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  1. Thoughts on the tax issues regarding the development of Islamic Finance in France Hicham KABBAJ 29 May 2008 Geneva Conference

  2. Table of Contents Section 1 1. Preamble/Synopsis A. Status in France B. Top Islamic Finance News as of May 2008 C. What Is Islamic Finance - in Theory - in Practice D. Introduction to Islamic Tools Section 2 2. Practical Examples to Highlight the Tax Issues A. The Islamic Leasing or Al Ijara B. The Alternative Islamic Finance Product or Sukuk Al Ijara C. Conclusion – Possible Solutions D. The Future of Islamic Finance

  3. Section 1 Preamble/Synopsis

  4. 1. Preamble/SynopsisA. Status in France (1/3) • The French Senate opened the path with a report issued on 22 June 2007, underlining the need to develop islamic finance tools in France . . . . The SEC equivalent, the French «Autorité des Marchés Financiers », authorized on 17 July 2007 a French REIT following the Sharia principles. • The French islamic community is among the largest islamic communities in Western Europe and the USA (6 millions). • Notwithstanding these elements, nothing concrete has been made as of today except . . . • On 14 May 2008, Senator Jean Arthuis held the first official roundtable discussion at the French Senate on whether it is possible to consider expansion of islamic finance in France. • Government representatives participated in the debate; we can quote, for example: “the government is extremely interested in this topic” but also that “initiatives in this domain are being considered.” • The meeting displayed a certain optimism concerning the development of this matter in Paris. • According to a McKinsey study on islamic finance, Middle Eastern investors’ wealth is estimated at $1500 billion. Almost 30 percent of these investors opt exclusively for islamic finance products, and 60 percent of these investors could favor Sharia-compliant financing, which demonstrates performance equivalent to that of “conventional” financing. • This statement emphasizes the importance of the growth of islamic finance within the Middle Eastern region. • Despite this global excitement, nothing concrete has yet occurred in France to allow the development of this market. Indeed, islamic products require certain changes in the well-established norms. • As per the participants at this meeting, it is not necessary to enact any law; a statement of practice should be sufficient. As per Senator Arthuis, it only requires certain “adaptations of good standing practice.”

  5. 1. Preamble/SynopsisA. Status in France (2/3) • Whatever the methods used, it is urgent to provide investors and their lawyers with the appropriate legal tools to secure the investments to be made and notably in the tax area. • No one is asking to give to islamic principles any specific civil recognition, we are just waiting for the neutral treatment for tax purposes. • A slight change in legislation or at least the fiscal doctrine could overcome the different obstacles. • We have understood that, except with respect to the French principle of tax neutrality, nothing will preclude the development of Sharia products in France. This means that the tax treatment granted to a Sharia product should not, taxwise, differ in any way from that of a conventional product. • Therefore, the development of these instruments in France will depend on the wish of the French government to develop, sooner or later, these different tools of financing. • Senator Arthuis’ initiative has been more than welcome from an optimistic point of view. This is a good starting point. • The UK showed us the way, but it does not wait for us. France should react and rapidly… • To conclude, we should remember that all of this is just a matter of business, from which Muslims draw faith, peace of mind, and profitability, while the others draw a profit and an investment return…WHAT ELSE?

  6. 1. Preamble/SynopsisB. Top Islamic Finance News of May 2008 • Aldar Properties, the United Arab Emirates' second-largest property developer according to market value, had mandated banks for its debut dirham-denominated Islamic bond sale, which could range from benchmark size to US $1.5 billion in value, depending on investor demand (May 2008). • Dubai Electricity & Water Authority (Dewa), which postponed an Islamic bond sale last year, had planned to sell as much as $2.5 billion of bonds in November (May 2008). • Ras Al-Khaimah plans to sell up to $2 billion in bonds that comply with Islamic law to fund infrastructure projects. The first group of bonds will be at least of benchmark size, typically $500 million (May 2008). • Sabic, the world's largest chemical firm according to market value, won regulatory approval to sell as much as 5 billion riyals ($1.33 billion) of Islamic bonds. The five-year bonds will be denominated in dollar-pegged Saudi riyals (April 2008). • Dubai-government-owned Nakheel, a developer of three palm-tree shaped islands off Dubai's coast, set a price guidance for as much as $1 billion of Islamic bonds. Nakheel set the guidance for the two-year bonds at between 225 basis points and 250 basis points above the Emirates’ Interbank Offered Rate, Eibor (April 2008). • Abu Dhabi Commercial Bank (ADCB), the third-largest by market value in Abu Dhabi, plans imminently to sell as much as 4.8 billion dirhams ($1.31 billion) of bonds in order to finance acquisitions (April 2008). • Dubai-based mortgage lender Amlak Finance plans to sell as much as 4.8 billion dirhams ($1.31 billion) worth of convertible and nonconvertible Islamic bonds this year to help finance expansion (March 2008).

