Diminishing Shared Ownership for property acquisitions with Islamic finance

I was recently asked to contribute an article on Islamic finance for the January 2007 edition of PwC’s client newsletter “UK Real Estate Insights.” I decided that readers might be interested in learning about the changes to UK tax law that have been enacted to facilitate diminishing musharaka.

A copy of the article is reproduced below:

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Many devout Muslims consider that Islam prohibits the receipt or payment of interest. Historically, this has precluded them from using mortgage finance for property acquisitions. Although Islamic finance has developed alternative acquisition structures that avoid the payment of interest, in a UK context without complex tax planning, such structures typically gave rise to additional tax costs compared with a conventional mortgage, such as double stamp duty or a lack of relief for finance costs; hence the need for legislation.

Over the last few years, tax law has been amended to facilitate property acquisition through shared ownership. The main driver for this has been a desire to make the tax system more inclusive, by creating a level playing field for Islamic housing finance compared with conventional mortgage finance. However everyone needs to be aware of the rules as the legislation is applicable to any transaction falling within its definitions, and can benefit non-Muslims as much as Muslims. In this article, Mohammed Amin considers the current tax treatment of one common structure used for Islamic mortgages, namely “diminishing musharaka”, or “diminishing shared ownership” as it is called in FA 2006. Although the legislation has primarily been aimed at facilitating the finance of housing through a domestic mortgage equivalent, it is applicable more broadly to property finance and may provide an alternative to the “Ijara” arrangements usually implemented for financing real estate investment.

Shared Ownership Property Transactions

Diminishing shared ownership is normally implemented as shown in the diagram below, where a person (the “Eventual Owner”) has sufficient funds to purchase 25% of a property, but needs finance for the other 75%.

With a conventional loan, the eventual owner would borrow 75 per cent of the total cost from the financial institution and have 100 per cent beneficial ownership of the asset from the beginning, even though legal title to the asset would usually be held by the financial institution as security.  Instead, with diminishing shared ownership the eventual owner and the financial institution purchase the property jointly, although for security the legal title is likely to be held entirely by the financial institution.

The eventual owner has sole occupancy rights, but pays rent to the financial institution on that part of the property that it does not own. It then acquires the remainder of the property from the financial institution in stages.

Stamp Duty Land Tax Relief

Without special relief, there would potentially be three SDLT charges on that part of the property which is financed. Firstly when the financial institution purchases the property, secondly on the lease when the financial institution rents its share of the property to the eventual owner, and finally when the eventual owner buys that share of the property from the financial institution. In contrast, SDLT would be payable only once if the buyer had taken out a conventional mortgage.

FA 2003 s71A provides relief in England and Wales from the second and third SDLT charges, provided that its precise conditions are met. (S72 deals with Scotland and is not covered in this article.) Some key points to note are:

• “Financial institution” is defined to mean a bank, a building society, or a wholly owned subsidiary thereof. Partially owned subsidiaries are excluded.
• The eventual owner needs to have the right to purchase the financial institutions share of the property, but does not have to be obliged to purchase.
• The legislation is silent on the price that the eventual owner pays for buying subsequent shares in the property. Accordingly, the price could be set at the financial institution’s original cost or at market value for example.

Tax relief for finance costs

In the absence of special provisions, in the diminishing shared ownership structure, the eventual owner would be regarded as paying rent to the financial institution.

This rent may or may not be a deductible cost to the eventual owner. For example, if the contract specifies that future purchases of the financial institution’s share of the property are to be at original cost, then arguably the rent being paid is partly to preserve this favourable purchase option, and may therefore be a capital item rather than a deductible cost. The financial institution would also be treated as receiving rent, which may have different tax consequences for it than receiving interest.

Accordingly, FA 2005 as amended by FA 2006 by the insertion of FA 2005 s47A sets out a specific legislative regime for the direct tax treatment of diminishing shared ownership. Where the parties are companies, for tax purposes they are treated as if they were parties to a loan, whose original amount is the price the financial institution pays to purchase its share of the property, and where the rent or other fees paid by the eventual owner to the financial institution are treated as if they were interest.

Perhaps because this legislation was enacted several years after the SDLT relief, there are several differences from the SDLT rules that need to be borne in mind.

• The SDLT definition of “financial institution” is extended in two ways. It includes “a person authorised in a jurisdiction outside the United Kingdom to receive deposits or other repayable funds from the public and to grant credits for its own account” and “a person authorised by a licence under Part 3 of the Consumer Credit Act 1974 (c 39) to carry on a consumer credit business or consumer hire business within the meaning of that Act.” Accordingly, foreign banks can take part in such transactions for direct tax purposes, but cannot benefit from the SDLT relief, which is illogical.
• The eventual owner must be exclusively entitled to any income, profit or gain arising from the asset (apart from the rent it pays to the financial institution) and in particular any increase in the value of the asset. The legislation expressly permits the financial institution to share in losses in value, but precludes it from sharing in gains.
• The legislation stipulates that the eventual owner “ is to make payments to the financial institution amounting in aggregate to the consideration paid for the acquisition of its beneficial interest.” Accordingly, a mere option to purchase appears insufficient; the eventual owner must be obliged to purchase.

Conclusion

The legislative provisions for diminishing shared ownership are not consistent between SDLT and direct taxation, but may be amended in future to make them consistent. At present, they are quite narrowly drawn, but may be extended by future legislation as Islamic finance becomes more common in the UK. As mentioned above, their use is not limited to Islamic finance, and any person is able to make use of them by structuring transactions to fit within the rules.

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I have also attached a copy of the full edition of the newsletter, as some readers of the blog might like to read it. If you would like to receive future editions by email, please respond on this blog asking to be added to the email distribution list.

Download uk_real_estate_insights_jan_2007.pdf