The CSSF clarifies that Sukuk may be treated as asset backed securities pursuant to the provisions of Article 2.5 of the Prospectus Regulation or, subject to certain conditions, as guaranteed debt securities pursuant to Article 23.2 and Annex VI of the Prospectus Regulation. Indeed, provided that the payments of principal and the periodic revenues under the securities are guaranteed on a contractual basis by one or more underlying entities, in other words, if the payment of principal and the periodic distributions are independent from the performance of the underlying asset, the CSSF considers that the underlying entities may be described in accordance with the provisions of Annex VI of the Prospectus Regulation.

The calendar of remittance dates for the statistical reporting of securitization vehicles in 2011 as provided by the BCL is as follows:

Report S.2.14 Report S.2.15
March 2011 03.05.2011 03.05.2011
June 2011 28.07.2011 28.07.2011
September 2011 31.10.2011 31.10.2011
December 2011 30.01.2012 30.01.2012

If the balance sheet total of reporting securitization vehicles fall durably within the year below to the aforementioned threshold, it is important to inform the BCL before the submission deadline in order to benefit from the reporting exemption.

On  17 June 2010, the Luxembourg indirect tax authorities (L’Administration de l’Enregistrement et des Domaines) have issued a circular (circular n°749, hereafter referred to as the “Circular”) providing guidance regarding the registration duties (i.e. real estate transfer taxes) and certain VAT aspects applicable to Murabaha and Ijara transactions in relation to Luxembourg real estate.

General background

Murabaha is a kind of sale with a deferred payment where the seller expressly mentions the cost he has incurred on the assets to be sold and sells it to another person by adding some mark-up / margin thereon which is previously known to the buyer.

In general, there are two agreements in a Murabaha financing: First, the purchase by a Luxembourg special purpose vehicle (“SPV”) of the real estate asset on request of the Islamic investor and secondly the sale by the SPV of the real estate asset to the Islamic investor with an agreed margin (mark-up) and paid by the Islamic investor to the SPV on a deferred payment basis. 

Registration duties

The Circular clarifies that a purchase and resale of a real estate asset is liable to registration duties based on the acquisition costs and not on the resale price. The difference between the acquisition price and the resale price (mark-up in a Murabaha transaction) will be considered as interest for  Luxembourg tax purposes and therefore not be subject to registration duties.

The above treatment is only possible if the following three conditions are met:

1. The Islamic investor (buyer under the second sale agreement) must take possession of the real estate asset immediately after the second sale;
2. The second sale agreement must be completed within 10 days after the first sale agreement; and
3. The first sale agreement must mention a clause that the purchase is realized under a Murabaha agreement and a copy of the Murabaha agreement (i.e. the second sale agreement) must be attached to the first sale agreement.

The Circular furthermore also confirmed that the disposal of shares of a company with substantial real estate assets are not subject to registration duties.

VAT aspects

The circular confirmed that SPVs created under Murabaha or Ijara agreements are subject to VAT. Any real estate transaction under such Sharia compliant financial instruments may however benefit from VAT exemption under article 44 §1 f) and g) of the VAT law. However, if all persons to the transaction are VAT taxpayers, they may opt for the application of VAT on the transfer or lease of the real estate asset.

Conclusion

This Circular provides clarity and more security in real estate transactions (and more in particular in relation to real estate transfer taxes and VAT issues) involving Sharia compliant instruments (such as Murabaha and Ijara). It furthermore confirms Luxembourg’s commitment to Islamic finance and to become a global hub for Islamic finance in Europe.

Well established as a world leader in the investment funds industry (second only to the USA), Luxembourg firmly held its position throughout the economic crisis, totalling EUR 1,840.993 billion net assets under management as at 31 December 2009. This five decade long success story originates from a continuing intention on the part of the local authorities to make the most of promising opportunities in the financial market. Islamic Finance is unquestionably one such opportunity and initiatives taken by the various actors operating in Luxembourg show how determined they are to lead the way in this fast growing market.  

