CFM6092 - Taxing loan relationships: alternative finance: section 48A conditions - exclusion of "profit sharing" sukuk

Reasonable commercial return and accounting tests

The Islamic concept of sukuk is an extremely flexible one. Sukuk that are issued to raise finance in capital markets will, in most cases, be economically equivalent to conventional debt securities, giving the holder a predictable return akin to interest. But this is not necessarily so: there is nothing to stop a company issuing sukuk which have the economic effect of profit-sharing or partnership arrangements, or which resemble equity rather than debt.

Example

X Ltd is a company carrying on a trade of cattle breeding. It wishes to improve its herd. It therefore issues a 3-year sukuk to investors and uses the subscription proceeds to buy a pedigree bull. The sale proceeds from calves or bullocks sired by the bull, and artificial insemination fees generated from the bull, are distributed to investors in proportion to their certificate holdings. After 3 years, the bull is sold at a profit, and the proceeds shared between the investors.

Here, the investors participate directly in the success (or failure) of the underlying husbandry business. The sukuk is less a financial instrument than an arrangement for sharing profits or losses. It would not be appropriate to tax this in the same way as an interest-bearing security.

Statutory provisions relating to other alternative finance arrangements require the alternative finance return to equate in substance to the return on an investment of money at interest (see, for example, CFM6052). Such a test is not possible for sukuk, because the return may equate to discount rather than (or as well as) interest – or it may include the value of a conversion right. Instead, FA05/S48A imposes two tests designed to distinguish those sukuk arrangements that are economically equivalent to debt securities.

Reasonable commercial return

Additional payments under the sukuk arrangements (which will include both “interest” and “discount”) must not exceed a reasonable commercial return on a loan of the capital. Where the return is not fixed at the outset, it is the maximum possible amount of the additional payments that must be considered.

Thus, in the example above, the issue terms of the sukuk impose no upper limit on the amount of the periodic distributions – a sukuk holder subscribing £100 may, in a year, get back £20 or even £200 if the bull sires particularly valuable calves (although equally, they could get nothing). The maximum return is clearly in excess of a reasonable commercial return on a loan of £100, and the sukuk would therefore not be an alternative finance investment bond within the legislation.

In applying the “reasonable commercial return” test, the sukuk should be compared to a hypothetical loan on similar terms and carrying similar risks. For example, a conventional security convertible into shares will normally carry a lower rate of interest because the conversion right has a value. The return on an “exchangeable” or “convertible” sukuk should be measured against the return on an equivalent exchangeable or convertible debt security.

However, investment in a sukuk will generally carry a slightly greater risk than investment in a conventional security, because investors have recourse only to the “bond assets” – they cannot sue the issuing company for return of their capital. So the “reasonable commercial return” for a sukuk is likely to be higher than the return were the same company to issue a conventional security.

As with any financial instrument, the pricing of sukuk will depend on the issuer’s view of the market at the time of issue, and “reasonable commercial return” may vary within quite a wide range. HMRC staff should bear in mind that the purpose of the test is to exclude sukuk where the return is blatantly above what would be reasonable and commercial for a debt security, or where the return is linked to profits.

“Financial liability” test

Alternative finance investment bonds must be wholly or partly treated as a financial liability of the issuer under international accounting standards (IAS), on the assumption that the issuer uses IAS.

IAS 32 defines “financial liability” in terms of a contractual obligation to deliver cash or another financial asset (such as shares) to another entity – see CFM16075. Although the obligation to repay sukuk is not contractual, where the sukuk are functionally equivalent to debt securities, the issuer will account for the substance of the transaction and recognise the sukuk as a financial liability.

A person holding sukuk will not necessarily know how the issuing company accounts for them. HMRC will regard the test as satisfied in any case where the holder reasonably believes that the instrument would be treated as a financial liability as in IAS 32. For most listed sukuk, it will be clear from the issue terms that this is so. It will only be necessary for a holder to seek an accounting opinion, or to approach the issuing company for information, in an exceptional case where the sukuk has “equity” features that would put the accounting treatment in doubt. Such an instrument, however, is likely to fail one of the other tests of Section 48A.

An alternative finance investment bond which is exchangeable for shares would be treated as a hybrid instrument (a host contract plus an embedded derivative – see CFM16100) under IAS. Provided that the host contract represents a financial liability, the sukuk will be partly treated as a financial liability and will thus satisfy the FA05/S48A (1)(i) condition.