ISLAMIC INVESTMENT IN THE US
W DONALD KNIGHT
In recent years a number of factors have increasingly caused Islamic banks and other financial services to seek to devise structures for investments in the United States and other Western countries, both for their own accounts and for the clients of such institutions.
Those factors include most basically the continuing, strong growth in the demand for Islamic investment products. Another significant factor is the post-Gulf War desire on the part of Islamic investors in that area to locate at least part of their investment assets outside the Gulf, and to structure such international investments so that they will be safe and available to the investors and their families – protected from governmental confiscation and governmental asset “freezes,” or the like – in the event of any future political emergency in the Gulf area.
In order for Islamic banks and other Islamic financial institutions to be competitive with respect to the US and other Western investment and financial products they offer to their investor-clients, such institutions must ensure that their products will yield to their clients an acceptable after-tax return. Accordingly, Islamic investments made in the United States and other high-tax countries in the West must be carefully structured so that taxes imposed by the host country will be minimised or avoided, both (a) during the time period the investment is held and (b) at the time the investment is sold or otherwise disposed of and the cash or other proceeds from disposing of the investment are repatriated to the investor’s home country.
In this article, the author will: (a) give a summary introduction to certain basic US federal tax rules which must be considered in order to structure various types of Islamic investments in the United States in a tax-efficient manner, and then (b) illustrate the application of such rules to certain specific types of US investments. To give an idea of just how summary in nature this treatment of US tax rules is, the author’s personal copy of the US Internal Revenue Code contains over nine thousand four hundred pages of small type. The official US Tax Regulations contain almost thirty thousand pages. In addition, primary sources of US federal tax law include numerous volumes of official tax rulings of the US Internal Revenue Service and opinions of US courts in tax cases.
This article only deals with the tax rules of the US federal (i.e., national) government. Certain US States and local governments also impose income or other taxes that must be taken into account in structuring specific investments in the United States. Such State and local taxes (which generally are deductible expenses for purposes of computing the net income amount to which the US federal income tax applies, a fact which reduces their negative economic effect) are beyond the scope of this article.
The reader is asked to understand that this article does not purport to set forth definitive or even necessarily reliable opinions as to Islamic law. The author’s limited understanding of Islamic law results from the author’s having had the good fortune to work with a number of Islamic financial institutions.
Executives of those Islamic institutions have patiently sought to convey to the author the fundamental considerations involved in Islamic finance and investment, so that these fundamentals may be made to mesh with US tax and other legal principles in devising specific tax-efficient investment structures for the clients in question. Accordingly, all references here to principles of Islamic law are made with the greatest humility and with the full fore-knowledge that certain readers may find the author’s understanding of the applicable Islamic rules either to be fundamentally in error or, at least, to be in need of amendment or modification.
The US federal tax law contains a special, limited exemption from US tax for income realised by agencies of non-US sovereign countries, from investments such as government agencies have made in the United States. These special rules would govern, for example, US taxation of income received by a GCC country’s Ministry of Finance or Investment Authority from investments in the United States. However, this article focuses on devising tax-efficient structures for Islamic private sector investors and does not address the special issues that relate to structuring non-US government investments.
This article also does not address the US taxation of Islamic charitable, religious or educational foundations, trusts, estates or other entities. Properly structured, the US source income of such entities may be exempt from US taxation.
Effect of Absence of US Tax Treaty with any GCC Country
The United States has negotiated and put into effect tax treaties (often called “double taxation agreements”) with a number of countries. Such tax treaties generally have the effect of modifying in a favourable way for persons resident in the non-US treaty country, the basic US tax rules which would otherwise apply to US investments of such persons, if no applicable tax treaty existed.
There is no tax treaty between the United States and any country in the GCC. For this reason, in creating a tax-efficient structure for the US investments of Gulf area Islamic investors (or Gulf area non-Islamic investors, for that matter), one generally must look to the US Internal Revenue Code, the official Regulations issued under the Code, tax rulings issued by the US Internal Revenue Service and applicable court decisions.
The only alternative structuring approach is (a) to establish a corporation in a country with which the United States has a tax treaty, (b) to make US investments in the name of that corporation and (c) to attempt to claim the benefits of the tax treaty between the United States and the country where the investor’s corporation is organised. This approach – widely referred to as “treaty shopping” – is under significant and continuing attack by the US tax authorities and is not advisable except in special circumstances.
The Starting Point in Structuring US Investments by Islamic Natural Persons
The United States would impose an estate tax on the estate of any non-US natural person Islamic investor who, at the time of his death, owned assets which the US tax rules treat as being located in the United States. Such “US situs” assets include shares of US corporations, interests in US real property and certain tangible personal property.
