A Prime Location For Structuring Sharia Compliant

Volume 62, Number 8
May 23, 2011

(C) Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
Luxembourg: A Prime Location for Structuring Sharia-Compliant Real Estate Investments

by Oliver R. Hoor and Pierre Kreemer
Reprinted from Tax Notes Intl, May 23, 2011, p. 653
Luxembourg: A Prime Location for Structuring Sharia-Compliant Real Estate Investments

by Oliver R. Hoor and Pierre Kreemer
Oliver R. Hoor is a tax manager (Luxembourg Certified Accountant and Certified German Tax Adviser) and Pierre Kreemer is a tax partner (leading the Real Estate & Infrastructure Tax Group) with KPMG in Luxembourg. E-mail: oliver.hoor@kpmg.lu and pierre.kreemer@kpmg.lu The authors wish to thank Oliver Kirk for his assistance. eal estate is the preferred asset class of many Islamic investors, and properties located in Europe seem to be more and more their focus. For tax efficiency purposes, these investments are commonly structured through real estate investment vehicles established in a tax-efficient jurisdiction such as Luxembourg. This article depicts the fundamental elements of sharia-compliant real estate investments and demonstrates Luxembourgs competitive advantage.
I. Introduction
With assets recently exceeding the US $1 trillion threshold and an impressive annual growth rate of approximately 15 percent, Islamic finance continues to grow from a niche to a mainstream mode of finance. Given Luxembourgs position as one of the leading international financial centers, it is not surprising that part of this growth has taken place in Luxembourg, which is now seen as an emerging global hub for Islamic finance. The growth of Islamic finance in Luxembourg is driven to a large extent by the investments of Middle East investors1 in European real estate. Islamic investors appear to focus on the same locations as conventional investors. Within Europe, investments are predominantly made in the U.K., France, and Ger-
many. Eastern European locations and Russia, however, are increasingly attracting investors. The structuring of sharia-compliant real estate investments is challenging because all transactions must adhere to the principles set out under Islamic law. Accordingly, great care must be taken in structuring the investment vehicles and financial transactions. Although the selection of the optimal investment structure depends on several factors, maximum tax efficiency is usually a key consideration. As one of the leading European centers for vehicles investing in international real estate, Luxembourg is perfectly equipped to address the dynamic needs of Islamic finance investments throughout Europe. Further, the Luxembourg government is confident that many interesting opportunities are made available by Islamic finance and is particularly keen to place Luxembourg as a partner of choice for Islamic finance transactions. This article outlines the specifics of sharia-compliant real estate investments and analyzes with a focus on Middle East investors how these investments may be structured through Luxembourg in a tax-efficient manner.
II. Real Estate in Islamic Asset Management

Investments are predominantly made by institutional investors, sovereign wealth funds, and high-net-worth individuals.
1
A. Overview The pervasive presence of real estate investment throughout the Islamic finance spectrum is linked to
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PRACTITIONERS CORNER the strong preference for investing in productive tangible assets and the fact that, cycles aside, property prices always eventually increase. The objectives sought by conventional and Islamic investors have much common ground: capital preservation, yield maximization, and a balance between liquidity and profitability. However, in contrast to conventional investments, a key characteristic of Islamic real estate investments is that they must be structured in a sharia-compliant manner. The structuring of Islamic real estate investments (and especially the financing instruments used) must be tailored to each individual case having regard to, inter alia, the location of the real estate assets, the tax profile of the investor, and any specific requirements from a sharia perspective. which interest is deemed to reflect growth, economic circumstances, and the availability of capital.3 In Islamic finance, however, rather than lending money at interest, financial relationships between financiers and borrowers are governed by shared business risk (and returns) from investment in lawful activities (halal).4 Gharar relates to the mere uncertainty in the quantity, quality, or existence of the subject matter of a contract and not to the risk as used in commercial terminology. Uncertainty in the meaning of business risk and entitlement to profit in business go hand in hand in Islamic law. Attached to the prohibition of uncertainty is the prohibition of transactions involving maysir (gambling), which involves asymmetric information, excessive uncertainty, risk, and lack of control.5 With the exception of elements deemed undesirable and prohibited by the sharia, debt plays a vital role in Islamic finance. Islamic financial institutions regularly create debt by providing financial facilities in trading activities. Thus, sharia compliance does not revolve around putting debt and equity in opposition, but rather emphasizes equity and subjects debt to the principle that once created, it should not increase on a conventional opportunity cost basis (that is, interest). Irrespective of the form, investments in businesses dealing with activities that the sharia considers unlawful are deemed prohibited. It follows that investments in the following businesses should be avoided: alcohol and tobacco (this prohibition extends to the production, marketing, and sale of alcohol, tobacco, and associated products); pork-related products and noncompliant food production (the latter covers everything that is not prepared in a halal way); conventional banking and insurance6; gambling (maysir)7;
B. Fundamentals of Islamic Finance

