taxation of conventional and shariah compliant mortgages ... · securitisation of residential and...

Taxation of conventional and Shariah compliant mortgages

© PricewaterhouseCoopers LLP November 2008 1

A review of the United Kingdom’s taxation rules regarding the granting andsecuritisation of residential and commercial mortgages, covering both conventionaland Shariah compliant transactions.

Mohammed Amin MA, FCA, AMCT, CTA (Fellow), Partner and UK head of IslamicFinance, PricewaterhouseCoopers LLP.

1 Overview of conventional mortgages................................................................................ 21.1 The grant of the mortgage........................................................................................ 21.2 The period which the mortgage subsists ................................................................. 21.3 Redemption .............................................................................................................. 31.4 The securitisation process ....................................................................................... 3

1.4.1 Reduces funding costs......................................................................................... 41.4.2 Lowers capital requirements................................................................................ 4

2 Overview of Shariah compliant mortgages ....................................................................... 52.1 Impact of riba prohibition.......................................................................................... 52.2 Analysis of a murabaha mortgage ........................................................................... 52.3 Analysis of a diminishing musharaka mortgage....................................................... 62.4 The Islamic securitisation process ........................................................................... 6

3 The UK tax law applicable to conventional mortgages..................................................... 73.1 Grant ........................................................................................................................ 73.2 Maintenance............................................................................................................. 83.3 Redemption .............................................................................................................. 93.4 Securitisation............................................................................................................ 9

4 Overview of the UK tax law applicable to Shariah compliant finance generally ............... 94.1 The overall UK approach to legislating for Islamic finance ...................................... 9

4.1.1 Alternative finance return................................................................................... 104.1.2 Profit share return .............................................................................................. 10

4.2 Definition of a financial institution........................................................................... 104.3 Contracts giving rise to alternative finance return.................................................. 10

4.3.1 Purchase and re-sale......................................................................................... 104.3.2 Diminishing shared ownership........................................................................... 114.3.3 Alternative finance investment bond.................................................................. 12

4.4 Overall treatment of alternative finance arrangements .......................................... 134.4.1 Companies - use of loan relationships rules...................................................... 134.4.2 Persons other than companies .......................................................................... 14

4.5 Tax treatment of alternative finance investment bonds ......................................... 144.6 Treatment specific to alternative finance return transactions ................................ 15

4.6.1 Sale and purchase of asset ............................................................................... 154.7 UK stamp duty land tax relief ................................................................................. 15

5 Application of the UK tax law to Shariah compliant mortgages...................................... 205.1 Murabaha mortgages ............................................................................................. 20

5.1.1 Grant .................................................................................................................. 205.1.2 Maintenance ...................................................................................................... 205.1.3 Redemption........................................................................................................ 205.1.4 Securitisation ..................................................................................................... 20

5.2 Diminishing musharaka mortgages........................................................................ 215.2.1 Grant .................................................................................................................. 215.2.2 Maintenance ...................................................................................................... 225.2.3 Redemption........................................................................................................ 225.2.4 Securitisation ..................................................................................................... 22

6 Recommendations for future changes to UK tax law ..................................................... 226.1 Refinancing transactions........................................................................................ 236.2 Expand diminishing shared ownership provisions ................................................. 246.3 Eliminate the uncertainties in the stamp duty treatment of sukuk.......................... 24

7 Disclaimer ....................................................................................................................... 24



1 Overview of conventional mortgages

The basic purpose of a mortgage is to enable a lender to have security for money lent to aborrower to enable the borrower to purchase real estate, either for personal occupation or forrenting to tenants. If the loan was made without security, the lender would have a significantcommercial risk that the borrower may default.

As a trivial example, assume Mr X has £100,000 of his own money and borrows £900,000from a bank to buy a tenanted office building, with the loan being unsecured. The bank isexposed to the risk that Mr X may sell the building to a third party for say £1m and thenabscond with the entire amount leaving the bank with a bad debt of £900,000.

A mortgage involves securing Mr X’s debt so that the building cannot be sold by him withouthim first clearing the £900,000 debt to the bank.

Furthermore, if Mr X falls into arrears in servicing the loan, the bank can enforce its debt byforeclosing on the mortgage and then selling the property. If the sale proceeds are more thanthe loan plus interest owed to the bank, the bank will clear the loan out of the sale proceeds,and then hand the balance of the property’s sale proceeds over to Mr X. Conversely if theproperty sale proceeds are less than the bank loan plus interest, the bank will retain all of thesale proceeds and then sue Mr X for the balance still owed to it.

1.1 The grant of the mortgage

This paper is primarily about taxation rather than land law. However, to understand the taxrules requires a basic appreciation of the mechanisms for effecting mortgages of land underEnglish law.

In everyday speech people tend to talk of a mortgage as if it were a loan (`I bought my housewith a mortgage'), but strictly speaking a mortgage is merely the security for a loan. Althoughit is common to think of a lender `giving a mortgage', legally it is the borrower who grants themortgagor, and is thus called the mortgagor. The lender is the mortgagee.

A legal mortgage must be granted by deed and, if the mortgaged estate is registered, enteredon the register maintained by the Land Registry against the mortgaged estate's title as a legalcharge.

If the mortgaged estate is unregistered, traditionally the lender would ask the borrower tohand over the title deeds.

Where the land is registered, title deeds are irrelevant. However, until 2003 (when the LandRegistration Act 2002 came into force) it was necessary for the mortgagor to surrender hisland certificate to the Land Registry, which would then issue a `charge certificate' as proof oftitle to the mortgagee. This practice is now no longer supported - evidence of the mortgage isthe entry on the register. To be safe from being overridden by other mortgages or dispositionsof the land, all mortgages that are not protected by a surrender of title deeds, of registered orunregistered land, must be protected by registration.

As outlined above, the purpose of the process is to prevent the mortgagor (Mr X above) fromselling the property without the express permission of the lender.

1.2 The period which the mortgage subsists

The mortgage will be for a set period of time, often 25 years.



During the period of the mortgage, the borrower will pay interest to the lender on the loanwhich is secured by the mortgage. In the case of domestic mortgages, this interest is usuallypaid monthly. The capital balance of the mortgage may be amortised by part payments madeat the time the interest is paid. Alternatively, with interest only mortgages, there is norequirement to reduce the loan balance each month, but the borrower is expected to clear theloan when the mortgage matures, and in practice often makes partial loan repayments duringthe life of the mortgage.

The rate of interest may be fixed for the entire life of the mortgage. This is quite rare in theUK, but is common in the USA. Alternatively, the rate of interest can be floating. Floating ratescan either linked to an external benchmark interest rate (e.g. 1 month sterling LIBOR + 0.6%,where the 0.6% is a fixed margin agreed between the borrower and the lender in themortgage terms) or a discretionary variable rate set by the lender.

With a discretionary variable rate, the borrower’s commercial protection against the risk thatthe lender may charge an extortionately high variable rate at some future time depends uponthe borrower’s ability to repay the mortgage by borrowing from another lender. If alternativelenders are not available, then the borrower is exposed to the lender raising the discretionaryvariable rate at will.

