The Sukuk market in Turkey has evolved substantially over the last few years. The evolution has been comparatively quick and helpful. In this article, RIZWAN KANJI and HAMED AFZAL will review some of the key milestones in the development of the market and, going forward, the key challenges and prospects for the market to further grow and evolve.
The story so far
Sukuk were introduced to the Turkish market in 2010 when the Turkish participation bank, Kuveyt Turk Katilim Bankasi (Kuveyt Turk), undertook a US$100 million debut issuance which it listed on the London Stock Exchange. Given the lack of legislative infrastructure to facilitate Sukuk issuance at the time, the transaction relied on numerous tax and regulatory exemptions by Turkish authorities.
This successful issuance led to the Capital Markets Board of Turkey (CMB) adopting a proactive approach to develop the legal infrastructure in Turkey to foster the growth of the Sukuk market. This resulted in the CMB issuing a communiqué in April 2011 (the CMB Communiqué) which provided the regulatory framework for the establishment of asset leasing companies (ALCs). The CMB Communiqué provided that such companies would be able to issue and sell ‘rental certificates’ (ie Sukuk) utilizing lease (ie Ijarah)-based structures. The omnibus bill 2011, Law number 6111 followed in February 2011, and provided for the various tax and levy exemptions applicable to ALCs and Sukuk cash flows. These changes prompted Kuveyt Turk, through KT Sukuk Varlik Kiralama, an ALC incorporated in Turkey pursuant to the CMB Communiqué, to issue its second benchmark Sukuk.
These issuances prompted further Sukuk issuances by other leading participation banks in subsequent years and, in September 2012, Turkey issued its first sovereign benchmark sukuk.
Further legislative reforms followed, most notably through the Lease Certificates Communiqué (Serial No. III/61.1) in June 2013 (the Revised Communiqué). The Revised Communiqué allowed, among other things, ALCs to undertake multiple issuances and introduced a broader range of approved structures for Sukuk issuance. The Revised Communiqué prompted a spate of further Sukuk issuances from the various participation banks shortly thereafter and in the following years.
To date, up until the end of 2015, international Sukuk issuances by private institutions out of Turkey have raised more than US$5.7 billion, according to the IIFM Sukuk database. In addition, the sovereign has issued eight Sukuk between 2011 and September 2015, with an approximate total value of US$7.7 billion.
Corporate issuance gap
While the Turkish Sukuk space has seen considerable growth, this growth has been limited to issuances by participation banks and the sovereign. Among the key challenges in creating a deeper capital market is encouraging Turkish corporates to issue Sukuk. At the time of writing this article, despite apparent drivers such as the large infrastructure funding gap in Turkey and the growth of the Islamic institutional investor base, only a small number of Turkish corporates have issued domestic Sukuk and none have issued Sukuk internationally. The following are some of the factors which have arguably resulted in the lack of corporates issuing Sukuk.
ALC regulatory framework
The regulatory framework governing the formation and ongoing operation of ALCs renders such entities unlike SPVs incorporated in offshore markets (such as the Cayman Islands) for the purpose of issuing Sukuk.
Firstly, under the Revised Communique, only certain limited entities are permitted to incorporate an ALC, which include financial institutions, certain intermediary institutions and companies which have been assigned a long-term investment grade credit rating. While corporates which are not rated may, as a technical matter, arrange for a financial institution to incorporate an ALC on their behalf or arrange to use an existing ALC set-up by a financial institution for the purposes of issuing their Sukuk, there has been a general reluctance on the part of some financial institutions to offer these services (due to, for example, uncertainties around the requirement to consolidate the ALC’s assets with those of the entity establishing it and issues around insolvency remoteness).
In addition, the operation of ALCs is heavily regulated by the CMB, for example, the CMB’s consent is required for a number of matters relating to an ALC (including any amendment to the ALC’s articles and where there is a transfer of shares granting management or voting privileges), there are prohibitions on an ALC undertaking certain activities (including engaging in any activities other than those indicated under its articles of association) and certain corporate governance and reporting requirements apply to an ALC on an ongoing basis. In relation to corporate governance, the CMB provides that an ALC must have at least three board members, one of which must be an independent board member who satisfies the CMB’s independency criteria, with certain board decisions requiring the vote of such a board member.
These requirements are much more onerous and burdensome compared to the equivalent regimes in other jurisdictions in which SPVs can be incorporated for structured finance and/or Sukuk transactions, such as the Cayman Islands. Consequently, many originators in Turkey (including corporates) have felt that the cost and administrative burden of using an ALC under the existing framework to issue Sukuk has been unduly high.