Islamic finance refers to financial transactions and techniques that are consistent with the principles of Islamic law (sharia). The basic sources of sharia are the Quran and the Sunnah, which are followed by a consensus of the jurists and interpreters of Islamic law. All contracts in the framework of Islamic finance must comply with the rules of the sharia, which ban interest and speculation and stipulate that income must be the fruit of shared business risk rather than guaranteed return. Any financial transaction under Islamic law assigns clearly identifiable rights and obligations to investors for which they are entitled to receive a return. A contract is deemed sharia-compliant if its terms and conditions do not violate the prohibitions of Islamic law. In other words, any economic activity is permissible unless explicitly prohibited. While investments in purely financial assets are prohibited under Islamic law, Islamic investors are encouraged to invest in productive assets. Therefore, Islamic finance transactions are commonly asset-based. It is interesting that Islamic law does not object to payments for the use of an asset. Thus, real estate is an asset class that may even generate a stable return. The sharia identifies three major prohibitions: riba,2 gharar, and maysir. These elements must be avoided in Islamic finance transactions. The prohibition of riba means that no interest can be charged or received, which is clearly different from conventional finance, in
The literal meaning of riba is an excess. Riba is generally interpreted as the predetermined interest collected by a lender, which the lender receives over and above the principal amount it has lent out. Any predetermined fixed rate return on a debt instrument be it substantial or not tied to its maturity, and whose principal amount is guaranteed regardless of the performance of the investment, is considered riba; see Oliver R. Hoor, La prohibition de Riba dans la finance islamique, AGEFI, Apr. 2010, p. 21.
3 See Munawar Iqbal, A Guide to Islamic Finance, Risk Books, 2007, pp. 13-14. 4 Although the ethical framework of the sharia recognizes that capital has a cost associated with it and is in favor of wealth generation, making money with money is deemed immoral, and wealth should be generated via trade or investments. Thus, as a general rule, profits must not be guaranteed based on assumption and can only accrue if the investment itself yields income. 5 Gambling is involved in many financial transactions and conventional banks schemes and products, which Islamic companies and financial institutions are to avoid (for example, conventional futures and options). 6 Conventional banking and insurance are interest-based and therefore not permissible. 7 Sharia prohibits transactions involving speculation and gambling (maysir), such as casinos, lotteries, and Internet gambling.
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PRACTITIONERS CORNER adult entertainment (for example, movies with explicit sexual content); and weapons and defense.8 Consequently, it is important to verify the use of real estate properties by their tenants before investing. (See Section II.D.) commodity murabaha12 (also referred to as Tawarruq); istisnaa13 (commissioned manufacture); and qard hasan14 (interest-free loan). Leasing (ijara) involves the lease of particular assets such as real estate for a period of time in exchange for predetermined rental payments. Notably, in Islamic finance the lessor remains the owner of the asset and bears its ownership risks for the period that the asset is leased. Accordingly, all liabilities emerging from the ownership are borne by the lessor (which may, however, be charged to the lessee), but the liabilities relating to the use of the property are borne by the lessee. Moreover, much of the recent growth in Islamic finance is linked to sukuk,15 the Islamic counterparts of conventional bonds. Unlike bonds, which are debtbased instruments with interest remuneration, sukuk are typically asset-based instruments and represent the beneficial ownership by the sukuk holders in an underlying asset (or a pool of assets). The underlying asset must be of a physical nature such as real estate.16 Returns are paid to the investors in line with their proportional ownership in that asset.17
C. Islamic Modes of Finance As a result of the prohibitions in sharia the majority of conventional financial instruments are not suitable to Islamic finance in their existing form.9 Instead, the structure of Islamic finance revolves around the prohibition of all fixed return derived from a debt instrument and the lawfulness of profit deriving from trade and investments. Thus, financial transactions are strongly based on the sharing of risk and reward between the provider of funds (the investor) and the user of funds (the entrepreneur). In the absence of interest as a basis of financing, the Islamic economic system has a set of interest-free core models that serve as a basis for the design of more sophisticated and complex financial instruments. For the sake of sharia compliance, however, it is not necessary for the income from a financial transaction to be variable, as in a number of Islamic finance modes, the remuneration is fixed and the transaction remains sharia-compliant. The most relevant Islamic modes of financing may be categorized into profit and loss sharing partnerships, debt creating modes, and leasing. Profit and loss sharing partnerships include: musharaka (joint venture); diminishing musharaka10 (declining balance partnership); and mudaraba (managed profit partnership). The most important debt creating modes include: murabaha11 (deferred payment sale);
8 Although these activities are generally prohibited, some scholars argue that it may be acceptable to invest in armament companies for defensive (as opposed to offensive) purposes. 9 In some cases, however, it may be possible to amend existing conventional instruments in a way that they comply with sharia principles by eliminating prohibited elements. 10 The diminishing musharaka involves the shared ownership of an asset that one party gradually buys from the other, thus incrementally increasing its share until the full ownership of the asset is transferred to one party. This variant is only feasible for fixed assets such as real estate property or other assets that can be leased or given for use to the other party. 11 Murabaha involves a contract between two parties for the sale of goods at a price that includes an agreed profit margin. It results in debt amounting to the cost, plus a profit margin. The debt must be paid back regardless of the profit or loss incurred by the purchaser. Modern murabaha transactions generally take the form of murabaha to purchase order, characterized by the bank purchasing an asset from a third party at the clients request, and selling it to the client on a deferred payment basis.
12 The commodity murabaha (or Tawarruq) avoids riba and involves a contract in which a commodity is purchased on credit and immediately sold at spot value with the objective of receiving cash. The commodity as such is not required by the buyer; rather, the buyer simply needs liquidity, which he receives via the purchase of a commodity on credit and its immediate sale against cash. Notably, the commodity murabaha is a vital element in Islamic liquidity management. 13 Istisnaa is a sales contract applicable to assets to be manufactured (such as buildings and infrastructure projects) that are identified by specifications and not by designation. This contract is only valid for those assets that must be manufactured or built. 14 The qard hasan is a loan agreement characterized by a guarantee for repayment in full by the end of a predetermined period without any further return (or share in the profit or loss of the business) to the creditor. A modest service charge is permissible, however. 15 Sukuk is the plural of the Arabic word sakk meaning certificate. 16 See Nathif J. Adam and Abdulkader Thomas, Islamic Bonds Your Guide to Issuing, Structuring and Investing in Sukuk, Euromoney Books 2004, p. 5; Zamir Iqbal and Abbas Mirakhor, An Introduction to Islamic Finance Theory and Practice, Wiley, 2007, p. 177; Muhammad Ayub, Understanding Islamic Finance, Wiley, 2007, p. 390; Natalie Schoon, Islamic Banking and Finance, Spiramus Press Ltd., 2009, p. 42; and Mansur Mannan, Islamic Capital Markets, in Islamic Finance: A Guide for International Business and Investment, GMB Publishing Ltd, 2008, p. 105. 17 While riba (interest) is prohibited, the sharia accepts the validity of financial assets that derive their return from the performance of a real asset. Most sukuk currently issued are based on underlying ijara transactions whereby the stream of income generated from the sale and leaseback of real property assets funds the coupon payments to the sukuk holders; see Adam and Thomas, supra note 16, at 69; Nathif J. Adam and Abdulkader Thomas, Islamic fixed-income securities: sukuk, in Islamic Asset
(Footnote continued on next page.)
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PRACTITIONERS CORNER Ultimately, describing the Islamic financial system as merely interest free would be wholly inaccurate. Instead, the promotion of entrepreneurship, preservation of property rights, transparency, and the sanctity of contractual obligations, crucial to any sound financial system, are the cornerstones of Islamic finance. Sharia scholars have yet to reach a unanimous consensus regarding the use of properties. For instance, some sharia scholars argue that an investment by a fund in a hotel or restaurant that serves alcohol is prohibited, whereas other scholars argue that if the alcohol sales are less than a certain percentage of the revenue of the hotel or restaurant, the investment by the fund may still qualify as sharia-compliant. Here, the investment manager together with the competent sharia board will define the appropriate selection criteria.22
D. Selection and Use of Assets

