SAIM2250 - Interest: specific inclusions: alternative finance return

Profit share return from alternative finance arrangements

Islamic law (the Shari’a) prohibits lending at interest. This stems from the principle in the Qur’an: “God hath permitted trade and forbidden usury”. Muslims (or anyone else) may enter into arrangements that have a similar economic effect to deposits or loans, but which do not involve interest. The tax treatment of some of the most commonly-used ‘alternative finance arrangements’ is set out in Chapter 5 Part 2 FA 2005. Detailed guidance is at CFM6050 onwards ( SAIM20000).

In particular, the legislation defines two arrangements that give rise to ‘profit share return’. FA05/S49 is aimed at an arrangement known by the Arabic name of Mudaraba. The investor deposits money with a bank or similar financial institution, which pools such deposits and invests the funds in a way that complies with Shari’a law. The bank then credits the investor with part of the investment proceeds from time to time, in proportion to the amount they have invested. Such credits are likely to equate, in substance, to the return on an investment of money at interest. Where they do so, they come within the legislation – in other words, they comprise ‘profit share return’.

Finance Act 2006 added a new section, FA05/S49A, which covers an agency arrangement known as Wakala. The investor appoints a bank or other financial institution as their agent, giving the bank a sum of money to invest on their behalf. The agent specifies an investment return it expects to receive. Provided that the investment achieves at least the expected return, this is the amount that is paid out to the investor (who is at risk if the return falls short of expectations). Any additional investment proceeds are retained by the agent as an ‘incentive fee’. FA05/S49A also characterises the amount received by the investor under such arrangements as ‘profit share return’.

For non-corporate investors, FA05/S51 provides that for the purposes of ITTOIA 2005, profit share return is treated as if it were interest. FA05/SCH2/PARA10 further provides that in circumstances where interest would be paid under deduction of tax (see SAIM9000), income tax is also deducted from alternative finance or profit share return.