1
Taxing Islamic Finance Instruments
under International Law
Luxembourg Circular and the Treatment of selected Islamic Finance Instruments
Khalil Jarrar J.D.
Candidate for the LL.M. Degree in International Taxation
aljarrar@yahoo.com
707-287-7286
Presented to Professor
Dr. Robert Munro
Thesis
Walter H. & Dorothy B. Diamond Graduate International Tax Program
March 2012
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Contents
I. Introduction ..................................................................................................................................... 5
II. Islamic Finance ................................................................................................................................ 9
1. Profit and loss sharing ................................................................................................................ 10
2. Growth of Modern Islamic Finance ............................................................................................ 11
3. Main Ethical Restrictions ........................................................................................................... 12
A. Riba (Usury or Charging Interest)........................................................................................... 12
B. Gharar (Uncertainty) .............................................................................................................. 13
C. Maysir (Games of Chance) ..................................................................................................... 14
D. Haram (Unlawful) .................................................................................................................. 14
4. Main Agreements- Islamic Finance ............................................................................................ 15
(a) Mudaraba (profit sharing) ................................................................................................... 15
(b) Murabaha (cost-plus profit sale) ......................................................................................... 17
(c) Musharaka (Partnership) ..................................................................................................... 18
(d) Diminishing Musharaka (joint-venture) .............................................................................. 18
(e) Ijara (leasing/rent) .............................................................................................................. 19
(f) Sukuk (asset-backed securities) .......................................................................................... 19
(g) Tawarruq ............................................................................................................................ 20
III. International Tax Issues and Implications ................................................................................... 21
1) Transfer Pricing ......................................................................................................................... 21
2) Triggering of capital gains taxes ................................................................................................. 21
3) Permanent establishment (PE) issues .......................................................................................... 21
4) Withholding taxes ...................................................................................................................... 22
5) Double Taxation Treaties ........................................................................................................... 22
6) Value added tax (VAT) .............................................................................................................. 23
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IV. Taxing Islamic Finance Instruments in Luxembourg .................................................................. 24
i. Luxembourg .............................................................................................................................. 24
ii. Why Luxembourg? .................................................................................................................... 24
iii. Luxembourg International Taxation........................................................................................ 25
A) The Effects of Tax Treaties ................................................................................................ 25
B) Permanent Establishment.................................................................................................... 25
C) Withholding Taxes (Interest, Dividends and Royalties) ....................................................... 26
D) Taxation of Capital Gains ................................................................................................... 27
iv. Luxembourg -Treatment of Islamic Finance Instruments ........................................................ 28
v. The Circular .................................................................................................................................. 29
vi. Practical Case Studies and Examples ............................................................................................ 34
V. Conclusion .................................................................................................................................... 35
VII. Appendix – The Circular ............................................................................................................ 41
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I. Introduction
Islamic law and Islamic finance have been a topic of interest for years. I have written for a few
online publications about it, and served a columnist for Opalesque1 from 2009 through 2011.
What I have noticed in the process of my research is the recent staggering number of books and
publications on the topic of Islamic finance. Conducting a research was a difficult task early on
where most of the publications where only in Arabic with few exceptions.
In 2009 ,there were only a handful of publications written in English addressing Islamic finance
instruments. The only books I was able to find were written by renowned scholars such as Frank
E. Vogel2, Mahmoud El-Gamal3 and Muhammad Ayub.4Conducting my research for this Thesis
yielded a number of books and publications addressing a range of issues from the basics of
Islamic finance to the most complex and exotic financial instrument structures. I have found a
good number of online publications addressing international taxation with very limited printed
resources addressing specific taxation issues. On one hand the lack of printed resources added an
extra layer of challenge but validated the novelty of this topic giving more value to my work.
Islamic finance is a financial system consistent with Islamic Law5 established fourteen centuries
ago and reincarnated in modern instruments to accommodate certain financial requirements in
today’s financial market. It is a set of restrictive covenants and prohibitions promoting social
justice through the prohibitions of usury and the promotion of socially responsible investments.
It is said to be asset based rather than currency based where currency itself is a payment
mechanism and has no intrinsic value.
The main principles of Islamic finance revolve around the prohibition of usury (Riba)6, however
it provides an alternative to lending money in exchange of interest in risk sharing between the
parties. Islamic finance has come of age after the recent global financial crisis of 2008 largely
because it is based on real assets and ethical principles closely aligned to socially responsible
investing (SRI). Such Islamic finance instruments were able to weather the financial crisis for
three main reasons largely because Islamic finance professionals are not allowed to use
derivative products and also the requirement to invest in tangible real assets with minimum
speculations.
1 Opalesque was formed in 2001 to provide professional news services to participants in the alternative investment
sector. Since inception, Opalesque has been providing premium online information services related to the hedge
fund and investment industries.
2 Frank E. Vogel, 61, is an independent scholar and legal consultant on Islamic law, especially on finance and other
contemporary applications.
3 Professor of Economics , at Rice University and the Author of Islamic Finance and Economics .
4 The Author of Understanding Islamic Finance.
5 The term Islamic and Shari’a are used interchangeably throughout this paper and all Arabic terms are italicized to
confirm the origin of the Islamic finance structure terms.
6 Id.
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At least $5007 billion in assets around the world are managed in accordance with Shari’a, 8 or
Islamic law, and the sector is growing at more than 10% per year. In spirit, Islamic finance seeks
to promote social justice by banning exploitative practices. In reality, this boils down to a set of
prohibitions--on paying interest, on gambling with derivatives and options, and on investing in
firms that make pornographic material or pork products. No one can say for sure how many of
the world's 1.3 billion Muslims will demand Shari’a-compliant financial products, but if even a
fraction does, the world's largest banks will be happy to oblige. 9
The purpose of this paper is to illustrate how and why Islamic finance transactions might create
challenges for tax systems and to serve as an aid to considering what tax changes might be
appropriate to enable Islamic finance to operate without suffering excessive taxation costs or
double taxation. 10 Most tax systems were developed for conventional finance therefore in many
cases; Islamic finance transactions suffer higher tax costs than their conventional equivalent.
In the process of outlining the treatment of Islamic finance tax treatment in Europe and in
Luxembourg specifically, we will introduce the reader to the basic principles of Islamic finance,
the most common instruments and attach a glossary of Islamic finance terms and its synonyms in
the English language.
Recently there have been a few directives and initiatives in Europe addressing taxing Islamic
finance instruments; in 2009 the French Ministry of the Economy clarified the tax treatment of
two of the main Islamic finance instruments used in France: Murabaha (Cost Plus)11 and Sukuk
(Islamic Bonds). 12The Irish government also has published a paper providing guidance on the
tax treatment of Islamic finance. Section 39 of the Finance Act of 2010 provides for the tax
treatment of certain credit sale, deposit and investment transactions (referred to in the legislation
as “specific financial transactions”) which achieve the same economic result in substance as
comparable conventional products.
Although designed to cover certain Shari’a compliant structures, the legislation applies to any
financing arrangement falling within the meaning of the term “specific financial transaction”
regardless of whether the arrangement is, in fact, Shari’a compliant. 13The term Islamic finance
7 The number has changed exponentially since the article was written.
8 Scholars describe the word Shari’a as an archaic Arabic word denoting "pathway to be followed". Although it is
used interchangeably with Islamic law, it rather denotes the origin of the evolving Islamic law that was codified
throughout the centuries into all aspects of a civil society. The concept evolved through the schools of thoughts that
is called Madhaheb and reached a level of maturity under the reign of Suleiman the magnificent.
9 Forbes Magazine special report on Islamic Finance 2008 , Edited by Elisabeth Eaves and Michael Noer 04.21.08,
6:00 PM ET.
10 Double taxation is the systematic imposition of two or more taxes on the same income by two different states.
There are bi-lateral treaties that are set to avoid such imposition.
11 Id.
12 http://www.loc.gov/lawweb/servlet/lloc_news?disp3_l205401548_text.
13 www.revenue.ie/ last accessed 3/29/2012.
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does not appear in tax legislation in most countries or in the United Nation’s Initiative on Islamic
finance, it rather groups it under non-conventional banking or finance. 14
For tax purposes, transactions which are structured to be Shari’a compliant may or may not be
treated equally to mainstream financial transactions that are similar in substance.
It is noteworthy to mention that the Irish tax treatment of Shari’a compliant transactions and
structures within the funds, leasing and insurance industries, is the same as that applying to
conventional transactions. The tax implications are not limited to the domestic tax issues as it
relates to Luxembourg rather International law implications. Unlike the conventional
transactions transfer taxes15 is a big issue as Islamic finance transactions are subject to multiple
transfers and normally involves the transfer of real estate assets. Other issues involve, capital
gains, permanent establishment, withholding taxes, double taxation and value added tax which
we will elaborate on in details throughout this paper. 16
The Organization of Economic Cooperation and Development (OECD)17 defines interest as
follows: The term “interest” as used in this Article18 means income from debt-claims of every
kind, whether or not secured by mortgage and whether or not carrying a right to participate in the
debtor’s profits, and in particular, income from government securities and income from bonds or
debentures, including premiums and prizes attaching to such securities, bonds or debentures.
Penalty charges for late payment shall not be regarded as interest for the purpose of this
Article.”19
This definition does not accommodate the economic equivalent of interest such as Islamic
finance instruments unless a wider definition of interest is included in double taxation treaties.
The United Kingdom (UK)/United States of America (USA) double taxation treaties added “all
other income that is subjected to the same taxation treatment as income from money lent by the
taxation law of the Contracting State in which the income arises”20, which is not limited to a
payment from a debt claim.
The use of such terms is more accommodating for any future finance structures whether it is
religious based or socially responsible investment schemes. The selection of Luxembourg in
particular is due to the rich history of the banking sector since the early seventies backed by
14 http://www.un.org/esa/ffd/tax/RevisionToArt11.pdf
15 Id. Transfer taxes is also referred to as transfer pricing.
16 The fact that the term interest does not appear in any Islamic finance transaction which can be a triggering issue in
most double taxation treaties.
17 OECD, an international organization helping governments tackle the economic, social and governance challenges
of a globalised economy
18 Article 11 of the OECD Model Convention.
19 11(3) of the OECD model convention 2010.
20 Article 11(2) USA/UK double taxation treaty.
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government initiatives to accommodate Islamic finance transactions and the treatment of each
financial instrument.21
To confirm its commitment to Islamic finance, the Luxembourg Tax Authority has issued
circular (L.G.-A Bo. 55).22 The purpose is to provide guidance on Islamic finance, with the tax
treatment of Murabaha23 (Cost Plus) and Sukuk24 (Islamic Bonds), but also describes other
instruments, such as Musharaka (Partnership)25, Mudaraba (Profit Sharing) 26, Ijara(Lease),
Ijara-wa-lqtina(Hire Purchase)27 and Istisnaa28 (Order to manufacture). 29
According to the circular, for Luxembourg tax purposes, Sukuk would be treated like
conventional bonds and the yield30 on Sukuk would be treated as interest payments on
conventional debt instruments. This tax treatment would apply even though the yield on the
instruments is directly contingent on the income earned on the underlying asset. Hence, the yield
will be tax deductible at the level of the Sukuk Issuer.
The paper will examine the current regulations in place in Luxembourg and demonstrate its
impact to facilitate investing in Islamic funds which makes the initiatives by this jurisdiction a
model to follow in advancing alternative investment modes in Europe and globally.
21 More details on such initiatives is explored in details under section Luxembourg-The treatment of Islamic Finance
instruments.
