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The Luxembourg Islamic Finance Package – Direct tax aspect discussed
Although many Islamic Finance deals have already been implemented through Luxembourg vehicles, both regulated and non-regulated, the Government found it appropriate to provide investors and Islamic Fund promoters with a dedicated Luxembourg tax framework. Taxand Luxembourg reviews the key elements of the framework, benefits for Islamic investors looking to expand out of their local markets and why Luxembourg is viewed favourably by Islamic fundraisers looking to broaden their base.
The Circular covers the Luxembourg corporate income tax and municipal business tax treatment applicable to Murabaha transactions and Sukuk issuance, as well as withholding tax on payments to Sukuks holders.
The Circular expressly excludes Luxembourg Undertakings for Collective Investments (UCITS) from its scope and does not address VAT and other indirect taxes (stamp duties, transfer taxes, etc...).
This technique basically consists of a purchase and re-sale at cost and includes an agreement entered into by an Islamic financing party (an Islamic Bank or its affiliate) and the Shari'ah compliant final customer. The latter will benefit from a price payment deferral. Instalments include the acquisition cost paid by the Islamic Financing party to the initial supplier of goods, as well as the mark up. Delivery of the goods subject to the Murabaha agreement is immediate. As is the payment price to the initial supplier of goods.
The Circular states that under a Murabaha transaction the profit realised by the financing party to the Murabaha agreement will be recognised for Luxembourg direct tax purposes on a linear basis during all the Murabaha payment deferral period, regardless of the effective instalments payments (Luxembourg tax spreading regime).
The profit of the Islamic Financing party derived from the Murabaha transaction may benefit from the Luxembourg tax spreading regime provided that the formal requirements are met. These requirements mainly comprise disclosure, in the Murabaha documentation, of certain information or statements (purpose of the transaction, definition of the various components of the price to be paid by the final customer to the financing party, etc...).
Accounting wise, the Islamic Financing party is required to spread its profit on a linear basis during the price payment deferral period provided for by the Murabaha agreement.
The Luxembourg tax spreading benefit is limited to the profit derived by the Islamic Financing party from the price payment deferral, and is not applicable to any other fee / income, e.g. for intermediation services, recognised by the Islamic Financing party.
The Circular defines Sukuks as securities whose yield and principal depend on the performance of tangible assets or the usufruct of such tangible assets (Assets). The Assets' cash flows are allocated to the Sukuks' yield and principal repayment. Based on these features, a risk exists that Sukuks' yield may be nil, and Sukuks principal may not be totally repaid in the case the Assets are underperforming.
Under the Circular, Sukuks are comparable to conventional finance debt instruments for Luxembourg direct tax purposes. Therefore, the yield on Sukuks qualifies as interest and is treated as tax deductible if incurred in the best interest of the Issuer. The Circular indicates that the yield is not considered as a dividend or hidden dividend distribution for Luxembourg direct tax purposes and thus is not subject to Luxembourg withholding tax.
The general terms under which the Circular's section on Sukuks is drafted should allow for most of Sukuks structured so far to qualify for the debt treatment for Luxembourg direct tax purposes.
It still needs to be determined from a legal perspective whether Sukuks, as defined under the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) statement on Sukuks issued in February 2008, can be implemented under Western European countries legal systems.
Major Islamic investors, especially those investing in pan-European real estate assets, have already experienced the Luxembourg tax and legal environment's compatibility with Shari'ah compliant financing techniques. More than 32 Shari'ah compliant UCITS have been launched or listed in Luxembourg and many more privately held investment structures were set up in accordance with Shari'ah compliant financing.
The issuance of the Circular makes Luxembourg a must-review jurisdiction for fundraisers seeking to broaden their investors base to Shari'ah compliant investors as well as to Islamic Finance institutions willing to expand out of their natural geographical markets of Middle East and South East Asia.
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