1.3 Redemption

Redemption involves the borrower repaying all of the money that is owed to the lender. At thatpoint, the lender must release any legal charges that have been registered against the land,and return any title deeds that are in the lender’s possession. The land becomes theunencumbered property of the owner, (Mr X) who is no longer a borrower.

1.4 The securitisation process

Mortgage securitisation involves pooling and repackaging mortgages into securities that arethen sold to investors.

A suitably large portfolio of mortgages is pooled and sold to a special purpose vehicle (SPV)which acts as the issuer. The SPV will be a company or trust formed for the specific purposeof funding the assets. Once the assets are transferred to the issuer, there is normally norecourse to the originator. The issuer is ‘bankruptcy remote’, meaning that if the originatorgoes into bankruptcy, the assets of the issuer will not be distributed to the creditors of theoriginator. In order to achieve this, the governing documents of the issuer restrict its activitiesto only those necessary to complete the issuance of securities.

To be able to buy the assets from the originator, the issuer SPV issues tradable securities tofund the purchase. Investors purchase the securities, either through a private offering(targeting institutional investors) or on the open market. The performance of the securities isthen directly linked to the performance of the assets. Credit rating agencies rate the securitieswhich are issued in order to provide an external perspective on the liabilities being createdand help the investor make a more informed decision. As the securities are backed by theassets owned by the SPV, they are commonly referred to as asset backed securities (ABS)

Some deals may include a third-party guarantor which provides guarantees or partialguarantees for the assets, the principal and the interest payments, for a fee.

The securities can be issued with either a fixed interest rate or a floating rate. Fixed rate ABSset the ‘coupon’ (rate) at the time of issuance, in a fashion similar to corporate bonds. Incontrast to fixed rate securities, the rates on floating rate securities will periodically adjust up



or down according to a designated index such the London Interbank Offered Rate (LIBOR).The floating rate usually reflects the movement in the index plus an additional fixed margin tocover the added risk.

The securities are often split into tranches, or categorized into varying degrees ofsubordination. Each tranche has a different level of credit protection or risk exposure thananother: there is generally a senior A class of securities and one or more junior subordinatedB, C, etc. classes that function as protective layers for the A class. The senior classes havefirst claim on the cash that the SPV receives, and the more junior classes only start receivingrepayment after the more senior classes have repaid. Because of the cascading effectbetween classes, this arrangement is often referred to as a cash flow waterfall.

In the event that the underlying asset pool becomes insufficient to make payments on thesecurities (e.g. when loans default within a portfolio of loan claims), the loss is absorbed firstby the subordinated tranches, and the upper-level tranches remain unaffected until the lossesexceed the entire amount of the subordinated tranches. The senior securities are typicallyAAA rated, signifying a lower risk, while the lower-credit quality subordinated classes receivea lower credit rating, signifying a higher risk.

The most junior class (often called the equity class) is the most exposed to payment risk. Insome cases, this is a special type of instrument which is retained by the originator as apotential profit flow. In some cases the equity class receives no coupon (either fixed orfloating), but only the residual cash flow (if any) after all the other classes have been paid.

There may also be a special class which absorbs early repayments in the underlying assets.This is often the case with mortgages which, in essence, are repaid every time the property issold. Since any early repayment is passed on to this class, it means the other investors havea more predictable cash flow.

The most common reasons for securitisation are as follows.

1.4.1 Reduces funding costs

Mortgages are usually less risky than other types of lending done by banks. Accordingly, alender who is financing only mortgages (by purchasing mortgage asset backed securitiesfrom an SPV) should accept a lower rate of interest than he would require if lending to theoriginating bank itself. By itself, this can lower the overall cost of funding to the bank.

1.4.2 Lowers capital requirements

Banks are required to hold specified amounts of capital against their assets. Selling themortgages to an SPV removes them from the bank’s balance sheet, reducing its capitalrequirements.

Recent events in the US mortgage securitisation market have shown how securitisation canincrease what is known in economics as ‘moral hazard’. Where a lender intends to retainownership of the mortgage for its entire life, it needs to be very confident that the borrower willrepay the debt. However, if the mortgage is to be sold, then there is a risk that the lender maybecome more lax in its credit assessment of borrowers as in this scenario the mortgagelosses will be borne by the securities holder or financial guarantor, rather than by theoriginator.



2 Overview of Shariah compliant mortgages

2.1 Impact of riba prohibition

Most Islamic scholars consider that the Quran’s prohibition of riba means that any form ofinterest based lending is forbidden. Accordingly interest bearing mortgages of the typeoutlined in the conventional case are not allowed.

Instead, Islamic banks have used murabaha, and more recently diminishing musharaka, toprovide mortgages.

2.2 Analysis of a murabaha mortgage

In this case, the bank will purchase the property and resell it to the householder at a higherprice which is paid in instalments over an extended period of time.

For example, assume that the customer wishes to purchase a property worth £1,000,000 andhas a deposit available of £100,000 and seeks finance over 25 years. Assume also that theprevailing rate of interest for 25 year fixed rate debt is 7% per annum. In that case it wouldmake economic sense for the bank to purchase the house for £1,000,000 and immediatelyresell it to the customer for a price of £1,971,428.27 payable as follows:

£100,000 payable immediately

The balance of £1,871,428.27 payable over 25 years in 300 equal monthlyinstalments of £6,238.09.

Mathematically, this gives the bank an effective return of 7% p.a. If recomputing the figures, itis essential to convert the 7% p.a. into a true monthly rate using the formula (1.07)^(1/12) – 1.

This type of contract has two principal drawbacks.

Firstly, it gives the bank the equivalent of a fixed rate asset. The instalments of the purchaseprice payable over the 300 month life of the mortgage are fixed, and do not change if marketinterest rates change. It is mathematically the same as the bank having granted a mortgageat a fixed annual interest rate of 7%. This is usually problematical, as the bank will be fundingthis mortgage by raising cash from customers, usually with contracts that are benchmarked toprevailing interest rates which change regularly.

Secondly, the customer is contractually ‘locked in’ for the entire 25 year period. If thecustomer wishes to sell the property after a few years to move elsewhere, he is contractuallyliable to pay the full purchase price at the time he wishes to sell the property, even though itwould otherwise be payable over an extended period of time. The bank cannot build incontractual provisions regarding taking a lesser sum if the customer wishes to pay all of theoutstanding instalments at once, as that is generally regarded as introducing riba into thecontract.

In practice, Islamic banks do grant customers a rebate if they wish to pay all of theoutstanding instalments early, and the rebate is usually broadly equivalent to an amountwhich leaves the customer paying roughly the net present value of the outstandinginstalments computed using the implied interest rate built into the pricing. However, thecustomer has no contractual certainty that such a rebate will be given.