  7. 1. Preamble/SynopsisC. What Is Islamic Finance in Theory? (1/3) Religious Background: Prohibition of usury in all three major religions • Judaism, Christianity, Islam: connection and continuity • Christ acknowledged the Old Testament • Muhammad acknowledged the Old and New Testaments 1. Usury in Christianity / the Old and New Testaments • “Think not that I am come to destroy the law, or the prophets: I am come not to destroy, but to fulfil.” • For verily I say unto you, ’Till heaven and earth pass, one jot or one title shall in no [ways] pass from the law, till all be fulfilled. • Whosoever therefore shall break one of these least commandments, and shall teach men so, he shall be called the least in the kingdom of heaven: (Matt.5:17-19). • 1179. Papal Bull. provided for excommunication for usury. • Medicis. Bills of Exchange. Medici Money, by Tim Parks. • Henry VIII, Statute, “In restraint of usury,” 1545.

  8. 1. Preamble/SynopsisC. What Is Islamic Finance in Theory? (2/3) 2. Usury in Judaism / the Old Testament • “Do not charge your brother interest, whether on money, food or anything else that may earn interest” (Deut. 23:19). • “Do not take interest of any kind from him, but fear your God, so that your countryman may continue to live among you” (Lev. 25:36). • If you lend money to one of my people among you who is needy, . . . charge him no interest (Ex. 22:25). • “He lends at usury and takes excessive interest. Will such a man live? He will not! . . . He will surely be put to death and his blood will be on his own head” (Ez. 18:10-13). • Talmud. IV/2/70B. Maimonides (1135-1204).

  9. 1. Preamble/SynopsisC. What is Islamic Finance in Theory (2/3) 3. Usury in Islam • “Those who devour usury will not stand except as stand one whom the Evil one by his touch hath driven to madness.” That is because they say: “Trade is like usury,” but Allah hath permitted trade and forbidden usury (Koran Sourat 2, Verse 275). • “O ye who believe! Fear Allah, and give up what remains of your demand for usury, if you are indeed believers. If ye do not, take notice of war from the Messenger (Koran, Sourat 2, Verse 278). • “O ye who believe! Devour not usury, doubled and multiplied; but fear Allah that you may really prosper” (Koran, Sourat 3, Verse 130). • No problem until recently as little banking. • Mahomet 600 A.D. Reformation 1500s, Reformation in Islam now.

  10. 1. Preamble/SynopsisC. What is Islamic Finance in Theory? (3/3) Conclusion: The Five Fundamental Pillars of Islamic Finance • Prohibition of any kind of interest, Riba • No remuneration without risk: Sharia law forbids any separation between risks and rewards • Prohibition of Gharar and Maisar (speculative investment and gambling), making the use of derivatives difficult • All transactions must be asset-backed by an identified underlying tangible asset (“general corporate needs” and other techniques of nonallocation of resources seem difficult to put in place) • Any transaction must comply with the ethical standards of Sharia law, and, therefore must concern assets considered as Sharia compliant, Halal. Transactions dealing with unacceptable assets such as alcohol, prostitution, pork, and gambling-related items are not allowed. • French law contains mechanisms “similar” to the Fundamental Pillars of Islamic Finance, such as the prohibition of usury (Section L. 313-3 CMF), regulation of gambling (section 1965 of the French Civil Code), protection of public order and accepted standards of behavior (section 6 of the French Civil Code), obligation to share profits and losses between joint venture partners (Section 1844-1 of the French Civil Code), etc. • It should also be emphasized that for islamic finance purposes, a Sharia board retained by the issuer/sponsor/arranger of the product will screen the islamic finance instruments for compliance with the above-mentioned five pillars. Per se, it is not a definitive approval because the investor should also on his own be convinced of the Sharia proofed characteristics of the islamic instrument in question.

