The UK tax treatment of Islamic finance "borrowing" costs

Islamic finance does not involve the lending and borrowing of money, or the charging of interest. Instead, Islamic banks and their customers engage in more complex transactions which have essentially the same economic effect as lending and borrowing money.

Countries whose tax systems take primarily an economic analysis approach to assessing income have relatively little problem accommodating Islamic finance. Their tax authorities look at the economic consequences of the transactions undertaken and apply their tax laws accordingly. For example, the economic cost suffered by someone receiving funding using Islamic finance is treated by such jurisdictions as an interest expense, even though the legal transactions undertaken do not involve the payment of interest.

Conversely, countries whose tax systems take primarily a legal analysis approach to assessing income have great difficulty accommodating Islamic finance. The legal contracts used in Islamic finance often generate peculiar results in such tax systems unless specific tax legislation is enacted to accommodate Islamic finance. The UK is such a country.

Against this background, I recently received an interesting email enquiry from a reader.

Over the last 10 or 20 years, far more people in the UK have become landlords of residential property, often referred to as “buy to let.” Typically, they will buy a house or flat, partly financed by a mortgage, and rent out that property to residential tenants. The interest paid is deductible against the rental income received, with the net amount of rent being subject to income tax.

Several years ago, in the budget of 2015, the Chancellor of the Exchequer George Osborne announced that higher rate tax relief for interest expense on buy to let loans would be eliminated. It is being phased out over several years, and from 6 April 2020 such interest expense will only be deductible at the basic tax rate, with no higher rate tax relief.

This means a significant increase in the tax burden suffered by landlords who have anything more than a trivial amount of rental income, since at present (tax year 2018-2019) the higher rate of tax is payable once your income minus personal allowances exceeds £34,500.

Islamic banks of course do not make buy to let loans. However, they do provide equivalent finance in the form of home purchase plans using a structure called diminishing musharaka (in Arabic), which is covered by a special provision in UK tax law known as diminishing shared ownership. Instead of interest, the person who buys a property with the aid of diminishing shared ownership pays rent to the bank on that part of the property which is owned by the bank.

In his email, my reader expressed the hope that since the expense paid to the bank is rent rather than interest, it would not be subject to the restrictions legislated by Parliament in accordance with George Osborne’s 2015 Budget announcement. Instead he hoped it would be treated as rent paid and deducted from the rent received before subjecting the net rent to taxation.

Without accepting legal responsibility for my answer, I gave the reader the bad news that in my view the rent paid would be treated like interest expense, with relief at only basic rate tax. (Each page of my website also contains a disclaimer of any legal responsibility.)

I used this correspondence as the basis for my 4 July 2018 article in the magazine Islamic Finance News. You can read it below.

The tax system gives, and the tax system takes away

Tax law is, of course, country-specific. Nevertheless, an aspect of UK tax law that a reader recently asked me about brings out some points of general interest.

Diminishing musharaka is an Islamic finance structure commonly used by banks to finance the purchase of real estate by their customers. Very briefly, the customer and the bank purchase a property together. The customer has occupancy rights over the entire property, and therefore must pay rent to the bank on the bank’s share of the property. Over time, the customer will buy out the banks share, normally at a predetermined price.

While the economics of the transaction will depend on the precise contractual terms, normally the contract is structured so that the rent payable to the bank is set by reference to market interest rates, rather than by reference to property rental yields. The reason is that the bank typically wishes to avoid the economic risks associated with property ownership and uses the contractual terms to pass these risks to the customer. Consequently, the bank’s return from the transaction will be purely a financing return, equivalent to a conventional property mortgage loan.

Countries vary in the extent to which their tax rules give priority to the economic aspects of a transaction or to the contractual legal form. Historically, the UK has been at the legalistic end of the spectrum, which is the reason so much specific tax law has been required in the UK to enable Islamic finance transactions to take place without adverse tax costs.

Since 2006, the UK has had specific tax legislation for diminishing musharaka transactions, which in UK tax law are referred to as “diminishing shared ownership.” Provided the requirements stipulated in the legislation are met, the rent paid by the customer to the bank is treated for all tax purposes as if it were interest on a loan equivalent to the bank’s investment in the property.

UK tax law is not saying that the customer’s payment to the bank is interest; that would be very hurtful to Muslims who have specifically structured a transaction that involves paying the rent, because they regarded the payment of interest as religiously impermissible. However, what the tax law is saying is that, for all tax purposes, the rental payment will be treated as if it were a payment of interest.

Treatment as interest for tax purposes is normally desirable. As an illustration, consider the situation when the bank is outside the UK. Rent on UK land paid to a foreigner is subject to withholding tax. However, due to double tax treaties, interest paid by a UK person to overseas banks is in most cases not subject to withholding tax.

However, the UK recently introduced restrictions on the ability of individuals to deduct interest expense on real estate rented to individual tenants who live there; colloquially called “buy to let” property. My reader was hopeful that where diminishing musharaka has been used to acquire the buy to let property, his interest expense would continue to be deductible on the grounds that his payment to the bank was not actually interest but rent.

While I do not give tax advice to readers, I shared with him my expectation that the buy to let rules would restrict a deduction for his rent paid to the bank since UK tax law specifies that for all tax purposes, the rental payment is treated as a payment of interest. Sometimes you win, and sometimes you lose!