22 The full text of the circular is included at the bottom of this paper.
23 Id.
24 Id.
25 Id.
26 Id.
27 (ljara wa lqtina) is an Arabic term with literal translation of lease to own that involves a longer-term lease which
usually ends with the transfer of ownership of the asset to the lessee. The monthly payment is based on the rent
value of the properly in the locality which is amortized to include an added payment of capital contribution in
addition to the rent payment. So instead a making a full payment that is prorated to the ownership interest of day one
and zero payment at the end of the lease term , the payment are amortized to have equal payments throughout the
agreed lease period.
28 The word Istisnaa is derived from Arabic term Sina’a , meaning to manufacture a specific commodity.
29 http://www.deloitte.com/ Luxembourg Tax Alert Tax authorities issue guidance on Islamic finance: “no interest,
but plenty of attention” Raymond Krawczykowski.
30 Using the term yield is more accommodating than the use interest , although both constitute a return on funds ,
interest refers to the income generated from the capital alone and not from the investment itself.
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II. Islamic Finance
In Islam, money is only considered as a medium of exchange and has no intrinsic value in itself
therefore; it cannot give rise to more money via fixed interest payments. However Islam
recognizes the time value of money only when it is invested prudently promoting economic
growth and the stream of commerce where the return percentage is based on the investment itself
not the capital.
Islam has a set of goals and values encompassing all aspects of human life including the social,
economic and political. 31 The term Islamic finance refers to financial transactions that are
consistent with the principles of Islamic law (Shari’a) that is based on fairness, equity, profit,
loss sharing and asset based transactions.
Transactions should be free of Riba (Usury), Gharar (uncertainty), Maysir32 (gambling), and
Haram which is unlawful or forbidden by the basic tenets of Islam. It is based on ethical
restrictions that prohibit Riba33, Gharar34 , and the exploitation individuals, encouraging asset
based investment to create more jobs and ensure the circulation of wealth In short Islamic
finance calls for ethical investment.
Islamic economic principles are set to promote fairness and equity based on sharing risks in real
transactions observing the aforementioned restrictions and the highest ethical and socially
responsible investments. Islamic transactions are considered Profit-Loss Sharing (PLS)
transactions, whereby profits and losses are shared by parties in proportion to their original
contribution. These limitations, in cumulative effect, strive to maintain equality among
individuals and dispel greed and exploitation.35
Other key principles include the the prohibition of activities based on speculation (Maysir) or
excessive uncertainty (gharar) and the prohibition on investment in unethical businesses,
products or services. It is forbidden to invest in the gambling industry, tobacco, pork products,
and porn or alcohol industries.
Islamic financial transactions are typically backed by or based on an identifiable and tangible
underlying asset, and involve risk sharing between the investor and the investee. 36
31 Global Trends in Real Estate Finance By Graeme Newell, Karen Sieracki
32 Id.
33 Supra
34 Supra
35 This model presumes that Islamic banks are strictly abiding by Islamic law and not attempting to avoid Shari’a
requirements by tweaking their contracts or responsibilities with a client.
36 GUIDANCE NOTES ON THE TAX TREATMENT OF ISLAMIC FINANCIAL TRANSACTIONS. Dave
Brennan.
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It is the opinion of the Irish tax authorities that Islamic financial instruments have been devised
in compliance with the basic principles of Shari’a law. Islamic financial instruments meet the
same economic needs as conventional financial products by using familiar legal structures in an
alternative way aiming to achieve the financing objectives.37
It is also stated that Islamic financial instruments are an alternative financing system based on a
subtle mix of economy; ethics and Islamic Law (Shari’a).Thus, providers of funds are rather
investors than creditors, and share business risks sharing potential profits and losses. The Islamic
rational behind the prohibition of Riba is that in Riba, the investors, which are depending on
interest income, will neglect the industry and the trading.38It is the human nature to devote more
time and effort when investments are placed at risk rather than the dependency on a capital return
regardless of the outcome.
1. Profit and loss sharing
Profit and loss sharing (PLS) financing is a form of partnership, where partners share profits and
losses on the basis of their capital share and effort.39 Islam supports the view that Muslims do not
act as nominal creditors in any investment, but as partners in the business (that is, essentially an
equity-based financing). The justification for the PLS financier's share in profit is their effort and
the risk they carry, because their profit would have been impossible without the investment. If
the investment makes a loss, their money is lost.40
While Islam employs various practices that do not involve charging or paying interest,
alternatively the Islamic financial system promotes the concept of participation in a transaction
backed by real assets, in utilizing the funds at risk on a profit-and- loss-sharing basis. Such
participatory modes used by Islamic banks are known as Musharaka41 and Mudaraba42. The
concept does not imply that investments with financial institutions are necessarily speculative.
This can be excluded by careful investment policy, diversification of risk and prudent
management by Islamic financial institutions, where risk is being regarded as a matter of
degree.43
The concept of profit-and-loss sharing in an enterprise as a basis of financial transactions is a
progressive one as it distinguishes good performance from the bad and the mediocre. This
37 As outlined in Section 39 of the Finance Act of 2010
38 tes for Guidance – Taxes Consolidation Act 1997 – Finance (No. 3) Act 2011 Edition - Part 8A .Publication by
the Irish Revenue Authority.
39 Unlike conventional finance, the rate of return on the capital is not preset.
40 The three principles of Islamic finance explained
41 Id.
42 Id.
43 Islam does not prohibit risk on its own, as it is an inherent part of doing business rather prohibits extreme
uncertainty and high risk modes and structures.
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concept therefore encourages better resource management. The Islamic sukuk system is similar
to bonds of capitalist system, but in sukuk, money is invested in asset based concrete projects and
profit/loss sharing is distributed to clients instead of interest earned.
Profit and loss sharing (PLS) financing is a form of partnership, where partners share profits and
losses on the basis of their capital share and effort.44 Islam supports the view that Muslims do not
act as nominal creditors in any investment, but as partners in the business (that is, essentially an
equity-based financing). The justification for the PLS financier's share in profit is their effort and
the risk they carry, because their profit would have been impossible without the investment. If
the investment makes a loss, their money is lost.45
2. Growth of Modern Islamic Finance
According to a report published by the IMF in 2007 there are more than 300 Islamic Financial
institutions operating in more than 75 countries and the number is growing and gaining
acceptance by both Muslim and non-Muslim investors alike.46Although there has been some
speculation about the future and sustainability of Islamic finance instruments compared to
conventional banking and finance, the financial collapse of 2008 created a golden opportunity for
such instruments to be a major global player in finance.
There has been a surge of legislation in most developing countries to accommodate Islamic
finance instruments especially Western European countries, including the UK, France, Ireland,
Spain and Luxembourg. Some scholars have attributed the following reasons behind the new
surge and demand for Islamic finance instruments:
1) Muslims worldwide are opting to invest in products that are consistent with Islamic laws.
2) The wealth growth the past few years created by the oil price boom triggered a surge in new
legislation in the West to cash in on such investments by accommodating and encouraging
Islamic finance.
3) The ethical and socially responsible approach of Islamic law is attracting both Muslims and
non Muslims to invest in such instruments.
The International Organization of Securities Commissions47 predicts that as much as half of the
savings of the worlds estimated 1.2-1.6 billion Muslims will be in Islamic financial institutions
by 2015.48
44 Unlike conventional finance, the rate of return on the capital is not preset.
45 The three principles of Islamic finance explained.
46 Working Paper WP/10/195 Islamic Banking: How Has it diffused? Patrick Imam and Kangni Kpodar.
47 The International Organization of Securities Commissions (IOSCO) is an association of organizations that
regulate the world’s securities and futures markets.
48 Working Paper WP/10/195 Islamic Banking: How Has it diffused? Patrick Imam and Kangni Kpodar.
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3. Main Ethical Restrictions
It is important to expand on the main ethical restrictions in Islam as it relates to the finance and
banking industry. The rationale behind such restriction and prohibitions is to avoid exploitation
of the weaker party, minimize risk and advance asset based commerce in a socially responsible
manner.
A. Riba49 (Usury or Charging Interest)
Riba is an Arabic term referring to the prohibition of usury or interest as Islam considers money
a medium of exchange and has no intrinsic value in itself and it cannot give rise to more money
via fixed interest payments. Riba is an exchange of Ribawi50 elements where there is a
difference in time and/or quantity. 51 It is believed that in Riba, the investors, which are
depending on interest income, will neglect the industry and the trading and the wealth will stay
stagnant or in the hand the rich minority.
In order for wealth to circulate, real economic activities have to occur in asset based investments.
Since Islam considers money to be no more than a medium of exchange and to have no value in
itself, it should not be allowed to give rise to more money (via fixed-interest payments). 52The
main prohibition comes straight from the text of Quran “Those who devour usury (Riba) do not
stand except as whom the Satan by his touch has driven to madness”.53That is because they say,
"trade is like usury", but Allah has permitted trade and has forbidden usury".54
Only one kind of loan that is permitted in Islam is Qard Hassan, which is interest free. Qard
Hassan is a loan that is given in good faith without a return on capital and at times has a
charitable nature. This does not mean that capital does not have a cost but the restriction of Riba
also implies that investments in e.g., shares of conventional banks are prohibited, as are
investments in highly geared companies in general.
Profits symbolize successful entrepreneurship and creation of wealth whereas interest is a cost
that is accrued irrespective of the outcome of business operations and may not create wealth if
there are business losses. The concept of Riba has more than one mode and not just making
money on a capital investment, it stems from the concept of payment in kind, dates for date’s
wheat for wheat.55
49 Id.
50 An Arabic term for person who practices usury.
51 General takaful practice: technical approach to eliminate Gharar, By Muhaimin Iqbal.
52 The American journal of Islamic social sciences, Volume 23.
53 Quran Chapter Al-Baqra(2), Verse No. (275)
54 Surah Al-baqarah verse no.275, the Holy Quran.
55 Bilal, a companion of the Prophet once visited the Messenger of Allah (Pbuh) with some high qualities dates. The
Prophet (Pbuh) inquired about their source. Bilal explained that, he traded two volumes of lower quality dates for
one volume of higher quality dates. Due to this, the Prophet (Pbuh) said; “This is precisely the forbidden riba! Do
not do this. Instead, sell the first type of dates, and use the proceeds to buy the others”
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Classification of Riba
1) Riba al- Buyu’ (Riba in trade transaction)
a. Riba al-Nasiah (Riba of delay)
b. charged based on deferment of completion of an exchange
Example: If 5 kg of gold is exchanged with another 5 kg of gold, with a delay of one year, the
said trade transaction will amount to riba al nasiah since there is an existence of delay in the said
transaction .
2) Riba al-Fadl (Riba by way of access)
a. arises when there is any additional quantity or in equality in the exchange of
goods
Example: An exchange of 5 kg of wheat with 6 kg of wheat amounts to Riba al-Fadl.
B. Gharar (Uncertainty)56
The second major prohibition is that of Gharar, which refers to the uncertainty or hazard caused
by lack of clarity regarding the subject matter or the price in a contract or exchange. 57Gharar is
an Arabic term referring to an act or a transaction that has deception or lack of enough
information to act which one party can outsmart another in either using trickery or deception for
the lack of knowledge of the other party.
It also includes any transaction with high level of risk or uncertainty for the underlying reason,
uncertainty. The prohibition is meant to protect personal and communal wealth and encourages
well founded investment behavior and a call for acquiring knowledge prior to investing in a
product.
After riba, gharar is the most important element to be avoided in economic and financial
contracts. In simple terms, gharar refers to asymmetrical information or any uncertainty created
in the contracts due to the lack of information or (Jahl).58Contracts must be clear, any element of
uncertainty as to the existence, quantity or quality of the subject of the contract is banned which
renders contractual ambiguity avoided therefore agreements may become void or voidable in
case of gharar. Based on Gharar, e.g., forward sales and investments in derivatives are generally
prohibited (with certain limited exceptions).
