds to the bank.Although mudharabah is most commonly used in the Islamic banking sector, its use is not limited tobanks. In practice, it can be used for the management of assets such as real estate by an asset



manager and also for the provision of expertise to a venture by a person in return for a fee and aprofit share.A mudharabah arrangement is shown below:Click here to view image

However, the special tax rules in FA 2005, s 49 apply only where funds are provided to a financialinstitution. Other mudharabah contracts, whether they entail a bank providing finance to a customeror two parties neither of whom is a financial institution, must be analysed from first principles. In mostcases they are likely to constitute a partnership for UK tax purposes.

Musharaka

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This is similar to a conventional partnership or joint venture. Under a musharaka contract, bothparties provide capital, and profits are shared according to a pre-agreed profit share ratio whereasShariah requires that any losses are shared according to the amount of capital contributed by eachpartner. Musharaka contracts are often used in long-term investment projects, property developmentand investment activities and the partnership continues until the project is finished. Each partnerleaves its share in the capital in the business until the end of the project.A diagram of a musharaka arrangement is shown below:Click here to view image

Diminishing musharaka[20.22]

Diminishing musharaka is a popular tool for banks particularly in the property sector. This methodinvolves a slight variation of the musharaka method in that the joint ownership of an asset or projectis divided into slices to be transferred for a fixed price during a fixed period of time from the bank tothe eventual owner. However, the eventual owner has the full right of occupation. Since the eventualowner does not own part of the property occupied (because it is owned by the bank) it pays rent tothe bank on that part. This type of arrangement is most commonly used in the UK forShariah-compliant mortgages for residential properties. The rent can be reset regularly based onprevailing interest rates. Accordingly, in economic terms this is equivalent to a floating rate lendingtransaction, in comparison to the fixed rate murabaha transaction.A diagrammatic description of a diminishing musharaka arrangement is shown below:Click here to view image

Ijara[20.23]

As discussed above ijara is a form of leasing. In practice, ijara is similar to a conventional leasewhere a lessor (typically an Islamic bank) purchases an asset and then leases it to a lessee for aspecific rental income. The bank retains the legal title to the asset during the term of the ijaracontract, whereas the lessee has the use of the asset during that term. In the case of a simple ijaracontract, the lessee returns the asset to the bank at the end of the ijara contract.In practice, most ijara contracts provide for a formal purchase feature whereby the lessee promisesto buy the asset at the end of the ijara contract period at a pre-agreed price. Often, the final purchaseprice is a token sum. This type of ijara contract is called as ijara-wa-iktana.



Ijara contracts are a familiar feature of Shariah-compliant real estate transactions. However, inpractice, the use of ijara contracts to provide asset finance is not limited to real estate and with theexception of certain consumables, (eg money, food or fuel) such contracts are used commonly for alltypes of permissible asset finance transactions.No special tax law was required for ijara transactions as the main UK tax rules for leasing ofequipment or real estate are applicable.A diagrammatic description of a typical ijara contract arrangement is shown below:Click here to view image

Istisna

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Istisna is a form of project or contract finance which takes the form of the sale of an asset before itcomes into existence. This type of financing arrangement is specifically permitted under Shariahdespite the fact that at the time the parties enter into the agreement, the contract lacks one of thethree main elements (contracting parties, subject-matter and offer and acceptance) of a validcontract under Shariah, ie non-existence of the subject-matter. The use of istisna is most prevalent inthe manufacturing, processing and construction sectors. In practice, on delivery of the finished asset,an Islamic bank may sell the asset back to its client under a murabaha or ijara contract, or enter intoa parallel istisna and sell the asset to a third party purchaser at a premium, which could in fact beunder a murabaha or enter into an ijara structure. Under an istisna contract, payments may be madein a lump sum in advance or progressively in accordance with the development phase. The deliverydate and price is agreed at the outset with the final settlement takes place on delivery of thecompleted product.A simple diagrammatic description of istisna and parallel istisna is as shown overleaf.Click here to view image

Sukuk[20.25]

Islamic bonds are known as sukuk (the plural term of sakk which means certificate). Sukuk areinvestment certificates linked to underlying assets and which represent an undivided ownershipinterest in those assets. The investment returns on sukuk are based on the performance of theunderlying assets and each holder is entitled to a proportionate share of the profit or loss generatedby the underlying asset.In practice, sukuk may take different forms depending on the nature of the contract under which theasset is used to generate income. For example, if the asset is rented out under an ijara contract, onewould refer to an ijara sukuk. Sukuk are usually issued by a special purpose company (SPV). TheSPV is typically established by the originator (ie the entity looking to raise funds). Depending on thenature of the underlying asset or project, the originator will sell the asset or enter into a mudharabahor musharaka arrangement with the issuer (the SPV). The SPV will hold the underlying asset in trustfor the benefit of the sukuk holders. The SPV is typically bankruptcy remote which means that in theevent of bankruptcy of the issuer, the creditors of the issuer cannot have any claim over the assetsheld in the SPV.A simple diagrammatic description of an ijara sukuk structure is as shown opposite.Click here to view image

