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Luxembourg as a hub for Islamic Finance investments
By Olivier Sciales Available at: Luxembourg as a hub for Islamic Finance investments
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 79 countries, including the United Arab Emirates, Kuwait and Saudi Arabia, 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) and has referred 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”. However, undertakings for collective investments under Luxembourg law and investing in Islamic assets are excluded from the scope of this circular.
The purpose of this article is to 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.
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 often defined as a particular kind of sale where the seller expressly mentions the cost he has incurred on the commodities to be sold and sells it to another person by adding some profit or mark-up thereon which is known to the buyer. Murabaha is mostly used when Mudaraba and Musharakah are not practicable.
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.
Sukuk is a term which encompasses a broad range of shariah compliant instruments, and that can be seen as an Islamic equivalent of bond. A sukuk has a pre-determined maturity and is backed by an asset that makes it possible to realise a return on the investment. Crucially, sukuk holders share the return generated by the sukuk assets and bear the losses in proportion to the certificates owned by them. It is therefore quite common in naming a sukuk to refer to the main underlying contract, for example Ijara or Musharaka.
IV. Main shariah compliant Luxembourg 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.
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 20th 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).
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.
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.
“America is a nation with no truly national city, no Paris, no Rome, no London, no city which is at once the social center, the political capital, and the financial hub.” C. Wright Mills