56 The Rule of Gharar is originally based on Hadith of Prophet Mohammad (peace be upon him) prohibited sales
done by throwing pebbles and sales of Gharar(ignorance).
57 Understanding Islamic Finance By Muhammad Ayub.
58 The Stability of Islamic Finance: Creating a Resilient Financial Environment.
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C. Maysir (Games of Chance)59
Maysir refers to the easy acquisition of wealth by games of chance, whether or not it deprives the
other’s right. Qimar (Gambling) means the game of chance in which one gains at the cost of
others. The term is derived from the word “Yusrun” which denotes wishing something valuable
with ease and without paying any an adequate consideration for it, without working for it, or
without undertaking any liability against it, or by way of a game of chance.Islamic finance law
dictates that economic transactions must be free, as far as possible from risk and speculation. But
investing into a business and being exposed to business risks is not Maysir.
The classical Muslim jurists based their theory of Gharar on the Koranic interdiction of
gambling (Maysir). They extended the sanction of absolute nullity to all contracts where a risk
was to be taken in a spirit of speculation or the extent of the obligations undertaken by one of the
parties and the advantages which would redound to the other party were not clearly defined. 60
D. Haram (Unlawful)
Haram is the prohibition of involvement in unlawful activities such as dealing with alcohol, pork
meat, weapon industry, gambling or the porn industries. The code of conduct for Islamic banks
allows them to finance only hala61l (legal, permissible) activities. They are not supposed to lend
to companies or individuals involved in activities deemed to have a negative impact on society
(such as gambling) or that are illegal under Islamic law (for example, financing construction of a
plant to make alcoholic beverages).62
Purification of Funds
There are instances where the majority of the underlying business transactions are halal but
might have activities that are noncompliant with the basic principles and prohibitions of Islam. A
good example is in the case of investing in an airline where alcohol or pork is served. In such
case some scholars took the fatwa63 of finance Sharia'a board where the tainted income can be
isolated and purified.64
If the income or revenue produced from a transaction is questionable or not compliant with
Islamic law, the board will ask the recipient entity to purify such income or the portion that is
noncompliant by donating the questionable portion of the fund to a charity or return the fund to a
59 Prohibition is from a primary source of Authority The Holly Quran They ask Thee concerning wine and gambling.
say: "In them is great sin, and some profit, for men; but the sin is greater than the profit." They ask Thee How much
They are to spend; say: "What is beyond your needs." Thus doth Allah make Clear to you His Signs: In order that ye
may consider. (al-Baqarah:219)
60 The American journal of comparative law: Volume 13.
61 Halal is the antinomy of Haram “meaning permissible “.
62 IMF working paper WP/10/195 Islamic Banking: How Has it diffused? Patrick Imam and Kangni Kpodar .
63 A fatwa is a jurist opinion specific to the situation at hand.
64 A Shari’a board is a team of prominent jurists and legal scholars that examine compliance of an instrument or a
transaction with Islamic law. It monitors the Sharia'a compliance of investment strategies and decisions during the
whole life of the fund/product with issuance of fatwa.
15
party that might have been adversely affected in case of penalties imposed for late payments or
the likes.
Another example will be investing in major hotel chains that at large have questionable or
forbidden practices, such as serving alcohol, from Islamic standpoint but the underlying business
is permissible under Islamic law.
4. Main Agreements- Islamic Finance
The most popular Islamic finance instruments are: Murabaha (Cost plus sale), Ijara (Leasing),
Musharaka (Equity Participation), Mudaraba (Partnership and Financing), Istisnaa
(Commissioned manufacturing) and Sukuk (Bonds).Although there are differences between
Islamic finance instruments and conventional finance, the major difference that the return is on
the investment and asset rather than the initial capital which is a difference in approach rather
than financial impact.
The Islamic finance industry is growing at an exponential rate (10–15% annual growth rate). It is
estimated to have a global worth of USD 1.200 billion by the year 2012. A growing Muslim
population might be a factor of this growth, now standing around 1.7 billion (24% of the world
population), out of which about 50 million residing in Europe. The industry would capture 60%
of the savings of the world’s Muslim population within 8-10 years for its appeal to Muslims and
Non-Muslim investors who are showing interest in ethical investments practices. 65
The modes of Islamic finance instruments can be broken to three major categories
1) Debt type instruments such as Murabaha, Salam66, Istisnaa, Tawarruq and Qard Hasan.
2) Quasi debt instrument67such as Ijara.
3) Profit sharing instrument: Musharaka, Mudaraba and other hybrid modes.
(a) Mudaraba (profit sharing)
Mudaraba is a form of a partnership where one partner (Rab-Al-Mal) provides the capital
required for a project while the other party (Mudarib) manages the investment using its
expertise. Although similar to partnership, a company needs not to be created so long as profit
can be determined separately. Profits from the investment can be distributed according to a fixed
predetermined ratio. The capital provider carries the loss in a Mudaraba contract unless it was
65 Global Islamic Finance magazine February 2012.
66 Id.
67 Quasi-debt financing involves issuing equity-debt securities. Such securities are also referred to as hybrid
securities.
16
due to a Mudarib’s gross negligence. A generic Mudaraba transaction is demonstrated in the
below diagram.
Figure 68
In a Mudaraba contract, the management of the investment is the sole responsibility of a
Mudarib, and all assets acquired by the Mudarib are the sole possession of (Rab-Al-Mal).
However, the Mudaraba contract eventually permits the Mudarib to buy out (Rab-Al-Mal’s)
investment and become the sole owner of the investment, if the contract stipulates so or later
agreed upon by both parties.69
Mudaraba may also be concluded between an Islamic bank as a provider of funds on behalf of
itself or on behalf of its depositors as a trustee (A trustee in Islamic law is a term of art that is
different than the common law system)1 of their funds and its business-owner clients. In the latter
case, the bank pays all profits from the investment to its depositors after deducting its
intermediary fees. Having said that, it is important to point out that the fees extracted by the bank
or Islamic institution cannot carry any punitive charges, such as late fees or the likes. The
Mudaraba contract may also be conducted between bank’s depositors as providers of funds and
an Islamic bank as a Mudarib.
Distribution of Profit & Loss for a Mudaraba contract70
68 Presentation on “Taxation of Islamic finance transactions” at ITIC MENA Tax Forum, Istanbul.
69 Handbook of Islamic Banking M. Kabir Hassan University of New Orleans, USA.
70 The Concept of Mudarabah, Dr. Muhammad Zubair Usmani Sharia Advisor Muslim Commercial Bank Ltd.
Jamia Darul Uloom KarachiAt AlHuda CIBE Workshop at NIBAF, State Bank of Pakistan – Islamabad.
Investor (Rab-Al-Mal) Bank (Mudarib)
Commercial
Venture
Cash Investment
Agreed Share of Profits Investor
bears losses
Manages Profits
17
A) It is necessary for the validity of Mudaraba that the parties agree, right at the beginning,
on a definite proportion of the actual profit to which each one of them is entitled. The loss is only
born by the financier in a Mudaraba contract.
B) The profit can be shared at any ratio they agree upon as long as it is fair and equitable
and free of exploitation of the weaker party.
C) The default rule entering into a Mudaraba contract without mentioning the exact
proportions of the profit, it will be presumed that they will share the profit in equal ratios.
D) It is permissible to have specific incentives to the Mudarib, such as targeted sales or goals
that is attached to a bonus to encourage performance or to compensate for a lower percentage.
E) Apart from the agreed proportion of the profit, the Mudarib cannot claim any periodical
salary or a fee or remuneration for the work done by him for the Mudaraba.
F) The Mudarib & Rabb-Al-Mal cannot allocate a lump sum amount of profit for any party
nor can they determine the share of any party at a specific rate tied up with the capital. The
operative phrase here is tying a specific rate to the capital is prohibited as a form of Riba.
(b) Murabaha (cost-plus profit sale)
Traditional Murabaha is fiduciary sale where the seller expressly mentions the cost he has
incurred on the commodities to be sold with a mark-up known to the buyer conditioned by an
honest declaration of cost.71Murabaha is basically the sale of goods at a price covering the cost of
purchase plus a margin of profit agreed upon between both parties.72
Modern Murabaha is the most popular form of Islamic financing. With a Murabaha contract the
bank agrees to buy an asset or goods from a third party at the request of its client under a promise
contract (WA’d), then resells the goods to its client with a markup profit. The client purchases the
goods against immediate payment or a deferred payment. The technique is sometimes considered
a clone to conventional interest-based transaction. However in theory the markup profit is
different.
Critics of modern Murabaha have pointed out that the similarities between conventional interest
bearing instruments and Murabaha and the fact that some Islamic banks use LIBOR73 as a bench
mark for the markup. They also point out that the bank never has an actual possession of the
items nor merchants in the sold products.
Islamic institutions justify such the markup in a Murabaha contract as follows:
1) The mark-up is the service the bank provides seeking and purchasing the required goods at
the best price.
2) Furthermore, the mark-up is not related to time because if the client fails to pay a deferred
payment on time the mark-up does not increase due to the delay and its stays as agreed.
71 Modern Murabaha - a fiduciary sale or a misnomer? By Khalil Jarrar, J.D. Opalesque .
72 The Islamic Banking and Finance Workbook by Brian B. Kettell.
73 It is an acronym for London Interbank Offered Rate.
18
3) Most importantly the bank owns the goods between the two sales and so assumes the title and
the risks of the purchased goods, pending their resale to the client.
4) This risk involves all risks involved in trading activities in addition to the risks of not making
the mark-up profits if the client does not purchase the goods from the bank whether or no they
have a justifiable reason to do so. 74
5) The use of LIBOR is a universal industry standard, using LIBOR as a benchmark alone
should not taint a transaction if the structural substance is compliant to the rules of Murabaha.
6) As for actual possession, Islamic banks point out that constructive (legal) possession is
sufficient in today’s market. A merchant residing in one country can purchase products and
resells them without leaving the comfort of his home as long as the merchant has constructive
possession.
A murabahah arrangement can be in the form of cost-plus financing on deferred payment terms.
This arrangement is used for the purchase and sale of assets and enables a business to acquire a
fixed asset or raise capital. A finance provider buys an asset and re-sells it to a customer at a preagreed
higher price, payable at a later date. This type of arrangement is reoffered to in the Islamic
industry as a BBA (Bay’ Bethaman Aajel).75
(c) Musharaka (Partnership)
Musharaka is a classic partnership agreement with similar characteristics to a limited liability
company. All parties involved or members contribute towards the financing and management
of a venture. The parties share profits on a pre-agreed ratio while losses are shared according to
each party’s equity participation. Management of the venture is carried out by all, some, or just
one party member based on the initial intent and contractual stipulations.
(d) Diminishing Musharaka (joint-venture)
Diminishing Musharaka (or digressive as sometimes known) is a special form of Musharaka
which ultimately culminates in the ownership of the asset or the project, by the client.76
Diminishing Musharaka allows equity participation and sharing of profit on a pro rata basis but also
provides a method through which the bank keeps on reducing its equity in the project and ultimately
transfers the ownership of the asset to the participants. The contract provides for a payment over and
above the bank share in the profit for the equity of the project held by the bank. That is the bank gets a
dividend on its equity. At the same time the entrepreneur purchases some of its equity. Thus, the equity
held by the bank is progressively reduced. After a certain time the equity held by the bank shall come to
zero and it shall cease to be a partner. Musharaka form of financing is being increasingly used by the
Islamic banks to finance domestic trade, imports and to issue letters of credit. It could also be applied in
74 Adil Manzoor Bakhshi Developing a financial model for Islamic credit card for the UK.
75 Critic of Murabaha contract assert the permissibility of a BBA , however they indicate that the rule of thumb in
Islamic contract law that you cannot have two contracts in one . As in Cost Plus and a differed payment contract.
