Leading the trend

Author: | Published: 18 Mar 2015
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Luxembourg was quick off the mark in welcoming Islamic finance into its framework. Jad Nader of NautaDutilh Avocats tracks its continued growth

Luxembourg offers a quality label for the marketing of financial products all around the world, and a gateway to the European market. In the last couple of years, we have witnessed the consolidation of Islamic finance in Luxembourg: many initiatives have materialised and paved the way to a steadily growing industry, which is in turn opening up a wide range of services. In 2014, the issuance of the sovereign sukuk by Luxembourg marked a milestone in the development of the Islamic finance industry in the country, while 2015 is expected to witness the launch of the first Islamic bank.

The development of Islamic finance in Luxembourg

Initiatives geared towards developing Islamic finance in Luxembourg started shortly after the birth of modern day Islamic finance. Luxembourg boasts a number of firsts in this field: Islamic finance first appeared in the Grand-Duchy in 1978 with the first Islamic finance institution to set up in a western country, followed by the first Shariah-compliant insurance company in Europe in 1983 and, in 2002, Luxembourg was the first European stock exchange to list a sukuk. The focus on Islamic finance was put on fast track during the financial crisis in 2008. The country rapidly entered a virtuous circle where the interlinked processes of developing business, developing knowledge and adapting new measures contributed to create what is now praised as a major European hub for Islamic finance. Luxembourg's private sector managed to gather, within a short timeframe, significant experience in the set-up and management of Sharia-compliant structures. Initiatives by the public sector to put Luxembourg on the international map of Islamic finance were numerous. Memoranda of understanding and double tax treaties were signed with a number of regulatory authorities and governments in Muslim countries, and specific regulations aimed at adapting the Luxembourg legal framework to Islamic finance were adopted. In 2009, the Luxembourg Central Bank was the first European entity to become an associate member of the Islamic Financial Services Board, and in 2010, Luxembourg became a founding member of the International Islamic Liquidity Management Corporation. The flexibility of policymakers, government support and a favourable regulatory environment encouraged Islamic finance professionals to set up operations in Luxembourg. Sukuk issuance by the Luxembourg State, the first sovereign issuer of sukuk in the eurozone, made headlines in September 2014, while in the same year Luxembourg was believed to be the largest non-Muslim state for the domiciliation of investment funds.

A favourable legal framework

The flexibility of Luxembourg structured finance tools together with the support and sponsoring of its authorities, have attracted Islamic finance professionals from the Middle East, North Africa, and Asia. Luxembourg boasts a broad investment treaty network with over 70 countries, including Azerbaijan, Bahrain, India, Indonesia, Kuwait, Malaysia, Morocco, Qatar, Saudi Arabia, Tajikistan, Tunisia, Turkey, the United Arab Emirates, and Uzbekistan (additional treaties are under negotiation with Brunei, Egypt, Kuwait, Lebanon, Oman, and Pakistan). The longstanding investment fund industry has played a key role in building bridges with the Islamic world, and all forms of Luxembourg funds may be adapted to the requirements of the Sharia. Luxembourg investment funds are used by Middle Eastern and Asian promoters for a wide range of investments including transferable securities, real estate, tangible assets, and microfinance. In addition to fund structures, the scope of the Securitisation Act of March 22 2004 has made it possible for practitioners to include various classes of assets, such as equity investments, commodities, receivables, whole businesses and even real estate. It is worth noting that Luxembourg securitisation undertakings have been used in several murabaha or ijara structures. Moreover, Luxembourg securitisation undertakings may be financed through the issuance of sukuk. When the securitisation undertaking is structured in compartments, it may issue several classes of sukuk, each representing a separate compartment.

"The longstanding investment fund industry has played a key role in building bridges with the Islamic world"

To add weight to its standard legal, tax and regulatory arguments, Luxembourg has had to address the concerns of Islamic finance professionals. The tax and regulatory authorities have adopted a number of initiatives aimed at providing an adapted and enhanced legal and tax framework for Islamic finance to thrive. In 2011, the Commission de Surveillance du Secteur Financier (CSSF), published a statement on Islamic debt securities that confirmed that sukuk can qualify as asset-backed securities (based on the provisions of article 2(5) of the EU Prospectus Regulation (809/2004/EC) or, under certain conditions, as guaranteed debt securities based on the provisions of article 23(2) and annex vi of the regulation). The Luxembourg inland revenue (Administration des Contributions Directes) issued a circular providing guidelines on certain aspects of direct taxes applicable to murabaha and sukuk on January 12 2010. The circular allowed the same amortisation treatment to apply to murabaha as the one generally applicable to interest on financings. It also clarified the treatment of sukuk as debt instruments for tax purposes, resulting in sukuk revenue being seen as simple interest, thus benefiting from the favourable Luxembourg regime of deduction at the level of the issuer and of exemption from Luxembourg withholding tax. Shortly after, on June 17 2010, the Luxembourg indirect tax authority (Administration de l'Enregistrement et des Domaines) issued a circular on certain aspects of the indirect tax treatment (VAT) of murabaha and ijara agreements and registration duties (applicable to real estate transfers); it allowed for provisions on certain VAT exemptions and a reduced rate for registration duties to apply to murabaha and ijara structures under certain circumstances. In May 2011, the CSSF published a note in which it concluded that no specific legislation was required for Shariah-compliant investment funds, since Luxembourg's existing legal framework contained no obstacles to it.

