Islamic finance in the Grand Duchy of Luxembourg

The Grand Duchy of Luxembourg (hereafter Luxembourg) is well known as a financial centre with a strong culture of investor protection and a multilingual and multicultural workforce. It has become the second largest fund centre in the world after the United States of America.¹

In the past four decades, in its endeavours to cater to various types of market participants with different backgrounds, Luxembourg has undertaken several initiatives to also play a major role in Islamic finance.

In this respect, the question arises as to what exactly is to be understood by Islamic finance and Islamic-compliant financial instruments and how these can be structured.

Contrary to common belief, Islamic financial instruments are available to the general public and are not restricted to investments made only by Muslims. These instruments are considered as an alternative to conventional financial products and are increasingly regarded as a form of socially responsible and ethical investments.

Although a simplification to some extent, it is fair to say that Islamic finance mainly represents financial instruments which are structured in accordance with Shariah principles, (the sources of which are mainly the Koran and the Sunna), meeting the consensus of jurists as interpreters of Islamic law. Shariah is the body of Islamic religious law within which the public and private aspects of life are regulated for those living in a legal system based on Islamic principles.

The key principles of Islamic finance are:²

• Prohibition on the payment of interest (riba);
• Risk and profit must be shared equally between parties to a transaction;

• Speculation (maysir) and uncertainty (gharar) in transactions are strictly prohibited;
• Certain kinds of activities are prohibited (haram) – products deemed incompatible with Shariah law include, eg. gambling, alcoholic drinks, weapons, adult entertainment; and
• Transactions must be asset-based or asset-backed.

Luxembourg as the European Islamic Finance Hub

Luxembourg is globally known for the domiciliation of investment funds and the structuring of cross-border acquisitions. However, Luxembourg also positioned itself early to be an actor in Islamic finance, capable of attracting numerous investors from the Middle East. In this respect, Luxembourg has become the third largest Islamic fund centre in the world after Saudi Arabia and Malaysia³ and the largest Islamic fund domicile centre in a non-Muslim country, ranked by the number of Islamic funds established in Luxembourg. According to the Association of the Luxembourg Fund Industry (ALFI), as at December 2021, Shariah-compliant funds had net assets of EUR 6,825.9 million.⁴

In this context, it is worthwhile focusing on some key figures reflecting Luxembourg’s active role for more than 40 years:

1978: Luxembourg is the first western country to host an Islamic financial institution.

1983: The first Islamic insurance company is set up in Luxembourg.

2002: Luxembourg is the first Eurozone country to list a sukuk.

2008: The Luxembourg government establishes a task force in order to promote Islamic finance.

2009: Luxembourg’s Central Bank is the first European central bank to become a member of the prudential standard setting body for global Islamic finance, the Islamic Financial Services Board (IFSB).⁵

2013: The Association of Luxembourg Fund Industry publishes “best practices guidelines” for the purposes of servicing Islamic funds.

2014: Luxembourg is the first Eurozone country to issue a sovereign sukuk. In order to do so, Luxembourg as sole shareholder set up a special purpose vehicle acting as the issuer of the instruments. The securities issued are sukuks of the Al-ijarah type (lease-based financing) which are backed by three administrative buildings having been purchased by the issuer from Luxembourg with the issuance proceeds of the sukuks. The rental income from the buildings constitutes the profit paid out to the holders of the sukuks. The buildings are to be transferred back to the state for a pre-agreed purchase price when the sukuks mature. The sukuks are admitted to trading on the Euro MTF market (Euro MTF) of the Luxembourg Stock Exchange (the LuxSE).

It should also be noted that, although there has not been any specific taxation framework regulating Islamic finance transactions in Luxembourg, Luxembourg tax authorities have clarified their position with respect to Islamic finance products, covering in particular the Luxembourg direct and indirect tax treatment of murabahah (cost plus financing, typically used for house purchase schemes) and sukuk transactions.⁶

Islamic Funds

In Luxembourg, Shariah-compliant investment funds are usually set up under the general Luxembourg legal framework as there is no particular legal system established for the regulation of Islamic funds⁷ and Islamic finance products. Consequently, from a supervisory and regulatory perspective, there is no particular distinction between a Shariah-compliant investment fund and any other type of investment fund.

From a practical perspective this means that a large variety of Shariah-compliant vehicles are generally available to asset managers and investors given that, in theory, any Luxembourg investment vehicle can be used de facto to set up a Shariah-compliant fund. A Luxembourg investment fund can take either a corporate form or a contractual form. The choice of the right investment structure mainly depends on the investment policy, the investors targeted and the level of regulation desired.

Generally speaking, they can be set up as regulated or unregulated funds.

