Ashurst Islamic Finance Insight - Transcript

Ashurst Talks - 9 October 2017

Speakers: Abradat Kamalpour and Simon Swann

Hello everyone. I'm Abradat Kamalpour, partner here in Ashurst, London and Global Head of our Islamic Finance Practice.

Hello everyone. My name is Simon Swann. I'm a partner in the Tax Department here at Ashurst in London and my practice is focused primarily on the taxation of real estate in all its forms.

Islamic finance, a conversation you and I always have consistently, especially in real estate. And it's particularly important to Islamic finance because we are usually dealing with asset based or asset backed structures involving either movement of assets, whether they're commodities or real estate itself when we're looking at Ijara structures. Tax plays an important element in structuring particularly in transactions in UK and Europe.

We both agree that the UK has been at the forefront of tax reform and putting in place legislation which puts Islamic finance on an equal footing with conventional finance. What do you think about that?

I think you're right and there are two areas there where I think the UK has made commendable efforts over the years to accommodate Islamic finance structures. The first one is in the area of Stamp Duty Land Tax, the UK version of RETT – Real Estate Transfer Tax. And often if one thinks say of Ijara structures, or similar structures, the asset moves about a lot and therefore there would be a tendency for multiple charges to Stamp Duty Land Tax to arise. And there's quite a highly developed code in the SDLT legislation which basically is designed to put Islamic compliance structures on the same footing – no better, no worse – than conventional structures.

The second area I think where the UK has a very developed system for Islamic compliance structures is in finance where there's a whole series of provisions designed to accommodate Islamic compliance structures, Ijara, Murabaha and so on, which basically accommodates the idea that the alternative finance return payable in these structures will be treated as equivalent to interest for tax purposes, with all the consequences that flow from that. Withholding tax for instance, and deductibility for tax purposes of that alternative finance return.

There are these limitations though with what's currently there in terms of financial institutions required to be part of the structure, you know, equalising legislation to kick in, isn’t there Simon?

That's quite right. In the finance side, and the legislation presumes that one party to the arrangements will be a financial institution as defined, and we've run into problems there, haven't we?

Yes, particularly if we're talking about larger transactions. So, you know, you're talking about Shariah compliant leverage coming into a fund which requires larger amounts of Shariah compliant debt financing to come in. Some of the banks … Shariah compliant banks … here in the UK, cannot service that. Clients have had to approach larger banks, and as a result there has been some tension as some of the larger banks real estate thinkers said "look, we like the transaction, but we want to do it on conventional terms". So we've had to come up with structures … well, with bridge structures where there's an orphan vehicle that sits there, it gets the conventional financing into it then it lends on a Shariah compliant basis to the structure. That has been a limitation despite the fact that the legislation is commendable.

That's right. And if we focus on that kind of bridge structure using an orphan company for a moment, then the orphan company would borrow from the bank … conventional debt. And then it would enter into an Islamic compliant arrangement. Usually you and I see a Murabaha, don’t we?

Yes.

But the point is that the orphan company is not a financial institution as defined and so therefore the Murabaha that it enters into cannot be with the asset owning company. And so what we've done with that is to say, well okay, the orphan company will enter into, for example, a Murabaha structure with the parent of the asset owning company … with the parent of the Propco. And then the parent will make a loan down to the asset owning company … to the Propco, and that loan will be a conventional loan at interest. And that's quite important.

And the distinction there is, that's allowed from a Shariah perspective because the parent is making an interest bearing loan to its own subsidiary and the view that scholars have taken is that there's nothing prohibiting you charging interest against yourself. If it was you know, a conventional loan to another party then obviously that's not Shariah compliant, a very basic Shariah component. But because you're lending to yourself, it's permissible. So that's enabled us to effectively create a structure where the returns are deductible, aren’t they?

Absolutely. And that structure has worked quite well up till now.

Both you and I have discussed recent possible changes coming in, in the UK and I think that's what's probably going to be of a lot of interest to our clients listening in. What do you see there on the horizon. What's the possibility?

Well I think what we should do is to first explain what the possibility is and then promise our listeners that we will return to them when we have more information and greater clarity.

Absolutely.

So, what are the possible changes? Well, they are these: with effect from the 1 April 2017 the UK will introduce an interest cap, or rules of restricting the amount of interest that can be deducted, and as we said, an alternative finance return is treated as interest for these purposes. Now, when the UK introduces these rules, from the 1 April 2017 they will be backdated. The rules, when they come in, will only apply to UK companies … to corporation tax payers. Now you might say, well, in real estate investment the kind of structure that we've been talking about almost always involves non-resident … non UK resident companies. And of course, non UK resident companies do not pay corporation tax on their rental profits for instance, they pay income tax. And so you might say well, Simon, why is that relevant? The answer to that is as follows, in March of this year the UK government issued a consultation document proposing to bring non UK companies into the charge to Corporation Tax. From what date we do not know, very unlikely, or most certainly not in 2017, but possibly in 2018 or 2019, if the government goes ahead with their proposals.

That soon?

That soon. Now, if that happens there will be good news and there will be bad news. The good news is that the headline rate of corporation tax is lower than the basic rate of income tax. The basic rate of income tax is 20 per cent. Currently the corporation tax rate is 19 per cent and is scheduled to reduce to 17 per cent by 2020.

Which is good news.

The bad news though is that if the government goes ahead with its proposals then non UK resident investors who are the target investors that we see investing into UK commercial real estate, will be brought into the charge to corporation tax and as a result of that they will then be subject to the interest deductibility restrictions that will already be in force for UK companies. So how does that play out and have an effect on the type of Murabaha bridge structure that we've been talking about? Well, we are optimistic that a company should be able to deduct interest, or an alternative finance return, where that alternative finance return is payable to an external third party bank.

But look at the structure that we described earlier to our listeners. There our non-resident property owning company isn’t paying an alternative finance return to a third party bank. It's paying interest to its parent. It's paying related party debt.

And it's that that we worry about. And we worry about that because if you just look at the non-resident asset owning company in isolation its debt all comes from a third party.

Whereas, if you stand back and look at the substance of the arrangement, actually the arrangement is tracking third party external debt and so one would hope, there, that the government in its legislation, if these proposals go ahead, take a holistic view … a broad view and say that well, directly, you have related party debt but indirectly when you stand back and look at an overview this is a third party arrangement.

We don’t want these structures being penalised when they are doing nothing wrong. What they are doing is taking effectively third party returns and streaming it up, but we're using the structure for UK tax purposes as well.

Absolutely. The the government has yet to respond to the consultation document, and to all the feedback that we've received from the consultation document in March. We would hope the government's response should be coming in a month or so. When the government does respond, you and I will need to revisit this subject and update our listeners as to where we are.

Absolutely. And you and I have been talking some possible solutions haven’t we? About what we can structure if this doesn’t catch this kind of structure properly and deal with it. Our listeners and clients will have to wait for our next podcast to see what's going to happen in this space.

Well, thank you very much everyone for listening, I'm Abradat Kamalpour, partner here at Ashurst and Global Head of Islamic Finance.

And I'm Simon Swann, partner in the Tax Department at Ashurst.