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Introduction to Islamic finance 1

Briefing note Spring 2013

Introduction to Islamic finance The current unprecedented level of interest in Islamic finance has been generated by a growth in the wealth of a number of Islamic states, together with a change in the socio political climate over the last few years.

The global Islamic market is now estimated to be worth almost US$1.14 trillion, having grown by approximately 33% between 2010 and 2012. Despite the rapid growth, the global Islamic finance market only represents about 1% of the worldwide financial services industry. The continued potential for growth of Islamic finance means that investors are increasingly looking to tap into the opportunities offered by Shari'a compliant products and services.

The techniques and structures developed for Islamic investments are based on traditional techniques and structures that have been available for centuries but which have evolved and been refined, within the parameters of Islamic jurisprudence, to accommodate modern financial institutions and modern banking.

This article provides an overview of the Islamic finance industry and seeks to identify the more common Islamic financing structures and demystify some of the terms.

transactions). Rather the concern is to that the Shari'a principle of unjust Main Features of prohibit forms of enrichment applies to an enrichment of one party at the expense of another speculation which are regarded as akin Islamic Banking which cannot be justified but also to the to gambling. The test is whether Islamic banking transactions are based enrichment of one party who exercises something has been gained by chance on Islamic principles and jurisprudence undue influence or duress over another rather than by productive effort. Of (together, the "Shari'a") which are and is therefore wider in its scope than course this distinction presents practical derived from a number of sources, the principle as applied under English difficulties. The distinction between including the primary sources of the law. general commercial speculation in Qu'ran and the Sunna (the living genuine commercial trading and tradition of the Prophet Mohammed speculation regarded as gambling is not (pbuh). Islamic finance structures have very clear. In each case the commercial developed in accordance with Shari'a substance of the transaction must be principles and these principles must be Key Topics analysed to evaluate whether or not it is kept in mind when trying to determine permissible under Shari'a. „ Main features of Islamic the Islamic acceptability of proposed Financing financing techniques. Some of the key Unjust enrichment/Unfair principles include: exploitation „ Shari'a Board/Committee Speculation () Contracts where one party is regarded „ Islamic Financing Structure Under Shari'a, contracts which involve as having gained unjustly at the „ Legal and Practical Issues speculation are not permissible (haram) expense of another are also considered „ A Global Industry and are considered void. Shari'a does void. Again, it is not clear exactly what not however prohibit general would amount to unjust enrichment and commercial speculation (which is each contract must be considered on a evident in most commercial case-by-case basis. It should be noted

