UK Tax & Islamic Financing Arrangements
Shari’a-compliant financing arrangements (also known as Islamic financing arrangements) are designed to comply with Islamic law, and as such must adhere to a number of principles, including:
- Investment must not be in businesses related to alcohol, pork products, gambling, etc.;
- Sharing of profit & risk between at least two parties;
- Prohibition on interest;
- Investment cannot include extreme uncertainty or speculation; and
- No unjust enrichment.
In light of the growing Islamic finance markets, in Finance Act 2005 the UK introduced specific provisions in order to deal with the tax treatment of certain forms of Shari’a financing. These provisions, known as the “Alternative Finance Arrangement” rules, aim to ensure that the tax treatment of Islamic finance transactions that resemble conventional products are treated equivalently for tax purposes.
When a transaction meets the conditions for an Alternative Finance Arrangement and produces a return, this is treated as interest for tax purposes. This is therefore relevant when considering your liability to income tax/corporation tax, the availability of deductions for loan interest, or determining whether the payments can be deducted when calculating a capital gain.
The Alternative Finance Arrangements set out in the legislation are as follows:
- Purchase and resale arrangements (Murabaha)
- Diminishing share ownership arrangements (Musharaka)
- Deposit Arrangements (Mudaraba)
- Profit share agency arrangements (Wakala)
- Investment bond arrangements (Sukuk)
We will consider each of these in turn, along with the relevant tax treatments.
Purchase and Resale Arrangements (Murabaha)
In a purchase and resale arrangement, the first purchaser (e.g. a financial institution) acquires an asset and then sells it onto the second purchaser at an increased cost, comprising the cost of the asset and a mark-up equivalent to, in substance, interest. The payment of all or part of the price paid by the second purchaser is deferred until a later date.
Under this arrangement, broadly the amount paid for the asset by the second purchaser in excess of the first purchase is treated as interest for tax purposes.
Diminishing Share-Ownership Arrangements (Musharaka)
In a typical diminishing share-ownership arrangement, a financial institution and an “eventual owner” each acquire a beneficial interest in an asset. The eventual owner then makes payments to the financial institution, either in stages or in full, in order to acquire its interest. To qualify, the eventual owner must have exclusive rights to occupy or use the asset, and to any income or profit attributable to the asset. This specifically includes any increase in the asset’s value over time.
Payments made by the eventual owner in excess of the amount paid by the financial institution (less arrangement and legal fees, plus other expenses) are treated as an alternative finance return, and therefore taxed as interest.
Deposit Arrangements (Mudaraba)
Under a deposit arrangement, a person deposits money with a financial institution which utilises those funds, together with money from other investors, with a view to producing a profit. From time to time, the institution makes or credits a payment to the depositor out of profits in proportion to the amounts originally deposited. This arrangement is broadly equivalent to a conventional bank deposit account.
The payments made or credited are treated as interest for UK tax purposes.
Profit-Share Agency Arrangement (Wakala)
A profit-share agency is a similar agreement to the deposit arrangement outlined above and is akin to a conventional bank savings account. In this case, an investor deposits money with a financial institution which is subsequently appointed as their agent with a view to producing a profit. Any profits arising are then shared with the investor as an agreed return. Unlike the deposit arrangement, title to the funds remains with the investor instead of the funds being loaned to the financial institution.
Profits received under this arrangement are treated as an alternative finance return, and therefore taxed as interest.
Investment-Bond Arrangement (Sukuk)
Alternative finance investment bonds are similar in economic substance to conventional corporate bonds and are typically held by financial institutions, pension funds, or other investors. The investor will purchase a certificate, which in turn grants them an ownership in the assets or business being financed. Returns on investment are tied to the performance of the underlying asset. Unlike the other arrangements outlined above, these are intended to be traded as listed securities on a recognised stock exchange.
Returns generated by the arrangement are treated as an alternative finance return and subject to UK tax as though it were interest.
As noted above, returns arising as a result of an Islamic Financing Arrangement that meet the relevant conditions will be taxed as though it were interest.
Therefore, returns that relate to a residential property are restricted when calculating rental profits in the same way that deductions for mortgage interest payments are restricted.
With respect to capital gains, the alternative finance return is specifically excluded from consideration when determining the chargeable gain.