Real estate covers a wide range of assets, including residential properties, office buildings, warehouses, shopping centers, hospitals, and infrastructure projects such as solar power plants and wind parks. The challenges faced when selecting real estate assets for investments should in principle be no different from those faced in conventional finance that is, maximizing the return and reducing the portfolio risk through a diversification strategy. In addition to the concerns involved in the asset selection of conventional investors, Islamic investors must screen the use of the properties by their tenants before any investment takes place in order to ensure compliance with sharia principles. Notably, as long as the property itself is used for halal (permissible) business activities, it has the potential to form part of a sharia-compliant structure.18 Accordingly, the industrial sector and the residential sector are well-suited markets for sharia-compliant real estate investments. In contrast, the retail property sector is more challenging because of prohibited retail operations including leisure and sales outlets.19 In 2005 the Securities Commission of Malaysia issued a set of guidelines on Islamic Real Estate Investment Trusts and their treatment.20 According to these guidelines, properties that are primarily used for prohibited activities should be excluded from the investment universe. An Islamic REIT is, however, permitted to invest into real estate in which the tenant(s) operate mixed activities, provided that nonpermissible activities do not exceed 20 percent of the total rental income.21 Further, new tenants planning to rent the real estate exclusively for non-sharia-compliant activities should not be accepted.
E. Islamic Real Estate Funds 1. Opening Comments In an Islamic real estate investment fund, money from a variety of investors is pooled together in order to buy, manage, and sell real estate assets. The management strategy might range from a moderate repositioning or releasing of properties to the development or extensive redevelopment of properties. Investments may also be made into sharia-compliant real estate companies holding sharia-compliant assets.23 In contrast to many conventional real estate funds, Islamic real estate investment funds do not invest in conventional debt securities. Nevertheless, investments via debt creating modes of finance such as commodity murabaha (resulting in a fixed return) may be considered as a sharia-compliant alternative.24 The main advantages of investing into Islamic real estate funds (as opposed to direct real estate investments) are that the investors may reduce their investment risk by diversifying their investment portfolio25 and thus benefit from greater liquidity than in direct real estate investments. Also, the investor has access to
Management Forming the Future for Sharia-Compliant Investment Strategies, Euromoney Books, 2004, p. 75; Iqbal, supra note 3, at 48; and Schoon, supra note 16, at 43. 18 The properties should not be used for haram (unlawful) activities such as liquor production, conventional banking, or casinos; see Section II.B of this article. 19 Although restrictions are imposed concerning investments in office, retail, hotel, and leisure property because of the type of activity, there is still substantial investment by Islamic funds in these sectors. 20 See http://www.sc.com.my/eng/html/resources/guidelines/ UTs/Islamic%20REIT%20GL.pdf. 21 This test should be applied regarding the floor area. Hence, up to 20 percent of the floor area may be occupied with prohibited activities.
22 As a pragmatic approach, sharia boards may determine acceptable limits of rental income deriving from prohibited business activities. 23 There is a general consensus between sharia scholars on the permissibility of holding ordinary shares in a company, since they represent undivided ownership in the business of the company by the shareholders, and all shareholders have equal rights. Investment in preferred shares is not permissible since preferred shares provide for a definite return to their holders, compared with the holders of other types of shares who bear the same liability but are not entitled to any definite return; see Rodney Wilson, Screening criteria for Islamic equity funds, in Islamic Asset Management Forming the Future for Sharia-compliant Investment Strategies, 2004, Euromoney Books, p. 35; Imtiaz Shah, Overview of Islamic asset management, in Islamic Finance: A Practical Guide, Globe Business Publishing Ltd., 2008, p. 15; Iqbal and Mirakhor, supra note 16, at 194. 24 Since the Islamic real estate fund would be disconnected from the investment where funding is granted under a commodity murabaha (provided that no participation is held in the real estate company or a holding company thereof), such investment strategies may allow the fund to invest into companies that, for example, exceed acceptable levels of conventional debt funding. 25 Moreover, collective investments can offer individual investors exposure to larger commercial or industrial properties that they would otherwise not have access to.
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PRACTITIONERS CORNER the services of a professional fund manager and the comfort of a sharia board that supervises and approves each investment made by the fund on their behalf. 2. Structuring and Management of the Fund Although many elements of a conventional fund will be present in a sharia-compliant fund, great care must be taken in structuring investment vehicles to ensure that they operate in compliance with sharia precepts. Nevertheless, the choice of the legal vehicle and the jurisdiction are not driven by sharia considerations but rather by costs, possible listing, and, above all, tax efficiency.26 In this regard, Luxembourg offers a unique platform with a choice of different vehicles that are suitable for a wide range of investor needs.27 The management of the fund may be carried out in two ways. Usually, the management acts as mudaribs (working partner) for the subscribers when the fund is undertaken on a mudaraba basis. Here, the management fee will correspond to a percentage of the annual profit accrued by the fund. Consequently, the management is only remunerated if the fund makes a profit.28 Alternatively, the management may act as a wakeel (agent) for the subscribers. Here, the management may be awarded a pre-agreed fee for their services, or a fee that is based on the net asset value of the fund may be calculated.29 Occasionally, both methods of management are combined. In this case, the manager receives a basic annual fee and an additional performance fee that is awarded if the fund exceeds performance thresholds.30 3. Other Aspects to Be Considered While a sharia-compliant fund may engage in leverage through the use of Islamic financing instruments, it may generally not obtain or provide conventional interest bearing loans or instruments. Cash held by a fund may only be invested in sharia-compliant, short-term investment products such as Islamic money market instruments. Finally, the insurance of real estate properties must be based on takaful31 schemes except where they do not operate. Any income generated by a sharia-compliant fund that is identified as impure (income from a nonsharia-compliant source), such as interest income, must generally be purified by the separation of that income and its payment to an authorized beneficiary (that is, charity).32 Sharia boards are responsible for identifying impure funds and in following through with their charitable distribution.33
F. The Role of the Sharia Board