2 Introduction to Islamic Finance

Interest () conventional financial institutions that customer at an agreed marked-up price. have an Islamic 'window' have a board The financier may hold title to the asset Under Shari'a, money is regarded as which scrutinises proposed transactions for only a brief period, perhaps just a having no intrinsic value and no time to ensure compliance with Islamic few seconds, but the profit generated by value and is seen merely as a means of precepts and maintain an overall review the financier on the marked-up sale exchange. Since, as noted above, of its financing methods and operations. price is nevertheless regarded as a Shari'a requires that any return on funds This board may be referred to as the profit derived from a sale of goods provided by the financier be earned by 's Shari'a board or Shari'a transaction and is not therefore way of profit derived from a commercial committee. The board will comprise a prohibited as interest paid on monies risk taken by the financier, the payment number of eminent Islamic scholars, lent (riba). The marked up sale price and receipt of interest (riba) under who meet at regular intervals to discuss may be payable immediately or deferred Islamic law is prohibited and any policy and/or specific transactions. for payment at a later date. The obligation to pay interest is considered Although a single issue may give rise to mark-up charged by the financier will be void. differing views held by different Shari'a an aggregate of the commodity risk Uncertainty (gharrar) boards as a result of the various schools borne by the financier in the asset, the of thought within Islamic jurisprudence, credit risk of the customer as well as an Contracts which contain uncertainty this is partly mitigated by the fact that amount equal to the conventional cost (gharrar), particularly any uncertainty as the four main schools of thought within of funds for raising the finance for to one of the fundamental terms of the Islamic jurisprudence share mutual undertaking the initial purchase. contract, such as the subject matter, agreement on the majority of issues and price or time for delivery, are, again, Tawarruq/Reverse that many modern day scholars sit on considered void. As with unjust the Shari'a boards of a number of This product is one of the few methods enrichment, the Shari'a principle of different Islamic institutions. The reason whereby the customer will end up with gharrar is wider than the English for this, quite simply, is that there are cash. In general terms, the financier common law principle of uncertainty. not enough scholars to go around. The (either directly or indirectly) purchases Whereas case law such as G.Scammel alignment of a single scholar to a commodities (usually metals other than & Nephew Ltd v Ouston ([1941] A.C. number of institutions which compete in gold or silver) at market value for spot 251) has established that an agreement the same industry may of course create delivery and spot payment and then may not be binding if a definite meaning commercial sensitivities but the immediately sells the commodities at an cannot be given due to the vagueness shortage of scholars, who are required agreed mark-up price to the customer or uncertainty of certain of its terms, the not only to be knowledgeable in matters on a spot delivery and deferred payment Shari'a principle is wider in two main of Shari'a but also to have an basis. The customer then immediately ways. Firstly, whereas English common understanding of modern banking, sells the commodities at market value to law will permit some vagueness finance and economics, is a reflection of a third party for spot delivery and spot provided that it can be resolved by an industry which has grown rapidly payment. The end result is that the interpretation, or examining the intention within a very short period of time. customer has received a cash amount and/or conduct of the parties, Shari'a and has a deferred payment obligation requires absolute certainty on all Islamic Financing for the marked-up price to the financier. fundamental terms on its face. Structures Although certain commentators have Secondly, the Shari'a does not permit a In order to comply with Shari'a raised the suggestion that this contract where uncertainty may arise transaction appears like a disguised out of the actual subject matter or principles a number of financing techniques have been developed. A agreement, the counter argument substance of a contract. For example a is that the risk profile of the transaction conventional insurance arrangement is description of some of the most common structures are as follows: is very different for the financier than the not permitted (haram) on the basis of, risk profile it would be expected to amongst other things, uncertainty Murabaha (cost plus financing) assume under a conventional loan (gharrar) as to whether the insured This popular method of Islamic financing facility. Under the conventional facility, event will occur or not. is frequently used in trade financing the primary risk is that of the borrowing Shari'a Board/Committee arrangements. The financier will buy entity whereas under the tawarruq the asset in question from the supplier structure, the financier also takes To ensure adherence to these (either directly or through an agent) and commodity risk and risk on the third underlying Shari'a principles, most will then on-sell the asset to the party supplier, in addition to the Islamic financial institutions or customer risk. The tawarruq facility