APPLICATION OF UK TAX RULES TO SHARIAH-COMPLIANT REAL



ESTATE ACQUISITION STRUCTURES

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As a result of the UK tax law changes introduced in FA 2005 and subsequent Finance Acts, many ofthe preferred Shariah compliant structures discussed above can now be used for UK real estatetransactions. Note that a Shariah compliant estate acquisition does not simply involve looking at theyield and credit rating of the tenant. The due diligence exercise would need to look at the activitiescarried on at the premises by the tenant to ascertain whether it is carrying on prohibited activities,before a decision is made to progress to the legal due diligence stage. In addition, some form ofpost-acquisition re-structuring exercise may also be needed to segregate certain segments of theinvestments into prohibited and non-prohibited income streams.

Property MurabahaDirect tax treatment of murabaha transactions

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The use of a murabaha structure is the simplest way of financing and acquiring real estate. Thestructure involves a bank (financial institution) acquiring the property and then selling it on to aShariah-compliant investor on a cost plus basis.Click here to view image

Example 2For example, if a property was available for purchase at 100, as a first step, the Shariah-compliantinvestor will set up an acquisition company (usually non-UK resident) and inject an appropriateamount of equity into the Acquisition Company eg 30. The bank buys the property at 100, pays anySDLT arising on the acquisition and then sells the property to Acquisition Company for 115 on thesame day under a murabaha arrangement. Given that the total cost of acquiring the property to thebank is 104 (100 plus 4 SDLT), the profit to the bank (corresponding to its financing income)under the murabaha arrangement over the financing period would be 11. On sale of the property toAcquisition Company, it would use the cash at its disposal of say 30 (equity injection) and wouldrecognise a liability of 85 payable over the period of the murabaha arrangement.

In order for the above transaction to fall within the alternative finance arrangement rules contained inFA 2005, s 47 the following requirements must be satisfied:

a person (X) purchases an asset and sells it either immediately or, in the case of afinancial institution, it purchases the asset for the purpose of entering into thearrangement with another person (Y);

the amount payable by Y for the asset is greater than the amount paid by X; all or part of the price is required to be paid until a date later than that of the sale; and the difference in the sale price and the purchase price equates in substance to the return

on an investment of money at interest.In addition, it also important that the murabaha financing arrangement is at arm's length otherwisethe borrower will not be entitled to any tax deduction in respect of the deemed interest: FA 2005, s52.

It is imperative that one of the parties to the transaction must be a financial institution as definedabove; otherwise the transaction would not fall within the alternative finance arrangements rules.



In the above example, assuming that the Bank satisfies the definition contained in ICTA 1988, s840A, and acquires the real estate for the purpose of entering into the alternative financearrangement (not holding the property as trading stock or currently being occupied by the Bank) andthe other conditions outlined above were satisfied, the transaction should fall within the alternativefinance arrangements rules. This would result in the mark up between the sale price and thepurchase price being treated as interest for the lender as well as the borrower.The deemed interest expense should be tax deductible for the borrower in the normal way against itsUK source rental income. The base cost for capital gains tax purposes would be the purchase priceexcluding the mark up (deemed interest) plus any other incidental costs wholly and exclusivelyincurred by the borrowers for the acquisition of real estate.The inclusion of a murabaha type transaction in the legislation now enables onshore and offshoreinvestors to undertake UK real estate investments in a simpler way than the traditional ijara typestructuring outlined at the beginning of the chapter.For UK tax purposes the periodic payments made under the murabaha arrangements would betreated as payments of interest and partial repayment of the outstanding principal as computed undergenerally accepted accounting practice. This means that the Acquisition Company should obtain atax deduction for the interest expense against its rental income chargeable to UK tax. Subject toarm's length considerations, the Shariah-compliant investor could of course partly inject the requiredfunding into the SPV as internal debt to maximise its tax deductions. Note that the Shariah-compliantinvestor would need to seek approval from the Shariah board on the provision of the required fundingin the form of internal interest bearing loan and equity, as the views of Shariah scholars on internaldebt funding vary.Assuming that the Shariah-compliant investor is non-UK resident, it would be preferable to set up theAcquisition Company offshore to ensure that its UK income tax exposure on the UK source rentalincome is limited to 20% of its net UK rental income. As a non-UK resident investor, (subject to thetransactions in land anti-avoidance rules in ITA 2007, s 752 et seq), a sale the Acquisition Companyshares by the investor or a sale of the property by the Acquisition Company should both be exemptfrom a charge to UK capital gains tax.

