BISHR SHIBLAQ discusses why Luxembourg is well equipped to remain a preferred jurisdiction for the structuring of Islamic finance products.
The recent 8th annual summit of the Islamic Financial Services Board (IFSB), one of the two standard setting bodies in Islamic finance, attracted particular interest throughout Europe, as well as in the Islamic finance community in the Middle East and Asia, as it was the first time that the summit was held in a European country. The location of the summit shows that Luxembourg has been successful in positioning itself in this growing sector. While other European countries are still reviewing their domestic legislation, in order to become more attractive for Islamic finance, Luxembourg has quietly established itself as a European hub for the sector.
This development should not come as a surprise to those who know Luxembourg and the strong position it has accomplished over the years. The country has gained global recognition as an international financial market combining the expertise of its service providers with a flexible regulatory environment and social, economic and political stability. Over the last 25 years, it has become an international player, offering a diverse range of products to the financial industry, ranging from highly regulated, lightly regulated to unregulated vehicles that can be used for conventional or alternative investments. These structures range from private equity vehicles to specialized investment funds, up to the globally known Undertakings for Collective Investment in Transferable Securities (UCITS) funds.
This service offering has made Luxembourg today the premier captive reinsurance market in the European Union (EU), the premier private banking center in the Eurozone and the second largest investment fund center in the world behind the US. This development has been equally true for Islamic finance, where Luxembourg is a leader among the European financial centers.
Development
Luxembourg has been a witness to the first steps of the Islamic finance industry, when in 1978 the first Islamic financial institution was established in a non-Muslim country. In 1983, Luxembourg was the chosen domicile for the establishment of the first Shariah compliant insurance company in Europe. Other renowned Islamic finance institutions followed in the 1990s with Faisal Finance and the FWU Group, the latter becoming a leading provider of Takaful solutions.
The Luxembourg Stock Exchange has additionally played a leading role as the first European stock exchange to enter the Sukuk market. One of the advantages for the listing of Sukuk in Luxembourg is that it is the domicile of the leading international clearing and settlement house, Clearstream, which has accepted international Sukuk issuances. According to the latest numbers available, 16 Sukuk have been listed and traded on the Luxembourg Stock Exchange since 2002.
Many Islamic finance deals have used Luxembourg investment structures for their real estate and private equity investments globally. Luxembourg has also become the leading European jurisdiction for the set-up of Islamic funds and one of the five leading domiciles, according to a recent study on Islamic funds by Ernst & Young.
The IFSB summit was the latest showcase of the strong position Luxembourg has gained in Islamic finance. The summit was hosted by Central Bank of Luxembourg (Banque Centrale du Luxembourg), which remains the only EU central bank to accede to membership of the IFSB and is also a founding member and equity subscriber of the recently established International Islamic Liquidity Management Corporation.
Investment funds
Luxembourg has today a leadership role in investment management and has assumed this role also for Islamic funds. Its multicultural workforce, the stable legal framework and the variety of asset management capacities available for managers globally is inviting. The Islamic financial sector was less affected by the financial crisis, but the industry did not escape its impact entirely. According to the Ernst & Young Islamic funds report, the development of Islamic funds stagnated and the creation of new funds was offset by the number of liquidated funds, but the potential for growth is substantial.
As of March 2011, there were 37 Shariah compliant funds established under Luxembourg law. More than 70% of the Luxembourg Islamic funds have been set up as UCITS. The advantage of UCITS is that it has a worldwide recognition and the benefits of its EU passport. UCITS funds that are approved in an EU country will be recognized by other EU member states. A Shariah compliant fund manager deciding to create a UCITS fund in Luxembourg will have the opportunity to sell units or shares of this fund without additional formalities that may otherwise incur throughout the EU.
More importantly UCITS funds are not only recognized throughout Europe, but also by a large number of other countries in other regions, including the Middle East and Asia. UCITS funds offer a brand which is recognized by market participants and normally dedicated to retail investors while offering a very high level of protection and regulation in terms of eligibility of asset classes, liquidity and risk management. From the perspective of an investment manager intending to set up an Islamic fund, they are advantageous because they can attract a wide range of investors by establishing their fund in a recognized jurisdiction like Luxembourg and offering a high level of protection.
Around 15% of all Luxembourg Islamic funds have been set up as specialized investment funds (SIFs), a fund type which benefits from great flexibility in terms of organization, eligible assets and investments, and may be offered to a wider range of eligible investors. In addition to the ‘traditional’ institutional investor, SIFs can be offered to ‘professional’ investors within the meaning of Directive 2004/39/EC as well as other well-informed investors.