One distinct feature of modern Islamic finance is the role of the sharia board. The sharia board monitors the operations of Islamic financial institutions34 and plays a central role in transactions, notably in clarifying elements that are doubtful from a sharia perspective through the issuance of legal opinions (fatwa).35 The fatwa is an important precondition for a fund or an investment to be marketed as sharia-compliant. Note that the sharia is open to interpretation and sharia boards may even have divergent views on key sharia issues.36 Thus, while a specific investment may be accepted by one sharia board, it may be rejected by another.37 The inclusion of key sharia principles serves as an indication of compliance, although any particular
See Shah, supra note 23. In some cases, it will be beneficial to establish a fund vehicle in an offshore jurisdiction (providing for maximum flexibility from a company law perspective) that invests through a Luxembourg holding company (and Luxembourg or foreign property companies, partnerships, or trusts) into real estate properties. 28 See Muhammad Taqi Usmani, An introduction to Islamic Finance, Kluwer Law International, 2002, p. 95; Trevor L. Norman, Islamic investment funds, in Islamic Asset Management Forming the Future for Sharia-compliant Investment Strategies, Euromoney Books, 2004, p. 5. 29 Usmani, id. 30 See Norman, supra note 28; Usmani, id. 31 Takaful is the Islamic version of insurance and is based on the concept of cooperation, responsibility, protection, and guarantee among its participants. Takaful avoids unlawful (haram)
27
26
elements that are present in conventional insurance such as riba, gharar, and maysir; see Asyraf Wajdi Dusuki and Nurdianawati Irwani Abdullah, Takaful: Philosophy, Legitimacy and Operation, in The Chancellor Guide to the Legal and Sharia Aspects of Islamic Finance, Chancellor Publications Limited, 2009, p. 285. 32 Purification is a method used by Islamic investment funds whereby income from non-sharia-compliant sources is identified, calculated, and distributed to suitable charities as directed by the sharia board; see Kamal Mian, Shariah screening and Islamic equity indexes, in Islamic Finance: A Practical Guide, Globe Business Publishing Ltd., 2008, p. 33; Norman, supra note 28, at 3, 9; Schoon, supra note 16, at 118; and Shah, supra note 23, at 22. 33 Alternatively, the fund manager may distribute the full amount of income and inform the investors of the amount of impure income arising from their investment. In this case, the Islamic investors should themselves donate the impure income to suitable charities. This alternative is clearly more appealing from a commercial perspective because the income generated by the fund will appear larger and the fund will attract more nonMuslim investors. 34 The requirement to have a sharia board applies equally to Islamic financial institutions and to Islamic windows of conventional banks. 35 A fatwa is a sharia opinion issued by the sharia board that it considers the structure and documentation of a transaction to be sharia compliant. The issuance of a fatwa will provide assurance to the Islamic financial institution, other participants, and the investors in the underlying transaction that the transaction conforms to the sharia. 36 For real estate investments, diverging opinions may exist, particularly regarding the accepted level of rental income deriving from tenants operating in prohibited businesses or the tolerance of conventional debt funding of real estate companies. 37 Decisively, however, sharia boards are not subject to any supervision.
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PRACTITIONERS CORNER Islamic finance transaction needs to be vetted by Islamic scholars to ensure compliance with sharia concepts. While gaining approval from the sharia board on the sharia compliance of a product before its launch is vital for Islamic finance providers, it is equally important for them to recognize that sharia compliance is a continuous monitoring process. In this regard, the sharia board: defines investment and compliance criteria that are designed to ensure that the real estate funds investments do not transgress sharia principles; and regularly reviews actions taken by the fund manager regarding the fund.38 capital risque),41 a securitization vehicle (for example, issuing sukuk), or a real estate public UCI (undertaking for collective investment).42
B. The SOPARFI
1. Opening Comments The Luxembourg holding company (socit de participation financire, or SOPARFI) is a fully taxable Luxembourg company benefiting from an extensive and flexible participation exemption regime, an ever-expanding tax treaty network, and EU directives. A SOPARFI may take the legal form of a private limited company (socit responsabilit limite, or S..r.l.), a public limited company (socit anonyme, or S.A.), or a partnership limited by shares (socit en commandite par actions, or S.C.A.) and is, in principle, not subject to any prudential control. Though the most suitable legal form should be determined for each specific case,43 the private limited company is most popular because of its flexible legal framework. Major steps have been taken by Luxembourg recently to elevate its status to that of a global hub for Islamic finance. Such steps include the issuance of a tax circular44 describing the major principles of Islamic finance and the tax treatment of Islamic finance techniques.45 Many Islamic finance techniques may be implemented in a very tax-efficient manner. For example, financing instruments may be structured with a direct link to a particular asset or investment portfolio bearing variable yield, depending on the income deriving from the asset and participating in the business risk of the borrower as required by the sharia. Unlike many other jurisdictions, yield paid on pure income or profit-participating financing instruments may be deductible for Luxembourg tax purposes and not subject to Luxembourg withholding tax, regardless of the status or residence of the recipient. Key to Islamic investors is the possibility to obtain advance certainty from the Luxembourg tax authorities on the Luxembourg tax treatment of their investments.
III. Luxembourg Investment Structures