SDLT treatment of murabaha transactions

[20.28]

The sale of the property by the bank to the Acquisition Company should not be subject to a charge toSDLT due to the relevant relieving provisions contained in FA 2003, s 73. The SDLT rulesspecifically provide relief for a murabaha type real estate transaction to ensure that there is nodouble charge to SDLT on the sale of real estate at a mark up by a financial institution to a propertyinvestor.

Click here to view image

The relief is available under FA 2003, s 73 provided that the following conditions are satisfied: a person enters into an arrangement with a financial institution; and under that arrangement the financial institution acquires a major interest in land (the

first transaction); it then sells the property to the person (the second transaction); and the person grants the financial institution a legal mortgage over the interest.

As the first transaction is between the Bank and the seller which is not the person disposing of theproperty to the Bank, the first transaction would not be exempt from a charge to SDLT. However, thesecond transaction would be exempt from SDLT provided that the financial institution pays SDLT onthe chargeable consideration (which it does in the first transaction) and that consideration is not lessthan the market value. Note that the legislation provides SDLT relief on the first transaction if the



financial institution acquires the property from same person to whom it sells the property under thearrangement (ie purchase and sell back) or where the property was acquired by another financialinstitution under other arrangements included under FA 2003, s 71A (sale and leaseback) and s 72A(diminishing musharaka).VAT treatment of murabaha transactions

[20.29]

The VAT treatment of Shariah-compliant real estate transactions is set out in HMRC's VATInformation Sheet 11/06. The Information Sheet covers various structures including, but not limitedto, real estate. Assuming that a property transaction qualifies as a transfer of a going concern(TOGC) for VAT purposes, the onward sale of the property with mark up would involve two suppliesbeing made by the bank to the purchaser ie property and the facility to defer payment. The mark upelement of the transaction will be treated as consideration for the facility to defer payment and will beexempt under VATA 1994, Sch 9, Group 5, item 3, whereas the property transaction should qualifyas a TOGC.

Obtaining finance by commodity murabaha transactions[20.30]

Instead of buying the property and reselling it, the bank may instead provide finance to the customerby engaging in commodity murabaha transactions as outlined above.

Direct tax treatment of commodity murabaha transactions

[20.31]

The use of commodity murabaha has gone through significant growth in recent years. As with themurabaha property financing method, the provider of finance does not need to be an Islamic financialinstitution; most conventional banks are able to provide finance through commodity murabahatransactions.

The use of commodity murabaha as a financing method has received a lot of attention from Shariahscholars recently. Views differ among scholars on its use due to the back to back nature of thetransaction, albeit the transactions do involve a real underlying asset. This financing arrangement ismore attractive and flexible than murabaha financing as it typically gives the bank a floating rateasset rather than a fixed rate asset by regularly rolling over the commodity contracts.Click here to view image

Under a commodity murabaha, a bank will buy a commodity (eg copper) at spot price from a traderand sell it on to its customer at a mark up under a murabaha. The customer will take the delivery andsell the commodity to another trader at spot price. In practice, both transactions will typically takeplace on the same day, normally within minutes of each other, and neither the bank nor the customershould not be exposed to any price risk. The term of the transaction is usually relatively short, egthree months, with the transactions being rolled over at prevailing benchmark interest rates under acommodity murabaha facility agreement that may have a tenor of several years.For UK tax purposes, the difference between the spot price and the cost plus price is treated asinterest provided that certain conditions in relation to the commodity murabaha arrangements asoutlined in FA 2005, s 47 are met. Note that without the introduction of the alternative financearrangements legislation in FA 2005, it would not have been possible for the Acquisition Company toclaim a tax deduction for the financing costs equivalent to the amount of mark up.The above arrangement falls within the provisions of FA 2005, s 47 as one of the parties to thearrangements is a financial institution, and the bank re-sells the commodity as soon as it buys it.Assuming that the other condition regarding the difference in the sale and purchase prices equating



in substance to the return on an investment of money at interest is also met, the borrower, ieAcquisition Company should be entitled to fully deduct the deemed interest cost over the term of thearrangement.

SDLT treatment of commodity murabaha transactions

[20.32]

The acquisition of property from the third party vendor will be subject to SDLT at the appropriate rate,as with any other property acquisition. The commodity transactions themselves have no SDLTconsequences.

