Islamic bonds in the UK

Over the past few years the UK Government has made a number of public statements about their vision of London becoming the centre for global Islamic Banking ('Islamic Banking' being the method of financing or investing which conforms to Islamic principles as laid out principally in the Qur'an). In June 2006 Gordon Brown said this at the Islamic Finance and Trade conference organised by the Muslim Council of Britain and in January 2007, speaking at the Euromoney conference on Islamic finance in London, Ed Balls, Economic Secretary to the Treasury, said much the same thing.

The Government's desire for this actually started soon after they came to power in 1997.  Sir Eddie George, then Governor of the Bank of England, established a working party in the late 1990's to help identify the main barriers that might prevent the growth of Islamic finance in the UK.  Since this time the Treasury has held regular meetings with those involved in the Islamic finance industry so that they could understand the issues and where appropriate legislate to allow Islamic banking products to compete on an even playing field with conventional finance. These issues arise as much of Islamic finance involves trading and ownership of physical assets in a way that does not usually occur with conventional forms of finance.  For example, an Islamic mortgage requires the financier to be the actual legal owner of the financed property.  Through trading and ownership though come potential liabilities and obligations that would not normally be expected to bother a financier and in the UK these are mainly to do with tax and regulation.

Much of what has been achieved already relates to the retail banking sector but more recently the focus has widened to include the capital markets and particularly creating a legal and regulatory environment which will allow the Islamic equivalent of bonds, known as Sukuk, to be issued and traded in viable way.  Sukuk can be described as Islamic bonds but actually the term has a wider meaning extending to many different types of Islamic instrument. Put simply, conventional bonds and securities are prohibited within Islam as they typically involve a commitment to pay interest and provide a pre-determined guaranteed return.  Sukuk on the other hand are always linked to underlying asset or business and the profit is calculated according to the performance of the assets or project. 

The essential concepts are;

• Transparency and clarity of rights and obligations
• The income from the Sukuk must be derived from the underlying asset for which the finance was originally provided.
• The Sukuk should be backed by underlying assets, real or intangible

Internationally, and particularly in the Gulf and Malaysia the Sukuk market has really started to take-off.  Much of the recent talk about the rapid growth in Islamic finance refers largely to the increasing number of high value Sukuk issues.  For the continued expansion of Islamic finance the growth of the Sukuk market is vital.  At present the range of securities for Islamic banks to invest in is minimal and a rise in the number of new Sukuk in issue and the establishment of a secondary market provides new opportunities and much needed liquidity.

So why is this of interest in the UK?

On the one hand there is the economic dimension; furthering London's claims as one of the world's two truly global financial centres.  Already many of the world's Sukuks are structured and created by City investment banks and UK law firms and in a market reckoned to be growing by 15% per year it can be understood why the Chancellor would want the UK to have a large piece of this.  Additionally there exists a political reason.  The UK has a Muslim population of 2million and historic ties and trade links with many Muslim countries.  In the current political climate it can be seen why the Government would want to try to foster and further develop good working relations with Muslim countries as well as its own Muslim citizens.

There is also another potential benefit which I believe the Government is very keen to explore.  In 2003 the German state of Saxony-Anhalt found a novel way to raise funds by issuing a Euro100 million 5 year Sukuk backed by state owned real estate assets.  The fundamental reason a German state would issue an Islamic certificate was to broaden their investor basis and to gain access to different sources of funding with a long-term view. Furthermore the state was also looking to encourage investors and entrepreneurs interested in going into Germany and choosing Saxony-Anhalt as their new location. So, following a similar model, and with the Government tacit support, there exists a real possibility that a substantial project, maybe a large social housing development or perhaps an infrastructure project, could be financed in the UK, via a Sukuk issue. Perhaps we might even see a 'Gilt Sukuk' issue - several countries such as Bahrain, Malaysia and Pakistan have gone down this route.

For this to happen however, the tax position needs to be clear.  Ed Balls has said that the March budget statement will include a tax framework for Sukuk.  This will have to consider the tax position of the issuer and investor and involves mainly income tax, capital gains tax and capital allowances.  To-date the general approach of Government when considering the tax issues involving Islamic finance structures has been to exclude arrangements that do not closely equate to debt.  This has been achieved by requiring the return to an investor to equate in substance to the return on an investment of money.  For retail banking products this process has been reasonably straight-forward, however for Sukuk this might prove to be more of a problem.  As mentioned earlier, a Sukuk can take several forms and have some aspects which appear economically more analogous to equity than debt.  Thus any future tax provisions for Sukuk will need to define the instruments or arrangements to which they apply.  A preliminary question to any consideration of a tax regime for Sukuk will therefore need to begin by defining the scope of the regime.  This may well restrict the opportunities for Sukuk structures in comparison to those found in other jurisdictions, particularly those in the Middle East and Malaysia.
For those involved in Islamic finance in the UK, seeking help from the Government has been akin to pushing on an open door.  The Government's vision though of the UK being a centre of Islamic finance might not be greeted with universal support.  Practising Islamic finance in a non-Muslim country is one thing.  Having a stated aim of making the UK the heart of global Islamic finance is something else and maybe at odds to those developing Muslim countries who see the growth of Islamic finance market as a key component to their own economic prosperity.

K Leach, Head of alburaq
ABC International Bank plc
Tel: 0207-776-4183 Fax: 0207-600-7569
Email - keith.leach@arabbanking.com
www.alburaq.co.uk