A. Overview
There are many ways to structure real estate investments through Luxembourg, either through a real estate fund or on a stand-alone basis. The choice of a real estate vehicle will generally depend on the type of funding that needs to be raised,39 the proposed investor base, the type of investments to be made, and any specific tax consideration. While Islamic finance structuring in non-Islamic jurisdictions must abide by all of the traditional limitations of sharia law, it generally faces the additional challenge of operating in legal and regulatory environments that are unaccustomed to Islamic finance techniques. The compatibility of the Luxembourg legal framework with Islamic finance requirements for the implementation of sharia-compliant products is in this context of major importance.40 In contrast to many other Western jurisdictions, when determining the Luxembourg tax treatment of a business transaction, the economic nature of the transaction generally takes precedence over its legal characteristics. Therefore, many Islamic finance techniques may be implemented tax efficiently in Luxembourg. The most common real estate investment structures are presented in the following sections. However, in some cases one may also consider structuring such investments through a SICAR (socit dinvestissement en
See Shah, supra note 23, at 15; and Schoon, supra note 16, at 117. 39 The Luxembourg Stock Exchange provides for an attractive international listing marketplace for shares and a wide range of securities such as sukuk. 40 See Oliver R. Hoor and Philippe Neefs, Islamic Finance in Luxembourg, Tax Notes Intl, Mar. 30, 2009, p. 1217, Doc 20091611, or 2009 WTD 60-11.
38
41 The SICAR is an investment vehicle reserved for wellinformed investors for investments in risk capital. Although a SICAR may not directly hold real estate assets, it may invest indirectly into real estate through entities that hold or invest into such assets (for example, a SOPARFI). 42 A real estate UCI may be used when funds should be raised from the public for investments into real estate. 43 In particular, differences regarding the management of the company and the possibility to issue financial instruments (including access to the financial market) may influence the choice of the legal form. 44 Circular L.G.-A No. 55 of Jan. 12, 2010. 45 On June 17, 2010, Luxembourgs indirect tax administration, responsible for the VAT, registration duty, and other indirect taxes, issued a second circular (Circular No. 749) outlining the indirect tax and VAT treatment of murabaha and ijara structures.
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PRACTITIONERS CORNER 2. Luxembourg Tax Aspects Luxembourg companies are subject to corporate income tax and municipal business tax at an aggregate standard rate of 28.8 percent (companies established in Luxembourg City) on their worldwide income.46 Moreover, Luxembourg companies are subject to a net wealth tax at a rate of 0.5 percent levied on the companys unitary value (a modified net asset value) as of January 1 of a given year.47 Luxembourg tax law, however, provides for a beneficial participation exemption regime48 applicable to income derived from qualifying participations (dividends, capital gains,49 and liquidation proceeds) held by fully taxable resident companies or Luxembourg permanent establishments of qualifying foreign companies.50 For a participation to qualify, the subsidiary must either be: an entity listed in the appendix to article 2 of the parent-subsidiary directive; a fully taxable Luxembourg resident company; or a nonresident company fully subject to tax at a rate comparable to Luxembourg corporate income tax (that is, minimum 10.5 percent effective tax rate on a comparable taxable basis).51 The tax exemption further requires that the participation exceeds 10 percent (or bears acquisition costs of 1.2 million for dividend income, and 6 million for capital gains) and be held for an uninterrupted period of at least 12 months.52 Likewise, qualifying participations may benefit from a full tax exemption from Luxembourg net wealth tax.53 Regarding the financing of Luxembourg companies, no detailed thin capitalization rules are defined in Luxembourgs domestic tax law. However, under current Luxembourg administrative practice, compliance with an 85/15 debt-equity ratio is essential when financing participations in order to avoid a recast of yield payments into hidden dividend distributions. The latter are not tax deductible and are in principle subject to Luxembourg withholding tax. As debt instruments that do not bear any fixed return (as required under Islamic law) qualify as equity for debt-equity ratio purposes, participations may, for example, be financed up to 99 percent with asset-linked instruments (if carefully structured).54 Alternatively, a Luxembourg company may finance participations qualifying for the Luxembourg participation exemption regime with interest-free loans (qard hasan), which also qualify as equity for the determination of the debt-equity ratio.55 Dividend payments made by Luxembourg companies are generally subject to Luxembourg withholding tax at a current rate of 15 percent.56 Corporate shareholders may, however, benefit from a domestic withholding tax exemption.57 Alternatively, Luxembourg withholding tax may be reduced or excluded based on an applicable tax treaty. When investors may benefit from a full dividend withholding tax exemption under Luxembourg domestic tax law or under an applicable tax treaty, Luxembourg companies may even be fully equity funded.58 Even when a withholding tax exemption on dividend payments is not available, investments may be
46 Effective January 1, 2011, Luxembourg implemented a minimum taxation of 1,575 per year. 47 Liabilities such as asset-linked, profit-participating, or interest-free financing instruments may be deductible when determining the taxable basis for net wealth tax purposes. Further, qualifying participations and foreign real estate property (under an applicable tax treaty) may benefit from a full net wealth tax exemption. 48 Article 166 LITL. The Luxembourg participation exemption regime implements the EU parent-subsidiary directive. 49 While capital gains realized on participations qualifying for the participation exemption regime may be tax exempt, the recapture rule implies that such capital gains are taxable, up to the amount of related expenses deducted in a past fiscal year or in the fiscal year in which the capital gains are realized. Accordingly, the recapture rule essentially results in a tax deferral on income generated by a companys taxable activities. The recapture rule is, however, tax-neutral as it triggers no additional tax liability. 50 Qualifying companies include EU companies mentioned in article 2 of the parent-subsidiary directive as well as EEA resident companies and companies resident of a country with which Luxembourg has signed a tax treaty. 51 Article 166(2) LITL. 52 Article 166(1) LITL; article 1(1) of the Rglement GrandDucal of Dec. 21, 2001. The minimum threshold may be (partly) held via transparent entities within the meaning of article 175 LITL; article 166(3) LITL.
53 The net wealth tax exemption requires that the Luxembourg company holds at least 10 percent or a participation with acquisition costs of at least 1.2 million in a qualifying company. 54 Such asset-linked instruments may finance a specific asset or a portfolio of assets. 55 Financing with interest-free loans (as opposed to share capital or share premium) may provide for more flexibility in terms of cash repatriation. 56 Article 97(1) No. 1 LITL, article 146(1) No. 1 LITL in connection with article 148(1) LITL. 57 Article 147(2) LITL; a full withholding tax exemption is available provided that a participation of at least 10 percent (or with acquisition costs exceeding 1.2 million) is held for an uninterrupted period of at least 12 months in a Luxembourg company by a qualifying company or a Luxembourg PE of a qualifying foreign company. A qualifying parent company must either be: an entity listed in the appendix to article 2 of the EU parent-subsidiary directive; a fully taxable Luxembourg resident company; or a company resident in a country with which Luxembourg has signed an income tax treaty. 58 The funding with interest-free or asset-linked financing instruments may, however, be implemented for maximum flexibility regarding the repatriation of cash.
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PRACTITIONERS CORNER structured in a tax-efficient manner through the funding with sharia-compliant, asset-linked, or profit participating instruments. Under some conditions, yield paid under such financing instruments is not subject to Luxembourg withholding tax.59 Moreover, a Luxembourg company that is funded in such a manner may even invest in participations that fall outside the scope of the Luxembourg participation exemption regime. Here, yield payments should be tax deductible and the company should only be taxable on a margin.60 Luxembourg investment structures may be further optimized through the implementation of shariacompliant financing instruments that need to be tailored to each case. A Luxembourg holding company may, for example, finance its foreign subsidiaries with asset-linked or profit participating instruments providing for specific terms and conditions for creating tax-deductible expenses at the level of the property company.61 Alternatively, funds may be granted to the property company under a commodity murabaha agreement whereby commodities are acquired by the Luxembourg company (spot sale) and sold on to the foreign subsidiary on a deferred payment basis (that is, the agreed sale price consists of the commodities acquisition price and a profit margin).62 Here, it is crucial that the foreign jurisdiction accepts the deductibility of the difference between the fair market value of the commodities and the sale price agreed between the Luxembourg company and the foreign company.63 A commodity murabaha transaction may also be used for structuring external debt funding in accordance with sharia principles.64 In light of the above, a typical investment structure may be illustrated as shown in Figure 1. Considering that Luxembourg companies may be tax efficiently financed with asset-linked (or profit participating) financing instruments, a Luxembourg company may also be used as an investment vehicle for a sharia-compliant real estate fund established in an offshore jurisdiction. (See Figure 2.) 3. International Tax Aspects As a founding member of the EU, Luxembourg has incorporated the EU parent-subsidiary, EU interest royalty, and EU merger directives into its domestic legislation. These directives are of great significance to international groups. The EU parent-subsidiary directive generally eliminates withholding tax on profits distributed by the subsidiary for substantial shareholdings and removes potential double taxation on those profits. The EU merger directive ensures that pan-European group reorganizations such as mergers, demergers, and sharefor-share transactions may be structured in a tax neutral manner. Further, Luxembourgs extensive tax treaty network (enabling tax-efficient structures through the avoidance of double taxation) includes several Islamic countries such as Bahrain, Indonesia, Malaysia, Qatar, Turkey, and United Arab Emirates, cementing Luxembourgs favorable status as an Islamic investor-friendly environment. Also, tax treaties with Azerbaijan, Kazakhstan, Kuwait, and Kyrgyzstan are awaiting ratification while tax treaties with Pakistan and Saudi Arabia are in negotiation. Luxembourg tax law neither provides for controlled foreign companies65 rules nor for detailed transfer pricing rules.66 However, as an OECD member country, Luxembourg adheres to the OECD transfer pricing guidelines requiring that all transactions between related parties comply with the arms-length principle.
59 Also, the repayment of (parts of) the principal amount of sharia-compliant financing instruments including interest-free loans should not be subject to Luxembourg withholding tax. 60 For example, companies that are not subject to tax at a minimum rate of 10.5 percent on a comparable taxable basis to Luxembourg companies. 61 For a financing transaction to be tax efficient, the yield payments should also not be subject to foreign withholding tax (or subject to tax at a limited rate). Further, sharia requirements must be closely monitored in the structuring phase. 62 The tax treatment of a murabaha agreement has been clarified in the tax circular issued on January 28, 2010, by the Luxembourg tax authorities. Accordingly, the profit margin realized under a murabaha agreement may be spread over the term of the agreement. 63 Subsequent to the acquisition of the commodities, the foreign company disposes of the commodities at their fair market value to a broker (spot sale) resulting in a loss that should ideally be tax deductible. Since a commodity murabaha involves the acquisition and disposal of tangible assets, the VAT and customs duty implications need to be carefully analyzed. 64 Notably, in such transactions sharia scholars may believe that a rebate for early payment reduces the original deferred purchase price for commodities used in the murabaha transaction (that is, the bank will receive less than the agreed price for the commodity in case of early repayment). Some scholars accept the incorporation of an amortization schedule setting out the
C. The SIF
1. Characteristics The SIF (specialized investment fund, or fonds dinvestissement spcialis) is designed as a classic investment fund collecting funds from a closed circle of experienced investors. The SIF is subject to registration
amount of the deferred purchase price payable on a given repayment date or a repayment formula. Repayment is usually analyzed by sharia scholars on a case-by-case basis. 65 CFC rules are specific antiabuse provisions adopted by many countries to attribute, under some conditions, the passive income obtained by a base company established in a low-tax jurisdiction to its economic owner, regardless of whether the base company has already remitted these profits. 66 The Luxembourg tax authorities, however, issued a tax circular regarding the tax treatment of companies engaged in intragroup financing activities.
(Footnote continued in next column.)
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PRACTITIONERS CORNER
Figure 1. Luxembourg Holding Structure