As of today, around 16 sukuks (asset backed securities) with a combined value of USD 6 billion and around 42 Sharia compliant funds (out of a total of 560 funds) are already listed on the dynamic Luxembourg Stock Exchange – the first in Europe to list a sukuk in 2002 -, while about 35 others are in the process of being launched. This fast growing development results from a harmonious interaction between Islamic finance mechanisms and the Luxembourg legal framework. Another determining factor is the unique network of investment treaties Luxembourg signed with 57 countries, including the United Arab Emirates, whilst others treaties with countries such as Bahrain are currently under negotiation. Those treaties aim at providing investors with a great deal of protection, and are a key to the development of Islamic finance in Luxembourg.  

Moreover, on January 12, 2010, to confirm Luxembourg’s commitment to Islamic finance, the Luxembourg tax administration has issued a circular in order to provide guidance on the Luxembourg tax aspects of certain Islamic financing instruments (more in particular Murabaha contracts and Sukuk) (see section IV hereunder).  

The purpose of this article is to (i) set out the use of Luxembourg investment vehicles (more in particular, Luxembourg investment funds (UCITS, SIFs) and special investment vehicles such as the SICAR and the securitization vehicle) for Sharia compliant investments and (ii) to clarify the Luxembourg tax treatment of Murabaha contracts and Sukuk transactions.  

II.  Basic Shariah principles relevant in Islamic finance

Islamic finance is finance under Shariah principles, whose basic sources are the Qur’an and the Sunna, followed by the consensus of the jurists and interpreters of Islamic law. Shariah is the body of Islamic religious law, within which the public and private aspects of life are regulated for those living in a legal system based on Islamic principles of jurisprudence and for Muslims living outside that domain.  

The central, distinguishing feature of Islamic finance is the prohibition of the payment and receipt of interest (or riba). Importantly, any contract based on the occurrence or non-occurrence of a future uncertain event is not allowable. In addition, capital must have a social and ethical purpose beyond unfettered returns, and speculation is strictly prohibited. Finally, of course, Islamic finance is restricted to islamically acceptable transactions, which exclude those involving alcohol, pork, gambling, etc.  

One crucial element of Islamic finance is the role of the Shariah board, which forms an integral part of every Islamic financial institution. This board includes Islamic law scholars who are to give their opinion on doubtful transactions from a Shariah point of view. It should be pointed out that there might be divergence amongst scholars depending on the jurisdiction or geographical regions.  

III. Basic methods of Islamic financing

Banning any charge of interest means that most conventional fixed income instruments are not eligible investments for a shariah compliant fund. Consequently, several Islamic finance techniques have developed. Those techniques include equity-related techniques such as Mudaraba (profit sharing agreement) and Musharaka (Joint-venture), as well as debt-related techniques such as Murabaha (forward sale), Ijara (leasing) and Sukuk (asset backed securities).  

Mudaraba is a profit sharing contract in which one party provides 100 per cent of the capital whereas the other party provides its expertise in order to assist in the process of investing the capital, managing the investment project and, if appropriate, providing labour. Mudaraba structures are widely used by investment funds, with investors providing money to the Islamic bank, which in turn invests it, taking a management fee.  

In contrast, the Musharaka involves a partnership between two parties who both provide capital towards the financing of new or established projects. Both parties are to share the profits on a pre-agreed ratio, whilst losses are to be shared on the basis of equity participation.  

Murabaha is a kind of sale with a deferred payment where the seller expressly mentions the cost he has incurred on the assets to be sold and sells it to another person by adding some mark-up / margin thereon which is known to the buyer. In general there are two contracts in a Murabaha financing: First the purchase by the financier (eg. the bank) of the asset on request of the client / buyer and secondly the sale by the financier (eg. the bank) of the asset to the client / buyer with an agreed margin (mark-up) and paid by the client to the financier on a deferred payment basis.  

The Ijara is a contract where the bank buys and leases out equipments required by the client for a rental fee. Throughout the contract, the ownership of the equipment remains with the lessor bank, which will seek to recover the capital cost of the equipment plus a profit margin out of the rentals payable.  

