A closer look at Islamic home finance in the UK: What might we see in 2025

The problem

Islamic residential property finance, in order to avoid creating an obligation for a customer to repay a loan with interest, tends to take the form of the financier purchasing the relevant residential property. That financier then agrees to sell the residential property to the customer at a price the covers the financier’s outlay in making the initial purchase of the property. The financier will also lease the property to the customer, to enable the customer to live in and enjoy the use of the property during the period while the financier is the legal owner of the property.

The contract of sale between the financier and the customer calls for the legal title to the property to be transferred to the customer when the purchase price of the residential property has been paid by the customer to the financier in full. The combination of the payments to purchase the residential property and the rental under the lease create an economic return for the financier that is economically similar to the return it would receive of making a loan repayable with interest.

The United Kingdom regulatory construct also calls for both the financier and the customer to have a beneficial interest in the residential property throughout the life of the arrangement, each party holding such interest in the proportion of the amount it has paid towards the purchase of the property. It is a further requirement under the United Kingdom construct that the financier complies with certain criteria, such that it is either a “financial institution” or an “HPP Provider” as defined under the relevant legislation. Such arrangements are known under United Kingdom law as a “diminishing shared ownership arrangement” (DSOA). 

CGT

Refinancings of DSOAs will involve a sale of the relevant property either from one DSOA provider to another or from a DSOA provider to the customer who will in turn sell it to the new DSOA provider. Where the property being refinanced is not the primary residence of the customer (which would include buy to let residential properties), such refinancing may expose the customer to capital gains tax on the part-disposal of the residential property that takes place in connection with the refinancing.

Legislation introduced with the 2024 Budget creates the concept of a “refinancing DSOA” which broadly mirrors the existing legislative DSOA concept, but caters for the circumstance in which a customer already holds a beneficial interest in an asset, and disposes of some or all of that asset to a DSOA provider. It also caters for circumstances in which a DSOA provider assigns/transfers its interest in an existing DSOA or a refinancing DSOA to another financier. That other financier may be another DSOA provider or a financial institution which is providing finance to the DSOA provider.

Where, under a refinancing DSOA: 

• A customer disposes all or part of its interest in an asset to a DSOA provider on a refinancing, any profit, gain or loss realised by the customer on that disposal is treated as not having been realised for income tax, capital gains tax or corporation tax purposes. 
• A customer re-acquires of all its interest in an asset from a DSOA provider under an existing refinancing (whether from the original DSOA provider or a transferee financier), that re-acquisition (and any other intervening disposals and acquisitions) is treated as not having taken place for the purposes of calculating the amount of any profit, gain or loss on a subsequent disposal of the asset by the customer. 
• A financier transfers their interest in a lease to another financier which forms part of a refinancing DSOA, that transfer is treated as involving no disposal or acquisition for income tax, capital gains tax or corporation tax purposes. 

This tax treatment will apply from 30 October 2024, but will not apply retrospectively.

The market for the refinancing of Islamic therefore finds itself in an interesting position. It is generally understood that the treatment now introduced by the October 2024 Budget reflects what is (or should have been) the intended legislative position for refinancing DSOAs since the introduction of the DSOA regime. There is no good policy reason for a re-mortgaging of a property to attract capital gains tax.

The fact that such transaction may be caught within the capital gains net merely because it is effected via a DSOA is clearly either an unintended consequence of, or an oversight when, amending complex tax legislation that impacts on property transactions in a number of different ways. It does seem unfair that someone who refinances a property (where that property is not their primary residence) under a DSOA on 29 October 2024 will potentially be subject to capital gains tax whereas someone who does so on 30 October 2024 will not.

Nevertheless, the UK Government has a long-standing policy against changing tax legislation with retrospective effect. Such policy is laudable, in that it enables UK taxpayers to conduct their affairs with some degree of certainty, knowing at least that a transaction done today will not be subjected to a completely unforeseeable tax effect in the future. And for property investors who have accrued tax losses under capital gains tax on refinancing DSOAs in the past, a retrospective application of the rules may have created a disadvantage. Making the refinancing DSOA rules prospective in their application retains certainty as to the tax regime around DSOAs. However, all this will be cold comfort for any UK taxpayers currently facing capital gains tax charges on previous refinancings of DSOAs. It will be interesting to see what approach HMRC takes to UK taxpayers in that position going forward from 30 October 2024.

ATED

The ATED rules give us another example of unintended consequences in the context of a taxing regime based on changes in ownership of real estate. Stamp duty land tax (or SDLT) is a transaction tax levied on the transfer of ownership interests in UK real estate. It applies to both residential and commercial properties.

There is debate about whether such taxes represent good policy – in particular given that SDLT rates increase with property prices – the additional cost of funding SDLT charges can make it harder for people living in areas with depressed economic opportunities (where property prices tend to be lower) to acquire accommodation in areas of greater economic opportunity (where property prices are typically higher). On the other hand, there is evidence that the increases in SDLT after 2010 have had some effect in reducing property prices – albeit not by anywhere near enough to significantly improve affordability for younger and first time buyers (at least in the more expensive parts of the UK). 

However, SDLT does not apply to transfers of shares and  the stamp duty rate applicable to share sales is significantly lower than the rates of SDLT applicable to property sales. To take advantage of this, some owners of residential property had taken to moving ownership of their properties into a company and then selling the shares in the company, rather than the property itself. The new owner of the company would then be able to reside in or use the property. But crucially, no SDLT would be charged on the transfer of the shares in the property-owning company (and the stamp duty payable on the value of the shares sold would be lower than the SDLT charge for selling property of the equivalent value).

The UK government introduced the ATED rules to disincentivise property owners from using this scheme. Unfortunately, DSOA providers are themselves companies. Given that they pay (or require their customer to pay) SDLT on each initial purchase of a property, there was no policy reason to capture DSOA providers within the ATED net (i.e. the government was not suffering a loss of revenue due to DSOA providers being the owners of residential properties). And the ATED rules could be read as not applying to properties held by DSOA providers. However, the original drafting of the ATED rules did not expressly disapply the ATED charge to residential properties held by DSOA providers. Ironically, DSOA providers do not need to worry about situations where their customers are company owners of residential properties, as in that case it is clear that the ATED charge will accrue to the customer of the DSOA provider.

The legislation introduced by the October 2024 Budget expands the existing DSOA provisions to clarify that DSOA providers are not within the ATED charge irrespective of whether their customer is a company or an individual. The legislation also makes certain consequential changes to ensure that the same treatment is applied in respect of properties located in Wales. This tax treatment will apply from 30 October 2024, such that DSOA providers will be outside the scope of ATED in respect of existing qualifying arrangements from that date, irrespective of whether those existing DSOAs arrangements were otherwise exempt or the DSOA provider was entitled to claim relief under the general rules.

Conclusion