Investors
Asset-linked instrument (financing activity) Asset-linked instrument (holding activity)
LuxCo
Sharia-compliant financing instrument
Bank
PropCo
Commodity murabaha
Real estate properties
and ongoing supervision by Luxembourgs banking and finance supervisory body, the Commission de Surveillance du Secteur Financier (CSSF), and can be implemented in contractual form (fond commun de placement, or FCP67) or in corporate form (SICAV or SICAF68) structured either as a single fund or an umbrella fund.69 The SIF is reserved to qualified investors, including institutional, professional, and other well-informed in-
vestors.70 As such, investor protection is downgraded and the SIF enjoys far more flexibility than other regulated funds (that is, undertakings for collective investment in transferable securities, or UCITS, funds). The SIF may further invest in any type of asset and therefore be used for any type of funds, such as Islamic real estate funds or private equity funds.71 As with any other UCI, the SIF will be required to diversify its investments. While no quantitative limits
An FCP is a mutual fund established by contract. It is a co-ownership of assets that does not have any legal personality of its own and is created and managed by a Luxembourg management company. 68 The socit dinvestissement capital variable (SICAV) is an investment company with variable share capital. The socit dinvestissement capital fixe (SICAF) is an investment company with fixed capital. 69 When the fund is organized as an umbrella structure, the entire investment vehicle consists of one or more compartments. These compartments may, for example, differ in their investment policy, distribution policy, or type of target investor.
67
70 Any other investor who confirmed in writing his adhesion to the status of a well-informed investor and who either invests a minimum of 125,000 in the SIF or has an appraisal from an EU bank, investment firm, or management company certifying that they have the appropriate expertise, experience, and knowledge to adequately understand the investment made in the fund. This gives sophisticated investors, including high-net-worth individuals, access to the flexible and tax-attractive regime of SIFs. 71 A SIF may, for example, invest into sharia-compliant real estate, real estate companies, or investment funds, sukuk, and other long-term real-estate-related interests such as long-term leases.
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Figure 2. Offshore Investment Fund

