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Promoting Islamic bonds in Japan

Yoichi Maekawa

The term Islamic banking refers to banking transactions that are made in compliance with the religious principles of Islam. For instance, Islam prohibits the imposition of interest obligations, and this raises unique issues with respect to lending arrangements and the issuance of debt instruments. In Japan, conventional bonds issued in accordance with the Companies Act generally provide the bondholder the right to receive interest payments on the amount invested or paid for the bond and, as such, do not comply with Islamic tenets.

Recently, the Act on the Securitisation of Assets and relevant tax laws were amended to facilitate the use of certain securitisation techniques that allow for the issuance of bonds in accordance with Islamic law (so-called Islamic bonds). Although parties have been able to issue Islamic bonds in Japan for quite some time, such financial instruments have remained largely unused in the Japanese financial markets. This lack of interest in was likely a result of overly burdensome regulations and the negative tax treatment of such instruments. In order to encourage the use of Islamic bonds in the Japanese market concurrent amendments to the Securitisation Act and relevant tax laws came into force on November 24 2011. The Act was amended to ease regulations with respect to such securitisation schemes and the relevant tax laws were amended to neutralise the tax treatment of Islamic bonds created by the way of a so-called bond-wise beneficial right (shasai-teki juekiken) structure as defined under the amended Securitisation Act.

The amendments adopt the existing specific purpose trust (tokutei mokuteki shintaku) as a vehicle for the issuance of Islamic bonds. An offeror wishing to issue Islamic bonds – bond-wise beneficial rights as defined under the amended Securitisation Act – must first transfer the subject assets in trust to a specific purpose trust. In return the offeror will receive beneficial rights to the specific purpose trust that are designed to receive predetermined amounts at predetermined times as a distribution. This beneficial right is referred to as a bond-wise beneficial right. The predetermined distributions from the trust to which the holders of these rights are entitled operate in a manner similar to the interest payments that conventional bondholders receive.

In order to promote the use of Specific Purpose Trusts to issue Islamic bonds the following amendments to the Securitisation Act were made: (i) eliminating the requirement that any bond-wise beneficial right issued must be accompanied by the issuance of another form of beneficial right; (ii) adding requirements that the terms of such bond-wise beneficial rights must clearly state the maturity date of such right and that bond-wise beneficial right holders have no right to vote at a beneficial certificate-holders meeting (kenrisha shukai) (the purpose of this amendment is to bring bond-wise beneficial rights in line with the rights of conventional bondholders); (iii) adding a requirement that where an underlying trust agreement includes provisions with respect to the repurchase of the trust assets, the offeror must provide timely notice of any material adverse change to its financial status to the trustee of the special purpose trust (the purpose of this amendment is to protect the bond-wise beneficial right holders); and (iv) permitting floating distributions to bond-wise beneficial right holders.

In conjunction with these amendments to the Securitisation Act, relevant tax laws were amended to neutralise the tax treatment between conventional bonds and bond-wise beneficial rights under the amended Act. Some of the key amendments to Japanese tax laws included: (i) an exemption from withholding tax on bond-wise beneficial right distributions to financial institutions; (ii) an exemption from withholding tax on bond-wise beneficial right distributions to non-residents and foreign entities; (iii) an exemption from capital gains tax on bond-wise beneficial right distributions to foreign entities; (iv) exempting bond-wise beneficial rights from the deduction clause under Japanese tax laws that requires more than half of issued securities be issued in the Japanese market; and (v) exempting offerors from the registration licence tax and real estate acquisition tax at the time of the dissolution of the special purpose trust and subsequent repurchase of the special purpose trust assets.

In addition to the above, as part of the efforts to encourage the issuance and distribution of Islamic bonds in Japanese financial markets the Japan Securities Depository Centre announced that it has commenced a feasibility study of bond-wise beneficial rights under its Book-Entry Transfer System for Corporate Bonds. The Centre presented an implementation guideline for bond-wise beneficial rights and is scheduled to amend the relevant rules this spring to include bond-wise beneficial rights as a tradable financial product in the Book-Entry Transfer System for Corporate Bonds. It is hoped that these various efforts on the part of Japanese regulators will attract investment and financing from Muslim states and investors.

Yoichi Maekawa

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