A Sukuk can be considered as an Islamic equivalent of a bond. Since fixed income, interest bearing bonds are not permissible under Shariah law, Sukuk securities are structured to comply with Shariah law and its investment principles, which prohibits the charging, or paying of interest. A Sukuk has a pre-determined maturity and is backed by an asset that makes it possible to realize a return on the investment. The remuneration on the Sukuk is linked to the performance of the asset held by the Sukuk issuer. The Circular defines Sukuks as securities, whose yield and principal depend on the performance of tangible assets or the usufruct of such assets. Sukuks can be structured alongside different techniques. While a conventional bond is a promise to repay a loan, a Sukuk constitutes partial ownership in a debt (Sukuk Murabaha), asset (Sukuk Al Ijara), project (Sukuk Al Istisna), business (Sukuk Al Musharaka), or investment (Sukuk Al Istithmar). Most commonly used Sukuk structures replicate the cash flows of conventional bonds. Such structures are listed on exchanges such as the Luxembourg Stock Exchange, and made tradable through organisations like Euroclear and Clearstream.  

IV. Luxembourg Tax Circular on Islamic Finance

The Luxembourg tax administration refers to Islamic Finance as the “financial instruments used by investors who wish to manage their investments observing the values of Islam”. The objective of Islamic finance is, according to such Circular, “to share profits and losses between those who provide the capital and those who use it.”  

The Circular in its first part provides a description of the major Shariah principles and Islamic finance techniques such as Murabaha, Muchakara, Mudaraba, Ijara, Ijara-wa-Iqtina, Istinah and Sukuk. The second part deals with the Luxembourg tax treatment of Murabaha contracts and Sukuk transactions.  

(a)   Murabaha contracts

The Circular mentions that from a Luxembourg tax perspective the agreement between the person providing the financing (eg. the bank) and the client / buyer is to be assimilated as a sale agreement. As such, the realized gain on the sale is realized by the person providing the financing at the date of signing of the agreement and the entirety of the revenue from the sale is immediately taxable (including the margin for the person providing the financing, in other words his profit).However, the Circular provides for an exception to the above principle of immediate taxation by allowing a taxation of the gain on a deferred straight-line basis over the life of the agreement regardless of the actual repayments made by the client / buyer. 

There are certain conditions set out in the Circular that need to be complied with in order to be able to benefit from the taxation on a deferred basis, namely:   

• The agreement between the parties must clearly demonstrate that the financier has acquired the assets to resell them, either immediately or in a maximum of 6 months, to the buyer / client;
• The agreement must mention (i) the remuneration perceived by the financier for his intermediation, (ii) the profit of the financier as consideration for the deferred payment and (iii) the acquisition price paid by the client / buyer and by the financier (eg. bank);
• The profit  of the finanier must clearly be mentioned, known and accepted by both parties to the agreement;
• The profit of the financier must expressly be designated as being the consideration for the service rendered by the financier to the client / buyer and which results from the deferred payment granted to the client / buyer;
• For accounting and tax purposes, the profit must be spread by the financier on a straight-line basis over the period of the deferred payment, regardless of the actual repayments made by the client/ buyer. 

(B)   Sukuk transactions

The Circular provides that that the Luxembourg tax treatment of a Sukuk is identical to the treatment of debt in conventional finance (although the income is linked to the performance of the underlying asset) and that the remuneration of the Sukuk is treated for Luxembourg tax purposes as an interest payment. As a result thereof, payments made under the Sukuk (the yield on the Sukuk) qualify as interest and should generally be deductible if incurred in the corporate interest of the company / issuer of the Sukuk. The payments made on the Sukuk should not be subject to withholding tax as under Luxembourg law, no withholding tax is due on interest payments (except for application of the Savings Directive). 

It should be noted that undertakings for collective investment under Luxembourg law and investing in Islamic assets are excluded from the scope of this Circular. This can be explained as UCIs are tax exempt entities for Luxembourg corporate income tax purposes.   

V. Luxembourg Sharia compliant investment vehicles

The Luxembourg regulatory authority does not intend to issue specific rules or definitions for shariah compliant funds. However, guidelines may be issued in the future. For the time being, such rules and restrictions for shariah compliant funds shall be detailed in the fund prospectus.  

(a)   UCITS

Undertakings for Collective Investments in Transferable Securities (UCITS) are designed for retail investors and benefit from the European Passport, enabling them to be freely marketed throughout the European Union (EU) with a minimum of formalities. These funds are open-ended and must comply with stringent requirements set down by the EU legislator in terms of substance and supervision.As any other Luxembourg UCITS, shariah compliant UCITS need to be set up in accordance with the law of 20^th December 2002 (the ‘2002 law’), and may be in the form of either a SICAV (investment company with variable capital) or a FCP (common fund). A distinction with traditional UCITS is that shariah compliant UCITS must exclude any reference to interest payments or investment in non-permitted activities mentioned above. Importantly, the board of directors, the conducting officers and the investment manager must all be supported in their roles by a Shariah board, composed of scholars whose roles must be described in the prospectus. There is a minimum of three and sometimes five scholars on the shariah board. 