Islamic Bank Investors
Fund (offshore)
LuxCo
Bank
Sharia-compliant external debt
PropCo
are set by law, a SIF may not invest more than 30 percent of its assets or commitments to subscribe in securities of the same nature issued by the same issuer.72 The SIFs founders will, however, set appropriate diversification rules that will subsequently be approved by the CSSF. Considering the endless possibilities offered by the SIF and the flexibility of its legal framework, it is an ideal vehicle for structuring sharia-compliant investments in a tax-efficient manner. 2. Luxembourg Tax Aspects Mutual funds (FCPs) are fiscally transparent and therefore not subject to Luxembourg income or net
wealth tax. In contrast, Luxembourg investment funds in corporate form (SICAVs, SICAFs) are in principle subject to tax but exempt from corporate income tax, municipal business tax, and net worth tax. However, Luxembourg regulated funds are subject to an insignificant annual subscription tax (taxe dabonnement). The rate at which the subscription tax is levied depends on the type of investment carried out by the fund and on the type of investor in the fund with some exemptions being available. The tax is payable every quarter and is based on the total net asset value of the fund on the last day of every calendar quarter. For the SIF, the annual subscription tax is set at 0.01 percent. To avoid double taxation, funds that exclusively hold units in other Luxembourg investment funds are exempt from the subscription tax. Also, some
72
See CSSF Circular 07/309 of Aug. 3, 2007.
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Figure 3. Luxembourg Fund Structure