VAT treatment of commodity murabaha transactions

[20.33]

Assuming that the property is tenanted and the vendor has opted to tax, the transfer of the propertyshould be treated as a TOGC for VAT purposes and hence outside the scope of VAT.As far as the commodity transactions are concerned, the VAT treatment commodities as set out inNotice 701/9 Derivatives and Terminal Markets will apply. The profit element arising to the bank onthe commodity murabaha transactions will be treated as consideration for the facility to deferpayment and will be exempt under VATA 1994, Sch 9, Group 5, item 3.The VAT treatment of the underlying commodities will depend on their nature. If the transactionshappen to be subject to VAT but take place in the same VAT return period, this should not give riseany cash flow issue as VAT input and VAT output will amount to the same amount. However, inpractice this is not likely to be feasible as typically there will be a series of commodity transactionsbeing rolled over. Instead, the parties normally ensure that the commodities are not subject to VATdue to being stored in a bonded warehouse.

Diminishing Musharaka[20.34]

As explained above, diminishing musharaka is preferred to murabaha as a form of property financingsince it gives the bank a floating rate asset instead of a fixed rate asset.

Direct tax treatment of diminishing musharaka transactions

[20.35]

Diminishing musharaka transactions are typically undertaken by individuals to purchase residentialproperties. However, it is also possible to acquire commercial properties through the diminishingmusharaka financing method. In practice, there is some evidence of property investors undertakingproperty investment transactions through a diminishing musharaka type of funding, but they are lesscommon than with residential properties.Click here to view image

A diminishing musharaka arrangement will fall within the alternative finance arrangements providedthat it satisfies the following requirements included under FA 2003, s 47A:

a financial institution acquires a beneficial interest in an asset, and another person (the eventual owner) also acquires a beneficial interest in the asset; and the eventual owner makes payments to the financial institution equal in aggregate to the

consideration paid for the acquisition of its beneficial interest; and



the eventual owner is to acquire the financial institution's beneficial interest (whether ornot in stages) as a result of those payments, and

the eventual owner makes other payment to the financial institution under a lease orotherwise for the use of the asset; and

the eventual owner has the exclusive right to occupy or use of the asset; and the eventual owner is entitled to any income, profit or gain arising from the asset.

It is interesting to note that the legislation permits only the eventual owner to share in any upside inthe value of the asset. However, the financial institution is permitted to share any loss arising fromthe fall in value of the underlying asset.There is no restriction on the eventual owner granting a lease to a person (other than the financialinstitution or person controlled by the financial institution) provided that the grant is not required bythe financial institution or under an arrangement to which the financial institution is a party. Thearrangement is specifically prevented from being treated as a partnership for UK tax purposes.The legislation treats the financing element of the payments, (other than the payments which theeventual owner makes to the financial institution as consideration for the acquisition of its beneficialinterest) as deemed interest and in the case of a person carrying on a property business, subject toarm's length provisions, it should be entitled to claim a tax deduction for the deemed interestexpense against the rental income. As stated above, although this type of financing is most commonin the residential sector, there is no reason why it cannot be undertaken for commercial propertytransactions.

SDLT treatment of diminishing musharaka transactions

[20.36]

The initial acquisition of a property under a diminishing musharaka will be subject to the normalSDLT charge at the appropriate rate. FA 2003, s 72A specifically exempts subsequent transactionsfrom a charge to SDLT whenever the eventual owner increases its interest in the underlying property.In order for the subsequent transactions in the changes in the ownership percentage to be exemptfrom a charge to SDLT, the following conditions must be satisfied:

the financial institution and the person must have a major interest in land as owners incommon (the first transaction);

the financial institution and the person enter into an agreement under which the personhas a right to occupy the property exclusively (the second transaction); and

a further agreement is entered into between the parties under which the person has theright to require the financial institution to transfer to the person in one or a series oftransactions the entire interest (further transaction).

Assuming that the property is acquired from a third party, as stated above, the first transaction willremain subject to SDLT; however, the second transaction will not be subject to any SDLT charge tothe extent that the SDLT charge on the first transaction has been paid. The further transactions willalso be exempt from a charge to SDLT provided that:

conditions relating to the first transaction are satisfied (in this case payment of SDLT);and

at all times between the first transaction and the further transaction(s), the interest isheld by the financial institution and the person as owners in common and the landoccupied by the person.

A simple diagrammatic description of the transactions is as shown below:Click here to view image



VAT treatment of diminishing musharaka transactions

[20.37]

The VAT treatment of a diminishing musharaka transaction will depend on whether the underlyingproperty is a residential or commercial property. Residential property will give rise to an exemptsupply. The treatment of commercial property will depend on its status for VAT purposes.The main supplies under a diminishing musharaka transaction are (i) the gradual sale of theequitable interest and (ii) a lease of property. As such, the VAT treatment of supplies made under thisform of arrangement will follow the normal rules for property transactions.