Although the Luxembourg legislation prevents a UCITS fund from exercising significant influence over an issuer, Shariah compliant UCITS will generally make clear their views to the issuers in which they invest. Even though securities of certain issuers can be per se eligible following the initial shariah screening, such an issuer may nevertheless be considered to have performed prohibited activities or have part of its income generated by interest payments. In that context – albeit only for equity funds -, a purification of the dividends received from the target issuers shall take place. This is the shariah board  who will determine what types of income need to be purified. This procedure will generally result in the fund being credited with the dividends paid by the issuer, minus the purification ratio (which will depend on the level of prohibited activities and interest based income). Any identified impure income shall be donated to a charity proposed by the shariah board and approved by the board of directors. In order to avoid non halal income, the fund administrative agent may calculate a Shariah compliant Net Asset Value (i.e the proportion of non Shariah compliant income which is determined at each valuation point is donated to a charity proposed by the investment manager and approved by the shariah board). 

It should furthermore be noted that the CSSF has recently signed a memorandum of understanding with the securities commission of Malaysia in which they agreed that managers supervised by the Malaysian authorities are authorized or registered for the purpose of asset management of UCITS in light of article 85 (1) (c) and (d) of the 2002 Law.

(b)   SIFs

Specialized Investment funds (SIFs) are lightly regulated and tax efficient funds, hence enjoying more flexibility than other regulated funds (such as UCITS). A SIF may for instance invest in any type of asset with less diversification requirements than UCITS. Flexibility is also present, inter alia, in the content of the prospectus, the subscription and redemption process, the reporting, the calculation of the Net Asset Value.Using Luxembourg’s specialised investment funds law, the Bank of London and the Middle East (BLME) has launched in 2009 the first Shariah compliant money market fund in Europe. 

(c)   SICAR

Luxembourg has long been a significant domicile for private equity vehicles but the jurisdiction has emerged as a major European and international centre since the introduction of the SICAR or risk capital investment company five years ago (more precisely by the introduction of the SICAR law of 15 June 2004). The SICAR is often used for private equity structures. A SICAR may issue Sukuk and other Shariah-compliant securities.Moreover, it is possible to implement in a SICAR a shariah compliant prospectus, shariah board, shariah audit etc as it is a very flexible vehicle. 

SICAR offers the possibility to make investments in compliance with Islamic principles by opening the right to the promoter to prohibit interest and to encourage risk-taking.   

(d)   Securitization vehicle

Since the groundbreaking law of 22 March 2004 on securitization (the “Securitization Law”) was adopted, offering investors a flexible regime for securitization vehicles (the SVs), Luxembourg gained reputation as an international securitization and structured finance hub.A determining factor in Luxembourg’s success in this field is the wide range of eligible assets which can be securitized. Under the Securitization Law, risks relating to the holding of assets, whether movable or immovable, tangible or intangible, as well as risks resulting from the obligations assumed by third parties may be securitized. Even though Islamic finance does not allow interest-bearing assets, shariah compliant assets are very diverse and include real estate, equity participations, ijara and murabaha contracts. Furthermore, the Luxembourg securitization vehicle can be unregulated (in other words not supervised by the Luxembourg supervisory authority on the financial sector (CSSF)) provided that such securitization vehicle does not make more than three issuances of securities to the “public” per year. In such case, there is no need to appoint a custodian bank and administrative agent. The annual running costs will then also be lower than in case of the use of a fund vehicle. 

A securitization fund is particular since it is organised as a co-ownership, the joint owners of which are only liable up to the amount they have contributed. This co-ownership of assets, by providing a higher connection to the securitized assets, ensures a harmonious compliance with the shariah principles mentioned above. Importantly, this kind of fund does not have its own legal personality and must be managed by a management company based in Luxembourg. 