76 Case Studies in Islamic Banking and Finance By Brian B. Kettell.
19
agriculture and Industry. 77 This is a type of partnership where one partner gradually buys out the
other. It is most commonly used in property transactions.
(e) Ijara (leasing/rent)
Ijara is defined as sale of Manfa’a (that is the right to use goods) for a specific period of time.
An Ijara arrangement is similar to a traditional lease. An Ijara arrangement which is similar to
a hire purchase arrangement is commonly referred to as Ijara Muntahia Bittamleek or a
diminishing lease ending with ownership78. Its features are broadly similar to a normal Ijara
arrangement (an operating lease) but the lease concludes with the legal title in the leased asset
passing to the lessee. In practice Ijara leasing agreements have many clauses that are similar to
conventional leasing arrangements. Where payments are late, the lessor cannot impose a
penalty79. Most Islamic scholars view imposing penalties as counterproductive to the principles
of equity unless bad faith can be proven, and they do not permit banks to impose such penalty.
In Islamic society, Ijara (leasing) began as a trading activity and then much later became a mode
of finance. Modern Ijara is a contract under which a bank buys and leases out an asset or
equipment required by its client for a rental fee. During a pre-determined period, the ownership
of the asset remains with the lessor (that is, the bank) who is responsible for its maintenance so
that it continues to give the service for which it was rented. Likewise, the lessor assumes the risk
of ownership and in practice seeks to mitigate such risk by insuring the asset in its own name.80
Under an Ijara contract, the lessor has the right to re-negotiate the lease terms and payment at
every agreed interval, to ensure that the rental remains aligned with in the locality of the leased
asset.
Under this contract, the lessee (that is, the client) does not have the option to purchase the asset
during or at the end of the lease term because this is considered under the Shari’a to be tainted
with uncertainty. But this object may be achieved by means of a similar type of contract, known
as an Ijara wa Iqtina (hire-purchase). In a hire-purchase situation, the commitment on the part of
the lessee to buy the asset at the end of the rental period, at an agreed price (with the rental fees
paid up to the point of sale constituting part of the price), is established at the outset. 81
(f) Sukuk (asset-backed securities)
The growth of Islamic finance has resulted in a thriving multibillion-dollar market in Shari’a
compliant financial instrument known as Sukuk (plural of the Arabic word Sakk82, meaning
certificate), it is noteworthy to mention that most of the new modern development and the
construction boom in the gulf region has been attributed to such instruments.
77 Islamic Banking and Finance By Natalie Schoon.
78 This type of contract is mainly used to purchase homes and cars. The concept was thoroughly explained in the
context of amortizing the first and last payment.
79 Islamic bonds: your guide to issuing, structuring and investing in sukuk.
80 Adil Manzoor Bakhshi Developing a financial model for Islamic credit card for the UK. Dissertation submitted in
partial fulfillment for the degree of MSc in International Banking & Finance, University of Salford 2006.
81 The three principles of Islamic finance explained | IFLR.com Last accessed 3/11/2012 5:56 PM
82 Legend has it that the term Check used in the banking industry is of an Arabic origin “Sakk” as in certificate.
20
Sukuk are commonly described as Islamic bonds, trust certificates, or Islamic securities and are
structured and traded in the capital market in accordance with Islamic law. The Accounting and
Auditing Organization for Islamic Financial Institution (AAOIFI) defines Sukuk as certificates
of equal value representing undivided shares in ownership of tangible assets, usufruct,83 and
services or the ownership of the assets of particular projects or special investment activity.
The AAOIFI84 has identified fourteen different types of Sukuk bonds, among these, Sukuk al-
Musharaka (partnership) and Sukuk al-Ijara (lease), these being the most common structures
currently. 85
(g) Tawarruq
Tawarruq86 means the purchase of an item on credit and selling it at spot value with the
objective of getting cash, meaning that the transaction is not the need of the buyer; he simply
wants liquidity, which he gets by purchasing a commodity ( usually silver or gold) on credit and
selling for it for cash. Here is a breakdown of a typical Tawarruq transaction”
1) Bank Sells Assets (Goods / Financial Instruments) to the consumer with market prices
plus margin.
2) The customer authorizes the bank to sell the same asset to a third party for cash using
an instrument called Wakala.87Wakala has the same function of a special power of
attorney under the common law system.
3) Bank sells the asset to the third party on behalf of the Customer at market price.
4) Cash is deposited in the customer’s account.
5) Customer pays back the price of the asset (increased with the margin) in installments
to the bank on the agreed upon differed purchase agreement.
This technique is a modern approach that was first used by Amana Bank to provide credit lines
for individuals that is not conventionally asset based.88
83 Usufruct is a right of enjoyment enabling a holder to derive profit or benefit from property that either is titled to
another person or which is held in common.
84 Accounting and Auditing Organization for Islamic Financial Institutions, (AAOIFI), Bahrain . The AAOIFI is an
Islamic international autonomous non-for-profit corporate body that prepares accounting, auditing, governance,
ethics and Shari'a standards for Islamic financial institutions and the industry. Professional qualification programs
(notably CIPA, the Shari’a Adviser and Auditor "CSAA", and the corporate compliance program) are presented by
AAOIFI in its efforts to enhance the industry’s human resources base and governance structures. AAOIFI is an
independent international organization supported by its members, which include central banks, Islamic financial
institutions, and other participants from the international Islamic banking and finance industry, worldwide.
85 http://www.opalesque.com Lex Islamicus: Preventative & Remedial Measures Protecting Sukuk Investment
Account Holders Khalil Jarrar, J.D.
86 Tawarruq is considered by most Islamic scholars as a questionable practice because of the underlying reason
behind the transaction..
87 A document that grants a person or an entity to represent or transact on behalf of another person .
88 HSBC Amanah provides unique Islamic banking and financial management services that suit both your ethical
preferences and personal circumstances.
21
III. International Tax Issues and Implications89
International taxation is the field of determination of tax on a person or business subject to the
tax laws of different countries or the international aspects of an individual country's tax laws.
Some of the major issues that encounter practitioners are transfer pricing, Capital gains, and
permanent establishment and withholding taxes treaties. Below is a detailed list of such issues
and the impact on Islamic finance instruments.
1) Transfer Pricing
Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges made
between related parties for goods, services, or use of property (including intangible property).
Transfer prices among components of an enterprise may be used to reflect allocation of resources
among such components, or for other purposes. OECD Transfer Pricing Guidelines state,
“Transfer prices are significant for both taxpayers and tax administrations because they
determine in large part the income and expenses, and therefore taxable profits, of associated
enterprises in different tax jurisdictions.” 90
Islamic finance transactions often involve multiple transfers of an asset (often real estate) where
the equivalent conventional transaction does not require asset transfers. Accordingly Islamic
finance transactions may suffer multiple instances of transfer taxes, especially if the country
concerned operates a real estate transfer tax.
2) Triggering of capital gains taxes
Where an asset is sold by the owner in order to raise finance, with the asset subsequently being
re-acquired, that may be treated as a disposal for capital gains tax purposes. Accordingly capital
gains tax may be payable with Islamic finance transactions even when there is no change in the
party that has the economic benefits and risks of ownership.
3) Permanent establishment (PE) issues
Permanent Establishment in treaty terms is a fixed place of business through which the business
of an enterprise is wholly or partly carried on. A non resident who is a partner in an enterprise
can qualify for tax relief under Luxembourg’s tax law. It is generally accepted by most countries
that where a foreign bank makes an interest-bearing loan to a borrower located in a second
country, then unless it has a branch located in that second country which is effectively connected
with the making of the loan, the bank is not liable to business profits taxes in that second
country. (Of course withholding taxes discussed below may be payable on interest paid from the
second country to the bank.)
However an Islamic finance transaction such as a commodity Murabaha transaction may involve
the foreign bank (either directly or through agents) purchasing and selling assets located in a
89 The main issues are extracted from the Irish Authorities document on Islamic finance.
90 Fundamentals of International Transfer Pricing in Law and Economics By Kai A. Konrad, Wolfgang Schön.
22
second country. It is possible that such activities could cause the foreign bank to be treated as
having a permanent establishment in that second country.
The same issues apply if money is provided to a bank using Mudaraba or wakala.91 The role of
the bank in acting as agent or partner for the customer may have significant consequences in
international transactions. The bank acting as agent or partner for the customer in providing
funds to the underlying commercial venture may be sufficient to cause the customer to have a
permanent establishment within that country since the bank as agent is making commercial
decisions on the customer's behalf.
The consequence may be to make the customer taxable on the profit paid to it whereas interest
paid on a conventional bank deposit to a foreign person may not have been taxed by that country,
either due to the country's domestic tax law or because many double taxation treaties give
exclusive taxing rights on interest to the country where the customer resides rather than to the
country of source. Accordingly, replacing a conventional deposit with a wakala contract or a
Mudaraba contract involves the risk of creating a taxable presence in the country where the bank
is located.
4) Withholding taxes
Many countries have withholding taxes that are charged on payments to foreign persons. It is
common to have a withholding tax on interest paid to foreigners, with the rate of withholding tax
being reduced (often to zero)92 where a double taxation treaty applies.
The cross-border payments made with Islamic finance transactions are legally different from
those made in conventional transactions. For example none of them is legally a payment of
interest. Accordingly the question arises as to how withholding taxes should be charged on
Islamic finance transactions and at what rates.
As an illustration, if a foreign bank makes an interest-bearing mortgage loan to a borrower in a
second country, that second country may apply withholding tax on the interest payments that the
borrower makes to the bank. However if the finance is structured as a diminishing Musharaka
transaction, the payment by the householder to the bank will be rent in respect of the occupation
of the property. The second country may apply a different rate of withholding to rent paid to
foreign persons than it applies to interest paid to foreign persons.
5) Double Taxation Treaties
Almost all existing double taxation treaties were negotiated in an environment where almost all
financial transactions comprised conventional finance. Accordingly they are unlikely to make
91 Supra.
92 Zero withholding taxes can be achieved through bilateral treaties or finding a third country with bi-lateral treaties,
it is the responsibility of the international taxation adviser to find such treaties and advise the client accordingly.
Some of such work might require setting up entities with holding companies in one place or another and having the
operating entities in another jurisdiction.
23
specific provision for Islamic finance transactions and in many cases may not be readily
adaptable to Islamic finance.
For example many double taxation treaties reduce the rate of withholding tax on cross-border
payments of interest. However the definition of interest under the treaty may not be extensible to
payments which are economically equivalent to interest made under Islamic finance transactions.
Accordingly if the country from which the payment is being made charges a withholding tax on
the payment, the recipient may not qualify for reduced withholding even if there is a double
taxation treaty which would reduce the rate of withholding tax on an equivalent interest payment.
For example, Article 11(3) of the Organization of Economic Cooperation and Development
(OECD) model convention 2010 defines interest as follows: The term “interest” as used in this
Article means income from debt-claims of every kind, whether or not secured by mortgage and
whether or not carrying a right to participate in the debtor’s profits, and in particular, income
from government securities and income from bonds or debentures, including premiums and
prizes attaching to such securities, bonds or debentures. Penalty charges for late payment shall
not be regarded as interest for the purpose of this Article.
This definition does not accommodate payments made under Islamic finance transactions which
are economically equivalent to interest, since such payments do not arise from a debt-claim.
