Will Islamic finance go Dutch? With significant demand for sharia-compliant products in the Netherlands, the challenge is on
for the authoritiaes to change their tax treatment of such products and develop an industry currently in its infancy. Niels Muller and Kees Hooft report

On 23 July this year, Bilaa-Riba Islamic Finance BV (Bilaa-Riba meaning 'no interest' in Arabic), a Dutch entity which had been set up for introducing Islamic finance products into the Dutch retail market, announced the closure of its operations. According to a spokesman for Bilaa-Riba, the main reason for closing down was the lack of cooperation by the Dutch Revenue Service.

According to Rabobank, the market leader in the Dutch retail mortgages market, the potential demand for sharia-compliant mortgages numbers around 200,000 households. It therefore seems contradictory that the Islamic home finance market has not yet developed in the Netherlands – unlike for example in the UK and US. As in the case of Bilaa-Riba, the main obstacle seems to be the reluctance of the Dutch Revenue Service to grant the same tax benefits to home owners choosing sharia-compliant home financing over a conventional mortgage. Costs of home financing are generally deductible in the Netherlands, but to date the Dutch Revenue Service has not accepted the costs relating to sharia-compliant home financing as deductible.

In a recent article we have, however, concluded that the Dutch legal and tax framework is already suitable for accommodating certain forms of sharia-compliant home financing, albeit that certain changes could be made to further streamline that framework. It is not entirely clear to what extent the failure of the Dutch Bilaa-Riba venture was related to the fact that it its founder was involved in a controversial share leasing scheme set up in the 1990s. We expect that various parties (including ourselves) will want to further test these waters in the near future.

As may be concluded from the above, the Dutch Islamic finance retail market is still in its infancy. By contrast, the Netherlands is rapidly developing into a hub for commercial (cross-border) Islamic finance transactions. The Netherlands traditionally plays an important role as a home for financing and holding companies. Important elements driving the consistent demand for Dutch financing and holding companies are the extensive tax treaty network (unlike for example the Cayman Islands vehicles commonly used in Islamic finance transactions), the participation exemption and the possibility to obtain certainty in advance from the Dutch Revenue Service on certain interpretive matters and on intercompany pricing.

Apart from these obvious (and mostly well-known) advantages of using the Netherlands in cross-border structures, a further specific advantage of the Dutch tax system for Islamic finance structures is the profit calculation method. Unlike, in the UK, for example there is no different tax treatment for different types of income. This means that, for example, trading losses can be offset against capital gains and vice versa. Since in Islamic finance transactions, income is often assigned a different qualification than in conventional finance structures, this has proven to be a significant advantage over profit calculation methods that treat different types of income separately. The risk of a mismatch causing tax leakage is therefore minimal in the Dutch system. In addition, the widely accepted substance-over-form approach in tax matters, in combination with the generic nature of the rules for profit determination leave room for the Dutch Revenue Service and issuers to agree in advance on an interpretation of the contracted relations that achieves the goals of both parties. This implies that no major changes of tax law are required to accommodate Islamic finance transactions. We note that this conclusion does put the Netherlands at a disadvantage from a marketing perspective compared to, for example, the UK, where every amendment made to the tax legislation is used to promote the UK Islamic finance industry.

In addition to tax efficiencies, the Dutch legal and regulatory framework caters well for the requirements of foreign investors. Significant amendments to the Dutch private company rules are imminent and will make the Dutch private limited liability company (BV) a cheaper and more flexible vehicle than ever before. An example of how the Dutch legal framework can play a complementary role in cross-border Islamic finance transactions is using a Dutch foundation known as a stichting as a trustee or agent. The stichting is often used as trustee or agent in structured (asset) finance transactions, such as securitisations and defeasance structures. In the 2004 Saxony-Anhalt sukuk issue, for example, a stichting was chosen to issue certificates to investors relating to the income derived from certain office buildings located in the German Bundesland Saxony-Anhalt. By using the stichting, a trust-like relationship is created for the investors (in this example the sukuk-holders).

A main advantage of a stichting is that it is easy to set up and the compliance costs are generally marginal. Another advantage of using a Dutch vehicle as opposed to an offshore vehicle (as often used in more traditional structures) is that a Dutch vehicle can have the benefit of an European Union (EU) passport facilitating a possible onshore listing of the sukuk within the EU. If a stichting does not carry on an enterprise, it is not subject to corporation tax in the Netherlands, unless it enters into competition with (taxable) entrepreneurs. Any payments made by a stichting are not subject to withholding taxes.

The amendments to the Dutch partnership legislation, to be effective as per 1 January, 2009, provide for an even more flexible partnership regime. Both limited partnerships (commanditaire vennootschap), as well as general partnerships (openbare vennootschap), will be able to have, if so desired, legal personality, without losing their tax transparent status. The Dutch partnership is therefore an attractive vehicle to bear in mind when, for example, structuring a Musharaka or Mudaraba transaction. In addition, a Dutch fund for joint account (fonds voor gemene rekening) obtaining a tax transparent status (vrijgestelde beleggingsinstelling) may also serve as suitable investment fund vehicle for Islamic investors.

A unification of the Dutch regulatory framework has been effective as of January 2008. The Dutch Central Bank has recently issued an exploratory analysis on the supervision of Islamic banking and finance, further underpinning the growing interest for Islamic finance in the Netherlands. One of the conclusions that drew media attention in the Netherlands was that the current supervision framework does not fully apply to Islamic finance providers (although conventional banks having a so-called Islamic window do fall within the current supervision framework). In our opinion, some minor amendments to the supervision framework would ensure that Islamic finance transactions fall within its scope. This may also facilitate the above-mentioned passporting of Sharia-compliant securities through the Netherlands.

We are currently advising on several Islamic finance transactions involving both Dutch assets and Dutch financing vehicles. These transactions show that Islamic finance is spreading out from its traditional bastions and parties are looking for more transparent onshore structures to facilitate the growing demand of Islamic investors. Also, the types of asset classes and the location of such assets is rapidly diversifying. We expect that in the coming year the Islamic finance industry will increasingly discover the benefits of the Netherlands as a reliable, onshore and transparent gateway for Islamic finance. Islamic finance will go Dutch.

Niels Muller is a tax lawyer and Kees Hooft a banking and finance lawyer at Loyens & Loeff in Amsterdam.