The tax treatment of the securitization vehicle is also advantageous. A securitization company is a fully taxable entity. It means that it is eligible for the application of double tax treaties entered into by and between Luxembourg and more than seventy countries. In other words, the income earned and distributed by the securitization company will be subject to reduced withholding taxes. Furthermore, securitization vehicles are able to deduct from their gross profits their operational costs and any amount distributed to the holders of the securities issued by the securitization vehicle.   

VI. CONCLUSION

Luxembourg is currently considered as a major international hub for financial services and Islamic finance investments. Strong government support and commitments to Islamic finance, proactive regulatory and supervising authorities and a flexible and secure legal framework offers a wide range of opportunities for implementing faith based ethical finance transactions, for devising Islamic finance products adapted to the needs of the most demanding investors and promoters. In November 2009, Luxembourg was the first European country to become an associate member of the prudential standard setting body for global Islamic finance, the Islamic Financial Services Board.

The Luxembourg tax administration refers to Islamic Finance as the “financial instruments used by investors who wish to manage their investments observing the values of Islam”. The objective of Islamic finance is, according to such Circular, “to share profits and losses between those who provide the capital and those who use it.”

The Circular in its first part provides a description of the major Shariah principles and Islamic finance techniques such as Murabaha, Muchakara, Mudaraba, Ijara, Ijara-wa-Iqtina, Istinah and Sukuk. The second part deals with the Luxembourg tax treatment of Murabaha contracts and Sukuk transactions.

Murabaha contracts

General background

Murabaha is a kind of sale with a deferred payment where the seller expressly mentions the cost he has incurred on the assets to be sold and sells it to another person by adding some mark-up / margin thereon which is known to the buyer.

In general there are two contracts in a Murabaha financing: First the purchase by the financier (eg. the bank) of the asset on request of the client / buyer and secondly the sale by the financier (eg. the bank) of the asset to the client / buyer with an agreed margin (mark-up) and paid by the client to the financier on a deferred payment basis.

Luxembourg tax treatment

The Circular mentions that from a Luxembourg tax perspective the agreement between the person providing the financing (eg. the bank) and the client / buyer is to be assimilated as a sale agreement. As such, the realized gain on the sale is realized by the person providing the financing at the date of signing of the agreement and the entirety of the revenue from the sale is immediately taxable (including the margin for the person providing the financing, in other words his profit).

However, the Circular provides for an exception to the above principle of immediate taxation by allowing a taxation of the gain on a deferred straight-line basis over the life of the agreement regardless of the actual repayments made by the client / buyer.

There are certain conditions set out in the Circular that need to be complied with in order to be able to benefit from the taxation on a deferred basis, namely:

• The agreement between the parties must clearly demonstrate that the financier has acquired the assets to resell them, either immediately or in a maximum of 6 months, to the buyer / client;
• The agreement must mention (i) the remuneration perceived by the financier for his intermediation, (ii) the profit of the financier as consideration for the deferred payment and (iii) the acquisition price paid by the client / buyer and by the financier (eg. bank);
• The profit  of the financier must clearly be mentioned, known and accepted by both parties to the agreement;
• The profit of the financier must expressly be designated as being the consideration for the service rendered by the financier to the client / buyer and which results from the deferred payment granted to the client / buyer;
• For accounting and tax purposes, the profit must be spread by the financier on a straight-line basis over the period of the deferred payment, regardless of the actual repayments made by the client/ buyer.

Sukuk transactions

General background

A Sukuk can be considered as an Islamic equivalent of a bond. Since fixed income, interest bearing bonds are not permissible under Shariah law, Sukuk securities are structured to comply with Shariah law and its investment principles, which prohibits the charging, or paying of interest. A Sukuk has a pre-determined maturity and is backed by an asset that makes it possible to realize a return on the investment. The remuneration on the Sukuk is linked to the performance of the asset held by the Sukuk issuer. The Circular defines Sukuks as securities, whose yield and principal depend on the performance of tangible assets or the usufruct of such assets. Sukuks can be structured alongside different techniques. While a conventional bond is a promise to repay a loan, a Sukuk constitutes partial ownership in a debt (Sukuk Murabaha), asset (Sukuk Al Ijara), project (Sukuk Al Istisna), business (Sukuk Al Musharaka), or investment (Sukuk Al Istithmar). Most commonly used Sukuk structures replicate the cash flows of conventional bonds. Such structures are listed on exchanges such as the Luxembourg Stock Exchange, and made tradable through organisations like Euroclear and Clearstream. As of the date of this article, around 16 Sukuks with a combined value of USD 6 billion are already listed on the Luxembourg Stock Exchange, the first in Europe to list a Sukuk in 2002 while about 35 others are in the process of being launched.