2.3 Analysis of a diminishing musharaka mortgage

If the above purchase were to be conducted using diminishing musharaka, the bank and thecustomer would enter into a musharaka contract with essentially the following terms:

The bank and the customer will purchase the property jointly, with the customercontributing £100,000 and the bank contributing £900,000.

The initial ownership of the property will be 10% by the customer and 90% by thebank.

The customer will have sole occupancy rights.

The customer will pay the bank rent for that part of the property which is owned bythe bank but occupied by the customer.

The rate of rent will be reset periodically, either annually, quarterly, or possibly evenevery month.

The contract will set out how the rent is to be reset. For example, it may be set at onemonth sterling LIBOR plus a margin of say 0.6%.

Over the term of the contract, the customer will buy out the bank in stages. Forexample, he may be required to purchase a portion of the bank’s share each monthaccording to a set formula, or he may have discretion to purchase in stages as hewishes, subject to purchasing the entire 90% owned by the bank during the 300month life of the diminishing musharaka contract.

The purchase price may be equal to the original cost to the bank, or it may be equalto market value at the time each extra fraction of the property is purchased.

It will be seen that mathematically this is equivalent to the bank having a floating rate asset.This allows better matching with the bank’s sources of funding. Furthermore, the contractcauses no difficulty if the customer wishes to move after a few years, as it will set out how heprice for the bank’s residual share of the property at that time is to be computed.

If the property is to be sold to the customer at market value, then the diminishing musharakacontract means that the bank will benefit / suffer from increases / decreases in the marketvalue of the property. This give the bank a much greater degree of exposure to real estatevalues than with the murabaha mortgage or the conventional mortgage.

2.4 The Islamic securitisation process

Any mechanism for securitising the Islamic mortgages is likely to involve the issue of sukuk.

The bank’s rights under the murabaha mortgages it has granted represent debts. Accordingly,most scholars consider that they cannot be sold to a sukuk issuing SPV except at theirundiscounted face value. This makes it problematical to find a way of using them as the assetfor an issue of sukuk.

However, the bank’s rights under the diminishing musharaka contracts it has entered into arereal estate interests; it owns land on which it is charging its customers rent, and hasarrangements under which they will by out the bank’s share of the properties concerned.



Accordingly, it is possible for the bank to sell these diminishing musharaka contracts to anSPV which pays for them by issuing sukuk. Over the remaining life of the diminishingmusharaka contracts, the sukuk holders will receive payment of income as rent is paid to theSPV, and should also receive repayments of their original investment as the customer’s buyout the SPV’s shares of the properties concerned.

This sukuk issue should achieve similar benefits for the bank to conventional securitisation.

As the diminishing musharaka contracts may have a lower risk than the generality of thebank’s business, the bank should be able to raise cash from the sukuk issue on better termsthan its normal funding sources cost. Similarly it should also be able to obtain similar relief forregulatory capital purposes, assuming that the sale to the sukuk issuing SPV does fullyeliminate any exposures that the bank has in relation to these diminishing musharakacontracts.

However, the tranching used in conventional securitisation mentioned above is generallyconsidered to be prohibited when issuing sukuk. It may also be problematical organising anyguarantee for the performance of the customers, unlike the credit guarantees used inconventional securitisation.

3 The UK tax law applicable to conventional mortgages

3.1 Grant

The purchase of property in the UK is generally subject to stamp duty land tax (SDLT). Thiswill be due on the customer’s purchase of the house.

However, the security interest registered by the bank does not give rise to any SDLT issues.The reason is that SDLT is only payable on acquisitions of chargeable interests as defined inFinance Act (FA) 2003 s.48 which was originally enacted as follows:

48 Chargeable interests

(1) In this Part “chargeable interest” means—

(a) an estate, interest, right or power in or over land in the United Kingdom, or

(b) the benefit of an obligation, restriction or condition affecting the value of any such estate,interest, right or power,other than an exempt interest.

(2) The following are exempt interests—

(a) any security interest;

(b) a licence to use or occupy land;

(c) in England and Wales or Northern Ireland—

(i) a tenancy at will;

(ii) an advowson, franchise or manor.

(3) In subsection (2)—



(a) “security interest” means an interest or right (other than a rentcharge) held for the purposeof securing the payment of money or the performance of any other obligation; and

(b) “franchise” means a grant from the Crown such as the right to hold a market or fair, or theright to take tolls.

(4) In the application of this Part in Scotland the reference in subsection (3)(a) to a rentchargeshall be read as a reference to a feu duty or a payment mentioned in section 56(1) of theAbolition of Feudal Tenure etc. (Scotland) Act 2000 (asp 5).

(5) The Treasury may by regulations provide that any other description of interest or right inrelation to land in the United Kingdom is an exempt interest.

(6) The regulations may contain such supplementary, incidental and transitional provision asappears to the Treasury to be appropriate.

The key provision above is FA 2003 s.48(2)(a) which provides that any security interest is anexempt interest.

Similarly, there are special rules for capital gains tax (CGT) purposes set out in Taxation ofChargeable Gains Act (TCGA) 1992 section 26:

26 Mortgages and charges not to be treated as disposals

(1) The conveyance or transfer by way of security of an asset or of an interest or right in orover it, or transfer of a subsisting interest or right by way of security in or over an asset(including a retransfer on redemption of the security), shall not be treated for the purposes ofthis Act as involving any acquisition or disposal of the asset.

(2) Where a person entitled to an asset by way of security or to the benefit of a charge orincumbrance on an asset deals with the asset for the purpose of enforcing or giving effect tothe security, charge or incumbrance, his dealings with it shall be treated for the purposes ofthis Act as if they were done through him as nominee by the person entitled to it subject to thesecurity, charge or incumbrance; and this subsection shall apply to the dealings of any personappointed to enforce or give effect to the security, charge or incumbrance as receiver andmanager or judicial factor as it applies to the dealings of the person entitled as aforesaid.

(3) An asset shall be treated as having been acquired free of any interest or right by way ofsecurity subsisting at the time of any acquisition of it, and as being disposed of free of anysuch interest or right subsisting at the time of the disposal; and where an asset is acquiredsubject to any such interest or right the full amount of the liability thereby assumed by theperson acquiring the asset shall form part of the consideration for the acquisition and disposalin addition to any other consideration.

For all capital gains tax purposes, the borrower is treated as the owner of the entire asset,even if the asset is pledged to a bank, which may even have taken full legal title as security.

3.2 Maintenance

The interest paid on the loan secured by the mortgage may be tax deductible, if the loan wastaken out for business purposes. The details of such circumstances are beyond the scope ofthis paper.

For the reasons outlined above, there are no SDLT or capital gains tax (CGT) consequencesof the customer paying interest and capital repayments over the life of the mortgage.



3.3 Redemption

Similarly, when the mortgage is redeemed, there are no SDLT or CGT consequences fromany release of the charge for the mortgage or any transfer of the legal title from the bank tothe customer.

3.4 Securitisation

Loans secured by a mortgage are debts. Accordingly, the profit and loss of the bank inrelation to the mortgages is computed using the loan relationship rules set out in FA 1996section 80 onwards. If the bank makes a profit or loss from selling the mortgage loans to theSPV, that gain or loss is taxable or deductible in the normal way.

