Islamic finance corresponds to financial transactions complying with principles set forth by the sharia, notably the prohibition of speculative operations ("gharar"), interest-bearing loans ("riba"), uncertainty on sales ("mayssir"), and investments in certain sectors such as weapons, alcohol and tobacco, or casinos ("haram").

 The main principle under Islamic finance is that the transaction must be backed on to tangible assets and then tied to the real economy.

 In order to be part of this $ 500 - 700 billion worldwide market, French authorities has decided to promote the development of Islamic financial transactions since July 2007, through progressive adaptation of the French civil, financial and tax regulations. Of course, certain Islamic financial transactions had already been carried out in France prior to 2007, mainly in the real estate sector. However, their tax treatment was still uncertain. New tax administrative regulations have been published last February 2009 in order to clarify the French tax treatment of two types of Islamic finance transactions, i.e. the murabaha and sukuk bonds transactions.

- Tax treatment on murhaba transaction

Main characteristics of Murhaba transaction for French tax purpose.

A murabaha transaction is one whereby a financier (Bank or SPV) borrows funds and then purchases an asset from third party, which he then immediately resells to an investor (i.e. its client) at a price higher than the initial purchase price (i.e. interests and intermediary fee included). The sale price is paid by installments. The difference between the purchase price and the resale price (the profit margin generated by the financier) corresponds to the cost of financing the investor would have borne if he had purchased the asset directly on credit.

A murabaha transaction is in fact an asset financing technique through a purchase and resale transactions on real estate properties, securities, goods or inventories. The agreement must contain specific provisions set forth by the tax administrative regulations in order to qualify as murhaba transaction for French tax purpose.

(ii) Tax regime applicable

Normally the agreement between the financier and the investor qualifies as sale agreement from legal standpoint and the profit deriving from such sale is immediately taxable. However, according to French tax authorities the profit margin made by the financier is the remuneration of the differed payment granted to the investor from economical standpoint.

Such differed payment is treated with regard to most French taxes as interest and not as a capital gain. Therefore the taxation of the profit margin generated by the financier is spread out over the term of the differed payment (on straight line basis) provided that the agreement is properly drafted and specific accounting requirements are met. However, the portion of the profit margin remunerating intermediary services rendered by the financier is directly subject to tax.

In the case of profit margin paid by the French investor company to the financier located outside France, such payment is exempted from French withholding tax according to domestic tax rules provided that the conditions indicated above are met.

The tax administrative regulations have also confirmed the cases where capital gain taxes on the real estate purchase/resale transaction, registration duties, business license tax and VAT can be mitigated.

Tax treatment on sukuk and similar indexed financial transactions

Main characteristics of Sukuk transaction for French tax purpose A sukuk transaction is one whereby investors finance the purchase of an asset by means of profit-sharing financing. In a common type of sukuk transaction, a French group set up an SPV in order to purchase an asset, that purchase being financed through the issuance of sukuk bonds subscribed by investors and the SPV's parent company. The SPV then rents the asset to third party and benefits from put option granted by the parent company on this asset. The SPV transfers the asset to a fiduciary for management purpose. The fiduciary will remunerate the sukuk bonds holders, and might repay to the SPV the management fees paid the SPV (such as statutory audit fees for example). Sukuk bonds are repaid either in the course of the transaction on the basis of predetermined term or at their maturity. Therefore, on this type of transaction the return on the sukuk bonds is directly correlated to the return on the underlying asset leased, and there is a combination between the issuance of bonds and trust mechanism as the sukuk bonds holders are also the beneficiaries of the rights attached to the trust.

(ii) Similar indexed financial transactions for French tax purpose Such transactions correspond to debts securities and participating loans giving right to remuneration indexed on the return generated by one or many underlying assets held with the issuer or the borrower. In case of debts securities and participating loans used for the financing of one or many assets, the refund of the principal is indexed on the value of such assets.

(iii) Tax regime applicable

French tax authorities point out the criteria upon which the sukuk or similar indexed transactions must fulfill to qualify as debt instruments for French tax purpose. Some of them are the following:

- Sukuk bonds or indexed debts securities holders should be repaid in priority to the shareholders of the issuing company; they should not receive any voting rights or any rights on the profit deriving from the liquidation of the issuer or the borrower;

- the remuneration of the sukuk bonds or indexed debts securities holders should be variable and linked to the return of an underlying asset or the profit generated by the issuer or the borrower. In addition, such remuneration should not exceed a ceiling defined by reference to market rate (e.g. Euribor or Libor) increased by a margin;

- partial repayment of the principal is allowed, and such repayment should be made either progressively or entirely at their maturity date.

Sukuk bonds or indexed debts securities complying with the criteria set forth by French tax administrative regulations qualify as debt instruments, and the remuneration paid to holders qualifies as interest from French tax standpoint. Such interests are tax deductible for the French paying company pursuant to the limitations applicable under domestic tax law. In the case of interest payments made by French company to foreign recipient, the withholding tax exemption stated under the domestic tax law applies even if the sukuk bonds or indexed debts securities are issued according to French or foreign law, provided that they qualify as debt instruments for French tax purpose.

The business license tax impact is analyzed at the level of the activity performed by the fiduciary, which can be in France either a bank or a Law firm. For banks, interest paid to sukuk bonds or indexed debt securities holders qualify as operating expenses and then will reduce such impact.

VAT exemption could be achieved on the transfer of goods, rights and warranties from the SPV to the fiduciary provided that the transaction is structured appropriately.

According to various statistics available there are 5 million Muslims in France and 55% of such population is interested by banking offer complying with sharia principles. The French finance place is targeting approximately € 100 billion stake on the whole Islamic finance market, notably from savings from gulf and Asian countries. The new tax provisions will undeniably contribute to facilitate the performance of Islamic financial transactions in France efficiently, safely and at low cost.