Luxembourg tax treatment

The Circular provides that that the Luxembourg tax treatment of a Sukuk is identical to the treatment of debt in conventional finance (although the income is linked to the performance of the underlying asset) and that the remuneration of the Sukuk is treated for Luxembourg tax purposes as an interest payment. As a result thereof, payments made under the Sukuk (the yield on the Sukuk) qualify as interest and should generally be deductible if incurred in the corporate interest of the company / issuer of the Sukuk. The payments made on the Sukuk should not be subject to withholding tax as under Luxembourg law, no withholding tax is due on interest payments (except for application of the Savings Directive).

It should be noted that undertakings for collective investment under Luxembourg law and investing in Islamic assets are excluded from the scope of this Circular. This can be explained as UCIs are tax exempt entities for Luxembourg corporate income tax purposes.

In addition to the above, the recent entry into force of a tax treaty between the Grand Duchy of Luxembourg and the United Arab Emirates on January, 1, 2010 and the signing of a memorandum of understanding between the Grand Duchy of Luxembourg and Bahrain, and between the Dubai International Financial Center and Luxembourg for Finance, on 11 and 12 January 2010 confirm the will of the Grand Duchy of Luxembourg to become a global hub for Islamic finance in Europe.

• A securitization vehicle may grant loans: third parties must set up the loans and the documentation of the issuance must mention the assets whereby the repayment of the loans relies on or the criteria as for the borrowers’ selection.
• A securitization vehicle may securitize revolving loans or loans that are not yet fully drawn down. However, a certain number of conditions need to be fulfilled. Indeed, a pre-determined framework for those loans has to be established and a securitization vehicle has no discretion when selecting or choosing the borrowers or the terms of the loans.
• A securitization vehicle may also securitize commodities but the purpose of the acquisition of such commodities by a securitization vehicle is to provide financing. Furthermore, such commodities create collateral in order to secure the repayment of the obligations of the entity to which the financing is provided and entail cash flows for the benefit of investors.
• A securitization vehicle may also borrow for leverage purposes in order to cover temporary shortfalls or during the warehousing period as long as the issuance of securities provides financing to a securitization vehicle.
• A securitization vehicle may securitize shares or units in UCIs, limited partnerships, hedge funds or other companies that hold the securitized risks provided that a securitization vehicle carries out any management activities in the entities to which it has direct or indirect participation. Lastly, a securitization must not provide services of any kind to such entities.

• Transposition of the European Directive 2004/39/CE on Markets in Financial Instruments (MiFID) into Luxembourg legislation.

• Review of the status of certain Professionals of the Financial Sector (PFS) and creates five new categories of PFS.

Firstly, certain categories of PFS, such as financial advisors, brokers in financial instruments and market makers changed from “PFS other than investment firms” to “investment firms”. From now on they will benefit from the European passport. On the contrary, registrar agents (i.e. TAs) and professional custodians of financial instruments are no longer “investment firms” but “PFS other than investment firms”, and loose the benefit of the European passport.

Secondly, five new categories of PFS have been created by the draft law:

- Financial intermediation companies;
- Investment firms operating a Multilateral Trading Facility (“MTF”) in Luxembourg;
- Operators of a regulated market authorized in Luxembourg;
- Primary IT systems operators of the financial sector;
- Secondary IT systems and communication networks operators.

• Reduction of the minimum share capital requirements for certain types of PFS.

This measure gives highly qualified financial specialists the opportunity to access the profession easier than before.

The question arose whether the bank has the obligation to inform its client of the existence of the order.

This question is particularly important in light of the law of 8 August 2000 relating to mutual assistance in criminal matters. This law enables the concerned person (i.e. the client) to lodge an appeal against the order within a period of 10 days following the day of notification of the Luxembourg order to the bank.

The court held that the bank had the obligation to inform its client of the measures within a reasonable time period and that failing to do so the bank could be held liable for the damages undergone by its client. However, the court stated that the bank can only be liable if the client can prove that if he had been informed in time he would have had a chance to obtain the cancellation of the order.