The legal framework in Luxembourg does not create any obstacles for Islamic funds and as confirmed by the Luxembourg financial regulatory authority, Commission de Surveillance du Secteur Financier (CSSF), there are no specific legal requirements concerning Shariah compliant funds set up under Luxembourg law. It is common practice that Islamic funds set up a Shariah board where scholars assess the compliance of the investments with the principles of Shariah. Where such a Shariah board is envisaged, the role, the competences and the practical details of the board have to be described in the prospectus.
With respect to the Shariah board the general regulatory principles applicable to the managers of an investment fund in Luxembourg must be fulfilled. It must therefore be determined whether the board will have a solely advisory role or a decision-making role. If the board members are considered to have a decision-making role, then their identity has to be disclosed to the CSSF and evidence provided that they are of good repute and have sufficient experience in relation to the investment policy of the fund.
Other vehicles
The most popular vehicle in Islamic finance transactions is still the participation company (société de participations financières, SOPARFI). Due to its high flexibility and the ability to structure global investments in a highly tax efficient manner, it has been used for a long time in many Shariah compliant transactions. The SOPARFI is an unregulated vehicle that may adopt any company form available under the Luxembourg law for commercial companies and that is eligible for the extensive Luxembourg tax treaty network, as well as the EC Parent-Subsidiary Directive.
The Islamic finance industry has also been looking at the Luxembourg Securitization Law of 2004, which is a flexible legal framework, linking high investor protection with a tax neutral status. According to its broad definition, a securitization is an undertaking that acquires or assumes, directly or through another undertaking, risks relating to claims, other assets, or obligations assumed by third parties. Deutsche Bank and Dar Al Istithmar have set up Sukuk issuance platforms, taking advantage of this flexible regime.
Strong government support
The Luxembourg government is a strong supporter of the development of Luxembourg as a center for Islamic finance. The CSSF and Luxembourg authorities are showing a proactive and flexible approach to accommodate the interests of the financial industry. In 2008, the government set up a task force to identify obstacles to the development of Islamic finance and suggest ways to promote its growth.
A dedicated working group within the Association of the Luxembourg Fund Industry (ALFI) was set up, which reported back favorably, noting that Luxembourg was able to offer a range of vehicles addressing the specific needs of both investors and promoters interested in Shariah compliant investment with a limited need for specific additional legislation.
A set of clarifications has been issued by the tax authorities, as well as the CSSF, to clarify the treatment of certain Islamic contracts and instruments.
The circular by the Luxembourg tax authorities dated the 12th June 2010 relating to Shariah compliant finance instruments for example, confirmed the view that no additional legislation was required in Luxembourg, as the tax system is based on the Wirtschaftliche Betrachtungsweise approach. This economic approach is based on the international accounting principle known as the ‘substance over form’ principle, meaning that in a conflict between the legal nature (the form) of a transaction and its actual economic result (the substance), the economic view must be used by the tax authorities. The tax authorities also clarified that Sukuk are analyzed as debt instruments from a Luxembourg tax point of view. Therefore the remuneration paid to the Sukukholder is treated as an interest payment and is thus tax deductible at the level of the Sukuk issuer and not subject to withholding tax in Luxembourg.
At the beginning of 2011, the CSSF also issued a statement concerning Islamic debt securities, with the purpose of strengthening further the legal security of Sukuk issuers, while ensuring adequate investor protection. The CSSF statement clarified that Sukuk are treated as asset-backed securities for the purposes of approval of the prospectus or, subject to certain conditions, as guaranteed debt securities.
While these circulars did not change the existing treatment of Islamic finance instruments and funds, they provided guidance on their qualification or clarified that no additional requirements, other than those existing for conventional instruments, were necessary from a Luxembourg perspective.
So far the Islamic contracts and modes of financing have been largely compatible with the Luxembourg legal framework and practices have proved that the legal context in Luxembourg is favorable for the creation of Shariah compliant investment funds.
Conclusion
As a leading center for investment management with a proactive government supporting the development of Islamic finance and service providers that are keen on developing this sector, Luxembourg is very well equipped to remain a preferred jurisdiction for the structuring of Islamic finance products.
Bishr Shiblaq is the head of the Dubai representative office of Luxembourg law firm Arendt & Medernach. He can be contacted at
[email protected]
.