Regulated funds

Regulated funds in general are subject to the prior authorisation and ongoing supervision of the Luxembourg regulator, the Commission de Surveillance du Secteur Financier (CSSF).

Shariah-compliant regulated funds can be set up as undertakings for collective investment in transferable securities (UCITS) or as alternative investment funds (AIFs).

UCITS must comply with part I of the law of 17 December 2010 relating to undertakings for collective investments (the 2010 UCI Law). UCITS are always open-ended funds and may invest only in certain liquid assets. They can be marketed on a pan-European cross-border basis under the UCITS passport. They offer a high level of investor protection and can be placed with all types of investors, ie retail and institutional investors.

AIFs can be used if certain terms or asset classes not available to UCITS such as real estate, private equity and venture capital, hedge funds and debt funds are to be offered to investors. AIFs must appoint an alternative investment fund manager (an AIFM), which may be based in or outside of Luxembourg. Depending on, among other things, the amount of assets under management, the Luxembourg AIFM must be authorised by or registered with the CSSF. When authorised by the CSSF, the AIFM benefits from a passport allowing it to market the fund to professional investors within the EEA.

The following regulated investment funds may be set up as AIFs:

• Undertakings for collective investment which are subject to Part II of the 2010 UCI Law (Part II UCIs) and which are flexible but heavily regulated vehicles as they may also target retail investors;
• Specialised investment funds (SIFs), which target well-informed investors and are subject to risk spreading requirements;
• Investment companies in risk capital (SICARs), which target well-informed investors and are specifically structured vehicles for venture capital that are required to invest in assets qualifying as risk capital only.

These funds may be launched as stand-alone funds or umbrella structures consisting of multiple compartments. It is therefore possible for a Shariah-compliant compartment to be launched alongside non-Shariah-compliant compartments.

Unregulated funds

Shariah-compliant funds can also be established as the following unregulated funds:

• Reserved alternative investment funds (RAIFs), which are not subject to the supervision of a regulator but are managed by a regulated AIFM (whether based in or outside Luxembourg). The RAIF can have the features of a SIF or a SICAR; and
• Luxembourg partnerships, in the form of a common limited partnership (SCS) or special limited partnership (SCSp), which are not under the supervision of the CSSF but are managed by an AIFM if they qualify as AIFs.

These unregulated funds can be open or closedended. They differ in that a RAIF can be set up as an umbrella structure, which is not possible for a partnership. And while there are per se no restrictions for a partnership with respect to the eligible investors, a RAIF may only target well-informed investors.

Islamic finance in the context of the Luxembourg Securitisation Law

The existing legal framework in Luxembourg has proved both flexible and innovative enough to accommodate the demands of Islamic finance practitioners implementing various Shariah-compliant structures through the use of Luxembourg vehicles.

In particular the Luxembourg law of 22 March 2004 on securitisation (the Luxembourg Securitisation Law) has shown that it is an ideal tool to establish sukuk issuance structures due to the asset-backed character of sukuks (as further explained below). This is mainly due to the fact that under the Luxembourg Securitisation Law it is easy to set up issuance platforms using multiple compartments within the same securitisation vehicle, where each is linked to a different type or pool of assets. This means that each compartment represents a distinct part of the assets and liabilities of the securitisation vehicle. Thus a Luxembourg securitisation vehicle can in fact issue several classes of sukuks with each class being allocated its own specific compartment of the vehicle.

It is also possible and relatively common to combine, in a single transaction, elements of Luxembourg law with foreign law-governed agreements and structuring tools since the financial instruments issued by a Luxembourg securitisation undertaking need not necessarily be governed by Luxembourg law.

Another reason for the increasing popularity of Shariah-compliant securitisation vehicles is the wide array of eligible assets which can be securitised under the Luxembourg Securitisation Law. Risks relating to the holding of assets, whether movable or immovable, tangible or intangible income, as well as risks resulting from the obligations of third parties or relating to all or part of the activities of third parties can be securitised. Consequently, Luxembourg securitisation transactions regularly securitise various classes of assets such as equity investments, real estate, commodities, receivables and other forms of business participations.

Furthermore, the fact that a Luxembourg securitisation vehicle is in principle an unregulated vehicle has also increased its popularity for Islamic finance issuance transactions. Generally speaking, Luxembourg securitisation vehicles are not subject to supervision as a regulated entity by the CSSF. Only securitisation undertakings which issue securities to the public on a regular basis (ie more than three times on an all-compartment level per financial year) must be authorised by the CSSF. However, any issuance of securities made in the context of a private placement does not qualify as a public offer as such. Another attractive feature of Luxembourg securitisation vehicles is the fact that due to a recent reform of the Luxembourg Securitisation Law such vehicles have ceased to be mere issuance vehicles and are now also allowed to enter into any form of loan agreement/structure with their investors instead of only issuing securities.