No stamp duty cost should arise on selling the mortgage debts to the SPV. While the stampduty treatment of debts was previously complex, FA 2003 s.125 eliminated the stamp dutycharge on instruments except for instruments relating to stock and marketable securities.

The securities issued by the SPV should be exempt from stamp duty as they should qualify as‘loan capital’ which was exempted from stamp duty by FA 1986 s.79 subject to some complexexclusions in that section, of which the most important in the current context is FA 1986s.79(6)(b) “a right to interest which falls to be determined…by reference to the results of … abusiness.” That exclusion should not apply to conventional debt securities issued onsecuritising conventional mortgages.

The securities should also be exempted from stamp duty reserve tax (SDRT) as that isautomatic if their transfer is not subject to stamp duty.

4 Overview of the UK tax law applicable to Shariahcompliant finance generally

The discussion below is not a comprehensive coverage of the relevant tax law, but insteadfocuses on provisions that are relevant to Islamic mortgages.

4.1 The overall UK approach to legislating for Islamic finance

The approach taken by the UK to set up a tax regime for Islamic finance is to enact specificlegislation which sets out a definite tax treatment for certain specific types of Islamic finance,with economic returns equivalent to interest being treated in the same way as interest for alltax purposes. The new legislation is applicable to all financing arrangements which fall into itsdefinitions, regardless of whether they are compliant with Shariah or not.

The legislation which is set out in Finance Act 2005 does not mention the Shariah or use anyIslamic finance terms. Instead the legislation creates a freestanding set of definitions for usein UK tax law which are entirely neutral regarding religion. For transactions which fall withinthese definitions, the legislation specifies how to determine the finance cost and how thatfinance cost is treated by both the payer and the recipient. Broadly speaking, the finance costis brought within the same tax rules as those that apply to interest.

The legislation does not change the nature of the financial arrangements, nor does it in anyway impute interest, or deem interest to arise where there is none. It simply sets out a codefor the tax treatment of transactions that fall within its definitions. The table below sets out theconcepts created by tax law and their Islamic finance analogues:



Tax law Islamic financePurchase and resale MurabahaDeposit MudarabaProfit share agency WakalaDiminishing shared ownership Diminishing musharakaAlternative finance investment bond Sukuk

The legislation refers to two different types of finance cost:

4.1.1 Alternative finance return

This refers to the finance costs involved in murabaha, diminishing musharaka and sukuktransactions.

4.1.2 Profit share return

This refers to the payments made to the investor in mudaraba and wakala transactions.

4.2 Definition of a financial institution

The legislation begins with some introductory definitions, including that of a financialinstitution for the purposes of the legislation. Financial institution means—

a) a bank as defined by ICTA 1988 s 840A;

b) a building society within the meaning of the Building Societies Act 1986;

c) a wholly-owned subsidiary of a bank within (a) or a building society within (b);

d) a person authorised by a licence under the Consumer Credit Act 1974 Pt 3 (sections21 - 42) to carry on a consumer credit business or consumer hire business within themeaning of that Act; or

e) a person authorised in a jurisdiction outside the UK to receive deposits or otherrepayable funds from the public and to grant credits for its own account.

For the purposes of (c), a company is a wholly-owned subsidiary of a bank or building society(the parent) if it has no members except the parent and the parent’s wholly-ownedsubsidiaries or persons acting on behalf of the parent or the parent’s wholly-ownedsubsidiaries.

The ICTA 1988 s 840A definition of a bank is limited to UK entities and to EuropeanEconomic Area (EEA) regulated institutions that have exercised their EU passporting rights toset up a branch in the UK. Accordingly (e) is needed to extend the definition of financialinstitution to non-UK authorised deposit takers.

4.3 Contracts giving rise to alternative finance return

4.3.1 Purchase and re-sale

A finance arrangement can, as an alternative to payment of interest, be structured as apurchase of an asset and its onward sale at a higher deferred price. (This is discussed aboveunder murabaha.) The provisions define the circumstances in which such a structure is to betaxed in the same way as if the return were a payment of interest. The difference betweenpurchase price and sale price is treated as “alternative finance return”.



The following four conditions must be present for an arrangement involving a purchase andsale of an asset to fall within the provisions described here:

(a) a person (X) purchases an asset and sells it, either immediately or in circumstances inwhich the conditions described below are met, to the other person (Y);

(b) the amount payable by Y in respect of the sale is more than the amount paid by X inrespect of the purchase;

(c) all or part of the sale price is deferred beyond the date of the sale; and

(d) the difference between the sale and purchase prices equates, in substance, to thereturn on an investment of money at interest.

The conditions referred to in (a) extend its scope where a financial institution holds a stock ofassets for the purposes of a sale under an alternative finance arrangement.

Arrangements are excluded where neither party is a financial institution.

For the purposes of these rules, “the effective return” is the excess of the sale price over thepurchase price of the asset. References to “alternative finance return” are to be read inaccordance with the following rules:

(a) Where the sale price is paid on one day in full, the sale price is to be taken to includealternative finance return equal to the effective return.

(b) Where the sale price is paid by instalments, each instalment is to be taken to includealternative finance return equal to the “appropriate amount”.

The “appropriate amount”, in relation to any instalment, is an amount equal to the interest thatwould have been included in the instalment if:

(a) the effective return was the total interest payable on a loan by X to Y of an amountequal to the purchase price;

(b) the instalment were part repayment of the principal with interest; and

(c) the loan were made on arm’s length terms and accounted for under generally acceptedaccounting practice.

4.3.2 Diminishing shared ownership

As discussed above, this is often used as a Shariah compliant alternative to a mortgage. Itrequires arrangements under which both a financial institution and another person (called theeventual owner) acquire a beneficial interest in an asset. There are then a number ofprescriptive requirements.

1. The eventual owner must have the exclusive right to occupy or use the asset, but thelegislation permits the eventual owner to grant an interest in the asset to other persons,excluding, however, the financial institution or its related parties as defined.

2. The eventual owner must be required to make payments to the financial institutionwhich will amount in aggregate to the price paid by the financial institution for its shareof the asset, and must acquire the financial institution’s beneficial interest as a result ofthose payments. Accordingly, the arrangements will not qualify if the eventual ownerhas an option whether or not to make the payments to acquire the financial institution’sbeneficial interest.

3. The eventual owner must be exclusively entitled to any income or growth in value fromthe asset. There is, however, some flexibility allowed regarding the contractualarrangements:



(1) The acquisition by the financial institution can be from a third party or from theeventual owner. This mirrors the scope for conventional mortgages to be usedto either acquire property or to refinance property already owned.

(2) In addition, third parties are permitted to have a beneficial interest in the asset.

(3) It does not matter who has the legal interest in the asset.