In a few cases, countries negotiating double taxation treaties have included a wider definition of
interest. For example, the definition of interest in Article 11(2) of the current UK/USA double
tax treaty reads as follows:
The term "interest" as used in this Article means income from debt-claims of every kind, whether
or not secured by mortgage, and whether or not carrying a right to participate in the debtor's
profits, and, in particular, income from government securities and income from bonds or
debentures, including premiums or prizes attaching to such securities, bonds or debentures, and
all other income that is subjected to the same taxation treatment as income from money lent by
the taxation law of the Contracting State in which the income arises. Income dealt with in Article
10 (Dividends) of this Convention and penalty charges for late payment shall not be regarded as
interest for the purposes of this Article.93
The United Kingdom has brought in legislation which for taxation purposes treats income arising
from defined transactions (transactions which are commonly carried out in Islamic finance) in
the same manner that interest is treated for taxation purposes. The underlined words in the above
definition have the effect of applying the treaty to such payments in exactly the same way that
the treaty applies to interest.
6) Value added tax (VAT)
VAT rules applicable within the European Union; stipulate that financial transactions are
normally "exempt" from VAT. Consequently, banks do not charge VAT when charging interest
93 Article 11 of the OECD Model Convention.
24
to customers but conversely since most of a bank’s transactions are exempt, the bank is able to
recover very little of the VAT that it suffers on its costs.
Islamic finance is normally provided by carrying out transactions involving real assets. In many
cases the supply of those assets will be subject to VAT.94 If VAT is charged on the supplies of
assets involved, this may give rise to additional costs if the party to the Islamic finance
transactions is not able to recover it.95
Conversely, if the parties to the transactions are able to recover the VAT then there may be an
overall loss of tax revenue since the bank which facilitates the transactions may now be able to
recover VAT on a higher proportion of its costs since it is making increased taxable supplies
while there is no increase in the net VAT payable by the parties to the transactions since they are
recovering any VAT suffered.
IV. Taxing Islamic Finance Instruments in Luxembourg
i. Luxembourg
A Western European country founded in 963, Luxembourg became a grand duchy in 1815 and
an independent state under the Netherlands. It lost more than half of its territory to Belgium in
1839 but gained a larger measure of autonomy. Full independence was attained in 1867. Overrun
by Germany in both world wars, it ended its neutrality in 1948 when it entered into the Benelux
Customs Union and when it joined NATO the following year. In 1957, Luxembourg became one
of the six founding countries of the European Economic Community (later the European Union),
and in 1999 it joined the euro currency area. 96
ii. Why Luxembourg?
Islamic finance enjoys the support of the Luxembourg Government, which set up a special task
force in 2008. The Central Bank of Luxembourg is a member of the Islamic Financial Services
Board (IFSB)97 and numerous Luxembourg companies and cross-functional working groups are
active in this area. Unlike some other jurisdictions, Luxembourg tax law is based on an economic
approach and substance over form principles. As a result, Luxembourg domestic tax law is
94 Not always; for example the commodity that is the subject of a commodity Murabaha transaction may be located
in a third country or inside a bonded warehouse with no VAT arising on its sale provided the commodity's location
does not change.
95 VAT is recoverable in most European countries based on residency and existing bilateral treaties.
96 CIA World Fact Book.
97 The Islamic Financial Services Board (IFSB) is an international standard-setting organization that promotes and
enhances the soundness and stability of the Islamic financial services industry by issuing global prudential standards
and guiding principles for the industry, broadly defined to include banking, capital markets and insurance sectors.
The IFSB also conducts research and coordinates initiatives on industry related issues, as well as organizes
roundtables, seminars and conferences for regulators and industry stakeholders.
25
considered as one of the most flexible of the European Union and is in constant evolution to
meet financial professionals and foreign investors' needs. 98
Luxembourg has become a domicile of choice for Islamic finance in Europe and has a history of
innovation in this field since 1983.It was the chosen domicile of the first Shari’a’ compliant
insurance company in Europe. The Luxembourg Stock Exchange was also the first European
stock exchange to enter the sukuk market in 2002 and 16 sukuk issues have since been listed and
traded on the Luxembourg Stock Exchange. As of September 2010, 37 regulated Shari’a
compliant investment funds and sub-funds have been established in Luxembourg.
iii. Luxembourg International Taxation
In order to assess the suitability of any jurisdiction for taxation purposes and Islamic finance
structures, we have to examine it against the four building blocks or key variables in
international tax structuring:99
1) The Effects of Tax Treaties
2) Permanent Establishment
3) Withholding Taxes (Interest, Dividends and Royalties)
4) Taxation of Capital Gains
A) The Effects of Tax Treaties
The most important building block in any contemplated cross-border investment structure is the
availability of a tax treaty. Tax treaties are important for many reasons, not the least of which is
the fact that they effectively set the rules of engagement for any cross-border transaction.
Although multi-purpose instruments, tax treaties main function is the elimination of double
taxation for multi-national businesses. To achieve this purpose, tax treaties are designed to
determine which country has the primary right to tax income, the country in which income arises
(the source country), or the country in which the taxpayer is resident (the residence country) and
otherwise establish terms for the taxation of cross-border income between the signatory
countries. The first thing any tax practitioner must do, therefore, is determine whether a tax
treaty is applicable.100Luxembourg is known for its flexible and secure tax environment with an
advantageous domestic tax system and a well-developed tax treaty network
B) Permanent Establishment
Once it has been determined whether a bilateral tax treaty exists, the practitioner should consider
the role of foreign taxes. The OECD Model Treaty, and all U.S. bilateral tax treaties, includes
provisions addressing the taxation of the "business" or "industrial and commercial" profits of an
98 Tax Law Design and Drafting (volume 1; International Monetary Fund: 1996; Victor Thuronyi.
99 Alexander Lee, Rob Culbertson, and Justin Hamer USC Gould School of Law 2009 Tax Institute: Practical
Strategies for Investment in the United States, Europe, and Asia – Building Blocks: Four Key Strategies in
International Tax Structuring 2009 Emerging Issues 4328T O
100 Because most tax treaties are bilateral arrangements between two countries, in multi-jurisdictional investments, a
practitioner may need to look at multiple tax treaties and the interplay between them.
26
enterprise. Generally, these provisions grant a country the right to tax the business profits of an
enterprise, even if earned by a resident of another country, if that enterprise maintains
"Permanent Establishment" (PE) within that country. Host countries may only tax the business
profits of the enterprise, and only to the extent that the profits are "attributable to" that Permanent
Establishment, however.101
One way to reduce withholding taxes is to take advantage of special reduced rates under tax
treaties. However that only works if the tax payer establishes a considerable presence where
elements of his ownership structure are situated. Luxembourg’s tax law provisions make it easier
for treaty relief to qualify for the treaty relief for earnings deriving from a permanent
establishment.102 A non resident who is a partner in an enterprise can qualify for tax relief under
Luxembourg’s tax law.
Another advantage of Luxembourg’s law, it is relatively simple to qualify for a tax break known
as the “participation exemption”.103 Dividends and capital gains arising from it are exempted
from Luxembourg corporate taxes. 104
C) Withholding Taxes (Interest, Dividends and Royalties)
Even if PE status is avoided, a foreign investor is not necessarily free from foreign income tax
liability on its investments. Withholding taxes are typically imposed on certain types of passive
investment income streams earned in a foreign jurisdiction. Unlike the more complicated PE
provisions in tax treaties, these sections tend to be relatively straight-forward, generally defining
particular income streams and then placing limitations on the extent to which a country may tax a
foreign investor's passive income stream of that type. Generally, this maximum rate is
considerably lower than the general rate of tax.105 Typically, by contrast, most tax treaties do not
provide a lower rate of tax on income earned by Permanent Establishments.
Another challenge in foreign tax planning is how to move earnings across international borders
without triggering a withholding tax. Most countries collect withholding taxes on dividends,
interest, rents, royalties and payments to service contractors when such amounts cross borders106.
101 The Permanent Establishment concept is a key building block because it determines whether the business
operations will be subject to the general income tax rules of a particular jurisdiction. For example, assume that a
company in Country A wishes to expand its sales activities into a foreign Country B. If the company avoids being
deemed to have a Permanent Establishment, then the company will not be subject to general County B income taxes
on its sales activities. The company would only be subject to its County A taxes as usual. Country B would be
limited to taxing the company under other specialized articles (e.g. withholding taxes) where the nature and scope of
the Country B taxes is minimized. Conversely, if the sales activities in Country B rise to the level of a Permanent
Establishment, then the company will be subject to Country B income tax (like any other Country B business
operation) on all profits attributable to the Country B.
102 Special Report on Securitization in Europe: 2005 page 134 By Amanda D. Johnson.
103 Participation exemption is a general term relating to an exemption from taxation for a shareholder in a company
on dividends received, and potential capital gains arising on the sale of shares.
104 Special Report on Securitization in Europe: 2005 By Amanda D. Johnson page 134.
105 For example, the United States typically taxes payments of passive income to foreigners at 30 percent. However,
most bilateral tax treaties reduce the rate on payments to 15 percent or less.
106 Special Report on Securitization in Europe: 2005 By Amanda D. Johnson.
27
Luxembourg withholding taxes can be summarized as follows:
a. There are no interest withholding taxes;
b. There are no withholding taxes on dividends paid to onshore shareholders provided some
basic conditions are met;
c. There are no withholding taxes on liquidation distributions.
The above (combined with Luxembourg’s generous participation exemption) mean that
Luxembourg is very interesting as an intermediary holding jurisdiction.
D) Taxation of Capital Gains
In many respects, the taxation of capital gains could be categorized as another form of
withholding tax. Capital gains taxes, however, ought to be analyzed separately for several
reasons. First, the taxation of capital gains tends to differ from the taxation of other types of
passive income streams in many bilateral tax treaties. Capital gains taxes are also of particular
import since they frequently arise in connection with the disposition of an entire investment in
the foreign entity, and the amounts at issue may be much greater than general distributions, as a
result.107
Although Luxembourg is an onshore jurisdiction with an aggregate corporate income rate of
28.59%,108 the flexibility of Luxembourg tax law (many exemptions are possible) combined with
appropriate tax planning often leads to significantly lower effective tax rate in the hands of
Luxembourg fully taxable companies. The main advantages of Luxembourg domestic tax law
could be summarized as follows:
1) An extensive participation exemption regime for corporate income tax on capital gains
and dividend income as well as for net wealth tax purposes and outbound dividend
payments
2) Tax certainty and security thanks to the possibility to obtain, on a case by case basis,
advance tax agreement letters from the Luxembourg tax authorities
3) Interests paid by Luxembourg companies are not subject to withholding tax in
Luxembourg and are generally considered as deductible expenses for corporate income
tax purposes
4) The financing of Luxembourg companies may be done through various debt, equity or
hybrid instruments which ensure a tax-efficient overall structure as well as a tax-efficient
profit repatriation to the investors
5) No exit tax nor controlled foreign corporation (CFC)109 rules in Luxembourg domestic
law
6) A VAT rate of 15% which is the lowest VAT rate within the European Union
107 For example, an investment fund in Country A purchases shares in a company incorporated and doing business in
Country B. After the value of the Country B Company has increased significantly, the investment fund sells the
shares of the company resident in Country B.
108 http://www.sharia-finance.lu/EN/index.asp?rubrique=16&article=224&titreArticle=Domestic-and-internationaltaxation&
relatif=222 last accessed 3/28/2012.
109 Controlled foreign corporation (CFC) rules are features of an income tax system designed to limit artificial
deferral of tax by using offshore low taxed entities.
28
In regard to international taxation and as a founding member of the European Union,
Luxembourg companies are entitled to the benefits of the parent-subsidiary, interest and
royalties, and merger directives (they have all been incorporated into domestic legislation).
Furthermore, Luxembourg companies have access to Luxembourg’s wide network of double tax
treaties with 59 treaties currently in force and 17 other treaties under negotiation or awaiting
ratification. Luxembourg tax treaty network includes the United States, major European
countries, India, China and Hong-Kong but also many Muslim countries all around the world.