Shariah Board

It is, however, common practice that Shariah compliant vehicles set up a Shariah Board the members of which assess the compliance of the intended investments with applicable Shariah precepts.

Sukuks

As mentioned, in Luxembourg there is no law dedicated specifically to Islamic financial products or services. However, so far several issuances of so-called sukuks have been made. A sukuk is a particular type of financial instrument, similar to a bond in western finance, which complies with Shariah principles. Sukuks mostly involve direct asset ownership while bonds are indirect interest-bearing obligations. Consequently, both sukuks and bonds provide their investors with payment streams. However, the income derived from a sukuk must not be speculative as such an approach would mean it would no longer be halal.

Therefore, the more traditional western types of debt instruments cannot be used as a viable investment approach, nor can they be used to raise capital. In order to bypass this issue, sukuks usually link the return and cash flows of a specific debt financing to a particular asset which is being acquired while distributing on a periodic basis the benefits generated by the acquisition of the asset to the investors, ie the asset-owners or asset-beneficiaries who do not qualify as creditors entitled to receive interest payments on their investments. In other words the holders of sukuks, in contrast to bond holders, receive a portion of the earnings (eg rental income) directly generated by the associated asset. Consequently, while a bond price is mainly determined by its credit rating, the valuation of a sukuk is based on the value of the assets backing it. This approach is a means to work around the prohibition under Shariah law on investing money in order primarily to receive interest payments. Due to this structure sukuks usually represent a viable instrument to raise financing for identifiable assets only. However, sukuks can also be structured so as to constitute part ownership in a debt (Sukuk Murabaha), asset (Sukuk Al Ijara), project (Sukuk al Istina), business (Sukuk Al Musharaka) or investment (Sukuk al Istithmar).

Summarising, one can therefore say that a sukuk can be considered the Islamic equivalent of a bond which does not give rise to periodic payments of interest.

Public offers of sukuks and admission to trading on stock exchanges

Furthermore, sukuks can also be offered to the public under Regulation (EU) 2017/1129 of the European Parliament and of the Council of 14 June 2017 on the prospectus to be published when securities are offered to the public or admitted to trading on a regulated market, and repealing Directive 2003/71/EC (the Prospectus Regulation). In this respect, the CSSF classifies sukuks as asset-backed securities to which annexes 9 and 19 of Commission Delegated Regulation (EU) 2019/980 of 14 March 2019 usually apply. Furthermore, sukuks can also be admitted to trading on a regulated market in the EEA under the aforementioned prospectus framework or in accordance with the relevant national listing framework for a multilateral trading facility.

From a Luxembourg listing perspective this means that sukuk issuers can choose between the regulated market (Bourse du Luxembourg) or the Euro MTF. The latter qualifies as a multilateral trading facility and therefore does not offer the possibility to passport the listing prospectus into other EEA jurisdictions for the purposes of a listing on another stock exchange.

In fact, as referred to above the LuxSE was the first European stock exchange to list an issuance of sukuks in 2002. The sukuks were issued by the state of Malaysia and were followed by other sovereign and corporate sukuk issuers from Malaysia, Saudi Arabia, the United Arab Emirates, Pakistan, Turkey, South Africa, Qatar, among other countries.

Conclusion

Over the years Luxembourg has evolved into an attractive financial centre for Islamic finance transactions due to strong government support and an innovative legal framework.

The Luxembourg legislator has not established a specific type of Islamic-compliant entity or legal structure. However, the wide array and flexibility of different fund entities can also be used to set up Islamic finance and Shariah compliant investment structures. Furthermore, securitisation vehicles on account of their unregulated status and due to the fact that a vast range of assets can be securitised on a multiple-compartment basis, with each asset being ring-fenced and segregated from the other compartment asset pools, provide another alternative for Islamic finance structures. Finally, it is worth noting that the LuxSE has become a very attractive trading venue for Islamic finance securities such as sukuks and has a long history of such listings.

Authors: Fabien Debroise, Antonios Nezeritis and Ludmilla Bouchez-Lecuy

<sub>1. Ernst & Young, Luxembourg: the gateway for Islamic finance and the Middle East, EY Luxembourg, May 2019, Ernst & Young, the Luxembourg fund series – chapter one, EY Luxembourg, 2020
2. Comprendre la Finance Islamique: Principes, Pratiques et Ethique», Dr Tarik Bengarai, 2010
3. See footnote 1
4. Alfi, Global overview Doc RR, updated on 4 February 2022 (source: CSSF)
5. See footnote 1
6. Circular LG-A No. 55, Luxembourg direct tax administration, 12 January 2010
7. Commission de Surveillance du Secteur Financier, Guidance, Investment Funds and Islamic Finance, May 2011</sub>