For well over a decade, the UK has been amending its tax laws for Islamic finance. The goal is to ensure that Islamic finance transactions are not tax more heavily, or more lightly, than their conventional finance equivalents.
The process of changing tax law has been very slow, as tax law is complex and every change to it risks unanticipated consequences, and the possible creation of "tax loopholes" enabling transactions to escape taxation entirely.
For several years, I have been aware of a specific need to change UK tax law to avoid penalising the Shariah compliant refinancing of appreciated real estate. I wrote about this in my 1 May 2018 column in the magazine "Islamic Finance News." You can read it below.
Every country I know originally developed its taxation system when all finance was conventional. This applies even with Muslim majority countries.
Although Islamic banks serve the same economic functions as conventional banks, they carry out transactions which are structurally quite different from those of conventional banks. Since the applicable tax systems were developed in a conventional finance environment, the consequence is that Islamic finance transactions are regularly taxed more heavily than equivalent conventional finance transactions.
To illustrate this, consider what happens when an individual owns commercial property which has appreciated in value and wishes to borrow money using the property as collateral.
Assume that the property originally cost $100,000, is now worth $1,000,000, and that the individual wishes to borrow $750,000 secured on the property.
The conventional finance transaction is straightforward.
A conventional bank will lend the individual $750,000 secured by a legal charge on the property. The loan will have agreed terms for repayment of the capital and for payment of interest.
From a taxation perspective, there has been no sale of the property since the individual continues to own it throughout. This applies even if the legal title is transferred to the bank as security for the loan; the individual continues to be the beneficial owner of the property and most (if not all) countries’ tax systems will therefore ignore the transfer of legal title.
As there has been no sale, in most countries there will be no real estate transfer tax either on the creation of the mortgage or on its repayment. Similarly, in most countries, as there is no sale of the property there is no disposal of it so borrowing the loan does not cause any part of the inbuilt $900,000 capital gain to be taxed.
The equivalent Shariah compliant transaction is more complex.
Typically, the individual and the bank will engage in a diminishing musharaka transaction. The individual sells the property to the bank for, say, $750,000. The bank then rents the property back to the individual for an annual rent, which in practice corresponds to market interest rates on $750,000. Over the life of the diminishing musharaka transaction, the individual buys back the property, normally for the same $750,000 price, normally in partial stages. As the individual increases his ownership share in the property, the proportion of the property on which he pays rent reduces correspondingly.
Accordingly, the Islamic finance transaction involves the property being sold twice, once by the individual to the bank and then by the bank back to the individual. Countries that charge tax on transfers of real estate will typically do so for both sales. Furthermore, the individual has sold for $750,000 a property that cost him $100,000, so if the country taxes gains arising on the sale of property, the individual can expect to be taxed on the $650,000 gain.
In the United Kingdom, the real estate transfer tax charges mentioned above were eliminated by the UK’s earliest changes to facilitate Islamic finance around 2003.
However, the capital gains tax charge triggered by the sale remains in the case of sales to Islamic banks, although the equivalent gain on a sale to a sukuk issuing special purpose vehicle is not taxed. With the assistance of the author the UK’s Chartered Institute of Taxation has now written to the UK tax authorities proposing that the gain on the Islamic financing transaction described above should not be taxed provided appropriate conditions are complied with.