The combination of a very attractive domestic tax law, access to European Union directives, and
a wide treaty network, makes Luxembourg a prime location for international tax planning.
iv. Luxembourg -Treatment of Islamic Finance Instruments
In accordance with the guidelines issued on 12 January 2010110 by the Luxembourg direct tax
administration (Administration des Contributions directes), the murabahah profit (i.e., the
consideration for the deferred payment) realized by a Luxembourg company may, subject to
certain conditions to be fulfilled at the level of the transaction documents, be taxed on a linear
basis over the period of the murabahah transaction, regardless of the actual payment dates of the
murabahah profit. This is important as the Luxembourg vehicle would otherwise immediately be
taxed on the difference between the acquisition price of the murabahah asset and its marked-up
sale price under the murabahah contract, while the actual payments would be made on a deferred
basis.
Luxembourg traditionally attracts investors for its extensive treaty network. However , there
were concerted efforts on all levels to attract Islamic funds .The Luxembourg tax authorities
issued a circular letter on 12 January 2010 that clarifies the tax treatment of various Islamic
financing arrangements and issues. The circular essentially deals with the tax treatment of
Murabaha and Sukuk, but also describes other instruments, such as Musharaka, Mudaraba,
Ijara, Ijara-wa-lqtina and Istisnaa.
The circular letter coincides with other activities designed to market Luxembourg as a European
hub for Islamic finance.
1) The Crown Prince of Luxembourg and the Finance Minister recently led a successful
mission to promote the country as a global financial services center to Bahrain and the
United Arab Emirates. This mission was embarked on shortly after it was announced that
the Luxembourg-United Arab Emirates tax treaty would become effective on January
2010.
2) Luxembourg’s tax treaty network now includes signed treaties with Bahrain, Kuwait and
Qatar, with negotiations in progress for treaties with Lebanon and Syria.
3) Luxembourg has actually played an active role in Islamic finance since the 1980s:
4) The first Islamic insurance company (Takaful) in Europe was established in Luxembourg
in 1983;
5) Sixteen Sukuk are currently listed on the Luxembourg stock exchange (representing
approximately EUR 6 billion in notes); and
6) Luxembourg hosts more than forty Shari’a-compliant investment funds and sub funds.
110 Circular LG-A Nr 55 of 12 January 2010.
29
7) Luxembourg extensive double tax treaty network.
Luxembourg is known to have extensive double taxation treaties. It also has expanded the list of
treaties to include the major players in Islamic finance and throughout the Muslim world. It
includes notably in-force tax treaties with Azerbaijan, Indonesia, Malaysia, Morocco, Qatar,
Singapore, Turkey, Tunisia, United Arab Emirates and Uzbekistan, signed treaties awaiting
ratification with Albania, Bahrain, Kazakhstan and Kuwait together with advanced negotiations
with Lebanon, Pakistan and Syria. Aside from its international initiatives, Luxembourg also acts
domestically.111
v. The Circular112
On January 12 2010 the Luxembourg Tax Administration, through the tax director, issued a Tax
circular on Islamic finance referring to financial instruments used by investors wishing to
manage their investments in a manner that respects and is consistent with Islamic values. “The
objective of Islamic finance is to ensure that risk and reward are shared between the party that
contributes capital and the party that uses it”.
The circular focused on two key principles of Islamic finance:
1) Both the lending entity, the bank, and the borrower of the funds has to play active roles in the
investment process and share risks.
2) Prohibiting the process of lending money against interest paid to a third party.
It further clarified the prudence of Islamic finance that the valuation and quotation of products
must be based on real assets (such as real estate, infrastructure projects or commodities such as
petrol, aluminum or wheat). Investments cannot be based on financial products. Any profit
arising from any interest based financial products would be considered as usury (riba), which is
contrary to Shari’a principles and must be purified in accordance with criteria generally applied
in Islamic finance. It should be noted that Luxembourg collective investment schemes that invest
in Islamic assets are excluded from the scope of this Circular where Murabaha, Musharaka and
Mudaraba are mentioned in the circular by name as the most popular instruments.
Besides the prohibition of riba (usury), gharar and Maysir113 (contractual uncertainty and
speculation and games of chance), and Haram (prohibited activities linked to the production of
pork, pornography and alcohol), certain other principles must be taken into consideration by
bankers and supervisors in order to respect Islamic rules. There are several financial products
that reflect these principles. Since the concept of interest does not exist in Islamic finance,
various rules are applied so that the profits and the potential losses of a venture are shared
111 Islamic finance at Deloitte No interest. but plenty of attention.
112 The Text of the circular is included verbatim in English at the end of this paper .
113 Supra.
30
between the party providing the capital and the party using it. Some of the most widely used
vehicles are Murabaha, Musharaka and Mudaraba.
The circular essentially deals with the tax treatment of Murabaha and sukuk but also describes
other instruments, such as Musharaka, Mudaraba, Ijara, Ijara-wa-Iqtina and Istisnaa.
The circular coincides with other activities designed to market Luxembourg as a European hub
for Islamic finance. The crown prince of Luxembourg and the finance minister recently led a
successful mission to promote Luxembourg as a global financial services center to Bahrain and
the United Arab Emirates.
This mission was embarked on shortly after it was announced that the Luxembourg-United Arab
Emirates tax treaty would become effective as from 1 January 2010. The circular further
enhances the attractiveness of Luxembourg as a hub for Islamic finance activities.
It confirms Luxembourg’s approach to Islamic finance and clarifies the tax treatment of Islamic
finance instruments such as Murabaha and sukuk.
The main features of the circular it defines each Islamic finance instrument outlining its salient
features for tax treatment purposes as it compares to its conventional counterpart.
As an example it defines Murabaha as follows: Murabaha refers to a sale transaction whereby
assets are sold under deferred terms at cost plus a profit mark-up. The cost price and the mark-up
are known by both the buyer and the seller. Both Islamic and conventional financial institutions
(FIs) can act as buyers-sellers in Murabaha financing arrangement. The pre-determined mark-up
represents the remuneration for the FI.
Murabaha can be defined as a purchase and resale agreement with deferred payment. Instead of
concluding a conventional loan agreement, which is not Shari’a-compliant, the party which
provides the capital purchases the targeted good (e.g. real estate, securities, commodities…) from
a third party and resells it at a predetermined higher price to the capital user (i.e. with a
predetermined mark-up).By paying this higher price over installments (i.e. deferred payment),
the capital user has effectively obtained credit without paying interest.
Luxembourg tax treatment of Murabaha
In principle, the entire profit is realized and therefore taxable upon disposal of the asset to the
client. However, the circular stipulates that the income taxation can be deferred over the term of
the transaction subject to the respect of the following conditions:
1. The agreement between the parties shall clearly states that the capital provider acquires the
targeted good with the objective of reselling it (immediately or within a period of time that
cannot exceed six months after the acquisition);
2. The predetermined mark-up, which stands for the remuneration of the capital provider for
providing the funds, must be clearly specified in the agreement, and explicitly known and
accepted by the parties involved;
3. The remuneration must be spread over the deferral period for accounting and tax purposes in
the finance provider’s books (based on a straight-line method), regardless of when
reimbursement is actually made.
31
114
The above diagram illustrates a straightforward Murabaha transaction. The customer wishes to
have use of a machine but cannot afford the purchase price. Instead, a bank will buy that
machine for, say, $100 and sell it to the customer for a price of $110, payable at a fixed future
time. The customer obtains immediate use of a machine worth $100, and has an obligation to
pay $110 in, say, two years time. The extra $10 that the customer pays is clearly, in economic
terms, the cost of the finance. However, the legal form of the transaction is that the customer is
paying $110 to the bank to purchase the machine.
From a taxation perspective, there are two alternative ways that the customer could be treated.
1. The customer has contracted to pay $110 to purchase a machine. That amount, $110,
represents its cost and is the depreciable amount for tax purposes if the machine is
eligible for tax depreciation. Accordingly, there is no separate recognition of the finance
cost built into the transaction price. Instead, tax relief will be given over the life of the
machine since the depreciable amount is $110 instead of the cash price of $100.
Conversely, if the asset being purchased is not eligible for tax depreciation, then no tax
relief will be obtained for the finance cost.
2. The alternative approach is to decompose the transaction in accordance with the
economic reality. As the machine could have been purchased for $100 with payment
being made immediately, the uplift in the purchase price of $10 in consideration of a two
year deferral in payment is treated separately as a finance cost. Accordingly, the cost of
the machine for tax depreciation purposes is recorded as $100. Meanwhile, the $10
114 http://www.mohammedamin.com/Islamic_finance/Presentation-at-MENA-Tax-Forum-Istanbul-20-October-
2011.html
Murabaha
Transaction involving a tangible asset
Banks
Goods Supplier
Sale for deferred payment of Customer
$110
Machine retained for own use cost $110
Machine Sale to immediate Payment
$100
32
finance cost is amortized over the two year deferral period obtained in exchange for this
cost.
Sukuk
Sukuk are certificates of equal value representing undivided shares in ownership of tangible
assets, usufruct,115 and services or the ownership of the assets of particular projects or special
investment activity.Sukuk has similar characteristics to those of a conventional bond with the
difference being that they are asset backed. Indeed, a sukuk represents the proportionate
ownership of the sukuk holders in the underlying assets. They may be issued by governments or
private companies.
Potential profits are periodically paid to the sukuk holders according to their proportionate
ownership in the sukuk. Sukuk holders are exposed to losses incurred on the assets that back the
sukuk.
The circular confirms that sukuk would be considered as debt for Luxembourg tax purposes.
Consequently: Any yield payment under the sukuk would be treated as tax deductible at the level
of the party that has issued the sukuk; and no withholding tax applies on such a yield payment
under Luxembourg law. The goal when structuring a Sukuk is to replicate the characteristics of
bonds without infringing the rules of Shari’a. The most important requirement is that there must
be no interest, which in turn means that there can be no legal debt involved. The goal is to design
an instrument which can be bought and sold between different holders, provide finance for a
fixed period of time, typically three to five years although longer periods of time are used.116The
diagram below illustrates how an Ijara sukuk transaction, where real estate is the underlying
asset, would normally be arranged.
117
115 Supra
116 From the perspective of investors, provides a flow of regular payments which has priority over the payment of
rewards to ordinary shareholders, without involving interest.
117Diagram of an Ijara Sukuk transaction
Charity
Special Purpose Vehicle
(SPV)
Investors
Issue Sukuk
Investors Pay Issue price
Periodic Payments representing SPV’s profit
Owner
Pay Price
Sell Building
Lease Owners pay rent periodically
33
To illustrate the Sukuk concept, here is a breakdown of the process
1. The property owner wishes to use the building to raise capital.
2. Accordingly, the owning company arranges for the creation of another company, typically a
special purpose vehicle (SPV).
3. This is a company which is not part of the owner company’s group; the shares of the SPV
are normally held by a charity.
4. The SPV raises the cash needed to purchase the building by issuing sukuk to the investors.
5. Legally, the sukuk are certificates which entitle the investors to a fractional share of the
building.
6. The SPV will normally declare itself as a trustee of the building on behalf of the sukuk
investors, so that they have a beneficial entitlement to a proportionate share of the building
and of the rent receivable from leasing it.
7. During the life of the sukuk, the owner will pay rent to the SPV which in turn will pay that
money to the investors.
8. In economic terms, the investors have a prior claim on the profits generated by the owner
from its business because part of those profits must be used to pay rent on the building to the
SPV prior to any distribution of profits to the equity shareholders. However, this is achieved
without creating a debt since leasing a building does not involve a debt claim. At the end of
the sukuk period, the owner will purchase the building back from the SPV and this provides
the SPV with cash to repay the sukuk investors.