(4) The financial institution is permitted (but not required) to share in any loss fromthe asset falling in value. As there is an express requirement for the eventualowner to make payments to the financial institution aggregating to the financialinstitution’s purchase price, it would appear that if the financial institution is toshare any loss, the contract will have to make separate provision for this - forexample, by requiring the financial institution to make an appropriately calculatedpayment to the eventual owner.

If the contract meets the statutory requirements, then payments by the eventual owner to thefinancial institution comprise alternative finance return, unless they are the payments for theacquisition by the eventual owner of the financial institution’s interest or payments for anarrangement fee, legal costs, or other expenses. For the avoidance of doubt, arrangementswhich qualify as diminishing shared ownership are expressly excluded from being apartnership for tax purposes.

4.3.3 Alternative finance investment bond

Finance Act 2007 contained provisions that enable UK companies to issue sukuk and clarifythe tax treatment of UK resident investors buying and selling sukuk. The new rules havebeen inserted into Finance Act 2005 (FA 2005) and follow the consistent UK approach ofprecisely defining transactions in the tax statute and then applying the tax law, irrespective ofwhether the transactions are intended to be Shariah compliant or not.

4.3.3.1 Definition

There is a new definition of arrangements which give rise to an alternative finance investmentbond. They require:

a) One person (the bond holder) to pay a sum of money (the capital) to another (thebond issuer).

b) Identification of assets (the bond assets) which the bond issuer will acquire togenerate income or gains.

c) A specified period when the arrangements will end (the bond term).

d) The bond issuer undertakes:

To dispose of any remaining bond assets at the end of the bond term.

To make repayments of capital during or at the end of the bond term.

To make other payments to the bond holder (additional payments).

e) The additional payments must not exceed what would be a reasonable commercialreturn on a loan equivalent to the capital.

f) The bond issuer undertakes to manage the bond assets.



g) The bond holder is able to transfer his rights to other persons who thereby becomebondholders.

h) The arrangements are listed on a recognised stock exchange as defined in theIncome Tax Act 2007 s.1005. (This mirrors the requirement for eurobonds to belisted if interest is to be paid gross without withholding tax.)

i) The arrangement would be treated as a financial liability of the bond issuer ifaccounted for under International Accounting Standards.

Having set out a prescriptive set of definitional requirements, the Finance Bill then contains anumber of relaxations:

The issuer can acquire the bond assets before or after the arrangements take effect.

Bond assets may be property of any kind, including rights in relation to property ownedby another person.

A declaration of trust may be used but is not mandatory.

Bond holders are allowed to have early termination rights.

The additional payments can be fixed or variable. However, if they are not fixed, thenthe test at (e) is made by reference to the maximum amount of the additionalpayments. This may cause difficulty if the maximum amount cannot be determined.

The redemption payment may be reducible if there is a decline in the value of the bondassets or their income.

It is permitted to satisfy the redemption payment by the issue or transfer of shares orsecurities.

It is possible to designate a stock exchange for the purposes of the alternative financeinvestment bond rules, without having to designate it for other purposes. (This power hasbeen used to designate certain foreign exchanges where existing sukuk are listed without theUK having to recognise those exchanges for all other tax purposes.)

4.4 Overall treatment of alternative finance arrangements

The following general provisions apply both to contracts giving rise to alternative financereturn and to contracts giving rise to profit share return.

4.4.1 Companies - use of loan relationships rules

Where a company is a party to an arrangement within the purchase and resale anddiminishing shared ownership provisions described above, the loan relationships regime setout in FA 1996 has effect in relation to the arrangements as if:

(a) the arrangements were a loan relationship to which the company is a party;

(b) the amount of the purchase price of the asset were the amount of a loan made to thecompany by, or by the company to, the other party to the arrangements; and

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



The effect of applying the loan relationships provisions is to bring in all the detailed rules setout in FA 1996 which govern the treatment of debt and interest in UK tax law. This isaccomplished by deeming loans and interest to exist for tax purposes; there is no implicationin the tax law that the transactions give rise to debt for any other legal purposes.

4.4.2 Persons other than companies

Alternative finance return or profit share return is treated for income tax purposes in the sameway as interest.

The rules for relief for interest against income tax in ICTA 1988 sections 353 - 368 are appliedto alternative finance arrangements as if the arrangements were loans and the alternativefinance return were interest. This includes the rules about certificates of interest paid.

The following rules apply where a person, other than, a company is a party to alternativefinance arrangements for the purposes of a trade, profession or vocation carried on by him ora property business of his.

(1) Alternative finance return or profit share return paid by a person is to be treated as anexpense of the trade, profession or vocation or of the property business.

(2) Incidental costs of an alternative finance arrangement qualify for tax relief on the samebasis as incidental costs of finance by applying the rules in the Income Tax Trading andOther Income Act (ITTOIA) 2005 s 58 as if:

(a) references to a loan included references to alternative finance arrangements;and

(b) references to interest included references to alternative finance return or profitshare return.

4.5 Tax treatment of alternative finance investment bonds

If an arrangement falls within the definitions given above, then a number of significant taxconsequences follow. It should be noted that these apply only for tax purposes, and not forother legal purposes.

The overall approach is that the rights of the bond holder (normally expressed in the form ofsukuk certificates) are treated for tax purposes as if they were debt securities giving rise tointerest income. This overall result is achieved by a number of detailed tax provisionsincluding the following:

The additional payments are treated as alternative finance return.

The bond holder is not treated as having any legal or a beneficial interest in the bondassets, and is not entitled to any relief for capital expenditure in connection with thebond assets. The aim is to tax the bond holder purely by reference to the redemptionand additional payments made to him, ignoring the legal form of the arrangements.

The bond issuer is not treated as a trustee of the bond assets, and any income or gainsderived from the bond assets are treated as those of the bond issuer in a beneficialcapacity. This ensures that the bond issuer is taxable on the income or gains.

The arrangements (the sukuk certificates) are treated as securities for tax purposes,with the alternative finance return treated as interest and the redemption paymenttreated as giving rise to redemption of the securities. This means that for corporateissuers or corporate investors, the loan relationships provisions apply. Non-corporateinvestors are taxed in the same way as they would be if they owned securities.



The bond issuer is treated as being party to a capital market arrangement for thepurposes of FA 2005 s.84. This enables the bond issuer to qualify for the newpermanent UK tax regime for securitisation companies if the other requirements of s.84are met.

The arrangements are treated as a qualifying corporate bond if they are in sterling andmeet requirements similar to those that must be met by actual qualifying corporatebonds. The consequence is that they are not chargeable assets for capital gains taxpurposes.

The arrangements are not treated as a collective investment scheme.

The definition of financial institution given previously is extended to include the issuer of analternative finance investment bond, but only in relation to bond assets which are rights underarrangements falling within purchase and resale and diminishing shared ownership discussedabove.

4.6 Treatment specific to alternative finance return transactions

4.6.1 Sale and purchase of asset

To ensure that the effective return on arrangements (within the rules described above) is nottaxed or relieved twice, the effective return is excluded in determining the consideration forthe sale and purchase for all other tax purposes where an asset is sold by one party to theother under an arrangement within those rules. This does not override cases where anyprovision of the Tax Acts or the Taxation of Chargeable Gains Act 1992 provides for theconsideration for a sale or purchase to be other than the actual consideration received.