Ijara lease[20.38]

An ijara lease transaction may take place in the following ways: a person sells real estate to a financial institution and leases back the property from the

financial institution (sale and leaseback transaction) with or without the option for theperson to buy the asset back at the end of the lease term; or

a financial institution buys real estate and leases it to a person with or without the optionfor the person to buy the asset at the end of the lease term.

Direct tax treatment of ijara lease transactions[20.39]

There are no specific tax rules dealing in the alternative finance arrangements rules to deal withdirect tax aspects of ijara type transactions. The general tax rules will be followed to determine thedisposal of asset for capital gains tax purposes and likewise deductibility of rental payments under anijara lease.SDLT treatment of ijara lease transactions[20.40]

An ijara based sale and leaseback transaction can best be explained diagrammatically as follows:Click here to view image

FA 2003, s 71A provides specific relief from SDLT provided that the arrangement complies with thefollowing conditions:

the financial institution purchases a major interest in land or an undivided share of amajor interest in land (the first transaction) here from the customer;

where the interest purchased is an undivided share, the major interest is held in trust forthe financial institution and the customer as beneficial tenants in common;

the financial institution grants a lease to the customer (the second transaction); and the financial institution and the customer enter into an agreement under which the

customer has a right to require the financial institution to transfer to the customer in oneor a series of transactions the whole interest under the first transaction (the furthertransaction).

The first transaction is exempt from SDLT if the seller is the customer as in the above example. Thesecond transaction relating to the grant of a lease is also exempt from SDLT. The further transaction



is also exempt from SDLT provided that: the requirements of the first and second transactions are complied with; and at all times between the second transaction and the further transaction the interest

purchased by the financial institution is held by the financial institution so far as nottransferred by a previous further transaction; and

the lease or sub-lease granted under the second transaction is held by the customer.Note that the provisions of FA 2003, s 71A do not apply to land in Scotland which is covered by FA2003, s 72A which provides the same SDLT treatment.

VAT Treatment of ijara lease transactions[20.41]

The VAT treatment of an ijara lease transaction where the title to the asset is not expected to pass tothe customer to buy the property back at the end of the lease term will follow the normal rules forproperty outlined in Notice 708 Buildings and construction, Notice 742 Land and Property and Notice742A Opting to tax land and buildings.Where the title of the property is expected to pass to the customer at the end of the lease term, thenormal rules for property will apply for the sale of the property as set out in Notice 708 Buildings andconstruction, Notice 742 Land and Property and Notice 742A Opting to tax land buildings. Anyadditional charge payable above the price of the property will be treated as consideration for adeferred payment facility and thus exempt under VATA 1994, Sch 9, Group 5, item 3.

Sukuk[20.42]

As mentioned above sukuk are the Islamic equivalent of bonds. Until the global financial crisis thisasset class was growing very rapidly. Sukuk issuance fell in 2008 but as capital markets have startedto unfreeze, there has been an increase in sukuk issues.

Direct tax treatment of sukuk

[20.43]

FA 2003, s 48A sets out the rules for alternative finance investment bonds (AFIBs) which correspondto sukuk. The provisions were introduced in FA 2007 and treat AFIBs as equivalent to debt securitiesfor UK tax purposes. Any profit return derived from the underlying asset and payable to AFIB holdersis treated as deemed interest and should be tax deductible against the income of the AFIB issuingentity.Click here to view image

In order for a particular sukuk issuance to fall within the AFIB rules contained in FA 2003, s 48A, thefollowing requirements must be met:

a bond-holder pays a sum of money to a bond issuer; the arrangement identifies assets, or class of assets (the bond assets) which the

bond-issuer will acquire for the purpose of directly or indirectly generating income orgain;

the arrangement specifies a period at the end of which it ceases to have effect (thebond term);

the bond-issuer undertakes to dispose of at the end of the bond term any bond assets



which are still in the issuer's possession and to make a repayment of the capital (theredemption payment) to the bond-holder during or at the end of the bond-term (whetheror not in instalments), and pays to the bond-holder other payments (additionalpayment) during or at the end of the bond term;

the amount of the additional payments does not exceed an amount which would be areasonable commercial return on a loan of the capital;

the bond issuer undertakes to arrange for the management of the bond assets with aview to generating income sufficient to pay the redemption payment and additionalpayments;

the bond-holder is able to transfer the rights under the arrangements to another person; the bonds are a listed security on a recognised stock exchange within the meaning of

