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Tuesday, 26 January 2010

Luxembourg aims to become hub for Islamic finance

25 January 2010

Luxembourg took an important first step toward developing the Duchy into the latest European hub for Islamic finance, especially Islamic capital markets, when it published last week a new tax circular on the treatment of a whole range of Islamic finance products including murabaha, musharaka, mudarabah, istisna, ijarah, ijarah wa Iktina and sukuk (Islamic bonds).

A circular from the Director of Contributions, the Luxembourg tax authority, describes the major principles and contracts of Islamic finance and their respective tax treatment. According to the preamble of the Circular, "Islamic finance involves financial instruments used by investors who wish to manage their investments observing the values of Islam. The objective of Islamic finance is to share profits and losses between those who provide the capital and those who use it."

The Director of Contributions identifies two Shariah principles that merit particular attention: "Third party" capital providers (such as banks for instance) cannot in principle play a passive role, but must in contrast act as true "partners"; and the prohibition on lending money (with interest) to third parties. The development and listing of these products must rely on real physical assets (real estate, infrastructure projects or even commodities, like oil, aluminum or wheat). They may not rely on other financial products. Any profit from other financial products, particularly interest, would be considered usury (riba), and as a consequence should be purified in accordance with a criteria generally applicable in Islamic finance.

However, Director of Contributions stresses that undertakings for collective investment under Luxembourg law and investing in Islamic assets are excluded from the scope of this circular.

The circular confirms the classification of sukuk as debt for Luxembourg tax purposes. Consequently, yield payments under the sukuk are treated under domestic tax law as deductible interest expenses at the level of the paying entity. In contrast to many other jurisdictions, the circular confirms that no Luxembourg withholding tax is levied on yield payments.

Having regard for its characteristics, says the circular, "a sukuk may be considered similar to conventional financial debt instruments, the remunerations to the bearer of a sukuk being analyzed fiscally in the same way as interest. By likening it in this manner, the remuneration paid to the holder of a sukuk is deductible, when it is shown that it was generated in the interests of the company. The income from a sukuk would thus be likened to income from movable assets within the meaning of Article 97 (1) 3 L.I.R. (or commercial profit). The fiscal provisions in relation to the providers of funds and to profit-sharing bonds (Articles 146 (1) 2 and 3 and 164 (2) L.I.R.) are not applicable to this type of financial instrument."

As regards the application of double taxation agreements, there is a place for recourse, if necessary, to the procedure for the amicable resolution of any difficulties.

The governor of the Banque centrale du Luxembourg, the central bank, Yves Mersch, has expressed support for sukuk as an alternative and cheaper way to raise finance, fueling speculation that Luxembourg's sovereign may be gearing itself for a debut sukuk issuance. In order to facilitate the emergence of a resilient Islamic financial market in Europe, suggested Gov. Mersch recently in Brussels, "we have to adapt and shape the infrastructure and supervisory environment to allow efficient and cost effective trading and clearing for a significant number of investment-grade Islamic financial papers across the whole maturity spectrum. In this perspective, it is worth noting that in the current turbulent period, raising finance through sukuk issuance appears to be cheaper than recurring to conventional bonds due to the burgeoning demand for Islamic instruments."

The circular treats murabaha as a sale agreement. Consequently, in principle, the profit realized on that sale is acquired by the financier from the signature of the agreement and the entire proceeds of the sale are taxable immediately, including the financier's margin, otherwise called its profit.

Nevertheless, to the extent that, on an economic level, the financier's profit constitutes the remuneration for a deferred payment during that period, that profit may benefit from a spread of taxation on the proceeds for continuous or discontinuous services at successive maturities, remunerated in particular by rents. In other words, the profits are taxed on a linear basis over the term of the payment deferment, whatever the reimbursement.

The above benefits, however, are subject to certain conditions, including, the agreement between the parties must clearly highlight the fact that the financier acquired the property in order to resell it, concomitantly or within a period which may not exceed six months, to its client; the agreement must separately indicate the specific remuneration of the financier for its involvement, with the financier's profit constituting the compensation for a payment deferment, the client's acquisition price and the price for acquisition of the property by the financier; the financier's profits must be clearly stated, known and accepted by the two parties to the agreement; the financier's profits must be expressly indicated as being compensation for the service provided by the financier to the client which results from the effective deferment of payment granted to the investor. There may for example be a clause presenting the profits as "compensation for the payment deferment granted to the purchaser by the vendor, the purchaser undertaking to pay the vendor the profit until the date of final reimbursement"; and with regard to accounts and fiscal aspects, the profits must be spread by the financier on a linear basis over the period of the payment deferment, whatever the reimbursement.

Luxembourg over the last few years has been slowly working toward establishing itself as an Islamic finance hub. Indeed, the Duchy has been the laboratory for Islamic finance in Europe since the late 1970s and early 1980s way before London. Today, there are some 15 sukuk listed on the Luxembourg Stock Exchange with a combined value of 5 billion euros; and over 40 Islamic investment funds, largely equity funds domiciled in Luxembourg.

As a further statement of intent, not surprisingly, in November 2009 the Duchy became the first European country to become an associate member of the Islamic Financial Services Board (IFSB), the prudential standard setting body for global Islamic finance. This is impressive given the fact that both the Financial Services Authority (FSA) in the UK and the Central Bank of France have both resisted in acceding to membership of the IFSB, whose other members include the IMF, Bank of China and the Monetary Authority of Singapore.

To further boost its Islamic finance credentials, Luxembourg recently signed double tax treaties with the United Arab Emirates, Qatar, Kuwait and Bahrain. This, in addition to 56 existing tax treaties that include several Islamic countries. On Jan. 12, 2010 Luxembourg for Finance also signed memoranda of understanding with Bahrain and the Dubai International Financial Center to foster strong existing business relationship and further enhance bilateral cooperation and wide-ranging industry development, including in Islamic finance.

Mersch, one of the most proactive European central bankers as far as Islamic financial inclusion is concerned, recently urged his fellow European regulators to "become more familiar with the principles and practices specific to Islamic finance in order to make appropriate supervisory and regulatory judgments" and maintained that the current needs of Europe's 38 million plus Muslims and those interested in faith-based ethical finance have "not yet appropriately been addressed by the conventional banking offering."

In April last year, the government set up a multi-disciplinary taskforce charged with identifying obstacles to the development of Islamic finance in Luxembourg and ways to support its growth. Working groups on Islamic finance were also formed by the Luxembourg Investment Fund Association (ALFI) and Luxembourg for Finance (LFF).

By Mushtak Parker & Marc Theisen (Arab News)

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