Introduction to Islamic finance 3

therefore enables Islamic to an increased price or may enter into a security where the primary credit risk is provide funding for customers who parallel bai salam contract. This that of the originator who is obliged to require a cash sum to be advanced to financing technique can be used when pay the holder irrespective of the them. providing a pre-export facility. performance of the underlying asset. To the extent that the sukuk are rated, Ijara (lease) Wakala (agency) the rating cannot exceed the rating This is Islamic financing's equivalent of A wakala is an agency relationship given to the entity which is ultimately leasing and may be seen as a hybrid between an investor (muwakkil), responsible for providing the funds for between conventional operational and typically a financial institution, and the the repayment of principal on maturity or finance leases. Rental payments under agent (wakil), the entity requiring early redemption of the sukuk. A an ijara will reflect an agreed profit financing. It is customarily used in conventional unsecured bond, although element and comparisons with rentals interbank arrangements and between with a similar risk profile, does not give on conventional leases (where interest group companies. A simple wakala any ownership rights in an underlying considerations would often be relevant) structure would operate as follows: asset but rather just a contractual claim can readily be made. If the intention is against the issuer. It is also important to „ the muwakkil agrees to put up to provide the lessee with title to the distinguish the sukuk from a traditional capital for a specified period of time goods at the end of the lease this can securitisation. In a securitisation the which the wakil invests, on behalf be achieved through a variant of ijara bond holder takes credit risk on the of the muwakkil, in certain called ijara wa-iktina. Unlike a finance cash-flow which is being securitised, the Shari'a-compliant investments; and lease, the obligation to insure and issuer simply being used to pass „ any profits generated by the undertake any major maintenance to the through the underlying debtor credit risk. investments are structured in a way leased asset remains with the lessor. Accordingly, to the extent a that ensures the muwakkil receives Further the lessee is only responsible securitisation is rated, the rating of the its agreed profit, with the wakil for payment of rent whilst the use of the issuing entity may be improved by credit entitled to retain any additional asset continues. So if, for example, the enhancement features and may also profit in excess of the agreed return lessee is no longer able to use the exceed the rating given to the parent of of the muwakkil. leased asset, for example, due to its the issuing entity. total destruction, then the rental Although the wakil can be any entity, payments will cease. the investments made by the wakil have Further information on sukuk is outlined to be Shari'a-compliant. In each case in our "Introduction to sukuk" client Istisna'a (construction financing) the wakil will charge a nominal fee for briefing. An Istisna'a is used for the advance providing its expertise. Musharaka (equity financing) funding of major industrial projects or Sukuk large items of equipment such as ships The financier and the investor provide or aircraft where the financier funds the A sukuk is a type of certificate or note financing for a project in agreed supplier, acquires title to the equipment which represents or evidences a proportions in the form of either cash on completion and immediately passes proportionate interest in underlying contributions or contributions in kind. In title to the purchaser on agreed deferred assets and revenues. It is a negotiable general, the financier and investor share payment terms or leases the asset to instrument which, depending on the equally in the profit and loss of the the developer under an ijara-wa-iktina. underlying asset, can be sold and project in proportion to their initial purchased in the secondary market. It investment. The party providing the Bai salam (forward financing) is often used in conjunction with other management or technical expertise may This technique may be used to provide Islamic financing techniques (e.g. ijara, charge a fee. A variation of this is the working capital. Essentially bai salam musharaka etc.). Approximately diminishing musharaka where the financing is a forward financing US$84.4 billion of sukuk were issued in investment participation of the financier transaction where the financier pays in 2011 which represents an increase of decreases gradually over time as its advance for the purchase of specified 62% from the US$52 billion issued in ownership interest is transferred to the assets which the seller will supply on a 2010. Although sukuk may be investor. pre-agreed date. As a mode of considered as the Islamic equivalent of Mudaraba (participation financing) financing, the financier is able to acquire bonds or capital market debt the assets by advance payment at a instruments, it is important to distinguish This is a contractual arrangement discounted price. The financier may sell between a sukuk and a conventional between a group of investors (Rab al the asset to be acquired on delivery for bond. The sukuk is an asset based Maal) and a manager (Mudarib). The