This transaction raises several potential taxation questions. Firstly, there are three land
transactions, namely the original sale of the building to the SPV, the lease of the building by the
SPV back to the original owner and finally the re-acquisition of the building by the owner. Each
of these is potentially subject to a real estate transfer tax or similar taxes on the leasing of land.
Furthermore, the building may have appreciated in value between the original purchase by the
owner and its sale to the SPV. Accordingly, the sale transaction may trigger a taxable capital
gain. When one considers the SPV, it is receiving rental income on the building which would
normally be taxable. It then passes on that rental income to the sukuk holders who are therefore
suffering taxation prior to receiving their cash. Conversely, if they had invested in conventional
interest-bearing bonds, such bonds normally pay their interest gross without withholding tax.
The guidelines of the Luxembourg direct tax administration clarify that the tax treatment of
sukuk is identical to the tax treatment of debt instruments in conventional finance 118 and the
remuneration of sukuk is considered as interest payment. Accordingly, payments made under a
sukuk transaction should generally be deductible, provided such expenses are incurred in the
corporate interest of the enterprise of the sukuk issuer. Furthermore, no withholding tax should
apply on payments to foreign holders of sukuk issued by a Luxembourg issuer except where such
payments fall within the scope of Luxembourg laws implementing the EU Savings Directive. In
an international taxation context, payments under a sukuk transaction should qualify under the
interest article of the tax treaties concluded in accordance with the OECD Model Convention119.
118 Although the income is linked to the performance of the underlying asset not the capital.
119 http://www.lff.lu/fileadmin/redaction/documents/brochures/New_Corporate_ID/Islamic_Finance_2011.pdf
34
Luxembourg’s tax treatment of Sukuk
From a tax point of view, the treatment of a sukuk is identical to the treatment of a loan in
conventional finance (even though the returns are linked to the performance of the underlying
assets) and sukuk payments are treated the same way as interest payments for a bond issuer in
conventional finance. With regard to their characteristics, sukuk may be considered as
comparable to debt instruments in conventional finance, the payments made to sukuk holders
being handled in the same was interest income from a tax point of view. As a consequence of
this, payments made to sukuk holders are deductible, providing it can be demonstrated that they
were incurred in the interest of the company.
Hence revenues from sukuk are to be considered as revenue from transferable securities in the
sense of article 97, paragraph 1, number 3 L.I.R. (business profits).
The tax provisions relating to professional fund raisers and participating bonds (articles 146 (1) 2
and 3 and 164 (2) L.I.R.) are not applicable to this type of financial instrument.
Where the application of double taxation treaties is concerned, any eventual problems can be
resolved by out of court settlement.
vi. Practical Case Studies and Examples
1) Murabaha
Buyer A approaches a financial institution (FI) to purchase a car, the market price of which is
$40,000. FI buys the car on the market for $40,000 and obtains title to the vehicle. FI sells the
car to its client, Buyer A, for $40,000, plus a mark-up of $8,000. FI transfers ownership of the
vehicle to Buyer A against deferred payments (e.g., $12,000 per year over four years). Since the
total price of the car amounts to $48,000, FI would realize a gain of $8,000 on the sale. In a
conventional ‘buy-sell’ transaction, that gain might be taxed in the year of disposal. The circular
however, adopts a ‘substance-over form’ approach and provides that the taxation of the income
can be deferred over the term of the transaction (as would be the case in a conventional financing
arrangement). This favorable treatment will be granted if the following condition is satisfied: The
agreement between FI and Buyer A clearly states that the finance provider acquires the goods
with the aim of reselling them and the good are in fact resold (immediately or within a maximum
period of six months following the acquisition).120
120 Interest is generally included in the conventional lease contract (margin in Ijara) where delay penalties are not
allowed in Sharia’a compliant products with no pre-determined price for the car if the customer wanted to exercise
the possibility of buying the car before the end of the contract.
35
2) Sukuk
Sukuk Holders (i.e. investors) acquire Sukuk issued by the Luxembourg vehicle for cash
payments. The Issuer uses the funds to finance the acquisition of specific assets (e.g. real estate,
an airplane, etc.).Potential profits are paid periodically to the Sukuk Holders or the Sukuk
Holders are exposed to losses incurred on the underlying investments.“Tracking Sukuk” can
enable the tracing of the profits and losses to specific assets. The securitization vehicle may
provide more guarantees to investors in terms of the segregation of assets and profits/losses.
According to the circular, for Luxembourg tax purposes, Sukuk would
be treated like conventional bonds and the yield on Sukuk would be treated as interest payments
on conventional debt instruments. This tax treatment would apply even though the yield on the
instruments is directly contingent on the income earned on the underlying asset. Hence, the yield
will be tax deductible at the level of the Sukuk Issuer in the same way as interest on a
conventional debt obligation. No withholding tax applies on such a yield under Luxembourg
domestic law (implications of EU savings directive should be fairly limited given the nature of
the instruments and the residency of the investors).121
V. Conclusion
While some Western countries are in the process of passing anti-Shari’a legislation,
Luxembourg has taken substantial steps in accommodating Islamic finance instruments. The
decision does not only reflect tolerance to Islamic principles, it is a reflection of financial and
economic prudence behind the decision. With its strong and stable legal environment and its
flexible tax organization, has been a domicile of choice for cross border distribution of
investment products.122
The appeal of Luxembourg as a financial center is empowered by the fact that tailor-made
structures, adapted to specific situations in order to deliver expected commercial outcome, are
coupled to tax efficient returns. Its unique blend of specialist service providers enables
Luxembourg to offer fund promoters an extraordinarily wide range of investment products
having progressive levels of flexibility, stretching from unregulated (i.e. Soparfi123) over lightly
regulated (Specialized Investment Funds, SICAR) to strongly regulated (i.e. UCITS funds)
vehicles. Size, location and type of investors or investments will drive the choice of vehicle. SIF
might be particularly suitable for structuring Sharia'a compliant investments for institutional
121 http://www.deloitte.com/assets/Dcom
Global/Local%20Assets/Documents/Tax/Alerts/dtt_tax_alert_luxembourg_140110.pdf.
122 Islamic finance at Deloitte No interest. but plenty of attention.
123 The SOPARFI is not a new legal form for a company. The term ”SOPARFI“ (from FR: Societe de Participations
Financieres) is applied to companies who have financial holdings. The SOPARFI is a typical incorporated
corporation subject to the general legal and tax-related regulations set forth by corporate law, which benefits from
the distinct Luxembourgian ”box privilege“.
36
investors, while Soparfi may be appropriate for MENASA124 based investment funds looking to
use Luxembourg as a holding location.125
The monitoring of potential withholding tax costs is one of the key aspects of the structuring.
Similarly, the review and development of exit strategies in a tax efficient perspective need to be
considered since they can dramatically impact the expected returns on investments. In this
respect, Luxembourg is particularly competitive thanks to its flexible environment allowing tax
efficient structuring and its extensive network of 75 double tax treaties in force, awaiting
ratification or under negotiation, offering interesting withholding tax rates and taxation regime of
gains.
The circular letter dealing with the tax treatment of Murabaha and sukuk equally to conventional
finance instruments made Luxembourg a more attractive destination for Islamic investment
funds.
In addition, the Luxembourg investment funds regulatory environment is particularly flexible
and offers the possibility to structure regulated vehicles in such a way that they can
accommodate Sharia'a compliant investments. Finally, besides an appealing tax and regulatory
regime, Luxembourg benefits from a full range of highly skilled service providers such as
administrative agents, custodian banks, domiciliation agents, paying agents, transfer and register
agents, lawyers, chartered accountants and tax advisors.
The circular also ensures clarity and security as to the tax treatment of Islamic instruments, in
particular, Murabaha and Sukuk, which is important for Islamic finance operators and investors.
Ultimately, the circular demonstrates a clear commitment on the part of the Luxembourg
government and the tax authorities to position the Grand Duchy as a significant hub for Islamic
finance.126
The Luxembourg tax authority has employed the best experts in the fields of international
taxation and Islamic law to reach such results and devise these regulations. Such efforts and
advanced regulations addressing Islamic finance instruments should be a benchmark and a model
to follow. As we have pointed throughout this paper, other jurisdictions have widened their
definitions of certain financial instruments to accommodate Islamic finance instruments but none
have taking substantial steps in defining each Islamic instrument and the specific treatment for
each instrument.
124 MENASA, Middle East North Africa South Asia.
125 Deloitte publication on Islamic Finance in Luxembourg , a paper titles no interest but plenty of attention.
http://www.deloitte.com/assets/Dcom
Luxembourg/Local%20Assets/Documents/Brochures/English/2010/lu_islamicefinance_10062010.pdf. Alst
accessed 3/29/2012.
126 Handbook of Islamic Banking by Abdirahman Sh. Mohamed Omer Dirir .
37
VI. Glossary of Islamic Finance
Below is a list of the most popular Islamic Finance Instrument with names in both Arabic and
English:
Type Sales Based Partnership
Based
Lease-
Based
Fee Based Others
Contract Murabaha
(cost-plus)
Istisnaa
(construction)
Salam
(deferred
delivery)
Mudaraba
(profit
sharing)
Musharaka
(joint
venture)
Ijara
(leasing)
Wakala
(agency)
Wadia
(safekeeping
Kafala
(guarantee)
Hiba (gift)
Amanah
Quick definition: trustworthiness, faithfulness and honesty.
Amanah is also used to define a situation in which one party is keeping another person’s property
in trust. This is the way in which the term is most commonly applied, especially within the
confines of Islam commercial law, and the term has a long history of use. The term is also
applied when
referring to goods on consignment, custody or deposit taking.
Arbun
Quick definition: down payment.
This term describes the deposit that the buyer makes to the seller at the same time as making the
agreement to complete payment by a set date.
Gharar
Quick definition: uncertainty.
Gharar is a conceptual term that refers to something that is not completely set in stone within a
contract. It is a fundamental disagreement between Islamic and conventional UK law and Islam
does not recognize the need for related practices such as speculation, derivatives and short
selling contracts.
Islamic finance
Quick definition: financial services specifically designed to adhere to Islamic law or Shari’a.
Although these financial services are designed for Muslims, they are not
exclusively available to Muslims. Non-Muslims can also provide and buy the services.
Ijara
Quick definition: Islamic leasing agreement. Because Islam forbids the charging of interest,
Muslims get an Ijara which enables the bank to seek profit through the leasing of assets (house,
car
etc) rather than by actually lending money. Ijara wa Iqtina is an extension of the concept which
38
is a hire purchase agreement.
Ijara wa-Iqtina
Quick definition: A lease to own arrangement.
Is a transaction whereby the lessee not only pays rent but progressively buys a share in the leased
property, reducing the rent as he does so. This is a very common transaction, and is now being
used for home mortgages.127
Maysir:
Quick definition: gambling. Maysir is forbidden in Islam and as such the concept fundamentally
disagrees with some standard financial practices such as speculation,
insurance and derivative contracts.
Mudaraba
Quick definition: investment partnership. This is the financial partnership between the investor
(Rab Al Mal) and another party (Mudarib). The contract will set out how profits will be
shared, and losses are absorbed by the Rab Al Mal. The Mudarib will lose some of the income
they were expecting as a result.
Mudarib
Quick definition: investment manager or entrepreneur partaking in a Mudaraba.
It is the Mudarib’s responsibility to ensure that the investor’s money is taken care of and is
profitable in its investments. In turn the Mudarib gets a share of the profits. The role is very
similar to a Discretionary Managed investment portfolio that we recognize from conventional
practice in the UK.
