Islamic Finance: From Niche to Mainstream

Islamic finance is based on Islamic principles and jurisprudence (Shariah).

The basic Shariah prohibitions are on the earning (or payment) of interest, speculation, contractual uncertainly and transactions which are overly advantageous to one party at the expense of another.

The Shariah also prohibits any participation in weapons, pork, gambling, pornography and alcohol businesses.

Overcoming most of these prohibitions is very difficult in the conventional finance system.

The Islamic finance industry has thus developed various Shariah-compliant structures in order to provide investment opportunities and to meet the financing needs of businesses and investors who want to comply with the Shariah.

These structures deliver results which are similar to those possible through conventional financing transactions.

Shariah-compliant

Some of the key Islamic financing techniques include Ijara (based on the leasing of an asset), Musharaka (equity investment/profit and loss sharing), Istisna (production/construction financing) and Salam (forward financing).

All of these techniques can be used to achieve the commercial objectives of “traditional” financing methods – but in a Shariah-compliant way.

However, the one Islamic financing vehicle which has been generating all the attention recently is the Sukuk. Sukuks are asset-backed, Shariah-compliant trust certificates.

The closest instrument comparable to them in the conventional financial system would be a bond (notably those issued in relation to a securitisation). However, a traditional bond generates interest and is therefore prohibited under Shariah law.

The chancellor’s changes are likely to be replicated in many other countries

Sukuks are asset-based and tend to be used in conjunction with an Ijara structure – where the lease rental income provides a profit for the Sukuk holders – or a Musharaka structure, where the profit share provides a return.

Holding a Sukuk confers a beneficial interest to the holder – in terms of holding a proportional ownership of the underlying asset – as well as the income that it generates.

The Sukuk holder also assumes all rights and obligations for the maintenance of the asset. In a conventional bond, the investor has no such beneficial interest (other than perhaps a security interest), nor rights and obligations and is only entitled to receiving interest.

Tax charges

The UK tax system is clear and well developed with regard to the treatment of cash and transaction flows for a conventional bond. Up until now, however, the tax law was unable to ensure that the cash and transaction flows for a Sukuk were also treated in the same way.

For example: let us say that a UK business wants to buy a factory and so issues a conventional bond to finance its purchase. The business would pay interest to the bondholders, and eventually redeem the bond.

The treatment of tax – income tax, corporation tax, withholding tax, stamp duty and so on – for the cash flows in these transactions are well-established in the current UK tax system, so all parties can be reasonably aware of their risks, obligations and post tax benefits.

Alternatively, a UK business which wants to buy the same factory but act in accordance with Shariah principles, would issue an Ijara Sukuk to purchase the factory. The business will pay an Ijara rental for the use of the factory which will form the profit to pay the Sukuk investors.

Up until now, the UK tax system would tax the rent and profit exactly as it would the rental income and profits arising from any other business arrangement.

This is what causes the difficulty, as the tax charge on these flows as “rent” and “profit” is much higher than it would have been if the same amount of return had been classed simply as interest.

Clearly, this meant that UK businesses or investors who wanted to adhere to the Shariah were severely disadvantaged and would, in effect, be unfairly taxed simply for adhering to the requirements of their faith.

Reform

The chancellor has introduced legislation which will now treat these Sukuk transactions as being similar to conventional bond transactions, thereby removing the tax disadvantage for its use.

This change should lead to a sharp increase in the usage of these kinds of Islamic financing instruments – not only by businesses which want to be Shariah-compliant, but also by other businesses which want to diversify their investor base and tap into the immense pool of Islamic finance in the oil rich Middle East.

The chancellor has not only created the framework for London to emerge as the leader in the global Islamic finance industry but his changes are likely to be replicated in many other countries.

Islamic finance will move from being niche to the mainstream as a viable and valid financing option for all.