Contributed By Winston & Strawn London LLP
There are a broad range of Islamic financial products available in the UK and each must be analysed independently for tax and regulatory compliance. The UK government does not employ a separate framework for regulating Islamic financial products and transactions; the main legislation governing Islamic finance in the UK is the Finance Act 2005 as amended by the Finance Act 2007. The Finance Act 2005 characterises Islamic finance transactions as "alternative finance arrangements" which must comply with all the laws and regulations applicable to such arrangements. Similarly, from a regulatory perspective, Islamic banks providing Islamic financial products are subject to the same regulations as conventional banks and must be authorised by both the FCA and the PRA.
This approach reflects the UK government’s neutral position as a secular regulator, focused solely on adherence to and enforcement of applicable laws and regulations rather than having deference to faith-based considerations. As such, the UK government does not take responsibility for the Shari’a-compliance (or lack thereof) of Islamic financial products. Instead, the responsibility for ensuring the Shari’a-compliance of such products is borne by private financial institutions and other private sector participants in such financing arrangements.
There is no official supervisory body for Islamic finance in the UK. Islamic banks and takaful operators operate as conventional banks and insurers respectively, and are regulated by the FCA and the PRA. However, the vast majority of financial institutions in the UK elect to establish Shari’a supervisory boards (SSBs) to monitor and regulate Islamic financial products.
The Islamic Financial Services Board (IFSB), an international standard-setting organisation and supervisory agency, publishes prudential standards and guiding principles for institutions offering Islamic financial services; however, membership of the IFSB and compliance with such standards are voluntary. Furthermore, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), a non-profit organisation, seeks to maintain and promote Shari’a standards for Islamic financial institutions, participants and the industry generally.
Islamic Financial Products
Tax legislation in the UK has developed to ensure that the tax treatment of Islamic financial products, as alternative finance arrangements, is neither more nor less advantageous than their conventional finance alternatives. This has been achieved in respect of some Shari’a-compliant products – such as murabaha (a financing structure based on asset/commodity purchase and resale), musharaka (a structure based on shared ownership), mudaraba (an arrangement in which one party provides the relevant funds and the other provides management expertise), wakala (an agency structure entailing profit sharing) and sukuk (Shari’a-compliant bond) – but not across the full range of available Shari’a-compliant products. Legislation to ensure a level playing field for Islamic finance in the UK was introduced by the government in 2003 and special exemptions were utilised to counter unintentional double-taxation charges caused by structures used by Islamic mortgages.
The tax treatment of some of the most commonly used Islamic financial products is currently set out for income tax purposes in Part 10A of the Income Tax Act 2007 and for corporate tax purposes in Chapter 6 of Part 6 of the Corporate Tax Act 2009 (CTA). For example, under English law, holders of sukuk will be treated like bondholders, provided that they meet the criteria set out in Section 507 of the CTA. If these conditions are satisfied, the returns paid on the sukuk will be treated as interest paid by the sukuk issuer to the sukuk holder and will be deductible or taxable accordingly, which may increase the popularity and development of sukuk in the financial market in the UK.
Under English law, the tax treatment of murabaha is equivalent to the payment or receipt of interest on a loan, provided that the arrangement meets the criteria set out in Section 511 of the CTA. If an asset is bought and sold under an alternative finance arrangement, Section 514 of the CTA excludes the return made on the arrangement for the purposes of capital gain tax under the Taxation of Chargeable Gains Act 1992.
The development of Islamic finance in the UK has entailed a rise in the Shari’a-compliant home finance market, which was facilitated by an amendment to the tax laws in 2003 that removed what had previously been a double charge to stamp duty land tax.
The takaful industry, a Shari’a-compliant form of insurance based on the principle of mutual protection and shared responsibility, is still at an early stage in the UK but is expected to benefit from the general promotion of Islamic finance by the government. The FCA and the PRA will determine on a case-by-case basis whether an arrangement amounts to insurance and some takaful providers have received FCA and PRA authorisation. Under English law, a takaful arrangement will generally be treated as an insurance contract.
Islamic banks and takaful providers are established in the UK as conventional banks and insurance companies respectively and have to be licensed by both the FCA and the PRA under the Financial Services and Markets Act 2000. There is no specific regulatory regime for Islamic banks or for takaful providers. As recommended by AAOIFI, each Islamic bank and takaful provider has its own SSB, which is generally comprised of three Shari’a scholars who oversee takaful operations, supervise the development and operation of takaful, and determine the Shari’a-compliance of Islamic financial products. In addition, SSBs carry out their own independent audit to determine whether any element of the institution’s operations is considered haram, ie, prohibited under Shari’a.