Islamic Bank Investors
Fund (SIF)
LuxCo
Bank
PropCo
investment funds used as pension fund pooling vehicles are exempt from the annual subscription tax. While FCPs are generally excluded from tax treaty benefits because of their fiscal transparency,73 only 36 of Luxembourgs 62 tax treaties are applicable to SICAVs and SICAFs as they generally do not pay tax. Nevertheless, to benefit from Luxembourgs extensive tax treaty network74 and the EU parent-subsidiary directive, such funds may invest through a fully taxable
Luxembourg company that is financed with assetlinked instruments. If carefully structured, the variable yield paid under the asset-linked instruments to the fund may not be subject to Luxembourg withholding tax. (See Section III.B.2 of this article.) In general, nonresidents that invest in Luxembourg funds are not subject to tax in Luxembourg since dividends paid by a Luxembourg UCI are not subject to withholding tax.75 These investors may only be subject to tax on capital gains realized within six months from the acquisition of shares in a fund in corporate form
The treaty should be applied to an FCP unit holder according to the treaty that exists between the unit holders residence state and the country where the FCPs investments are located. 74 Tax treaties may restrict or even exclude the taxing rights of the other contracting states when dividends or capital gains are derived from the shares in a company that is resident in that state.
73
75 Withholding tax may, however, be applicable on the basis of the EU savings directive (Council Directive 2003/48/EC of June 3, 2003, on taxation of savings income in the form of interest payments) or when interest is paid to Luxembourg resident individuals.
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PRACTITIONERS CORNER (SICAVs or SICAFs) provided that the participation exceeds 10 percent. Nevertheless, when a tax treaty is applicable, the taxing right of Luxembourg is regularly excluded. Figure 3 reflects a generic investment structure for real estate investments through a SIF. Typically, investments are made through a Luxembourg company that holds the real estate either directly or indirectly via a property company (PropCo) established in Luxembourg or abroad.76
Figure 4. Family Wealth Management

Investors
Equity
SPF
Asset-linked securities
D. The SPF 1. Characteristics The family wealth management vehicle (socit de gestion de patrimoine familial, or SPF) is an investment vehicle with a privileged tax regime aimed at individuals for the purpose of passively holding shares or other investments. The SPF is the ideal investment vehicle for family offices or wealthy Islamic individuals willing to pool their European-based investments. The SPF takes the legal form of a Luxembourg company but may only perform private wealth management activities including the holding, management, and disposal of financial assets. The SPF may hold any kind of financial instruments, be it shares in (real estate) companies, units in sharia-compliant real estate funds, and securities such as sukuk. Importantly, real estate may only be held indirectly via a Luxembourg company (SOPARFI). Because of its private nature, the number of investors in an SPF should be limited and may be made up of family members, an investor club, or any other group of individuals willing to manage all or part of their private wealth in common. Shares issued by an SPF may not be publicly traded or listed on a stock exchange. 2. Luxembourg Tax Aspects The SPF is exempt from corporate income tax, municipal business tax, and net worth tax. It is also exempt from Luxembourg withholding tax on distributions. The SPF is nevertheless subject to a subscription tax of 0.25 percent on its net asset value capped at 125,000 per annum. The taxable basis for subscription tax purposes may, however, be significantly reduced by funding the SPF with sharia-compliant interest-free loans (qard hasan).77 Because of its particular tax regime, the SPF is out of the scope of income tax treaty benefits and cannot benefit from the EU parent-subsidiary directive. The latter may be circumvented through the interposition of
Bank
LuxCo
a SOPARFI that could be efficiently financed with sharia-compliant, asset-linked securities.78 Capital gains and liquidation proceeds connected to an SPF and received by nonresident investors are tax exempt in Luxembourg even if they are short-term gains or proceeds. An SPF loses its tax-exempt status (for a given year) if it receives more than 5 percent of its dividends from nonresident, non-listed companies that are not subject to an income tax similar to Luxembourg corporate income tax (that is, at least 10.5 percent on a comparable taxable basis).79 However, investments should generally be structured through a Luxembourg fully taxable company. Figure 4 reflects a generic investment structure for real estate investments by an SPF using a Luxembourg company as a property company. Note that an SPF may only invest indirectly into real estate assets.
IV. Conclusion
There is no denying that real estate is an attractive asset class for Islamic investors wishing to manage their wealth in accordance with sharia principles. For
Alternatively, it may be beneficial to hold foreign real estate through a transparent partnership or a trust. 77 The SPF may be financed up to eight times the amount of share capital and share premium with debt decreasing the subscription tax basis.
76
78 Notably, the SPF may only invest into shares and securities but not into (asset-linked or profit participating) loans. The securities issued by a Luxembourg subsidiary may, however, provide for the same features as such loan agreements. 79 Companies listed in the EU parent-subsidiary directive are deemed to be subject to comparable taxation.
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PRACTITIONERS CORNER many Islamic investors pursuing an international strategy to diversify their investment portfolios, European real estate represents an exciting opportunity. For investors that are resident in low- or no-tax environments, tax efficiency is clearly a key factor when structuring investments. As direct investment into European real estate may not be optimal from a tax perspective, investments are commonly structured through an investment vehicle established in an intermediary location. Here, Luxembourg, with its wide tax treaty network and access to EU directives, provides for numerous tax planning opportunities. It is not surprising that the growth of Islamic finance in Luxembourg has primarily been driven by real estate investments. The flexibility and tax efficiency offered by Luxembourgs sharia-compliant investment structures remains unsurpassed and provides for a level playing field between conventional and shariacompliant transactions cementing Luxembourgs role as an emerging hub for Islamic finance.
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A Prime Location For Structuring Sharia Compliant

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A Prime Location For Structuring Sharia Compliant

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Volume 62, Number 8

May 23, 2011

Luxembourg: A Prime Location for Structuring Sharia-Compliant Real Estate Investments

Luxembourg: A Prime Location for Structuring Sharia-Compliant Real Estate Investments

II. Real Estate in Islamic Asset Management

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B. Fundamentals of Islamic Finance

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(Footnote continued on next page.)

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D. Selection and Use of Assets

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F. The Role of the Sharia Board

(Footnote continued in next column.)

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III. Luxembourg Investment Structures

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(Footnote continued in next column.)

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Figure 1. Luxembourg Holding Structure

Real estate properties

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Figure 2. Offshore Investment Fund

Real estate properties

See CSSF Circular 07/309 of Aug. 3, 2007.

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Figure 3. Luxembourg Fund Structure

Real estate properties

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Figure 4. Family Wealth Management

Real estate properties

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