ITA 2007, s 1005), and the arrangement is wholly or partly treated in accordance with international accounting

standards as financial liability of the bond-issuer.The legislation does not explicitly define what is meant by a reasonable commercial return on a loanof the capital. In practice, the issuer should consider market returns on debt securities having asimilar duration and credit rating to ensure that the return does not exceed the level of a reasonablecommercial return on a loan of the capital. In addition, payments which equate in substance todiscount are taxed in a similar way to discounts on conventional bonds under FA 2005, s 51A.The bond-issuer can acquire the bond assets before or after the issuance of the sukuk. Given thatfunds are needed for the bond-issuer to acquire the bond-asset, in practice, the acquisition willtypically take place after cash has been raised through the issuance of sukuk. The legislation doesnot limit the bond-assets to any specific asset class. There is also no restriction on the nature of theadditional payments which can be fixed or variable, and can be determined wholly or partly withreference to the value of income arising from the bond-asset or determined on some different basis.In addition, the additional payment may be paid by the issuer or by transfer of shares or othersecurities by the issuer. Therefore it is possible to issue exchangeable or convertible AFIBs.It should be noted that the legislation specifically provides in FA 2005, s 54 an override of theprovisions contained in ICTA 1988, s 209(2)(e)(iii), so that redemption payments and additionalpayments falling within the provisions of FA 2005, s 48A are not treated as distributions which wouldnot be tax deductible.Where the above requirements are met, the additional payments payable by the issuer to thebond-holders are treated as alternative finance returns: FA 2005, s 48B. For UK tax purposes, thebond-holder is:

not treated as having an interest in the bond-assets even though it may have anundivided interest in the bond-asset from a Shariah or UK legal perspective; and

any income arising to the issuer will belong solely to the issuer and no bond-holder isentitled to claim capital allowances in respect of the bond-asset other than the issuer.

AFIBs are treated as a qualifying corporate bond (QCB) within the provisions of TCGA1992, s 117 if: the capital is expressed in sterling; the arrangements do not include provision for the redemption payment to be in

a currency other than sterling; the right to the redemption payment cannot be converted directly or indirectly

into an entitlement of securities apart from other arrangements falling within FA2007, s 48A; and

the additional payments are not determined wholly or partly by reference to thevalue of the bond assets.



No withholding tax should arise on the alternative finance return payments if the AFIBs are listed ona stock exchange which is recognised for all tax purposes under ITA 2007, s 1005 as the AFIBsshould then qualify as eurobonds under ITA 2007, s 882. However, there is a trap to be avoided. FA2005, s 48A(3) enables a stock exchange to be designated solely for the purposes of FA 2005, s 48A,and some exchanges have been so designated. AFIBs listed only on such exchanges will not qualifyas eurobonds, and withholding tax would be due on additional payments if the issuer is UK resident.There are specific provisions in FA 2005, s 48B which ensure that the arrangements are not treatedas a unit trust scheme for TCGA 1992 purposes, or a unit trust scheme for income tax purposes or anoffshore fund for purposes of the offshore fund rules or a relevant holding for the purposes of FA1996, Sch 10 (loan relationships collective investment schemes).On a disposal of AFIBs, any gains will generally be taxed under the loan relationships rules forcorporate holders. They will be exempt from capital gains tax for non-corporate holders provided thatthey meet the above requirements to be treated as QCBs which are outside the scope of a charge tocapital gains tax.

SDLT treatment of AFIBs

[20.44]

For transfers executed on or after 21 July 2008, AFIBs may fall within the meaning of loan capitalexemption from stamp duty. The relevant legislation is included under FA 2008, s 154 which treatsAFIBs as loan capital and returns thereon as interest, for the purposes of the loan capital exemption.In addition, for instruments executed on or after 21 July 2008, the loan capital exemption is notdenied solely because interest on the bond is dependent on the results ie the interest ceases orreduces only if (or to the extent that) the issuer, after meeting, or providing for, other obligationsspecified in the capital market arrangement concerned, has insufficient funds available from thatcapital market arrangement to pay all or part of the interest: FA 2008, s 101.

VAT treatment of sukuk

[20.45]

There are no special VAT rules for sukuk related transactions and the VAT treatment of costsassociated with the issuance should follow the normal VAT rules.

CHANGES TO AFIB RULES FOR PROPERTY RELATED SALE ANDLEASEBACK TRANSACTIONS FA 2009

[20.46]

Although the AFIB rules were enacted by FA 2007, no UK issues took place as the legislation in FA2005, s 48A did not address the tax treatment of transactions in the underlying asset. For example,the sale of UK real estate to a sukuk issuing SPV and its later repurchase would entail a total SDLTcharge of 8%.