To give an idea of the serious nature of this tax, the US estate tax rate for values in excess of US$3 million is fifty-five percent (55%), and the effective rate of tax on the first US| 3 million of US situs assets held by a non-US natural person investor at the time of his death is forty-one percent (41%).
These are tax rates, which some would view as almost confiscatory in nature and, in the author’s judgement, unless there are very specific, special reasons to the contrary, no non-US natural person Islamic investor should ever make an investment in the United States through an ownership structure which could give rise to the US estate tax if the investor should die while owning the investment.
Obviously, where the investor in question is itself an institution, such as a corporation or government agency, the US estate tax is not a concern because such legal entities do not “die”.
Fortunately, the US estate tax does not apply to shares of a non-US corporation that are owned by a non-US person at the time of his death – even if all the assets of the non-US corporation in question are made up of US real property, shares of US corporations, or the like – provided the non-US corporation is properly maintained and appropriate corporate formalities are consistently observed.
For this reason, a generally applicable principle to be used as the starting point in the analysis of which legal structure should be employed by a non-US natural person Islamic investor to hold his US Investments is as follows:
Absent highly unusual circumstances, a non-US natural person Islamic investor should always hold his US investments through a non-US corporation.
Any properly interposed and maintained non-US corporation will serve to insulate a non-US natural person Islamic investor from the US estate tax. For example, a Kuwaiti investor could use a Kuwaiti corporation as the holding company for his US investments and thus avoid the US estate tax.
However, for administrative convenience and with a view to protecting the underlying US assets from the adverse effects of political emergencies which might occur in the investor’s home country, most Gulf area investors choose to employ a non-US holding corporation organised and based in a politically stable “offshore tax haven” country, such as the Cayman Islands, the British Virgin Islands, Bermuda, or the like, which imposes no local taxation of any kind.
Such an offshore corporation which would shield the non-US natural person Islamic investor from the US estate tax may be either (a) a personal or family holding corporation, organised by an individual investor or his family to hold private US investments, or (b) an offshore corporation which is the “parent” of a collective investment fund in which an investor chooses to invest, together with unrelated investors.
US income: Taxation of US Investments of Private Sector Islamic Investors
As discussed to this point, except in very unusual circumstances, non-US natural person Islamic investors should structure their individual or fund investments in the United States so that what the natural person investors hold directly in their own names is shares of a non-US corporation. Accordingly, assuming that a non-US corporate structure will be used either as the only legal entity involved in a non-US Islamic investor’s structure for investments in the United States or as the parent corporation of such a structure, we turn now to the US income tax considerations involved.
Speaking generally, the US income tax rules which apply to non-US corporations divide the US source income of such corporations into two categories: (a) Income derived from a US “trade or business,” and (b) “Passive” income (i.e., income which is not viewed under US tax rules as “effectively connected with a US trade or business”).
The United States imposes on each corporation (US or non-US) a corporate income tax (maximum current rate: 35%) on the net taxable income (determined by subtracting all allowable expenses and other deductions) that the corporation derives from the conduct of a US trade or business. (It should be noted that a US corporation is subject to US income tax on its world-wide income, not merely its income from US sources.)
Where a non-US corporation, itself, is directly engaged in a US trade or business, the United States imposes an additional thirty percent (30%) “branch profits tax” on the earnings and profits which the non-US corporation takes out of the United States – or is “deemed” to have taken out of the United States, under the terms of a set of complicated tax regulations.
This means that, if a non-US corporation itself directly derives income from a “US trade or business” (for example, income from investments in most types of US real property), the net income from that investment will be subject to a total effective US corporate and branch profits tax rate, of fifty-four and one-half percent (54.5%) by the time the income is paid out to the investor who owns the non-US corporation.
(Example calculation: US$100 of net income is subject to 35% (maximum) regular US federal corporate tax, leaving US$65. The US$65 of after-regular income tax earnings and profits is subject to a 30% branch profits tax of US$19.50 when repatriated. Total tax on US$100 of net income thus equals US$54.50, an effective, combined rate of 54.5%.) Obviously, such an effective tax rate would produce after-tax returns which would be completely unacceptable in virtually every case.
In the discussion above, it was concluded that, absent unusual circumstances, non-US natural person Islamic investors should always hold their US investments through non-US corporations, in order to avoid the US estate tax. The fact that the effective rate of US tax on the repatriated net income derived by a non-US corporation from a “US trade or business”-type investment would exceed fifty percent (50%) suggests another generally applicable structuring principle.
