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Middle East Report 2009| pfi| 21

Structures are being considered to address the concerns raised by AAOIFI

Returns and risk-sharing – By way of background, a fun- damental principle of Sharia law is the prohibition of riba (ie, interest), which is essentially defined as a payment resulting from a return on money, as opposed to a pay- ment from a return made on a Sharia-compliant asset. A starting point for architects of sukuk structures is typi- cally to provide cashflows in the structure that would gen- erate returns payable to sukuk holders.

These returns would then be attributed and traceable to Sharia-compliant assets. In these structures, sukuk hold- ers own an undivided share in the underlying asset. This in turn meets the Sharia requirement of shared risk and reward in the underlying asset as opposed to the payment of money on money, as is the case in conventional bonds. Sharia compliance – With conventional bonds, a termi- nation event triggers, among other things, acceleration in the repayment of an investor's principal. In the Islam- ic context, a termination event accelerating the repay- ment of sukuk proceeds is typically managed through a purchase undertaking.

In a purchase undertaking, the transferor of the asset is required to repurchase the asset it initially transferred to a special purpose vehicle (SPV) at a predetermined price. As such, in terms of credit risk, sukuk investors are less concerned with the credit quality of the subject-asset, and more concerned with the transferor's ability to repurchase the assets at the predetermined price.

Certain market commentators are critical of a purchase undertaking purporting to guarantee capital while offer- ing fixed profit payments. Some Islamic scholars argue that these types of purchase undertakings undermine cer- tain fundamental Sharia principles, including the concept of risk-sharing.

The Accounting and Auditing Organization of Islamic Financial Institution (AAOIFI) has criticised structures util- ising the purchase undertaking in sukuk other than in ijara (lease) structures. As noted above, purchase undertakings provide a mechanism at termination whereby the subject- asset reverts to the original owner at a predetermined price so that sukuk holders are repaid their initial capital outlay. It is argued by AAOIFI that the purchase undertaking

effectively provides a capital-guarantee feature and as a result the sukuk holder is not considered having a risk exposure to the value of the asset. By predetermining the repurchase price in the purchase undertaking, it is argued that the Sharia principle of risk sharing is under- mined. That said, it should be noted that the sukuk holder is nonetheless exposed to risk because there is an assurance in a form of undertaking that the obligor will have to repurchase the asset at the predetermined price. As a result, there has been a significant reduction in the number of sukuk utilising the musharaka, mudaraba and other similar structures. The ijara structure is currently the most prominent. Structures are being considered to address the concerns raised by AAOIFI.

Historically, the majority of debt issues from Saudi Arabia

The enforce- ment of the promissory note does not require a court decision.

have been in the form of sukuk and it is expected that going forward this trend will continue. Accordingly, the above gen- eral structuring aspects will be applicable in addition to spe- cific structuring factors in relation to Saudi Arabia. Purchase undertaking and promissory notes – As set out above, under the ijara structure, the initial sukuk proceeds amount (which is analogous to the principal amount under a conventional bond) is essentially guaranteed by the requirement that the SPV sell back the underlying asset to the obligor at the original price. One alternative that has been utilised previously in sukuk is the use of the promissory note, whereby the obligor issues a promissory note to the SPV in return for the initial capi- tal outlay. This in turn provides sukuk holders with comfort that their initial investment will be repaid. In Saudi Arabia, the promissory note is evidence of debt owed by the promis- sor. As such, the enforcement of the promissory note does not require a court decision, as simple production of the promissory note is sufficient to invoke enforcement. Tax implications (zakat and withholding tax) – In structuring sukuk originating from Saudi Arabia, one should be mind- ful of tax law implications. It should be noted that the ini- tial one-off payment generated from the proceeds of the sale of sukuk (ie, the aggregate proceeds from the issue of sukuk) made to the obligor is subject to 2.5% zakat (a form of Islamic income tax). Second, the periodic payments made by the obligor to the issuer (ie, rental payments if an ijara structure is utilised) are subject to a 5% withholding tax. The implication of zakat on the proceeds of the sale of sukuk is a cost that in most cases is borne by the obligor and is considered as a cost of borrowing. In relation to the with- holding tax implications, most transactions have provided gross-up provisions that ensure that payments to sukuk hold- ers are made at the amount due without any deductions. Recently, there has been some reconsideration in rela- tion to the applicable tax laws in Saudi Arabia in order to facilitate Sharia-compliant transactions, particularly in rela- tion to zakat and withholding tax implications. Such reconsideration would naturally be welcomed by the obligor as there would be no requirement to gross up rental payments and therefore effectively allowing for lower prof- it rate premiums.

Conclusion We have above briefly highlighted sukuk market trends in the GCC and the key indicators in relation to market trends going forward. The potential and opportunity that Saudi Arabia provides within the GCC and globally is widely acknowledged. Once certain key issues (some of which have been discussed above) are resolved, and with the passing of the proposed legislation, it is likely that Saudi Arabia will be a key contributor to the growth of sukuk issuance within the GCC.

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