Outline of changes[20.47]

FA 2009 introduced various changes to the AFIB legislation. They cover capital gains tax, capitalallowances and SDLT.A typical diagrammatic description of an ijara sukuk structure is shown below to illustrate the



changes.Click here to view image

Provided certain qualifying conditions are satisfied, any capital gain arising on the transfer of realestate by the Originator (P) with a view to entering into an alternative finance arrangement involvingissuance of AFIBs by an SPV is ignored for capital gains tax purposes. In addition, the transfer of thereal estate does not result in the SPV being treated as having incurred capital expenditure for capitalallowances and, therefore, the capital allowances will continue to be claimed by the originator. Thesale from P to Q and the eventual sale back from Q to P are both exempt from SDLT.SDLT relief is not available if control of the bond asset is acquired by a bond holder or a group ofconnected bond holders. Control arises if bond holders have the right of management and control ofthe bond asset and a single bond holder or a connected group of bond holders acquires sufficientrights to enable it or them to exercise the right of management and control of the bond asset to theexclusion of others. Whether or not a person is connected with another will be determined underICTA 1988, s 839. In view of the listed nature of AFIBs, where ownership can change and be hard toidentify, this requirement can create uncertainty. Unless procedures are put in place to protectagainst the risk of such control being acquired, it could cause the transaction transferring the landfrom P to Q to be subject to SDLT.One way to deal with the above issue would be for the AFIB documentation to limit any managementand control rights under all circumstance to the administrator or trustees of the arrangement.Certain exclusions are provided within the rules to ensure innocent failures are not caught under theprovisions above. The first case is where at the time the rights were acquired by the bond holder (orall of the connected bond holders), they did not know and had no reason to suspect the existence ofthe right to management and control and as soon as reasonably practicable after that event, the bondholder transfers sufficient AFIBs so that management and control is no longer possible. The secondcase is where the bond holder underwrites a public offer of AFIBs and does not exercise themanagement and control right.

Conditions to qualify for these reliefs[20.48]

In order for the transfer of land to be treated as an arrangement falling within the alternative financearrangements involving the issuance of AFIBs, the following conditions contained in FA 2009, Sch61, para 5 must be satisfied:

(A) P transfers a qualifying interest in land to Q (the first transaction) and enters into anagreement with Q to purchase the asset back at the end of the bond term.

(B) Q issues AFIBs and holds the land as a bond asset.(C) Q and P enter into a leaseback agreement.(D) Q before the end of 120 days from the date of Condition A transaction registers a

satisfactory legal charge in favour of HMRC and provides evidence thereof to HMRC.The legal charge: must be a first charge or a security which ranks first; must be imposed on or granted over the interest transferred; and must be equivalent to the SDLT amount which would have been payable at the

time of Condition A plus interest and penalties.(E) The total payments of capital made to Q before termination are not less than 60% of the

value of the land at the time of Condition A. This 60% refers to the amount of moneyraised from investors by issuing AFIBs, not to capital payments made whenre-purchasing the land from Q. It can be thought of as requiring a minimum loan to



value ratio.

(F) Q holds the interest in land as a bond asset until termination of the bond.(G) Q transfers the interest in land to P within 30 days following the interest in land ceasing

to be held as a bond asset and this does not take place later than 10 years afterCondition A having been met (the second transaction).

These conditions should be manageable for P and Q in most cases.

Capital gains tax relief[20.49]

The first transaction, ie the transfer of land by P to Q will not be treated as a chargeable disposal byP nor an acquisition of land by Q for capital gains tax purposes provided that each of conditions A toC is met before the end of the 30-day period from the effective date, ie the date of the transfer ofland by P to Q. If condition C is met by virtue of Q and P having entered into a leaseback agreement,the granting of the lease or sub-lease by Q to P will also not be treated for the purposes of TCGA1992 as an acquisition by P or a disposal by Q of a chargeable asset.Capital gains tax relief is also available if certain other conditions relating to asset substitution arealso met when an interest in land is replaced with another interest in land.Note that no capital gains tax relief is available if:

the interest in land is transferred by Q to P without conditions E (not less than 60%capital payment) and F (bond asset requirement) having been met;

the period mentioned in Condition G expires, or if it becomes apparent that Conditions E to G cannot or will not be met, or Condition D is not met (registration of legal charge in favour of HMRC).

The second transaction will not result in a disposal or acquisition of asset by Q and P if each ofconditions A to C and E to G is met and condition D is also met in the case of UK land. If certainconditions relating to substitution of land are satisfied, relief should also be available for replacementof interest of land with another interest in land.