While non-US natural person Islamic investors should utilise non-US corporations for their US investments in order to avoid the US estate tax, such non-US corporations, themselves, generally should not invest directly in US investments which will produce “trade or business”-type income.
Instead of having a non-US corporation in an investment structure directly make US investments which will produce “trade or business”-type income, it is generally preferable for a non-US corporation:
(a) to hold its “trade or business”-type US investment (such as most US real estate) through a separate US subsidiary corporation;
(b) to reduce the regular US federal corporate tax liability of the US subsidiary through techniques aimed at reducing the subsidiary’s net income, such as leveraging (sometimes called “gearing”) during the period while the US subsidiary corporation owns the investment;
(c) to avoid having the US subsidiary corporation pay dividends to its non-US parent corporation (because such dividends would be subject to a 30% US withholding tax, analogous to the branch profits tax); and
(d) to affect a complete liquidation of the US subsidiary after the US subsidiary corporation ultimately sells or otherwise disposes of the US “trade or business” investment.
Speaking generally, this procedure should drastically reduce the overall US taxation of the income and capital gains derived from holding and ultimately selling a US “trade or business”-type investment. This reduction would include elimination of the additional 30 per cent branch profits tax that otherwise would apply, if the non-US corporation in the structure directly held the investment and removed its earnings and profits from the United States.
(Note that, using this structure and procedure, care must be taken to avoid the US “accumulated earnings tax” which could apply if the US subsidiary corporation does not pay dividends in order to avoid the 30 per cent withholding tax on dividends, and in the process accumulates earnings in an amount which the US tax laws would treat as being “beyond the reasonable needs” of its business.)
As described above, the overall rate of US federal tax which can apply if a non-US corporation directly owns a US investment which produces “trade or business”-type income exceeds 50 per cent of the net income produced, generally a wholly unacceptable situation. By contrast, the United States imposes a tax of 30 per cent, enforced by a withholding requirement, on the gross amount of “passive” (i.e., non-“trade or business”) income derived in the United States by a non-US corporation. Such “passive income” includes dividends, interest, royalties from patents and licences and the like and other “fixed or determinable annual or periodical” income.
There is an important exemption from the 30 per cent withholding tax on “passive income.” That is, no US income tax applies to US source interest which a non-US corporation receives if such interest qualifies as “portfolio interest” under the special US tax law definition of that phrase.
Generally stated, “portfolio interest” is interest received by a non-US lender who, or which, owns (directly and under complicated ownership attribution rules) less than ten per cent of the voting shares of a US corporate borrower, provided the debt instrument is structured to meet certain US tax requirements.
Interest earned by a non-US bank in the ordinary course of its lending business cannot qualify as US tax-exempt “portfolio interest.” As discussed below, while a normal first reaction is that no payment characterised as “interest” can ever be acceptable under Islamic law, it appears that: (a) there are certain corporate finance structures where distributions of profits in the form of interest may be allowable or permissible under Islamic law and (b) there are other situations (including Murabaha cost-plus sales and Ijara leasing transactions) where, properly structured, the profit element involved can be characterised solely for US tax-planning purposes, as tax-exempt “portfolio interest”.
In addition to the fact that certain types of “passive” income (such as dividends, interest and royalties) are subject to a 30 per cent withholding tax when received by a non-US corporation, another important principle is that capital gains realised by a non-US corporation from the sale of US assets (such as shares in a US corporation) are generally free of US taxation, unless such capital gains are “effectively connected” with a “US trade or business” actually being conducted by the non-US corporation.
The major exception to this rule is that, under a special US tax law (i.e., the US Foreign Investment in Real Property Tax Act, often abbreviated as “FIRPTA”), any capital gain realised by a non-US corporation from the sale of an interest in US real property will be treated as ‘trade or business” income.
For purposes of FIRPTA, with certain limited exceptions for shares of Real Estate Investment Trusts (often called “REITs”), the shares of a US corporation which derives the majority of its value from its US real estate holdings will be treated as constituting an interest in US real estate. This means that capital gains realised by a non-US corporation from the sale of shares of such a “United States real property holding corporation” also will be taxed as “trade or business” income.
Structures and Investments Utilising the Payment of Interest
As indicated in the introduction to this article, in order to be competitive with other forms of investments. Islamic investment products focusing on the United States or other high-tax investment host countries must be carefully structured so as to minimise their taxation both (a) during the time period the investment is held and (b) when the investment is sold or otherwise disposed of and the cash or other proceeds from disposition of the investment are repatriated to the investor’s home country.