4 Introduction to Islamic Finance

investors put up capital which the end-user, such as liability for death „ a mechanism to establish the manager invests. The arrangement is or injury or environmental damage. amount of the 'investment' in the flexible and may be used in a number of Although typically a financier would project by each financier (which will ways, for example, it may be: seek to ensure that it does not own allow comparison of with, for the asset for any prolonged period example, purchase or lease „ considered akin to a funded of time so as to avoid this risk, this payments); participation arrangement in may not be avoidable in instances conventional financing where the „ the agreed 'investment' amount can where the asset is to be leased by investors are similar to the then be used as a benchmark in the financier to the end-user. participants who provide funds to relation to a number of issues such Although the financier may seek the grantor or in this case Mudarib as agreeing scheduled payments, insurance to protect itself, the who in turn has a direct relationship voting rights, and allocation of insurance must ideally take the with the customer; or funds if there is a payment shortfall form of Islamic insurance () on acceleration and termination of „ used for the establishment of and not conventional insurance; the financings; and investment funds with the fund „ tax liability e.g. do taxes arise on manager acting as Mudarib. „ how to exercise their remedies on the acquisition or on-sale of an Customers subscribe to the default such as the right to sell asset? What are the income and mudaraba fund where the Mudarib project assets, how proceeds of capital gains tax consequences for exercises its professional sale will be used and how proceeds a financier? How can the investment skills. of insurance (e.g. if a financial transaction be made tax neutral?; asset is destroyed or lost) will be Although the Mudarib can be any entity, „ warranties e.g. is the financier, as applied. Islamic financiers and the Mudarib's investments have to be owner or seller of an asset, making conventional financiers may in Shari'a-compliant. In each case the any warranty (e.g. as to its title to theory have very different rights (for Mudarib will charge a fee for providing the asset or the condition or example as owner or lessor in its expertise which will customarily be a usability of the asset) which it possession in the case of the proportion of the profits generated from would want to disclaim?; Islamic financier, or as secured the investments. Savings accounts party in the case of a conventional operated by Islamic banks operate on „ effectively interposing a third party lender) but parties would expect this basis and strive to provide a rate of between a supplier and an assets to be available for the return which is comparable to end-user may give rise to issues benefit of all the financiers. conventional savings accounts by e.g. can the end-user receive the investing those funds in benefit of a supplier's warranties?; A Global Industry Shari'a-compliant transactions. and „ loss or destruction or delays in the As Islamic finance continues to grow, production or construction of the many governments have taken, or are Legal and Practical asset may be an issue for the taking, steps to accommodate the asset Issues Islamic financier: if there is no based nature of Islamic financing to 'deliverable' asset, can it claim any ensure equal treatment, particularly Risks and Liabilities payments from the end-user? In from a tax perspective, between Islamic and conventional forms of finance. The contracts and techniques used in other words, can it pass on the Examples of jurisdictions that have Islamic financing, such as ijara and asset risk to its customer? introduced legislation targeting the Murabaha, may give rise to additional Co-financings Islamic finance industry are set out risks and liabilities for the financier or for below. the transaction that need to be There are an increasing number of financings, particularly in project assessed and, if appropriate, mitigated. United Kingdom However, many of these arise in finance, where an Islamic finance conventional financing structures, such tranche is used in conjunction with Traditionally, the United Kingdom took as traditional leasing, and are not conventional financing. As in any multi no steps to accommodate Islamic unique to Islamic finance. For example: sourced financing, the parties will want financing within its body of laws. This to agree how the two financings will has changed significantly in the last „ ownership liability may be incurred operate together and what rights each decade as the government has sought if the financier owns an asset for a group of financiers will have. For to position London as a main period before transferring it to the example, they may want to agree: international hub for Islamic finance.

