Islamic Finance in France – Overview of the Legal Framework
Hereunder is an article co-authored with Mr. Ibrahim Cekici who co-heads the Islamic Finance department at the University of Strasbourg. It was published in August 2009 in Islamic Finance News Volume 6 Issue 34. Islamic Finance News organised a roadshow aimed at informing on the latest development in the field of Islamic Finance. I was a moderator at the Hong Kong event.
ISLAMIC FINANCE IN FRANCE:
AN OVERVIEW OF THE LEGAL FRAMEWORK
Gerald Pasquier – Member of the Paris Bar – Registered with the Hong Kong Law Society – Part-time lecturer at the University of Strasbourg
Ibrahim-Zeyyad Cekici – Lecturer-Researcher – Co-head of University Diploma in Islamic Finance (Executive Master’s Degree) – Business School EM Strasbourg – University of Strasbourg
In the European landscape, Paris is, along with Frankfurt, Zurich and Luxembourg, one of the financial centres willing to challenge London’s leadership in the field of Islamic Finance.
The French civil law system takes its historical roots in both Roman law and Canon law. As such, French law rests on principles that are similar to those of the Islamic law: some prohibitions are common to both legal systems even though their scope vary.
For instance, the Shari’ah’s prohibition of paying, charging and facilitating interests may be compared with French laws prohibiting usury (even though Islam clearly prohibits interests)under which interests rates applicable to some loans granted to non-professionals shall not exceed of more than 33% the average rate used by banks for the same category of loans. Accordingly, when the Shari’ah contract law prohibits uncertainty in object, price and delivery, the French Civil Code provides that contracts’ objects shall be determined or capable of determination. Also, the Shari’ah’s prohibition of involvement in haram items echoes French statute laws aimed at ensuring public protection and moral, which may not be waived or derogated from by private agreements.
Over the past few years France has seen noticeable developments of its legal framework that are aimed at better accommodating Islamic finance products and activities: a number of French public authorities, organisations, scholars and legal professionals have discussed and will continue discussing what amendments shall be made to French laws and regulations if Paris wants to achieve its ambitions to become a prominent Islamic finance centre.
The most salient measures facilitating Islamic finance in France have been taken by the financial regulator, i.e. l’Autorité des Marchés Financiers (“AMF”) on the one hand, and the tax authorities on the other hand.
AMF’S POLICY STATEMENTS
The AMF has issued two statements relating to Islamic finance, which are available in English on its website.
Setting-up Shari’ah compliant investment funds
The first statement is dated July 17th 2007 and relates to the asset management industry. It should be noted at the outset that the structures of investment funds available under French law are compatible with the Mudaraba, i.e. the Islamic law structure typically used to set-up Shari’ah compliant investment funds. Under the Mudaraba model, the party funding the scheme is to be distinguished from the party bringing-in the know-how, which corresponds to the classic division between the investors and the managers of a French collective investment scheme. However, some special features of the management techniques used by Shari’ah compliant investment funds had to be addressed by the AMF.
First, in order to be compliant with the Shari’ah, a fund manager shall operate a financial screening of the assets invested by the fund, typically in order to avoid investments in companies having a gearing ratio higher than 33% and a too high liquidity ratio. A moral screening shall be conducted as well, in order to avoid investments in haram assets. In its statement, the AMF treats Shari’ah funds in the same manner as it treats other investment funds using extra-financial criteria to build their portfolios, such as socially responsible funds. The regulator insists on the fact that such screening process shall not impair the independence of the management company: an external investment advisor may duly provide the manager with its opinion with respect to the selection of investments, but the ultimate decision shall rest in the fund manager. As a Shari’ah board usually elaborates extra-financial investment guidelines to be observed by the manager, such independence condition can easily be fulfilled provided that (1) the said guidelines comply with French public policy principles and (2) the manager is able to understand and assess those guidelines. If a fund invests in a Shari’ah compliant index such as the Dow Jones Islamic Index, the practices of the entity compiling the said index will be scrutinised by the AMF when assessing the independence of the manager.
Second, Shari’ah compliant funds commonly use purification techniques aimed at morally neutralising an investment that appeared to be non-Shari’ah compliant, typically after an audit has been conducted on the morality of the assets. Such purification is effected by distributing part of the fund’s income to charities or selected non-for-profit organisations. This may harm the interests of the investors in the fund, as it will negatively impact the return on their investment. Therefore, the AMF authorises such management techniques under the condition that both the use of purification and the details of each charitable organisation be stated in the fund’s prospectus. The regulator also recalls that the investors shall be offered the possibility to trace the purification monies.
It is not surprising that the very first piece of French legislation dealing with Islamic Finance focuses on the asset management industry: with a volume of assets under management ranking third after the United States and Luxembourg, France is a strong player. On a global scale, Islamic asset management is however developing at a slower pace than other branches of Islamic finance, certainly because of the difficulties to screen non-equity assets. New screening processes for such non-equity assets would be worth developing further. Sukuks are currently difficult to price because they are commonly held until maturity: their secondary market is therefore not a relevant benchmark for pricing since it is poorly liquid. If funds managers were to increase their exposure to Sukuks, such liquidity gap may be plugged.
Issuing Sukuks
The second statement dated July 2nd 2008 explicitly states that Sukuks are admitted to the French regulated market, although they can only target qualified investors.
The AMF identifies two broad categories of Sukuks: (1) the asset backed Sukuks, where cash outflows are solely linked to the performance of underlying assets, and (2) the asset-based Sukuks, namely guaranteed Sukuks. The AMF has warned that it shall not be expected to verify the compliance of a Sukuk with the Islamic law. However, as a Sukuk’s prospectus should inform the investors of such Shari’ah compliance issues, the statement sets out a summary of the European laws governing the drafting of prospectuses, and indicates for each two categories of Sukuks how to construe the EU laws when preparing a prospectus.
