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As soon as I started learning about taxation, I understood that you can often accomplish a goal in more than one way, with those ways receiving different tax treatment. That is why large businesses, and wealthy individuals, put so much effort into thinking about their tax affairs.

I was reminded of this by a recent email from a website reader. I used our correspondence as the basis for my March 2023 column in the magazine "Islamic Finance News".

You can read it below.

How a transaction is done normally changes its tax treatment

Like many previous columns, this one was inspired by an enquiry from a website reader.

This person has diminishing musharaka finance provided by a UK Islamic bank on some UK real estate that is not the person’s principal private residence. (A gain realised by selling a principal private residence is normally exempt from capital gains tax.) The real estate is let by the person to some tenants, who are legally the person’s sub-tenants since the person is renting from the bank the share of the property which is not owned by the person. There is more than one property involved.

This real estate needs to be refinanced for two possible reasons:

• In the case of some properties because the nature of the person’s sub-tenants is going to change.
• In the case of some properties because the finance was at a fixed finance rate for a fixed period which is about to expire, and floating rate finance would be too expensive, so another fixed rate financing is desired.

As I have mentioned on several occasions, most recently in my column of 3 August 2022, “The UK government needs to tackle Shariah compliant refinancing” there is no general relief from capital gains tax when real estate is refinanced using Shariah compliant bank finance.

That is unfair because no such tax charge arises on conventional real estate refinancing. The UK failure to correct this anomaly looks even more unreasonable once you are aware that there is relief from capital gains tax when real estate is sold to a special purpose vehicle to enable the issue of sukuk!

In this case, the existing Islamic bank may be willing to refinance the property. However, I understand from meeting the person that the bank wishes to carry out the refinancing as follows.

Assume for ease of understanding that the real estate originally cost £ 10,000, and that by now the person has paid £ 2,500 to the bank to purchase 25%, while the remaining 75% belongs to the bank and is being rented from the bank by the person under the diminishing musharaka contract. Assume also that the property is now worth £ 100,000.

Step 1 – The bank sells its 75% to the person for £ 75,000.

Step 2 – The person immediately sells that 75% back to the bank for £ 75,000 and enters into a new diminishing musharaka contract at the new fixed rental rate, with the appropriate sub-letting provisions.

While this seems logical to the bank’s lawyers, the UK tax rules work as follows:

• After step 1, the person owns 100% of the property, having paid £ 77,500 for it (namely £ 2,500 + £ 75,000).
• The person then sells 75% of the property to the bank for £ 75,000.
• 75% of the property cost the person only £ 58,125 (namely 75% of £ 77,500)
• The person has a taxable capital gain of £ 16,875 (£ 75,000 - £ 58,125)

While the UK needs to improve its tax law, in this case of refinancing with the bank being unchanged, the tax liability is entirely self-inflicted.

If the terms of the existing diminishing musharaka contract were simply amended to vary the provisions determining the rent the person pay to the bank, and varying the sub-letting permissions, there would be no sale and sale-back of the bank’s 75%, and no taxable gain should arise.

This example illustrates the general principle that there is often more than one way of carrying out a transaction, with different amounts of tax arising.

Mohammed Amin is an Islamic finance consultant and former tax partner at PwC in the UK.