4.7 UK stamp duty land tax relief

SDLT was legislated in FA 2003, and is the name given to the UK's form of real estatetransfer tax. When FA 2003 was enacted, it contained the UK's first tax provision to facilitateIslamic finance by eliminating the double charge to SDLT on Islamic mortgages (once when abank purchases the property and again when the property is resold to the customer) providedspecified qualifying conditions were met.

Originally, the relief only applied to acquisitions by individuals but FA 2006 extended the reliefto acquisitions by all persons, so it also applies to acquisitions by companies andpartnerships. The SDLT legislation originally used a definition of ‘financial institution’ which isnarrower than used in the alternative finance arrangement rules. However, FA 2007harmonised the two sets of legislation so in future the SDLT rules will always use thedefinition of financial institution set out in FA 2005 for the alternative finance arrangementrules.

The detailed provisions are contained in FA 2003 s.71A to s.73B and their application iscovered when the relevant transactions are discussed below. They are reproduced below forconvenience.

71A Alternative property finance: land sold to financial institution and leased to person

(1) This section applies where arrangements are entered into between a person and afinancial institution under which—

(a) the institution purchases a major interest in land or an undivided share of a majorinterest in land (“the first transaction”),



(b) where the interest purchased is an undivided share, the major interest is held ontrust for the institution and the person as beneficial tenants in common,

(c) the institution (or the person holding the land on trust as mentioned in paragraph(b)) grants to the person out of the major interest a lease (if the major interest isfreehold) or a sub-lease (if the major interest is leasehold) (“the secondtransaction”), and

(d) the institution and the person enter into an agreement under which the personhas a right to require the institution or its successor in title to transfer to theperson (in one transaction or a series of transactions) the whole interestpurchased by the institution under the first transaction.

(2) The first transaction is exempt from charge if the vendor is—

(a) the person, or

(b) another financial institution by whom the interest was acquired underarrangements of the kind mentioned in subsection (1) entered into between itand the person.

(3) The second transaction is exempt from charge if the provisions of this Part relating to thefirst transaction are complied with (including the payment of any tax chargeable).

(4) Any transfer to the person that results from the exercise of the right mentioned insubsection (1)(d) (“a further transaction”) is exempt from charge if—

(a) the provisions of this Part relating to the first and second transactions arecomplied with, and

(b) at all times between the second transaction and the further transaction—

(i) the interest purchased under the first transaction is held by a financialinstitution so far as not transferred by a previous further transaction, and

(ii) the lease or sub-lease granted under the second transaction is held by theperson.

(5) The agreement mentioned in subsection (1)(d) is not to be treated—

(a) as substantially performed unless and until the whole interest purchased by theinstitution under the first transaction has been transferred (and accordinglysection 44(5) does not apply), or

(b) as a distinct land transaction by virtue of section 46 (options and rights of pre-emption).

(6) …

(7) A further transaction that is exempt from charge by virtue of subsection (4) is not anotifiable transaction unless the transaction involves the transfer to the person of the wholeinterest purchased by the institution under the first transaction, so far as not transferred by aprevious further transaction.

(8) In this section “financial institution” has the meaning given by section 46 of the FinanceAct 2005 (alternative finance arrangements).

(9) References in this section to a person shall be read, in relation to times after the death ofthe person concerned, as references to his personal representatives.

(10) This section does not apply in relation to land in Scotland.

72 Alternative property finance in Scotland: land sold to financial institution and leasedto person

(1) This section applies where arrangements are entered into between a person and afinancial institution under which the institution—

(a) purchases a major interest in land (“the first transaction”),



(b) grants to the person out of that interest a lease (if the interest acquired is theinterest of the owner) or a sub-lease (if the interest acquired is the tenant’s rightover or interest in a property subject to a lease) (“the second transaction”), and

(c) enters into an agreement under which the person has a right to require theinstitution … to transfer the major interest purchased by the institution under thefirst transaction.


(a) the person, or



(4) A transfer to the person that results from the exercise of the right mentioned in subsection(1)(c) (“the third transaction”) is exempt from charge if—

(a) the provisions of this Part relating to the first and second transactions arecomplied with, and

(b) at all times between the second and third transactions—

(i) the interest purchased under the first transaction is held by a financialinstitution, and

(ii) the lease or sub-lease granted under the second transaction is held by theperson.

(5) The agreement mentioned in subsection (1)(c) is not to be treated—

(a) as substantially performed unless and until the third transaction is entered into(and accordingly section 44(5) does not apply), or


(6) …


(8) …


(10) This section applies only in relation to land in Scotland.

72A Alternative property finance in Scotland: land sold to financial institution andperson in common


(a) the institution and the person purchase a major interest in land as owners incommon (“the first transaction”),

(b) the institution and the person enter into an agreement under which the personhas a right to occupy the land exclusively (“the second transaction”), and

(c) the institution and the person enter into an agreement under which the personhas a right to require the institution to transfer to the person (in one transactionor a series of transactions) the whole interest purchased under the firsttransaction.




(a) the person, or



(4) Any transfer to the person that results from the exercise of the right mentioned insubsection (1)(c) (“a further transaction”) is exempt from charge if—

(a) the provisions of this Part relating to the first transaction are complied with, and

(b) at all times between the first and the further transaction—

(i) the interest purchased under the first transaction is held by a financialinstitution and the person as owners in common, and

(ii) the land is occupied by the person under the agreement mentioned insubsection (1)(b).

(5) The agreement mentioned in subsection (1)(c) is not to be treated—

(a) as substantially performed unless and until the whole interest purchased by theinstitution under the first transaction has been transferred (and accordinglysection 44(5) does not apply), or


(6) …

(7) A further transaction that is exempt from charge by virtue of subsection (4) is not anotifiable transaction unless the transaction involves the transfer to the person of the wholeinterest purchased by the institution under the first transaction, so far as not transferred by aprevious further transaction.



(10) This section applies only in relation to land in Scotland.

73 Alternative property finance: land sold to financial institution and re-sold to person


(a) the institution—

(i) purchases a major interest in land (“the first transaction”), and

(ii) sells that interest to the person (“the second transaction”), and

(b) the person grants the institution a legal mortgage over that interest.


(a) the person concerned, or

(b) another financial institution by whom the interest was acquired under otherarrangements of the kind mentioned in section 71A(1), 72(1) or 72A(1) enteredinto between it and the person.

(3) The second transaction is exempt from charge if the financial institution complies with theprovisions of this Part relating to the first transaction (including the payment of any tax



chargeable on a chargeable consideration that is not less than the market value of the interestand, in the case of the grant of a lease at a rent, the rent).