Murabaha
Quick definition: purchase and resale. As opposed to lending money, the capital provider
purchases the required asset or product (for which a loan would otherwise have been taken out)
from a third party.
The asset is then resold at a higher price to the capital user. By paying this higher price by
installments, the capital user
effectively gets credit without paying interest. (Also see Tawarruq the opposite of Murabaha.)
Musharaka
Quick definition: profit and loss sharing. This is considered to be the purest form of Islamic
financing, because profits and shared in pre-arranged proportions and losses are shared in
proportion to the investment made by each investor. Each partner within the Musharaka
contributes capital and can make executive decisions
however they are under no obligation to. It is basically very similar to a partnership which
involves owning voting stock in a limited company.
127 Islamic banking and finance in the European Union: a challenge - Page 53 M. Fahim Khan, Mario Porzio.
39
Diminishing Musharaka
Quick definition: A partnership where one partner buys out the shares of another partner
gradually ending with complete ownership of the commodity or product.
This concept is used mainly in real estate transactions in the united states or financing
commercial vehicles.
Riba
Quick definition: interest. This is forbidden by the Quran and it forbids any return of money on
money, whatever type of interest it may be.
Salam
Quick definition: Advanced payment on a future project.
Salam is a forward financing transaction where the financial institution pays in advance for
buying specified assets, which the seller will supply on a pre-agreed date. What is given in
exchange for the advance payment of the price should not in itself be in the nature of money. For
the payment in advance, the contracting parties stipulate a future date for the supply of goods of
specified quantity and quality.
Shari’a
Quick definition: Islamic law This refers to the law set down in the Quran and performed by
example by Prophet Muhammad (PBUH).128 Any product purporting to be Shari’a must adhere
to Islamic law in all respects and to ensure this, a company will usually appoint a Shari’a board
which will overlook the development and implementation of all Shari’a products to ensure they
comply.
Shari’a adviser
Quick definition: person who advises on Islamic financial law. A Shari’a adviser is generally a
Islamic legal scholar who has been classically trained and has the expertise and knowledge to
ensure products comply with Shari’a. Some work individually to advice companies but most are
employed as part of a Shari’a board to ensure full compliance.
Shari’a compliant
Quick definition: observing Islamic law The Shari’a board ensures that products are Shari’a
compliant, a term that is also covered by the word? Islamic?. Many financial products use the
term
Shari’a compliant as a prefix so customers can be totally sure that the product has followed the
law to the letter.
Sukuk
Quick definition: a conventional bond
Sukuk are certificates of equal value representing undivided shares in ownership of tangible
128 PBUH : Stands for peace be upon him , this is normally found in the text of Islamic literature in any reference to
the Prophet of Islam Muhammad PBUH. It is considered undignified in the faith of Islam to mention any prophet’s
name without making this reference.
40
assets, usufruct,129 and services or the ownership of the assets of particular projects or special
investment activity.
Takaful 130
Quick definition: Islamic insurance because the concept of insurance relates to uncertainty,
which could then be related to interest and gambling, Takaful takes a different approach.
The arrangement can be summed up as a charitable collection of funds based on the idea of
mutual assistance.
It is the name given to Islamic based insurance based on principles of mutual assistance .131
Istisnaa132
Quick Dentition: To manufacture
The word Istisnaa is derived from the Arabic term Sina'a, meaning to manufacture a specific
commodity. Istisnaa is an agreement whereby a customer requiring an item, equipment, building,
or project, which needs to be constructed, manufactured, fabricated, or assembled, approaches
the bank for financing.
Tawarruq
Quick Definition: Cash Liquidity .
Tawarruq means to buy on credit and sell at spot value with the objective of getting cash,
meaning that the transaction is not the need of the buyer; he simply wants liquidity, which he
gets by purchasing a commodity on credit and selling forthwith for cash.133
129 Supra
130 Takaful is an Arabic word meaning “guaranteeing each other”.
131 English insurance texts - Words for the week By Keith Purvis.
132 Islamic Finance in a Nutshell: A Guide for Non-Specialists page 66 -By Brian Kettell
133 Understanding Islamic Finance By Muhammad Ayub.
41
VII. Appendix – The Circular 134
Circular of the Tax Director
L.G.-A nr 55 of 12 January 2010
L.G.-A nr 55
45/1 L.I.R. nr ⎯⎯ / Eval. n° 55 / I.C.C. n° 38 97/1
Subject: Islamic finance
1. Background
Islamic finance refers to financial instruments used by investors wishing to manage their
investments in a manner that respects Islamic values. The objective of Islamic finance is to
ensure that risk and reward are shared between the party that contributes capital and the party
that uses it.
Hence, two key principles can be observed:
a) The lender (such as a bank) may not in principle adopt a passive role, but must act as a real «
partner »; and
b) The prohibition of lending money (against payment of interest) to a third party.
Islamic finance is prudent in several ways. Firstly, the valuation and quotation of products must
be based on real physical assets (such as real estate, infrastructure projects or commodities such
as petrol, aluminum or wheat). It cannot be based on other financial products. Any profit arising
from other financial products – and in particular interest – would be considered as usury (riba),
which is contrary to Shari’a principles and must be purified in accordance with criteria generally
applied in Islamic finance.
It should be noted that Luxembourg collective investment schemes that invest in Islamic assets
are excluded from the scope of this Circular.
2. Investment instruments such as Murabaha, Musharaka and Mudaraba.
Besides the prohibition of riba (usury), gharar and Maysir (contractual uncertainty and
speculation), and Haram (prohibited activities linked to the production of pork, pornography and
alcohol), certain other principles must be taken into consideration by bankers and supervisors in
order to respect Islamic rules. There are several financial products that reflect these principles.
2.1. Description
134 http://www.lff.lu/fileadmin/redaction/documents/Legal_texts/2010_IF_TaxCirc-55_12Jan10_EN.pdf last
accessed 3/16/2012 Luxembourg Tax Administration publication.
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Since the concept of interest does not exist in Islamic finance, various rules are applied so that
the profits and the potential losses of a venture are shared between the party providing the capital
and the party using it. Some of the most widely used vehicles are Murabaha, Musharaka and
Mudaraba.
1) Murabaha: a transaction that, in contrast to conventional finance, allows the client to buy an
asset without having to take out an interest bearing loan. The party contributing the capital (for
example, a bank) acquires the asset and sells it on to the client on a deferred payment basis
(forward sale). Such a scheme can be used to finance any sort of asset, but is most often used in
the purchase of real estate (it could equally be securities, commodities or machinery).
2) Musharaka: a joint venture where profits are shared in accordance with a pre-established
agreement and losses are limited to the amount invested. The payments made by the beneficiary
of the capital to the party contributing the capital represent both repayment of the principal and a
share in the profits of the investment.
3) Mudaraba: a specialized investment scheme where the party contributing the capital and the
beneficiary share in the profits. If the investment project fails, the assets invested may be lost,
but if the investment is profitable, the contributing party receives only a commission for its
expertise. If the investment does not make a profit, the contributing party renounces its right to a
commission.
4) Ijara: leasing agreement by which the party contributing the capital (generally a bank)
acquires an asset for its client and places it as his disposal in return for a rental payment for a
fixed period.
5) Ijara-wa-Iqtina: similar mechanism, where the client has the possibility of buying the asset at
the end of the contract (lease purchase).
6) Istisnaa: method of financing the production of a good that allows advance payment for a
future delivery, or deferred payment for a future delivery.
2.2. Taxation method
This section principally addresses tax aspects of Murabaha.
In a tax context, the contract between the party contributing the capital (the financier) and the
client can be compared to a sales contract. In principle, the income from the sale is realized at the
moment of the signing of the contract and the full sum is immediately taxable, including the
margin earned by the financier, that is, his profit.
Nevertheless, in so far as the profit made by the financier constitutes remuneration for a deferred
payment (comparable to the interest due in the context of a conventional loan), due during this
period, such profit may benefit from deferred payment of the tax due on income arising regularly
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or irregularly from a stream of payments, notably from rental income. In other words, the profit
is taxed in a linear fashion over the life of the contract, regardless of the actual repayments made.
In order for the profit of an Islamic product to be treated for tax purposes like interest income in
conventional finance, the transaction must meet the following conditions:
1) The contract between the parties must clearly state that the financier is buying the asset with
the purpose of reselling it to its client, immediately, or within a period that may not exceed six
months;
2) The contract must clearly identify the remuneration payable to the financier in payment for his
services, the profit to be made by the financier in return for deferment of payment, the
acquisition price for the client and the price paid by the financier for the asset;
3) The profit to be made by the financier must be clearly stated, known and accepted by both
contracting parties;
4) The financier’s profit must be specifically identified as a fee for services rendered to the client
by the financier and which result from the effective deferral of the agreed payment to the
investor. For instance, there could be a clause presenting the profit as a «fee for the deferral of
payment granted by the seller to the purchaser, the purchaser undertaking to pay such profit to
the seller until the date that repayment is completed»;
5) From an accounting and tax point of view, the financier must spread the profit evenly across
the duration of the repayment period, however the reimbursements are made.
Only the profits earned in return for a deferred payment may be treated in this way, hence
spreading may not be applied to the profit margin earned by the financier for his services.
Where taxation falls under the regime of privately held assets, the relevant tax rules are
applicable.
3. Sukuk (Arab name for finance certificates that can be compared in many ways to conventional
financial bonds.)
3.1. Description
Islamic bonds known as sukuk are securities representing entitlement to a claim or share where
both the income and capital are indexed to the performance of one or more assets held by the
issuer, the income stream from which is used to remunerate and reimburse the sukuk. The holder
benefits from a right to proportional ownership on these assets that he can exercise in the case of
default by the issuer. The asset or assets concerned are tangible assets, or the right to usufruct of
tangible assets.
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Remuneration is linked to the performance of the assets but is nevertheless capped. Income from
sukuk is variable and depends on the profits realized on assets or the results of the issuer or the
borrower. In consequence, it could be zero in the case of a loss.
Repayment of the capital may be partial. Repayment of sukuk can be either gradual or made in
full at the term agreed in the contract.
For securities that have been used to finance one or more assets, repayment is a function of the
market value of the assets at the maturity date of the securities, as are the repayments of capital
included in the rent, notably in the case of lease-financing.
Where the value of the assets financed is not enough to repay the nominal value of the securities
or the amount of the loan, the right to repayment of capital is reduced by the amount concerned.
On the other hand, where the value of one or more assets exceeds the nominal value of the
securities, only the capital is effectively repaid.
3.2. Taxation method
From a tax point of view, the treatment of a sukuk is identical to the treatment of a loan in
conventional finance (even though the returns are linked to the performance of the underlying
assets) and sukuk payments are treated the same way as interest payments for a bond issuer in
conventional finance.
With regard to their characteristics, sukuk may be considered as comparable to debt instruments
in conventional finance, the payments made to sukuk holders being handled in the same was
interest income from a tax point of view. As a consequence of this, payments made to sukuk
holders are deductible, providing it can be demonstrated that they were incurred in the interest of
the company. 135Hence revenues from sukuk are to be considered as revenue from transferable
securities in the sense of article 97, paragraph 1, number 3 L.I.R. (business profits). The tax
provisions relating to professional fund raisers and participating bonds (articles 146 (1) 2 and 3
and 164 (2) L.I.R.) are not applicable to this type of financial instrument. Where the application
of double taxation treaties is concerned, any eventual problems can be resolved by out of court
settlement.
Luxembourg, the 12 January 2010
The Tax Director
Unofficial translation by Luxembourg for Finance136
135 Parts of the circular was modified to conform with the style required for the purposes of this Thesis, however the
substance remained unchanged.
136 The original text was not found in English the text above was provided by Luxembourg for Finance.