  11. 1. Preamble/SynopsisC. What Is Islamic Finance in Practice? (1/3) History of Islamic Banking (1/2) • Local Islamic banks started in Egypt in the 1960s and in Malaysia, Pakistan, and Dubai in the 1970s • Originally emphasized joint-venture structures akin to private equity, Musharakah • Quickly evolved to provide short-term credit facilities by using the Murabaha structure • With an increase in scale, Islamic banks began to branch out to more complex financing schemes, such as: • Retail banking, including, deposit taking and consumer lending • Bonds (Sukuk) • Medium- and Long-term leases (Ijara) • The Impact of 9/11 – Reverse Capital Flight • Perception of a hostile climate in many Western jurisdictions, in particular, the United States, led to repatriation of dollars by Arab investors to Middle Eastern banks • Islamic banks, along with conventional banks in the region, benefited from this reverse flight of capital • Increase in oil prices led to a dramatic increase in liquidity in the Gulf

  12. 1. Preamble/SynopsisC. What Is Islamic Finance in Practice? (2/3) History of Islamic Banking (2/2) • Conventional Banks Open “Islamic Windows” • Conventional banks both in the West and in the Islamic world began to respond to requests from Muslim clients to offer products that complied with Islamic law • As the size of the potential market became clear, conventional banks responded with the creation of divisions dedicated to Islamic banking • Conventional International Banks with Islamic Windows: • BNP PARIBAS (“BNP PARIBAS NAJMAH”). In July 2007, BNP PARIBAS obtained an agreement to market a Sharia compliant fund • In February 2008, SGAM obtained two agreements for such funds to be opened in the overseas foreign department La Réunion. • HSBC (“HSBC AMANAH”) • Citigroup • Deutsche Bank • UBS • ABN AMRO • Standard Chartered Bank

  13. 1. Preamble/SynopsisC. What Is Islamic Finance in Practice? (3/3) Size of the Islamic Financial and Banking Sector • There is no precise measure of the size of deposits held in Islamic banks or Islamic divisions of conventional banks: • Ranges from a low of $250 billion to a high of $750 billion • As much as $300 billion held in Islamic investment funds awaiting investment opportunities • Arab investors hold approximately $800 billion in assets in European banks, with a growing trend to invest that money in Islamic products • The 22 Islamic banks in the Gulf have in excess of $300 billion in Sharia-compliant assets and are set for double-digit growth over the next 10 years • Arab bank assets will for the first time top $2 trillion in 2008 as Middle Eastern and North African economies expand • The Islamic finance market has experienced an annual growth of 15 percent for the past three years, with Islamic bonds, or Sukuk, the fastest growing market segment • The Sukuk market more than doubled in 2007 to exceed $90 billion at the end of the year — in 2001, it totaled less than U.S.$500 million • The Islamic bond market should hit $200 billion by 2010, and is predicted to grow by up to 35 percent in 2008 • Islamic finance is estimated to be worth approximately $700 billion globally • Gulf and Southeast Asia savings awaiting to be invested are estimated to be worth approximately U.S.$5000 billion.

  14. Investor Client Portion of the profits and losses Portion of the profits and losses Funds Assets JV 1. Preamble/SynopsisD. Introduction to Islamic Tools (1/4) The Islamic JV Musharakah • This is a Sharia-approved equivalent of a joint ownership arrangement between a financial institution and another party to share profits and losses. The bank provides funds, as does the business, and profits are distributed in preagreed ratios. Losses are allocated in proportion to the allocation of capital. • As the asset generates a profit which returns the principal and interest of the financing granted by the bank, the entrepreneur repurchases the quota share of the bank in the joint venture. The client is generally given the title of manager of the Musharakah. • The terms of the repurchase of the investor’s share economically correspond to the reimbursement of the principal and to the payment of interest to the lender. • Diminishing form. Pre agreed sale of share over time. Limited Partnership.

