Regulating the Islamic finance industry

The very first Islamic finance products were introduced in the UK during the 1980s and were subjected to a range of legislation which was not originally drafted with such structures in mind. Consequently, customers often faced increased difficulties when using Islamic finance facilities, in contrast to customers seeking finance via conventional means. This triggered a movement within the industry which advocated for changes to the tax regime in the early 2000s, ensuring tax equality for Islamic finance products. Despite this, there remain several examples of places in wider legislation where Islamic finance customers or providers are placed in disadvantageous positions compared to their conventional counterparts. Why is Islamic finance more prone to legislative change? Islam prohibits a lender from securing any monetary or other benefit by reason of simply disbursing a loan to a borrower, instead requiring an underlying trade or investment activity to take place before a financier can be entitled to a return. Consequently, most Islamic finance structures include a combination of sale, leasing and investment transactions, which are brought together to produce a viable financial product. For example, the Diminishing Musharakah model involves the Islamic finance institution purchasing, say, a real estate asset and then leasing it to a customer, who purchases the IFI’s proprietary interest over time. Although a DM includes a lease and a sale, it is more appropriate, based on the substance of the transaction, to categorise this as a composite finance lease. UK legislation is often drafted with a clear separation in mind between trade and finance, however, insofar as Islamic finance is concerned, these can often end up being one and the same. Therefore, any change in law which affects any of these categories is likely to significantly impact Islamic finance products. Alternative Finance Tax Regime – capital gains on Diminishing Musharakah refinancings A great example of the above dynamic is the capital gains treatment of certain aspects of a DM refinancing. In such a transaction, an IFI would be expected to purchase a residential property from a customer with the sale proceeds being used to refinance existing debt. The IFI, now the legal owner of the property, would then lease the same asset back to the customer while the customer gradually purchases the IFI’s proprietary interest over time. If each transaction is viewed from a strictly isolated perspective, one could argue that any gains accruing as part of the first sale from the customer to the IFI should be taxable under the capital gains tax regime. In fact, this was the position until only very recently. In early 2024, the Islamic Finance/Halal Economy Hybrid Group (Tax, Legal and Regulatory Working Group) heard several cases of customers incurring significant tax liabilities due to this interpretation of the Taxation of Chargeable Gains Act 1992. Noting wider industry concerns, the Hybrid Group proposed that HM Treasury consider amending the legislation, citing the differences between a DM refinancing, traditional sale and leaseback transactions and outright property sales. Following a consultation held later that same year, the Labour government introduced changes to the CGT regime as part of the 2024 Autumn Budget to ensure that DM refinancings would be treated in the same way as conventional refinancings in view of the shared commercial purpose underpinning the two. This is just one of many examples of the UK government’s commitment to ensure that the UK remains a competitive place for IFIs and Shari’ah sensitive customers who are looking to do business in accordance with their faith. Right to buy – the Housing Act 1985 Despite notable progress in the realm of tax, gaps remain in other sectors, such as social housing. For instance, in the right to buy scheme, certain council housing tenants are permitted to buy their home at a discount after a given period of time renting the property. However, this right is expressed in the Housing Act 1985 as only applying to the tenant themselves. This means that it is currently impossible for Shari’ah sensitive tenants to purchase their council home using a DM model or even a Murabaha model, which involves the IFI purchasing the property and selling it at a markup to the end customer. The only alternative for such customers therefore appears to be interest-free loans (Qard Hassan), which unfortunately are only generally provided by small-scale charitable organisations that are unlikely to be able to meet growing demand and require other regulatory permissions; a costly and often lengthy process. Given that the Muslim demographic contains the highest percentage of people from a given group living in social rented housing according to the 2021 Census, 26.6% compared with 16.6% of the overall population, the current legislation unintentionally bars a large segment of the UK population from obtaining finance to fund their housing needs. A consultation was organised by the UK government in 2005 to address this issue, but no changes to the legislation have so far been made. The UK government has, however, previously shown an encouraging keenness to make the housing market more inclusive by granting Shari’ah sensitive customers access to previously inaccessible Help to Buy guarantees in 2014. The Building Safety Act 2022 The 2022 Act was introduced in response to the Grenfell Tower fire in 2017, which was caused by poor building safety practices. It is aimed at ensuring high-rise residential properties are constructed and maintained properly while reducing the risk of structural failures, for example. A key part of the strategy is to ensure the relevant parties are made responsible for remediating any buildings that fall short of standards under the 2022 Act. In the event of remediation, it also aims to minimise the extent to which leaseholders are made to share any associated costs. Within the Act currently, customers under an Islamic mortgage entered into before 14 February 2022 are unlikely to receive the same protections as those with conventional mortgages, due to the concept of a “qualifying lease”. A landlord cannot, in relation to the removal of dangerous cladding, pass on any remediation costs to tenants under such leases. In other cases, a landlord may only ask such tenants to contribute to remediation costs on a capped basis. At present, a tenant can only take benefit of “qualifying lease” status where, on the cutoff date, they occupied the property as their only or principal home or they did not own more than three dwellings in the UK. If an IFI had funded the purchase of a leasehold property prior to the cutoff date, under a DM structure, it would not have been able to claim that its leasehold interest constituted a qualifying lease. This is because IFIs cannot occupy the property as a dwelling and they are likely to have owned multiple residential properties on the cutoff date. As such, a superior landlord may be entitled to recoup any remediation costs from such IFIs via a service charge, giving rise to unexpected liabilities. IFI end customers are also likely to lose out if their own lease, under the DM arrangements, does not constitute a qualifying lease, eg the term does not exceed 21 years. In this case, the IFI can pass on the substantial remediation costs which it inherits from the superior landlord down to the end customer. This is increasingly likely, considering that it is common to grant DM customers a lease with a term not exceeding 21 years in order to avoid them obtaining property rights which are likely to be incompatible with the DM structure. Thus, had a customer not chosen to obtain a DM facility, they could have replaced their DM provider as a long leaseholder and become entitled to 2022 Act protections depending on their circumstances. Such tenants are therefore excluded from statutory protections through no fault of their own. In summary Islamic finance products often manifest as hybrid structures which comprise different sale, leasing and investment contracts. For this reason, introducing legislation into these sectors without impacting at least some Islamic finance products has proven difficult. This has sparked the creation of a movement which is responsible for the development of a constantly evolving Alternative Finance Tax Regime, the latest example of which is the introduction of certain changes to the CGT regime to secure tax equality for DM refinancing products. Although these changes represent a move in the right direction for financial inclusion, clear gaps in the law persist. Discussions on these challenges must continue so more thought can be given to Shari’ah sensitive customers and IFIs when introducing new legislation. Next time How Islamic finance applies to different asset classes and identifying investor trends. Note: this article is for general information purposes only and does not constitute legal advice. If unsure about how the provisions referenced in this piece will affect you or your business, please seek specific legal or tax advice. Zahir Nayani is a partner and Adnan Shafi is a trainee solicitor at Foot Anstey Image © Adobe Stock