Time for the Heavy Roller? Or has the Budget finally levelled the playing field for UK Islamic Finance

Tax and asset transfer

Most sharia-compliant financings involve some element of a transfer of assets, rather than a loan and security. The UK has a number of taxes that typically arise on the transfer of an asset, such as stamp duty, Stamp Duty Land Tax (SDLT) (and its equivalents in Scotland and Wales), VAT and capital gains tax (CGT). There is also the Annual Tax Enveloped Dwelling charge (ATED), which applies where a UK residential property is held by a legal entity, such as a limited company. The ATED charge was originally designed to catch SDLT transactions (for example, where a property was held by a limited company and shares in the company were sold, rather than the property itself) thus avoiding potentially large amounts of SDLT. 

The trigger for paying these taxes is usually the transfer of the asset in question (except for ATED, which is an annual charge). Where the transaction is a loan (and a corresponding mortgage over the property) there is no transfer of the asset (ignoring the initial purchase by the customer). The borrower can refinance any number of times during the lifetime of owning that property and no new tax charges will be triggered. 

By contrast, the principal form of sharia-compliant home purchase financing that the UK tax regime recognises is the “diminishing shared ownership arrangement” (DSOA). These involve the financier purchasing a home, holding it on trust for themselves and their customer and granting a lease or other right to occupy the home to the customer. The customer then pays rent and separately purchases the home from the financier (either in instalments or at the term of the financing). This means that additional taxes can be triggered twice – upon the initial sale of the property to the financier and again upon the transfer back to the customer. If the underlying financing is itself financed (say through a securitisation), these taxes might in principle also arise on a transfer from the financier (and again when the funder of the financier is repaid). 

Although economically a DSOA may mirror the economics of a secured loan, if additional taxes are payable that would not be payable under a secured loan transaction this can distort the market and might prejudice the ability to arrange sharia-compliant financings.

The existing exemptions

The alternative finance arrangements provisions of the UK tax code have sought to level the playing field for sharia-compliant financings. To return to the cricket analogy, both the sharia-compliant and conventional home finance products should face deliveries that bounce and turn the same. Unfortunately, those various reforms have not always succeeded. 

Two tax charges that have created particular concern for the sharia-compliant finance industry have been the application of CGT to refinancings of buy-to-let properties and the possibility of the ATED rules causing sharia-compliant financiers to become liable for ATED on properties they are financing for (ironically) individuals (because the financier itself is a company and takes title to the property). 

The recent Budget seeks to eliminate these inconsistencies – but has it? 

Capital Gains Tax

The Budget introduces the concept of a “refinancing DSOA” which broadly mirrors the existing legislative DSOA concept, but also includes circumstances where a customer already holds a beneficial interest in a home and disposes of some or all of the home to a financier. It also caters for circumstances in which a financier assigns or transfers its interest in an existing DSOA or a refinancing DSOA to another financier.  

The concern being addressed is that, where a property has risen in value since its original acquisition, a homeowner would generally be able to remortgage that property with conventional financing, even if the amount borrowed exceeds the original cost of the property. Such refinancing would not give rise to a capital gains tax charge (even if the home in question was not the homeowner’s principal residence), as the homeowner has not disposed of the property. Under typical sharia-compliant structures, prior to introduction of this legislation, unless the property in question was the homeowner’s principal residence. this fact-pattern would put the homeowner at risk of a capital gains tax charge on the uplift in value realised from the refinancing.

As the legislation now provides that the “disposal” by the homeowner in these circumstances is not to be treated as giving rise to a capital gain, the risk of such charge arising is now removed. There are similar reliefs in the legislation for transfers of the property back to the homeowner by the financier or from one financier to another financier. 

These are welcome changes in addressing a known, industry-wide issue and seeks to put alternative finance and conventional finance of buy to let properties on an equal footing from a tax perspective. 

ATED

The existing ATED rules have not historically contained provisions that specifically exempt financiers in connection with qualifying alternative finance provided to customers that are individuals; in these circumstances the general tax rules have to be considered to determine the ATED treatment. Whilst these rules normally ensured that a DSOA transaction with an individual customer would not give rise to an ATED charge (even though title to the property would now be held by a non-individual financier), it is helpful for the position to be put beyond doubt.

The draft legislation expands the existing alternative finance provisions to clarify that alternative finance 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. 

Timing

The Budget proposals remain to be enacted in the Finance Act, but it is not anticipated that there will be any material changes to the draft rules and past practice suggests that taxpayers would be largely able to rely on the draft legislation in the interim. Whilst the proposed tax treatment applicable to DSOAs will only apply on or after 30 October 2024 (i.e. it will not apply retrospectively to refinancing arrangements entered into prior to Budget Day in 2024) the proposed changes in respect of ATED will apply in respect of existing qualifying arrangements from that date, irrespective of whether those existing arrangements were otherwise exempt or the financer was entitled to claim relief under the general rules.

A level playing field

The effect of these revisions to the alternative finance arrangement rules should be that refinancing of sharia-compliant home purchase financings of buy to let properties should no longer be at risk of attracting a capital gains charge. Further, sharia-compliant financiers will no longer be at risk of being subject to ATED charges. Whilst the UK tax regime has for many years been favourable to sharia-compliant financing in terms of aiming to treat them in the same way as conventional financings, these changes remove some of the remaining difficulties in achieving that consistent level playing field with conventional home mortgage financing.