  15. Payment (cash on delivery) Seller Islamic Bank Resale of the goods Buyer Price + mark-up (deferred payment) 1. Preamble/SynopsisD. Introduction to Islamic Tools (2/4) The islamic cost-plus, Murabaha • This consists of cost plus sale/resale with a profit return that economically corresponds to a mark up/interest. The price is paid in the future. • This involves a request by the client to the bank to purchase a certain item for him at a defined price which includes a profit. The purchase is repaid in installments, and the property passes to the client (depending at payment or at inception). • The buyer often acts as an unofficial representative of the financier toward the seller in order to not disturb the usual buyer/seller commercial relationship. • The buyer depreciates the asset on the price marked up by the accrued interest if the asset could be amortized. If the asset is not depreciable, there is a tax issue. Can the marked-up price paid at term be compared to a zero coupon bond or to a single coupon bond? • Most used (75 percent)

  16. Resale of the good Sale of commodity Seller Financier Buyer/Broker Delivery Payment (cash on delivery) Price + mark-up (cash on delivery) Final consumer Resale of the good (deferred payment) 1. Preamble/SynopsisD. Introduction to Islamic Tools (3/4) Reverse Murabaha,Attawarruq • Instead of holding the asset for its activity, the buyer resells it, either to the initial seller or to a third party. • The buyer is not the unofficial representativeof the financier insofar as he himself immediately resells the asset to a third party. • Used in trade financing operations where the assets (usually commodities) are acquired by the buyer through a broker to be immediately resold to the end-user.

  17. 1. Preamble/SynopsisD. Introduction to Islamic Tools (4/4) Mudarabah • Partnership where one party, Rab Al Mal, provides funds while the other, Mudarib, provides, expertise and management. Profits are shared on a pre-agreed basis. Loss is borne by the funds provider. • Private equity. Also used as a basis for the deposit contract. Salam/Salaf • A short-term agreement whereby a financial institution makes full prepayment for future delivery of specific goods at a future fixed date. • Forward contract. Commodities. Parallels. • Istisna, as above: Infrastructure, Houses. Preshipment export finance. Islamic bondsor Sukuk • Sukuk bonds are among the most used instruments in islamic financing. • Cash flow from defined assets is transferred to the holder for a defined period. • There must be assets (even company equity) in the structure even by specific designation in the issue documents.

  18. Section 2 Practical examples to highlight the French tax issues

  19. 2. Practical Examples to Highlight the Tax IssuesA. The Islamic Leasing or Al Ijara (1/2) Islamic Leasing, Al Ijara • The “financial investor” (the Islamic bank) acquires an asset and makes it available to a client in exchange for a rental payment together with (or without) an undertaking by the bank or the owner that the ownership will be transferred to the lessee at the end of the lease period. The mention of this option in the Ijara contract divides the Sharia board members, as the insertion of an additional condition does not seem to comply with the Sharia rule stating that a contract must contain only one obligation. • The right to use the asset is transferred by the bank, Al Mujir, to the client, Al Mustajir, in exchange for the rental payment, Al Ujrah. • Al Mustajir can otherwise select and buy on behalf of Al Mujir the asset for which the right of possession and use will be transferred, Mustajir. This allows the financial investor, Al Mujir, to avoid changing its business. • A separate agent’s agreement should then be drafted. The wording of this separate agreement must be drawn up so as to avoid tax exposure (specifically, permanent establishment risk of the nonresident bank if the services are rendered outside its country of residence, triggering the taxation of the bank’s profits in the investor’s country of residence of the investor) • The contract of Ijara leasing is similar to that of conventional leasing. • Both are used for finance leasing and hire purchase (15 percent).