Sharia-compliant investment funds

The Luxembourg investment funds framework is well-suited to Islamic finance.

On the one hand, the investment funds framework includes the Luxembourg retail investment funds governed by the Luxembourg Act of December 17 2010 on undertakings for collective investment. This covers the undertakings for collective investment in transferable securities, the flagship of investment funds (Part I of the law), together with the Part II undertakings for collective investment (more flexible, as it relates to the type of assets). Funds set up under one of these two forms benefit from a European passport automatically for Part I funds, and subject to certain conditions for Part II funds, and may be marketed throughout the European Union and in many other countries, in particular in the Middle East and Asia.

On the other hand, separate legislation addresses two other forms of non-Ucits (undertakings for collective investment in transferable securities) funds. First, the specialised investment fund (fonds d'investissement spécialisé – SIF), a very flexible vehicle introduced by the Luxembourg Act of February 13 2007, which may be used for a wide range of investment strategies (a significant number of real estate funds have been set up by managers and promoters from the Middle East in accordance with this law), but is reserved for qualified investors. Second, the private equity and venture capital vehicle (société d'investissement en capital à risque – SICAR introduced by the Luxembourg Act of June 15 2004). In 2012, the Association of the Luxembourg Fund Industry (ALFI) published a collection of best practice and conduct rules for setting up and servicing Islamic investment funds. Although non-binding, the guidelines provide comfort on the legal situation, set-up documentation, and fund administration of Sharia-compliant investment structures. It sheds light on the interplay between local legislation and the principles of Sharia, and refers to the freedom of contract as a main rule.

"2014 has been an active year for the sukuk market in Luxembourg"

The main challenges that the investment fund industry in Luxembourg faces when it comes to servicing clients in Asia and the MENA (Middle East and North Africa) region lie perhaps in the competition with non-EU funds. Costs may be viewed as a major concern, and the entry into force of the alternative investment fund managers legislation adding more requirements and complexity to the process could be a hindrance. It nevertheless creates opportunities in terms of marketing. On the one hand, the full implementation of the Alternative Investment Fund Managers Directive (AIFMD) has provided non-Ucits funds with a passport for sale to professional and well-informed investors in the EU, and on the other hand, Luxembourg funds continue to be viewed by asset managers in the Middle East and Asia as a quality label and a guarantee of a stable legal and economic framework with high quality service.

The listing of sukuk in Luxembourg

The Luxembourg Stock Exchange (LuxSE) is a leading exchange for the listing of international securities. In 2013, the Luxembourg Stock Exchange had 40,000 listed securities coming from 3000 issuers in more than 100 jurisdictions. The Luxembourg Stock Exchange operates both a regulated market called the Bourse de Luxembourg and an exchange-regulated market (in the form of a multilateral trading facility) called the Euro MTF. The LuxSE has succeeded in opening largely to diversified issuers and diversified types of securities (such as CoCo bonds, dim sum bonds, indexed bonds and tier one issues). The listing of bonds on the LuxSE has become a preferred choice for issuers from non-EU countries, including the Middle East and Asia. The latest bond issued by an entity from the Middle East was in November 2014, a $1 billion five-year bond, issued by Emirates NBD PJSC.

Issuers whose debts securities are admitted to trading on the regulated market must abide by the provisions of: the Luxembourg Act of July 10 2005 on prospectuses for securities as amended; the Luxembourg Act of January 11 2008 on transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market (for issuers whose home member state is Luxembourg) as amended; and, the Luxembourg Act of May 9 2006 on market abuse as amended. However, issuers whose debt securities are admitted to trading on the Euro MTF are, save for a few exceptions, only subject to the rules and regulations of the LuxSE.

Some of the features of sukuk may be similar to bonds issued by a securitisation entity. However, sukuk may only be based on tangible assets, they may not bear interest, and they generally represent a right of co-ownership in the underlying assets. Luxembourg has been a primary location for the issuers of sukuk since the beginning of such market. Around 18 sukuk are listed on the LuxSE, and admitted to trading either on the Euro MTF or on the regulated market.