Introduction to Islamic finance 5

The UK has now become the leading the financier are generally not to be together with certain tax reforms which western centre for Islamic finance, with taken into account in the calculation of came into effect on 24 November 2011 approximately £10 billion of reported business tax, and, in the case of a have made investing in Japan in a assets held in Shari'a complaints funds. sukuk, that a sukuk should be treated as Shari'a-compliant manner more The United Kingdom's stated aim is to a debt instrument for the purpose of attractive and have helped to level the create a "level playing field" between corporate income tax calculations. playing field between conventional Islamic and conventional finance financing and Islamic financing for such Further information on France and the through the passing of several pieces of investments in Japan. tax treatment of murabaha and sukuk legislation, including the provisions set structures is outlined in our "Islamic Further information on Japan and the out in Chapter 6 of Part 6 of the finance – French tax rules clarified" Islamic finance industry is outlined in Corporation Tax Act 2009 (passed on 1 Client Briefing. our "Islamic Finance – an opportunity April 2009) and the Finance Act 2009 for Japanese banks" and "Islamic (passed on 21 July 2009). All of these Japan Finance – Japanese law reforms" Client legislative changes have helped reduce Briefings. tax barriers which, in the past, have Under the Banking Law of Japan, made Islamic products less tax efficient Japanese Banks are prohibited from United Arab Emirates than their conventional counterparts. purchasing assets (other than certain asset classes such as securities). As Many provisions of the Civil Code of the The combined effects of the legislation such, Japanese banks have historically United Arab Emirates are founded in are that Islamic financing arrangements been prohibited from entering into Islamic law rules and principles, and (including sukuk) will be treated as 'loan Shari'a-compliant structures. However, Islamic finance is no exception. The relationships'. 'Loan relationships' are, subsidiaries of Japanese banks have Civil Code describes many of the broadly, loans to which a company is enjoyed a relatively wider scope of Islamic financing structures referred to party and are, generally, taxed or business and an amendment to the above, including murabaha (article 506), relieved (under Part 5 of the Corporation Japanese banking laws has provided bai salam (article 568), musharaka Tax Act 2009) as income in accordance such subsidiaries with the freedom to (article 654), mudaraba (article 693), with their treatment in the company's participate in the Islamic finance ijara (article 742) and Istisna'a (article accounts, assuming the company industry. The enactment of Article 872). follows generally accepting accounting 17-3.2.(ii)-2 of the Amendment to the practice (as defined). As such, the Ordinance on the Enforcement of Concluding return under the Islamic structure is Banking Law, which became effective treated as if it were interest payable on 12 December 2008, expressly Remarks under the relevant loan relationship. All provides that a subsidiary company of a references in the relevant legislation to Japanese bank (or bank holding The Islamic finance industry has grown a "loan relationship" are now stated to company) which engages only in exponentially over the last few years include references to "alternative Financial Related Businesses (as and Islamic structures are no longer finance arrangement which captures defined in the Banking Law) or the specific to the Middle East or other Islamic products". securities business may also engage in traditional Islamic financial centres. France Islamic finance transactions. This growth, which is expected to continue at its current rate, is only likely There have historically also been a On 25 February 2009, the French tax to be inhibited by flaws in the industry number of other factors that have made authorities published, in the Official Tax itself such as a failure to invest it difficult to structure Shari'a-compliant Bulletin, circulars 4 FE/09, 3 CA/09, 5 adequately in resources both in terms of financing structures in Japan, including FP/09, 6 IDL/09 and 7 E/09 commenting regulation and personnel. It is therefore the tax treatment of the distribution of on the tax treatment of murabaha and to be expected that other jurisdictions profits to overseas Islamic investors. sukuk. Amongst other things, the will enact legislation to provide a friendly However, a recent amendment to the circulars make it clear that, in the case environment for Islamic finance Japanese Asset Securitisation Law of a murabaha, the assets acquired by investments.

6 Introduction to Islamic finance

Authors

Qudeer Latif Robin Abraham Peter Avery Partner Partner Partner T: +971 4 362 0675 T: +971 4 362 0609 T: +971 4 362 0682 E: qudeer.latif E: robin.abraham E: peter.avery @cliffordchance.com @cliffordchance.com @cliffordchance.com

Debashis Dey Habib Motani Leonard Cleland Partner Partner Partner T: +971 4 362 0624 T: +44 20 7006 1718 T: +44 20 7006 2070 E: debashis.dey E: habib.motani E: leonard.cleland @cliffordchance.com @cliffordchance.com @cliffordchance.com

Simon Sinclair Andrew Coats Gregory Man Partner Partner Registered Foreign Lawyer T: +44 20 7006 2977 T: +44 20 7006 2574 T: +852 2825 8903 E: simon.sinclair E: andrew.coats E: greg.man @cliffordchance.com @cliffordchance.com @cliffordchance.com

Introduction to Islamic finance 7

NOTES:

This publication does not necessarily deal with every important topic or cover every Clifford Chance, Building 6, Level 2, The Gate Precinct, Dubai International aspect of the topics with which it deals. It is not designed to provide legal or other Financial Centre, P.O. Box 9380, Dubai, United Arab Emirates advice. © Clifford Chance LLP 2012 Clifford Chance LLP is a limited liability partnership registered in England and Wales under number OC323571. Registered office: 10 Upper Bank Street, London, E14 5JJ. We use the word 'partner' to refer to a member of Clifford Chance LLP, or an employee or consultant with equivalent standing and qualifications. Licensed by the DFSA. www.cliffordchance.com

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