Tax disadvantages
To foster growth in the Sukuk market in Turkey, the CMB has, over the past several years, reformed applicable tax legislation to create a level playing field for Sukuk Ijarah structures, so that:
- pursuant to the Corporate Tax Law (Law No 5520), any capital gains derived from the sale of an asset portfolio by an originator to an ALC, and vice versa, were made exempt from corporate tax
- pursuant to the VAT Law (Law No 3065), the delivery of Sukuk to holders was made exempt from value-added tax (VAT), as was the transfer of assets to an ALC and the subsequent leasing of those by an ALC and transfer back to the originator
- pursuant to the Charges Law (Law No 492), the sale of an asset portfolio was made exempt from applicable land transfer fees, such as the title deed registry fee
- under the Income Tax Law (Law No 193), any Sukuk facility with a maturity of five years or more was made exempt from withholding tax in respect of income earned by the Sukukholders, and
- under the Stamp Tax Law (Law No 488), stamp duty exemptions were applied on documents covering the transfer and lease of assets between an originator and an ALC
The aforementioned exemptions applied mainly to Sukuk Ijarah, and remained silent on the applicable tax treatment in respect of other Sukuk structures. There was also concern about the application of the exemptions to Sukuk Ijarah itself, including in relation to the scope of the stamp duty exemption.
To overcome these issues and to further encourage corporate issuances, the Turkish Tax Bill Regarding Improvement of Investment Environment (the Omnibus Bill) was introduced in August 2016. Pursuant to the Omnibus Bill, the Stamp Tax Law, the Value Added Tax Law and the Law on Charges were amended to grant stamp tax exemption to all Sukuk transaction documents, VAT exemption to all types of Sukuk transactions and exemption from duties to be levied on all Sukuk transactions involving the establishment of security, mortgage, pledge and other similar transactions.
Asset eligibility
As with other Islamic finance structures, in the context of Sukuk, returns to Sukukholders must originate from underlying assets or ventures. The returns must also be Shariah compliant and, accordingly, cash flows used to pay Sukukholders must flow from Shariah compliant assets and/or ventures. While, according to Shariah principles, only 33% of the issue amount of the Sukuk will need to be supported by tangible assets for the Sukuk to be tradeable in the secondary market at a premium or discount, finding sufficient eligible assets still presents a significant problem for some corporates. This is particularly the case given that, both from a Shariah perspective and as a matter of Turkish law (by virtue of the Revised Communiqué), all such assets underlying the Sukuk are required to be free of any encumbrances (such as mortgages or other security interests).
The path forward
The tax reforms introduced under the Omnibus Bill have brought much-needed clarity to originators, particularly corporates, looking to issue Sukuk in the Turkish market. The numerous stamp tax, VAT and duty exemptions, which now apply to all types of Sukuk structure transactions, are likely to help create a level playing field for originators compared to the conventional funding space, and it is hoped that this will encourage corporates to come to market.
Nevertheless, challenges remain, particularly given the highly regulated legal framework applicable to ALCs. For example, the cost, administrative burden and control issues around corporate governance requirements applying to the formation and ongoing operation of an ALC may continue to prove too onerous for many Turkish corporates looking to issue Sukuk.
Despite this, given the strong demand for alternative finance in the Turkish market (particularly to fund the country’s growing infrastructure funding requirements) and the willingness on the part of the Turkish regulators and authorities (including the CMB and Borsa Istanbul) to make Turkey a regional hub for Islamic finance, the outlook for the deepening of the Sukuk market in Turkey seems positive. This will however, in our view, require continued dialogue and feedback among all market participants, including regulators, banks, corporates, law firms and others to ensure an enabling environment is created in Turkey to foster the development of the Sukuk market.
Rizwan H Kanji is a debt capital markets partner at King & Spalding based in Dubai. He has broad experience advising arrangers, issuers and sovereigns. He has considerable experience in the Turkish Sukuk market having pioneered the first international Sukuk issuance out of Turkey in 2010. He has a sizeable market share of issuances out of Turkey according to Chambers and Partners. He can be contacted at [email protected].
Hamed Afzal is a senior associate in the debt capital markets team at King & Spalding based in Dubai and has broad experience advising issuers and arrangers on the full spectrum of debt capital markets and structured financed transactions, both conventional and Shariah compliant. He can be contacted at [email protected].