23 February 2010
Will Luxembourg become a European hub for Islamic finance? Chokri Bouzidi says new, clearer definitions will help
The Luxembourg tax authorities last month issued a circular clarifying the definition of certain Islamic financing arrangements including Murabaha, Mucharaka, Mudaraba, Ijara, Ijara-wa-iqtina and Istinah as well as the tax treatment of Murabaha and Sukuk.
This is a move to provide greater certainty on the tax treatment of Islamic financial products and should be of interest to investors seeking a European location for Shariah compliant investment.
The circular defines certain concepts, as follows:
- Murabaha: A sale based transaction whereby an investor acquires an asset for resale to a client at a cost-plus profit. This is a financing arrangement where the cost-plus profit margin of the investor is determined in advance and may apply to all types of assets.
- Musharaka: A partnership based transaction whereby investors agree on the terms of the financing and the ratio of the allocation of profits. Losses arising in Musharaka are limited to the capital invested.
- Mudaraba: A profit sharing arrangement where one or more investors provide capital to an entrepreneur. The profits arising in connection with the investment are allocated according to a ratio pre-agreed between parties. Losses are generally borne by the investors.
- Ijara: A lease-based arrangement whereby an investor acquires an asset and grants a client its right of use for a consideration payable over a certain timeframe.
- Ijara-wa-iqtina: An arrangement similar to the Ijara with the possibility for the client to acquire the asset at the term of the contract.
- Istinah: An arrangement which allows a person to finance in advance the manufacturing and delivery of a specific asset by the seller.
Tax treatment of Murabaha
The circular indicates that the Murabaha is treated as a sale transaction. In principle, the profit in connection with the re-sale of assets by the investor to the client is deemed to be realised by the investor for income tax purposes at the date of the Murabaha agreement.
However, the tax authorities indicate that, as the investor’s remuneration is deferred over a period of time, the taxation of such remuneration may also be deferred over the period of the agreement, providing certain conditions are met.
Specifically, the agreement must clearly provide that the investor purchases the relevant asset for immediate re-sale or within a period not exceeding six months. The agreement must distinctly indicate the remuneration payable to the investor in connection with his intermediation services, the remuneration component related to the deferral of the payment of the re-sale price as well as the acquisition cost of the asset and its re-sale price.
The investor’s profit margin must be agreed between parties and also explicitly determined in the agreement. To ensure a coherent tax treatment of the agreement, the profit margin realised by the investor must be reported for commercial accounting and tax purposes over the agreed deferred payment period, regardless of the amounts of the re-sale price/principal amount effectively ‘repaid’ by the client to the investor.
Tax treatment of Sukuk
According to the circular, sukuk is an instrument evidencing a receivable or a profit participating right whose principal amount and the remuneration in connection thereto is based on the economic performance of one or more assets which are allocated by the Sukuk issuer to the servicing of Sukuk. The underlying assets may be tangible assets or the right to use of such assets.
The remuneration payable in connection with Sukuk is variable as it is generally determined on the basis of the performance of the underlying assets or the profit results of the issuer. However, it is generally benchmarked on the conventional rates (such as Euribor or Libor) plus a margin.
The repayment of the principal of sukuk is generally deferred over a period of time but may take place at an agreed date. The repayment of sukuk may be contingent to the realisation value of certain assets, therefore, the holders of an asset-based sukuk are exposed to a credit risk if the underlying assets drops in value or are realised at a price below the principal of sukuk.
The circular provides that Sukuk is treated for income tax purposes as conventional financing instruments such as bonds, regardless of whether or not the remuneration payable to sukuk holders is dependent on the performance of underlying assets. Such remuneration is taxable as interest.
Therefore, for the issuer, sukuk remuneration is deductible for income tax providing it is paid in connection with the issuer’s business enterprise. For resident holders, the remuneration is normally subject to tax either as income from movable capital or as business income. For non-Luxembourg sukuk holders, the remuneration is not subject to any withholding tax.
In view of the nature of the remuneration and the type and tax residence of sukuk holders, sukuk should be outside the scope of the EU Savings Directive.
The circular can be considered as a first step towards clarification of Shariah compliant financial instruments and should enhance Luxembourg as a key European hub for investments of this type.
While Luxembourg has already reinforced its ties with Islamic countries through tax treaties with Bahrain, Kuwait, Qatar and the United Arab Emirates and taking membership in certain reputable Islamic boards, this is a step which may well be followed by others.
However, it is to note that such circular is evidently not sufficient to lift all the legal, accounting and tax uncertainties that may surround such instruments.
Chokri Bouzidi is a principal at Oostvogels Pfister Feyten