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New Luxembourg tax guidelines for Islamic finance

 

Having already issued guidelines on 12 January 2010 on specific income tax aspects of Islamic finance, the Luxembourg tax authorities issued a second set of guidelines on 17 June 2010 to clarify specific registration tax and value added tax (VAT) aspects of Murabaha and Ijara structures. In substance, the guidelines clarify how registration taxes apply with respect to Murabaha transactions on Luxembourg real estate and confirm that a special purpose vehicle (SPV) entering into a Murabaha or Ijara transaction will be treated as a taxpayer for VAT purposes.

Over the last two years, the Luxembourg authorities have made considerable efforts to promote the country for Islamic finance. Previously, while Sharia compliant funds and securitisation vehicles found fertile ground in Luxembourg's flexible and versatile legislation, more traditional Islamic finance products, such as Murabaha structures, fared more poorly in Luxembourg, due in particular to certain uncertainties regarding their tax treatment. As part of its efforts to make Luxembourg more attractive for traditional Islamic finance products, the government invited the tax authorities to analyse the tax obstacles these products currently faced when compared to conventional financing structures and to propose solutions to reduce such obstacles.

In its guidelines dated 12 January 2010, the Luxembourg tax authorities responsible for direct taxes (Administration des Contributions Directes) adopted an economic approach in assessing the income tax treatment of Sukuk and Murabaha structures, and decided to bring this into line with the tax regime applicable to conventional financing methods. Even though these guidelines address only Murabaha and Sukuk structures, alternative forms of Islamic finance may also be assessed from an economic perspective.

On 17 June 2010, the Luxembourg tax authorities responsible for VAT, registration taxes and other indirect taxes (Administration de l'Enregistrement et des Domaines) issued guidelines (the Guidelines) outlining the indirect tax and VAT treatment of Murabaha and Ijara structures.

1. Real estate transfer taxes and Murabaha structures

A Murabaha structure aims to allow an Islamic investor to finance the acquisition of an asset, most commonly a real estate asset, without having recourse to an ordinary interest-bearing loan. To that end, the asset is acquired by an intermediary, generally an SPV, which then transfers it to the Islamic investor under a Murabaha agreement for a deferred purchase price corresponding to the aggregate of (i) the purchase price paid by the SPV, (ii) the financing costs and (iii) a fee for the intermediary's services.

Murabaha transactions on real estate assets usually involve two sales, each of which is subject to a real estate transfer tax, whereas only one sale is required under a conventional financing structure.

Real estate assets located in Luxembourg are required to be transferred by way of a public deed and the purchase price is subject to real estate transfer tax at a rate of 6%, plus a 1% transcription tax. In Luxembourg City, real estate transfer tax on commercial properties is in principle levied at a rate of 9%, plus a 1% transcription tax.

Where the purchaser (i.e., the SPV) declares in the notarial deed that he is purchasing the property to sell it immediately thereafter, the purchaser may apply to pay an increased registration tax of 10.8%, plus a transcription tax of 1%. Provided that the purchaser/SPV transfers the asset within a period of two years, it will be entitled to a refund of 5/6 of the real estate transfer tax paid. The effective rate on real estate located in Luxembourg City is therefore only 2.8% (a 1.8% real estate transfer tax, plus a 1% transcription tax).

However, this would still cause upfront structural issues for Murabaha structures, given that the purchaser/SPV would have to pay the full real estate transfer tax at the outset, while only receiving the refund at a later stage.

The Guidelines clarify that the first sale is only subject to the reduced transfer taxes (of 2.8% if the asset is located in Luxembourg City) if the first and the second transfer deeds are registered at the same time and provided that the purchaser/SPV states in the first transfer deed that the asset is being bought to be resold afterwards. As a result, the purchaser/SPV will have to pay only the reduced rate upfront and not the real estate taxes in full.

Another potential issue encountered under a Murabaha agreement is the determination of the tax basis for real estate transfer tax purposes. The Guidelines clarify that the difference between the purchase price of the first sale and the purchase price of the second sale is to be classified as capitalised interest for indirect tax purposes. As a result, such difference will not be liable to registration duties in Luxembourg, subject to the following conditions:

  • the Islamic investor must take possession of the real estate asset immediately after the second sale;
  • the second sale must be completed no later than 10 days after the first sale; and
  • the first sale must provide that it is being realised as a Murabaha transaction and the copy of the Murabaha agreement must be annexed to the first sale deed.

Finally, the Guidelines reaffirm that the transfer of shares issued by a limited corporation holding real estate assets located in Luxembourg is not subject to real estate transfer taxes in Luxembourg.

2. VAT

In the case where all parties involved in a Murabaha or Ijara structure are VAT taxpayers, such parties may opt, under certain conditions, to apply VAT on the transfer or lease of an immovable property. The Guidelines clarify that an SPV created for the purpose of entering into a Murabaha or Ijara transaction is to be considered a taxpayer for VAT purposes. Thus, if the initial seller and the Islamic investor are VAT taxpayers, the parties to the Murabaha or Ijara structure may opt for the application of VAT on the transfer or lease of the real estate asset.

 

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