Under the US income tax system, one of the most effective tools for minimising taxation in both of these situations can be the use of interest-bearing loans. This follows from two aspects of the treatment of interest in the US federal tax system:
(a) Interest is generally a deductible expense in arriving at the net income of a US “trade or business” which is subject to the regular US corporation tax; and
(b) Under some circumstances (including, for example, when structures qualify for the “portfolio interest” exemption from US taxation, mentioned above), it is possible for interest to be paid out of the United States to a non-US lender free of any US withholding tax.
Given the usefulness of interest-bearing loans in minimising or avoiding US taxation of US investments by non-US investors, the question which must be addressed is whether it is ever permissible for an Islamic investor to take part in an investment which, even in a merely formal sense, includes one or more interest-bearing loans.
(For the record, it is recognised that some Islamic scholars are of the view that interest is only prohibited if the amount of interest charged is excessive or usurious. This article assumes that, once a determination is made that interest of the type prohibited by Islamic law is involved in a structure, such interest is prohibited, even if it is reasonable in amount and non-usurious.)
Based on the author’s experience with a number of Islamic financial institutions, it appears that the use of profit distribution methods in the form of interest-bearing loans can, indeed, be Islamically permissible or allowable in certain investment structures.
Let us take a simple example. Assume (a) that an Islamic investor owns all of the shares of a US corporation, (b) that his wholly-owned US corporation is engaged in a US trade or business of a nature which is clearly Islamically-permissible and (c) that the US corporation is in need of additional capital in order to expand its business. In this situation, it is the author’s understanding that the Islamic investor, owning 100 per cent of the shares of the US corporation in question, would be permitted to provide the needed capital by means of making an interest-bearing loan to his corporation.
The author understands that such a loan would be permissible, because the Islamic investor would not be imposing the burden of interest on any other person. Rather, instead of investing more money in his corporation as share capital and causing the corporation to distribute its later profits to him as dividends, the Islamic investor merely would be using the “shareholder loan” form as an alternative (and more tax-efficient) means of distributing profits to himself from his own business – which he happens to have chosen to operate in the form of a corporation.
Assuming that this understanding is correct, the Islamic investor would, indeed, effect a tax savings by making a shareholder loan to his wholly-owned US corporation that is engaged in a US trade or business. This follows because the corporation would obtain a US tax deduction for the profit’s distribution paid to its shareholder in the form of interest. At the 35 per cent maximum regular US federal corporate income tax rate, for every US$100 of interest paid, there would be a corporate-level tax savings of US$35.
Unfortunately, the US corporation would be required to withhold 30 per cent of the US$100 of profits-in-the-form-of-interest paid out to the investor/ shareholder and pay the resulting amount ($30) over to the US taxing authorities. The result, nonetheless, would be that, using the shareholder loan approach to profits distribution, the shareholder would receive a net US$70 repatriated after-tax return as a result of the payment of the US$ 100 of profits-in-the-form-of-interest.
By contrast, if the corporation had US$100 of pre-tax profits and did not distribute profits-in-the-form-of-interest to its shareholder, the US$100 of corporate level profits would be subject to a US federal income tax of 35 per cent (i.e., US$35 of tax). This would leave US$65 of after-tax profits at the corporate level to be paid out to the shareholder as a dividend.
The dividend of US$65 would be subject to a 30 per cent US withholding tax (i.e., US$19.50 of tax), leaving the investor/shareholder with a net repatriated after-tax return of only US$45.50 from the US$100 of pre-tax profits earned at the corporate level.
In the above example, there is a US$24.50 tax saving, comprising; (a) the US$70 net after-tax, repatriated return to the shareholder using the shareholder loan approach with (b) the US$45.50 net after-tax, repatriated return resulting without the shareholder loan. Obviously, the structure would be even more tax-efficient if it were possible to claim the US$100 tax deduction at the level of the US pay or corporation and pay out the US$100 of interest free of any US withholding tax.
Such a structure would achieve the dual goals of (a) reducing taxation of the “trade or business” investment on its operating income and (b) avoiding taxation on profits that are being “brought home” by the shareholder/lender in the form of the interest payment on the shareholder loan.
In certain situations, it appears both such goals can be accomplished. In the example above, it is suggested that, under Islamic principles, it is permissible for an investor who owns 100 per cent of the shares of a corporation to provide additional funds to his corporation through the form of making an interest-bearing loan to that corporation.
