Sukuk are a form of Sharia compliant financial product, which broadly replicate the financial profile of a bond, but without the payment or receipt of interest, which is forbidden under Sharia law. Sukuk may be structured in a number of different ways and often involve complex structures and multiple transfers of underlying assets.
Sakk example structure
As shown in the above diagram, the typical structure of a sakk would entail two arrangements: a “bond arrangement” and an “investment arrangement” involving three parties, namely the “bond-holders”, “bond-issuer” and the “originator”. Under such a structure, the bond-issuer is typically a special purpose vehicle formed by the originator for issuing bonds to the initial bond-holders.
At the beginning of the term of the sakk, the originator would typically sell an underlying asset to the bond-issuer. Based on the security and investment returns to be generated from the underlying asset, the bond-issuer would issue bonds to the bond-holders (these bonds are described as alternative bonds in the diagram above as their entitlement and rights are legally different from those of a conventional bond).
The proceeds of these alternative bonds are to be used by the bond-issuer to acquire the underlying asset from the originator. The bond-issuer would hold the underlying asset on trust for the bond-holders, and the alternative bonds would denote the beneficial interest in the underlying asset that the initial bond-holders have acquired.
At the end of the sakk, typically the bond-issuer would sell the underlying asset back to the originator and the sale proceeds would then be used by the bond-issuer to redeem the alternative bonds from the initial or subsequent bond-holders.
While the economic substance of sukuk are broadly equivalent to bonds, their legal form is typically more complicated and may involve a number of separate contractual agreements and transactions. This may give rise to unintended tax consequences which are significantly different to those of a conventional bond.
For example, in the sakk summarized above, stamp duty may be levied on the transfer of the asset to the originator, the bond-issuer may not obtain a deduction for the payments to the bond-holders (even where they are equivalent to interest payments on a conventional bond) and the bond-holders may not be entitled to beneficial tax treatment in respect of income from the alternative bonds such as that afforded to Qualifying Debt Instruments. The Bill seeks to reduce the difference between the taxation of sukuk arrangements and conventional bonds.
Proposed tax legislation for sukuk
A sakk arrangement described above is referred to as an alternative bond scheme (“ABS”) in the Bill. However, in order to qualify for the special tax treatment under the Bill, the investment arrangement of a sakk has to be one of the following types:
- Lease arrangements (“Ijarah”): where a bond-issuer enters into a lease in respect of an acquired asset with an originator to generate an investment return
- Profit sharing arrangements (“Musharakah” and “Mudarabah”): where a bond-issuer enters into a business undertaking with an originator to carry on business activities to generate an investment return
- Purchase and sale arrangements (“Murabahah”): where a bond-issuer sells an acquired asset to an originator with a markup to generate an investment return
- Agency arrangements (“Wakalah”): where a bond-issuer appoints an originator as its agent to manage an acquired asset to generate an investment return
An ABS with one of the above investment structures is referred to in the Bill as a specified ABS. Should it be necessary to cover ABS with other types of investment structure , the Bill contains a clause empowering the Financial Secretary to do so by way of subsidiary legislation.
Proposed tax and stamp duty treatment
The Bill will add new parts to the Inland Revenue Ordinance (“IRO”) and Stamp Duty Ordinance (“SDO”) which if applicable to the specified ABS, will treat the bond arrangement and investment arrangement as debt arrangements for the purposes of the IRO and SDO, and apply comparable tax treatments accordingly. The primary changes are summarized below:
Treatment of bond arrangements
Proceeds paid by bond-holders to bond-issuers for the initial issuance of the specified ABS will be regarded as money borrowed by the bond-issuer. Coupon payments payable by the bond-issuer will be regarded as interest payable on such money borrowed and will be accorded the same deductibility under section 16(2)(f) of the IRO that applies to interest payable on conventional bonds.
The bond-holders will not be regarded as having any legal or beneficial interest in the asset under the specified ABS and the bond-issuer shall not be regarded as being the trustee in respect of the asset.
Treatment of investment arrangements
The acquisition cost of the assets paid by the bond-issuer to the originator will be regarded as money borrowed by the originator from the bond-issuer. The investment return payable to the bond-issuer is to be regarded as interest payable on the money borrowed and the bond-issuer will treat the same as interest receivable. The bond-issuer will not be regarded as having any legal or beneficial interest in the specified asset under the specified ABS.
The sale and purchase transactions that take place between the bond-issuer and the originator will be disregarded for profits tax purposes; accordingly any depreciation allowances associated with the asset will continue to belong to the originator, as will any income or loss arising from the asset. Any balancing charge or allowance on disposal that might have otherwise arisen, will not arise.
Instruments executed to effect the transfer of the assets as part of an investment arrangement will also be exempt from stamp duty under the SDO, although security must be posted with the Collector of Stamp Revenue (“CSR”) sufficient to cover a stamp duty liability should the exemption not apply or be disapplied at a future date.
In order for a specified ABS to qualify for the above tax treatment the bond arrangement and the investment arrangement must be a “qualified bond arrangement” and “qualified investment arrangement” respectively, meeting the below specified qualifying conditions.
It should be noted that the existence of a qualified investment arrangement is dependent on the existence of a qualified bond arrangement. If the qualifying conditions are not met at any time, a disqualifying event will occur, which will cause the bond arrangement, investment arrangement, or both to be treated as if they had never qualified.
Bond arrangement qualifying conditions
- “Reasonable commercial return” condition: both the maximum total amount of the bond return that may be payable to the bond-holders under the terms of a specified ABS, and the total amount actually paid to the bond-holders, must not exceed an amount that would be a reasonable commercial return on money borrowed of the amount of the bond proceeds
- “Bond arrangement as financial liability” condition: the bond arrangement in a specified ABS must be treated as a financial liability of the bond-issuer in accordance with either the Hong Kong Financial Reporting Standards or International Financial Reporting Standards
- “Hong Kong connection” condition: the alternative bonds must be listed on a stock exchange in Hong Kong, or issued in good faith and in the course of carrying on business in Hong Kong, or marketed in Hong Kong, or lodged with and cleared by the Central Moneymarkets Unit operated by the Monetary Authority
- “Maximum term length” condition: the term of a specified ABS must not be longer than 15 years “Arrangements performed according to terms” condition: the specified ABS must be performed according to the features and characteristics as prescribed in the Bill
Investment arrangement qualifying conditions
- “Bond-issuer as conduit” condition: under the terms of a specified ABS, the maximum total amount of the investment return that may be receivable by the bond-issuer must not exceed the maximum total amount of the bond return payable to the bond-holders. And the total amount of the investment return actually received by the bond-issuer must not exceed the total amount of the bond return actually paid to bond-holders
- “Investment arrangement as financial liability” condition: the investment arrangement in the specified ABS must be treated as a financial liability of the originator in accordance with either the Hong Kong Financial Reporting Standards or International Financial Reporting Standards
- The qualifying conditions have been designed to ensure that specified ABS are economically equivalent to conventional bonds, although as discussed below they do not cater for all profiles of bonds and their application in practice may give rise to some uncertainty until further guidance is published and transactions are undertaken within the new regime
The qualifying conditions have been designed to ensure that specified ABS are economically equivalent to conventional bonds, although as discussed below they do not cater for all profiles of bonds and their application in practice may give rise to some uncertainty until further guidance is published and transactions are undertaken within the new regime.