In its statement, the AMF seems to consider that a Sukuk is a debt instrument, which substantially differs from the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions’ definition, according to which Sukuks are “certificates representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) the assets of particular projects”. This should be of particular concern since some influential scholars consider that a large majority of existing Sukuks structures are not Islamic. French law is however sophisticated enough to allow the issue of a wide range of fixed-income securities, including intensively equity-tainted hybrid instruments called “titres participatifs”, that could possibly permit the structuring of Sukuks affected by little Sharia’ah risk. As seen hereunder, such type of Sukuk may however not benefit from a favourable tax treatment.
TAX AUTHORITIES’ POLICIES
On February 25th 2009, the French tax department issued a statement (“instruction”) clarifying the tax treatment of Sukuk and Murabaha. The said statement is binding upon the tax authorities and will be referred to in tax rulings, thus providing consequent legal comfort.
Taxation of Sukuks
The main operative provisions pertaining to Sukuks state that the remuneration received by an investor in a Sukuk may be deducted from the issuer/borrower’s income tax basis, and that no withholding tax shall apply at source when such investor is not a French resident.
Such deductibility is available only when the Sukuk is structured as a debt instrument. In order to be considered a debt instrument, a Sukuk shall meet two series of conditions:
First, the Sukuk shall not have the characteristics of an equity instrument: the investors shall rank above the issuer/borrower in the event that the latter defaults, and the investors shall not be granted economic or political rights usually conferred to equity investors.
Second, the cash flow received by the investor shall be structured in accordance with specific rules. The remuneration of the Sukuk (which would correspond to the payment of interests in a conventional debt instrument) can effectively be correlated to the performance of the underlying assets, but it shall not exceed a recognised market rate increased by a margin (e.g. LIBOR + 2%). As for the reimbursement of the capital, its nominal value may not entirely be repaid if the value of the underlying assets is insufficient, but it may not exceed the nominal value if the underlying assets’ value is relatively higher.
Moreover, in compliance with the general French tax rules, the issuer/borrower may deduct the remuneration only if the investor in the Sukuk is a minority shareholder of the issuer/borrower or a company connected to the issuer/borrower – two companies being connected when one company directly or indirectly owns a majority stake in the other company. Finally, the deductibility is also limited by the average rates set out by the French banks in loans extended to companies which incorporate a maturity exceeding two years and a floating rate. Some exceptions apply to this last rule.
Considering the AMF’s statement hereupon, Shari’ah risk may be carefully weighted against tax efficiency when structuring a Sukuk under French law: if a Sukuk is structured as an equity-tainted hybrid, the issuer may not be allowed to deduct the remuneration it pays to the investor from its income tax basis. To date, no Sukuk is listed on the Paris stock exchange.
Taxation of Murabaha
Murabaha is duly described in the statement as a technique used to finance an asset acquisition: a bank or its SPV acting as a financier, purchases an asset from a seller and subsequently transfers the asset to a buyer in consideration of the payment of a profit margin, which will be settled by the buyer in instalments.
The two main features of a Murabaha transaction are therefore a double property transfer on the one hand, and the intermediation of a financier on the other hand, both of which triggered disadvantageous consequences under French tax law that are neutralised by the statement.
The statement indicates that the profit margin paid to the financier by the buyer shall be treated as an interest under French tax law, which implies that it can be deducted from the financier’s income tax basis. A series of conditions shall be met to allow such deductibility:
First, the agreement shall state that the asset purchased by the financier shall be transferred to the buyer within a six months period.
Second, the agreement shall stipulate the acquisition price by the buyer and by the financier. Most importantly, the agreement shall clearly distinguish which part of the profit margin results from commission fees and which part results from the facilitation of a deferred payment. Only the latter part of the profit margin may be deducted – on a linear basis until maturity – which certainly involves that the commission fees have to be computed on a lump-sum basis.
Besides income tax issues, the statement comprehensively addresses other tax regimes, this paper covering only some of the most relevant aspects.
The statement notably deals with the taxation of real estate transactions. Under French tax law, a tax is levied on capital gains realised on such transactions. Murabaha operating a double transfer of property, double taxations would have been detrimental to the development of Islamic finance in France, especially since Murabaha is commonly used to structure the acquisitions of real estate properties by retail clients, which is a promising market niche for Islamic banks willing to set-up in France.
The statement provides that the profit margin paid by the buyer to the financier shall not be treated as capital gains. It further provides that if the buyer sells the property, capital gains shall be derived from the price paid by the seller to the financier, and not on the price paid by the buyer to the financier, this regime being aimed at discouraging speculation.
The statement also envisages the taxation of commodities Murabaha, which are crucial to the sound functioning of Islamic banks that are obliged to back their financing operations with real assets in order to be compliant with the Shari’ah. According to French tax law; only the physical delivery in France of personal chattels is subject to VAT, therefore commodities Murabaha transactions conducted on a foreign exchange such as the London Metal Exchange are VAT exempt provided that the commodities are not located in France.
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In conclusion, some significant adaptations of the French legal framework to the specifics of Islamic finance have been achieved although additional measures certainly need to be implemented. For example, French statute law provides that a seller shall warrant a buyer against the hidden defects affecting the goods it sells. Within the framework of a Murabaha transaction, the financier should be allowed to waive this currently compulsory warranty, as it essentially acts as a financial intermediary.
Published on 10 August 2009