As noted, the author understands that such a corporate finance form is Islamically acceptable, because the investor would not be imposing the burden of interest on any person other than himself. It appears this principle can be extended, and significant tax benefits can be obtained, through use of a corporate structure with multiple shareholders where the shareholders make loans to the corporation in amounts exactly in proportion to their respective percentage interests in the corporation as shareholders.
For simplicity’s sake, put aside for the moment the US estate tax problem which arises when non-US natural persons own shares of a US corporation and assume, for example, that 11 non-related Islamic natural persons form a US corporation, and that each owns the exact same percentage of the shares of the corporation as all the others (meaning that each would own less than 10% of the corporation’s shares).
Assume further that a decision is made to provide an additional US$ I million of capital to the corporation and that, as an alternative to providing the funds as additional share capital, each Islamic investor then lends to the corporation the same percentage of US$1 million as he owns of the shares of the corporation (being 9.09%).
From an Islamic standpoint, it appears that this is directly analogous to the situation where a single Islamic investor owns 100 per cent of the shares of a corporation and, in the author’s understanding, it is permissible for him to make interest-bearing loans to his wholly-owned corporation.
This follows because, looking at each investor’s share and loan investment in the corporation in question as a single “vertical slice,” each of the 11 shareholders in this example has made a loan which burdens only himself and his percentage ownership interest of the corporation and does not burden, economically, any of the other shareholders or their respective ownership interests.
What makes this structure particularly interesting is that, under the “portfolio interest” rules, if each of the shareholder loans is structured properly, the desired dual tax benefit will follow: First, the corporation will be entitled to a tax deduction for interest paid on the loans, thus reducing its net income that is subject to the regular US federal corporate level tax. Second, the interest can be paid out of the United States to the Islamic investor-shareholders entirely free of US withholding tax.
In the preceding paragraphs, shareholder loan corporate finance structures have been analysed which the author understands are Islamically acceptable and, under proper circumstances, can provide significant US tax savings. Going beyond this kind of corporate finance structural arrangement, certain types of instalment sale (Murabaha) and lease (Ijara) transactions can be structured so that the US tax authorities will view the Islamically- acceptable “profit element” inherent in these transactions as being “interest,” for US tax purposes.
The author understands that many Islamic authorities are of the view that, if an investment or business transaction is inherently Islamically acceptable, the fact that the US tax authorities choose to treat the profit element involved as “interest” for US tax purposes is irrelevant, for purposes of the Islamic analysis.
Two simple examples illustrate the US tax advantages which can follow from this concept. First, assume that a non-US corporation owned by an Islamic investor (or investors) purchases certain medical equipment and then sells the medical equipment to a US hospital corporation on a cost-plus basis with the hospital agreeing to pay for the equipment over a period of several years. If the agreements establishing the hospital’s obligation to make the instalment payments to the non-US corporation owned by the Islamic investor are structured correctly, the profit element inherent in the cost-plus sale would be viewed for US tax purposes as “portfolio interest” and could be paid by the US hospital to the non-US corporation free of any US tax.
Second, assume similarly that a non-US corporation owned by an Islamic investor (or investors) purchases certain medical equipment and leases that equipment to a US hospital corporation, with the lease either giving the hospital an option to purchase the equipment at the end of the lease term for an option price that is substantially less than the equipment’s market value at the time the option will be exercisable or obligating the hospital to purchase the equipment at the end of the lease. Again, if the lease is properly structured for US tax purposes, the profit element in the lease will be viewed by the US tax authorities as “portfolio interest” and will be free of US tax when paid by the US hospital to the Islamic investor’s non-US corporation.
Conclusion
The discussion above sets out certain of the most basic and general US federal tax principles applicable to US investments of non-US Islamic investors, outlining certain structures and investment situations where profit distributions or payments the US tax authorities will treat as “interest”, may be permissible or allowable under Islamic law. Obviously, a case-by-case analysis is necessary in order to apply to specific types of investments and investment structures the relevant Islamic rules and the described US tax principles and other US tax principles that may be pertinent.
In the author’s experience, if a particular US investment object is, itself, not repugnant to the principles of Islam (as would be the case with a brewery, for example), it is generally possible to devise a structure that is both Islamically-permissible and US tax-efficient.
Moreover, Islamically-acceptable, US tax-efficient structures can often be devised where, on the surface and without a degree of creativity, it first appears that the principles of Islam simply cannot be accommodated – an example being the provision of third-party “mortgage” financings with respect to US real estate acquired by Islamic investors. Achieving an acceptable after-tax return from US investments made by Islamic investors is a goal worth the additional effort involved.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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