(4) …

(5) In this section—

(a) In this section “financial institution” has the meaning given by section 46 of theFinance Act 2005 (alternative finance arrangements).;

(b) “legal mortgage”—

(i) in relation to land in England or Wales, means a legal mortgage as definedin section 205(1)(xvi) of the Law of Property Act 1925 (c 20);

(ii) in relation to land in Scotland, means a standard security;

(iii) in relation to land in Northern Ireland, means a mortgage by conveyanceof a legal estate or by demise or sub-demise or a charge by way of legalmortgage.


73A Sections 71A to 73: relationship with Schedule 7

Sections 71A to 73 do not apply to arrangements in which the first transaction is exempt fromcharge by virtue of Schedule 7.

73B Exempt interests

(1) An interest held by a financial institution as a result of the first transaction within themeaning of section 71A(1)(a), 72(1)(a) or 72A(1)(a) is an exempt interest for the purposes ofstamp duty land tax.

(2) That interest ceases to be an exempt interest if—

(a) the lease or agreement mentioned in section 71A(1)(c), 72(1)(b) or 72A(1)(b)ceases to have effect, or

(b) the right under section 71A(1)(d), 72(1)(c) or 72A(1)(c) ceases to have effect orbecomes subject to a restriction.

(3) Subsection (1) does not apply if the first transaction is exempt from charge by virtue ofSchedule 7.

(4) Subsection (1) does not make an interest exempt in respect of—

(a) the first transaction itself, or

(b) a further transaction or third transaction within the meaning of section 71A(4),72(4) or 72A(4).



5 Application of the UK tax law to Shariah compliantmortgages

5.1 Murabaha mortgages

5.1.1 Grant

As discussed above, as far as the bank is concerned a murabaha mortgage is economicallyequivalent to granting a fixed rate loan. The banks computation of taxable income is governedby the purchase and resale provisions in FA 2005 s.47. The profit margin between purchaseand resale is the bank’s taxable income, and is spread rateably over the life of the mortgage.

The equivalent treatment also applies for computing the customer’s financial expense if thecustomer is conducting a business and therefore able to claim tax relief for his financialexpense. It should be noted that for tax purposes the customer has purchased the entireproperty from the bank on day one, even though payment may be spread out over 25 years.

FA 2003 s.73 should apply to relieve the sale from the bank to the customer from SDLT.

5.1.2 Maintenance

As explained in FA 2005 s.47, each part payment of the purchase price will be decomposedfor tax purposes into a part which comprises payment of the notional loan and a part whichcomprises alternative finance return, treated for tax purposes like interest.

5.1.3 Redemption

There are no tax consequences arising on the redemption of the mortgage after all paymentsdue have been made, when the property is transferred to the customer outright and anycharges released.

5.1.4 Securitisation

As discussed above, murabaha contracts comprise debts in the hands of the bank.Accordingly, they are unlikely to be securitised by transfer to an SPV which issues sukuk.

However, if that is actually done, then provided the detailed provisions for alternative financeinvestment bonds in FA 2005 s.48A are complied with, the issuing SPV should be treated asa financial institution in relation to the murabaha contracts. This should mean that thecustomer’s tax treatment is not disturbed by the securitisation, and the sukuk issuing SPV willbe taxed in the same way as outlined above for the bank.

If the bank makes a profit on transferring to the SPV its rights under the murabaha contracts,that profit will be taxed as a loan relationship profit, as with the securitisation of conventionalmortgages.

For SDLT purposes, the land has already been sold to the customer, although payment hasnot yet been paid. Accordingly, the bank’s interest in the land which is transferred to thesukuk issuing SPV is only a security interest, and its sale to the SPV therefore attracts noSDLT. Furthermore FA 200 s.73B puts the matter beyond doubt by stating that the bank’sinterest is an exempt interest.

Technical issues do potentially arise on the sale of sukuk after they have been issued, andthey could be subject to stamp duty reserve tax. The issue is quite complex and the relevantprovisions of FA 2008 s.154 are explained below.



FA 2007 s.53 enacted the provisions for alternative finance investment bonds (AFIBs) whichare now contained in FA 2005 s.48A and s.48B. Although s.48B(3) states that AFIBs ‘aresecurities for the purposes of an enactment about any tax’, there remained doubts about thestamp duty position on a transfer of AFIBs on the grounds that stamp duty is a ‘duty’ and nota tax. Accordingly s.154 puts the matter beyond doubt for instruments executed on or afterRoyal Assent being given to FA 2008.

Section 154(2) extends the definition of loan capital in FA 1986 s.78 to include AFIBs. Thisenables the exemption from stamp duty in FA 1986 s.79(4) to apply.

Section 79(5) disapplies the exemption in the case of loan capital which carries a right ofconversion into shares or other securities, and this disapplication applies equally to AFIBscarrying similar conversion rights.

The disapplication of the stamp duty exemption contained in FA 1986 s.79(6) is not directlyapplicable to AFIBs as they do not pay any interest. Accordingly s.154(3) sets out a modifiedform of s.79(6) to apply to AFIBs. There is, however, an apparent flaw in the drafting.

The existing s.79(6)(a) regarding interest exceeding a reasonable commercial return isdeleted since s.79(6)(a) and s.79(6)(c) are together replaced by a new s.79(8A)(a) which hasthe effect of disapplying the stamp duty exemption where the total return to the holder overthe life of the AFIB exceeds a reasonable commercial return. This provision should operate ina satisfactory manner.

However s.79(6)(b) has been retained with the clarification in the new s.79(8A)(b) that in thecase of an AFIB interest is taken to mean ‘additional payments’ as defined in FA 2005 s.48A.This retention of s.79(6)(b) appears to be a mistake since the AFIB legislation explicitlypermits additional payments to be dependent upon the results of the issuer’s business byoverriding ICTA 1988 s.209(2)(e)(iii) in FA 2005 s.54(2). Accordingly policy consistency wouldappear to require not disapplying the stamp duty exemption, and s.79(6)(b) should have beendeleted.

As it stands, many AFIBs will fail to qualify for the stamp duty exemption, despite FA 1986s.79(7B) having been inserted by FA 2008 s.101. Where an AFIB specifies a fixed amount ofadditional payments which may be reduced if the issuer has insufficient funds, s.79(7B)ensures that the possibility of that reduction does not, by itself, cause s.79(6)(b) to disqualifythe instrument from the stamp duty exemption. However, it is common for AFIBs to stipulatethat the issuer shall pay to the investors all of the income received by the issuer from aparticular asset or collection of assets. This linkage with the results of the issuer’s business islikely to cause them to fail to qualify for the stamp duty exemption.

Where an AFIB qualifies for exemption from stamp duty under FA 1986 s.79(4), it alsobecomes exempt from stamp duty reserve tax under FA 1986 s.99(5)(b). FA 2005 s.48B(5)(a)and (b) provided that an AFIB is not a unit trust scheme for the tax provisions specified;s.154(4) ensures that an AFIB will not be treated as a unit trust scheme for stamp dutyreserve tax purposes.

5.2 Diminishing musharaka mortgages

5.2.1 Grant

As explained above, although legally the bank owns a part share of the land which it is rentingto the customer, for tax purposes the transaction is treated as a loan relationship for the bank.