SDLT relief[20.50]

Relief from SDLT from the first transaction will be available to Q if each of the conditions A to Cabove is met before the end of 30 days of the effective date of the first transaction, no charge toSDLT will arise on the first transaction.The SDLT relief will be withdrawn if:

the interest in land is transferred by Q to P without conditions E and F having been met; the period mentioned in Condition G expires, or if it becomes apparent that Conditions E to G cannot or will not be met, or Condition D is not met.

The SDLT charge will be based on the market value of the land at the time of the first transaction. Inaddition, penalties and interest will also be payable after the end of the 30-day period from theeffective date of the first transaction. Q will also need to deliver a further SDLT return within 30 daysto HMRC and include a self-assessment of the amount chargeable.Relief from SDLT on the second transaction will be available if each of the conditions A to G above is



met and the provisions of FA 2003, Pt 4 relating to the first transaction are also complied with. Qmust provide evidence to HMRC of each of the conditions A to C and E to G being met to ensurethat the land ceases to be subject to SDLT charge.Subject to further conditions being met, SDLT relief should also be available in the case ofreplacement of interest in land with another interest in land.

Capital allowances[20.51]

For capital allowances, Q will not to be regarded as having incurred any capital expenditure forcapital allowances purposes on the acquisition of interest in land nor is to be regarded as becomingthe owner of the asset provided that:

each of the conditions A to C is met before the end of 30 days of the first transaction;and

the asset is the subject matter of the first transaction constituting plant and machinery orindustrial buildings.

For capital allowance purposes, loss or destruction of the asset will be treated as a disposal by P inthe period in which it occurs provided:

the asset is part of the subject matter of the first transaction and constitutes plant andmachinery; and

while the asset is held as a bond asset, the person in possession loses the asset and theloss is permanent or the asset ceases to exist, eg destruction, dismantling or otherwise.

The disposal value for P is as per CAA 2001, s 61(2) if an amount is received by P and in any othercase, the market value at the time of the event.Note that Q is treated as becoming the owner of the asset if the asset is part of the subject matter ofthe first transaction and constitutes plant and machinery or industrial building and Q ceases to holdthe asset as a bond asset (during or after the expiry term) but does not transfer the asset to P. Insuch a case, Q ceasing to hold the asset is treated as a disposal event for P in the period in which ittakes place and for IBAs (Industrial Buildings Allowances) purposes the balancing event takes placein the same chargeable period. The disposal value for P for plant and machinery purposes is themarket value of the asset at the time of the transfer, and for IBAs purposes, P is treated as receiving,as the proceeds of the balancing event, the market value of the asset at the time of the transfer.In the event of Q transferring asset to a third person, the transfer is also treated as a disposal by P inthe chargeable period in which it takes place. The disposal value for P for plant and machinerypurposes is the market value of the asset at the time of the transfer by P to Q, and for IBAspurposes, the market value of the asset at the time of the transfer by P to Q.

Substitution of assets[20.52]

Under the rules, provided that certain additional conditions are satisfied, it is possible for substitutionof assets to take place under an AFIB arrangement without any adverse tax implications.In order for the reliefs to continue to apply to substituted assets, it is important that:

conditions A to G are met in relation to an interest in land; Q ceases to hold the original land as a bond asset (transfers it to P) before the

termination of the arrangement; P and Q enter into a further arrangement relating to another land (replacement land);



the value of the replacement land at the time of transfer is = to the original land at thetime of the first transaction;

condition F does not need to be met provided that A, B, C, F and G are met; condition D will need to be satisfied in relation to the replacement land; if the replacement land is not in the UK the original land ceases to be subject to the

charge; and HMRC notify Land Registry of the discharge and must do so within 30 days from the

date Q provides the evidence.The inclusion of this facility within the legislation is a step in the right direction to ensure for thesubstitution of assets to take place which is a common feature of sukuk.

Anti-avoidance[20.53]

The legislation also introduces an anti-avoidance measure to prevent avoidance of tax. No SDLT andcapital gains tax relief is available if the arrangements not effected for genuine commercial reasonsor form part of arrangements of which of the main purpose, or one of the main purposes, avoidanceof tax. There is no formal advance clearance process available for taxpayers to seek advanceclearance for particular types of transactions from HMRC so that the arrangements fall within theAFIBs rules.

Conclusion[20.54]

The FA 2009 changes mean that the UK now has a workable regime for the issue of sukuk. We mayexpect to see sukuk being issued in future as a means for Shariah compliant investors to leveragetheir investment in real estate.

There should also be scope for conventional real estate investors to leverage by issuing sukuk incertain cases where the underlying property is used for permissible purposes. Until the globalfinancial crisis there was significant investor demand for sukuk, and this source of capital may beexpected to return to the markets as capital markets normalise.

shariah compliant ways of investing

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