  20. 2. Practical Examples to Highlight the Tax Issues A. The Islamic Leasing or Al Ijara (2/2) Islamic Leasing, Al Ijara • The rents are higher than the usual cost of credit as the double transactions generate additional fees (purchase of the asset by the bank involving notary fees and registration duties, leasing the asset then repurchasing the asset at the end of the term involving additional notary fees and registration duties). However, it should be noted that the rent is tax deductible (which, in practice, corresponds to the interest deduction and the depreciation of the asset). • In an international context, the problems are as follows: • withholding tax on rentals • taxation in France of the rentals • VAT • permanent establishment of lessor in the lessee’s jurisdiction

  21. 2. Practical Examples to Highlight the Tax IssuesB. The Alternative Islamic finance product or SukukAl Ijara (1/2) Alternative product, Sukuk Al Ijara • In comparison to the former structure, the financing of the initial acquisition of the movable/immovable assets to be leased is not made through a bank loan but rather via the public issuance of a certificate representing a debt of the issuer, i.e., the Sukuk. • Often the seller of the underlying asset to be leased and the client constitute the same person (lease-back). • In this structure, the rentals represent the periodic payments to the Sukuk bondholders through SPV/SPC constituted in countries generally recognized as advantageous for the leasing business. • The seller is both the originator of the transaction and the final client that sells the underlying assets to the SPV that are allocated to a trust for the benefit of the Sukuk bondholders. • The remuneration received by the Sukuk bondholders is proportional to the economic performance of the underlying assets. It is the financing of the acquisition that necessitates an Ijara between the user and the owner of the assets. The future rent to be received by the shareholder of assets allows the latter to pledge the issuance of the debt certificate vis-à-vis (i) the investor who will underwrite and (ii) to comply with the standards of Sharia law.

  22. 2. Practical Examples to Highlight the Tax IssuesB. The Alternative Islamic Finance Product or Sukuk Al Ijara (2/2) Alternative product, Sukuk Al Ijara Step 3 Issuance of the Sukuk The profit return of the Sukuk holder is not determined by reference to the loan but upon the investment return of the underlying assets financed. Step 1 Sale of assets – Car floating Receivable against the acquirer As soon as the proceeds of the Sukuk’s issuance will be at the level of the SPV, the receivable will be reimbursed. Assets (trust) Step 2 Securitization of the rental payments corresponding to the future rental payments S.110 of the Irish Act. SPV Rental Seller/Client • Rental agreement upon an Ijara agreement. • Issue of the WHT on rental payments. • VAT: reverse charge mechanism.

  23. 2. Practical Examples to Highlight the Tax IssuesC. Conclusion – Possible Solutions (1/2) Regarding Islamic Financial Tools • French law does not need fundamental changes but, rather, adaptations of good standing practice. • Specific regimes already exists in France and could easily be adapted to islamic finance. Indeed, the regime applicable to French real estate developers “marchands de biens” could be used for Murabaha operations. • The French leasing or “crédit-bail” regime could also be used for movable and immovable assets to be used in Ijara schemes. Indeed, as per Sections 313-317 et seq. of the Financial and Monetary Code, French law is globally adapted to Ijara operations. • The law enacted in February 2007 regarding the French trust or “Fiducie” could be used for the structuring of Sharia-compliant financing operations in France. • Slight adaptations of (i) the Civil Code, (ii) the Financial and Monetary Code and also of (iii) the French Tax Code could be envisaged. The tax is crucial. • Taxwise, the major issue concerns frictions linked to sale and resale transactions. • Adaptations of the tax regime applicable to French real estate developers could allow the payment of registration duties and real estate duties such as taxe de publicité foncière on either the sale or the resale, and thus should allow the development of this business in France.

  24. 2. Practical Examples to Highlight the Tax IssuesC. Conclusion – Possible Solutions (2/2) Statement of practice of the French Tax Authorities • The French tax authorities should issue a statement of practice in order to confirm the tax treatment applicable to operations realized within the framework of Islamic financing projects. • Through this Statement of Practice the French tax authorities should in particular confirm the deductibility for tax purposes of amounts paid to investors (payments should be assimilated to interest) and their treatment as interest for withholding tax purposes.

  25. 2. Practical Examples to Highlight the Tax IssuesD. The Future of Islamic Banking • Judaism has dealt from the outset. • Christianity took longer, but there is separation of the secular world and religion. Enlightenment. • Islam: there is no such separation, hence the many debates today, e.g., headscarves. • Either the Western route or Islamic approach. • The Western majority today • Sharia standardization. Need a legal framework? • Globalization. Subprime crisis. Northern Rock. Debt is very much removed from assets or primary lender. • Could islamic instruments help to solve some of these problems through a better connection of finance and real economy and by the risk sharing concept? • French tax reform? • UK model?

  26. Thank you for your attention.

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