The same applies for the purposes of computing any tax deductible expense for the customerif the customer has a business and is entitle to tax relief for the financing cost.



FA 2003 s.71A should apply to relieve the lease to the customer from SDLT.

5.2.2 Maintenance

For tax purposes, the rent paid by the customer to the bank is treated as alternative financereturn, which receives the same tax treatment as interest. This can be very favourable if thebank is overseas. Rent paid to a foreign person on UK land is subject to withholding tax at20%, and this withholding tax is not reduced even if the UK has a double tax treaty with thecountry concerned. However, most of the UK double tax treaties reduce the rate ofwithholding tax on interest, commonly to zero.

For CGT purposes, strictly speaking each purchase by the customer from the bank of anadditional part of the land is treated as a separate acquisition, which could have made thecalculation of CGT taper relief (now abolished) or indexation allowance (for companies) quitecomplex. HMRC however set out guidance on the implications of diminishing sharedownership for capital allowances for plant and machinery and capital gains (for taper reliefand indexation allowance purposes) in HMRC Brief 26/07 dated 22 March 2007, of which anextract is reproduced below:

In relation to both taper relief and indexation allowance the prime issue is the time when thebuyer is treated as acquiring the asset in question. Where DSO arrangements take the formoutlined above, HMRC’s view is that – unless there are any special features of thearrangements which lead to a different conclusion – the buyer should be treated as acquiringeach successive tranche of beneficial interest at the time he or she entered into theunconditional contracts with the seller and the financial institution for acquiring their respectivebeneficial interests in the asset. This follows from section 28(1) of the Taxation of Chargeable

Gains Act 1992 (TCGA 1992).

5.2.3 Redemption

There are no special tax consequences from the completion of the diminishing musharakacontract.

5.2.4 Securitisation

If the bank securitises its diminishing musharaka contracts, this will be accomplished bytransferring its ownership of the land, legally or beneficially, to an SPV that will issue sukuk,i.e. alternative finance investment bonds. Provided the detailed provisions for alternativefinance investment bonds in FA 2005 s.48A are complied with, the issuing SPV should betreated as a financial institution in relation to the diminishing musharaka (technicallydiminishing shared ownership) contracts. This should mean that the customer’s tax treatmentis not disturbed by the securitisation, and the sukuk issuing SPV will be taxed in the sameway as outlined above for the bank.

If the bank makes a profit on transferring to the SPV its rights under the diminishingmusharaka contracts, that profit will be taxed as a loan relationship profit, as with thesecuritisation of conventional mortgages.

Legally, the sale to the SPV is a sale of an interest in land by the bank, potentially subject toSDLT. Relief is given by FA 2003 s.71A(2)(b) since the SPV is a financial institution in relationto the diminishing shared ownership contract, so the sale from the bank to the SPV qualifiesas an exempt “first transaction” within s.71A. Furthermore FA 200 s.73B puts the matterbeyond doubt by stating that the bank’s interest is an exempt interest.

6 Recommendations for future changes to UK tax law

Since it started in 2003 with the elimination of the double stamp duty on Islamic mortgages,the UK has made excellent progress in adapting its tax system to enable Islamic finance to



take place without experiencing a tax penalty. However, parity of treatment has not yet beenachieved.

In the context of Islamic mortgages, the most pressing changes needed are as follows.

6.1 Refinancing transactions

When the owner of a property wishes to borrow conventionally against the security of thatproperty, there are no significant tax consequences.

If that transaction is done Islamically, it will entail the sale of all or part of the property to abank and the execution of a murabaha purchase contract (if permitted by Shariah) or adiminishing musharaka contract.

For SDLT, there are relieving provisions which will prevent any SDLT arising. In the case ofdiminishing musharaka, FA 2003 s.71A(2)(a) will apply to exempt the first sale from SDLT,and as seen above the repurchase by the individual is also exempt from SDLT. Similarly, FA2003 s.73(2)(a) protects the first sale from SDLT in the case of the murabaha basedremortgage, while s.73(3) protects the repurchase by the individual.

Similarly, the computation of business income provisions in FA 2005 s.47 and s.47A applyrelatively satisfactorily to remortgage transactions using murabaha or diminishing musharaka.

However, the provisions are not well integrated with the CGT rules. A conventionalremortgage transaction does not constitute a disposal of the property concerned, asexplained above. However, there are no CGT provisions to stop the sale by the owner to thebank needed for an Islamic remortgage from being a disposal for CGT purposes. Accordingly,any built in gain on the property is potentially taxable. This will not matter if the property isexempt from CGT as a principal private residence, but will matter in the case of secondhomes or business assets. Here there is no parity between conventional finance and Islamicfinance.

What is needed is an equivalent of TCGA 1992 s.263A for land transactions, since s.263A,reproduced below, applies only to the sale and repurchase of securities.

263A Agreements for sale and repurchase of securities

(1) Subject to subsections (2) to (4) below, in any case falling within subsection (1) of section730A of the Taxes Act (treatment of price differential on sale and repurchase of securities)and in any case which would fall within that subsection if the sale price and the repurchaseprice were different—

(a) the acquisition of the securities in question by the interim holder and the disposal of thosesecurities by him to the repurchaser, and

(b) except where the repurchaser is or may be different from the original owner, the disposalof those securities by the original owner and any acquisition of those securities by the originalowner as the repurchaser,shall be disregarded for the purposes of capital gains tax.

(2) Subsection (1) above does not apply in any case where the repurchase price of thesecurities in question falls to be calculated for the purposes of section 730A of the Taxes Actby reference to provisions of section 737C of that Act that are not in force in relation to thosesecurities when the repurchase price becomes due.

(3) Subsection (1) above does not apply if—



(a) the agreement or agreements under which provision is made for the sale and repurchaseare not such as would be entered into by persons dealing with each other at arm’s length; or

(b) any of the benefits or risks arising from fluctuations, before the repurchase takes place, inthe market value of the securities sold accrues to, or falls on, the interim holder.

(4) Subsection (1) above does not apply in relation to any disposal or acquisition of qualifyingcorporate bonds in a case where the securities disposed of by the original owner or thoseacquired by him, or by any other person, as the repurchaser are not such bonds.

(5) Expressions used in this section and in section 730A of the Taxes Act have the samemeanings in this section as in that section.

As can be seen from the text above, if the section was not limited to securities but alsoextended to other assets, there would be no adverse CGT consequences from the Islamicrefinancing transaction.

6.2 Expand diminishing shared ownership provisions

As explained above, the tax law in FA 2005 s.47A does not apply if the bank can participate inany increase in the value of the property. There appears to be no good policy reason for thisexclusion, and it should be eliminated. This would enable a broader range of contracts to beused.

6.3 Eliminate the uncertainties in the stamp duty treatment of sukuk

This point was explained in detail earlier.

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Mohammed Amin

9 November 2008

taxation of conventional and shariah compliant mortgages ... · securitisation of residential and...

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