"Luxembourg has an established track record in catering to the needs of high net worth individuals"

2014 has been an active year for the sukuk market in Luxembourg. On July 12 2014, Luxembourg approved a law allowing the transfer of assets owned by the Luxembourg State in the framework of the structuring of a sukuk transaction. Such approval paved the way for Luxembourg to successfully issue its landmark €200 million ($233 million) five-year sukuk at the end of September 2014. The Luxembourg sovereign sukuk is based on three buildings owned by the Luxembourg State, which have been transferred to a special purpose entity (the issuing vehicle) owned by the Luxembourg State. It offers an annual fixed income of 0.436% for investors with a promise of buy-back of the issued sukuk after five years. The sukuk is listed and admitted to trading on the Euro MTF market of the LuxSE. By issuing this sukuk, Luxembourg has become the first European Economic and Monetary Union sovereign to issue in the sukuk format. Also, in September 2014, Goldman Sachs listed and admitted to trading on the LuxSE a $500 million five-year debut sukuk, based on Sharia-compliant commodities, structured in the form of sukuk al-wakala whereby funds are intrusted to an agent (wakeel), together with a $500 million five-year sukuk by the Republic of South Africa. More recently, in December 2014, the LuxSE listed and admitted to trading on the Euro MTF market a $1 billion five-year sovereign sukuk in the form of an ijara or leasing sukuk, from the Islamic Republic of Pakistan.

A long-awaited innovation

The first Islamic bank in Luxembourg is expected to be launched in the course of 2015, according to the initiators of the project. The ambitious project aims at establishing the first fully-fledged Islamic bank, headquartered in the eurozone. According to the same source, the bank will be held by private investors from Gulf Cooperation Council countries, including a royal family from the United Arab Emirates. It would offer retail, corporate and private banking services. This would be a milestone in the development of Islamic finance in Luxembourg. The setting up of Sharia-compliant banks requires the scanning of the whole business and the implementation of a model that avoids prohibited activities (haram) in the whole chain of services and internal processes. One of the major challenges lies in the capital requirements and liquidity coverage ratio resulting from the full entry into force of the capital requirements regulation and directive (CRR and CRD) IV package. In order to maintain an acceptable ratio of capital adequacy, banks are required to maintain reserves of liquid assets in their portfolios. Sharia-compliant liquid assets remain scarce on the market, and the challenge for any Islamic bank, in Luxembourg and in Europe (and in any jurisdiction where the Basel III principles apply), will be to meet the prudential requirements with little offer of Sharia-compliant liquid assets worldwide.

Sharia-compliant wealth management

As one of the largest wealth management centres in Europe, Luxembourg has an established track record in catering to the needs of high net worth individuals. Various tools are traditionally used for wealth planning in Luxembourg, including: the private wealth management company (société de gestion de patrimoine familial) with its favourable tax regime; specialised investment funds, which allow global investors a single umbrella solution that invests in a number of diverse asset classes; and, more recently, the institution of the family office as a category of financial sector professionals, established in the Luxembourg Act of December 21 2012, offers a practical and popular solution. Professionals have managed to adapt these tools to serve Muslim clients and provide long-term robust solutions in line with religious considerations. In July 2013, a draft law on private wealth foundations (fondation patrimoniale) was submitted to the parliament. It is likely that the private wealth foundation will be an additional tool for wealth management professionals, who will be looking to adapt such foundations in order to achieve tailor-made Sharia-compliant solutions similar to trusts in common law countries.

The growing trend


Jad Nader PhD
NautaDutilh Avocats Luxembourg S.à r.l.

2, rue Jean Bertholet
L-1233 Luxembourg
T: +352 26 12 29 63
W: www.nautadutilh.com

As the Islamic finance industry moves from niche to mass, professionals around the globe are conscious of the potential of a sector that remains underdeveloped in Europe, and particularly in the eurozone. There seems to be a discernible mood in favour of following this trend in Luxembourg and further developing the local Islamic finance industry. Several events are keenly awaited this year: the move towards onshore Islamic banking, with the first Islamic bank to be launched early in the year (which may also serve as a model for Islamic banks wishing to expand their activity in Europe); the consolidation of new practices in small scale financings initiated in 2014 by local banks in compliance with Islamic finance models (such as murabaha on local real estate structured by a Luxembourg private bank); the licensing of an Islamic insurance company (most insurance companies established in Luxembourg specialise in cross-border distribution, and the offer of takaful remains rare and mainly targets Malaysia or the Gulf Cooperation Council countries); and, the strengthening of the Islamic fund industry to take full advantage of the potential created by the AIFMD.