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HMRC internal manual

Corporate Finance Manual

HM Revenue & Customs
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Deemed loan relationships: alternative finance: investment bond arrangements: example

Sukuk arrangements: example

Z is a company owning a portfolio of property, from which it derives a steady and reasonably predictable stream of rental income. It wishes to utilise its property assets in order to reduce the cost of its borrowing. It might do this by issuing debt secured on the properties, or by issuing covered bonds, or by securitising the rental receipts (CFM72000).

Instead, it decides to issue sukuk, with a 10-year term. It sets up a special purpose vehicle (company S) in order to issue the sukuk. S may be a member of the same group as Z, or it may contrive for the shares to be owned by a charitable trust, to protect investors should the Z group suffer financial collapse.

S raises £50 million by issuing sukuk into the market - in the same way as an issue of conventional securities. The sukuk carry the right to receive quarterly distributions of all of the income earned by S from the properties to be acquired, but limited to a maximum rate equal to LIBOR plus 1%. S then uses the £50 million to buy the properties from Z.

S, however, makes a Declaration of Trust, stating that it holds the properties on trust for the sukuk holders. The trust so created then leases the properties back to Z; the income arising under the lease is used to fund the periodic distributions to sukuk holders. The rent payable under the lease is equal to LIBOR plus 1% to mirror the payments the investors expect under the sukuk.

At the start of the arrangements, Z also signs a forward purchase agreement with S, committing it to repurchasing the properties at the end of 10 years, at a price of £50 million. When the sukuk mature, the properties are sold back to Z, the trust is dissolved and a £50 million ‘dissolution distribution’ is made - effectively a redemption of the certificates at par.

So, from the perspective of a holder, the arrangements function very similarly to a conventional bond carrying an interest coupon of LIBOR plus 1%. The difference is that, in legal terms, no debt is owed. The holder has recourse only to the property assets, and if they do not generate sufficient income or sale proceeds to pay LIBOR plus 1%, or to redeem the sukuk in full, or both, the holder has no option but to accept less. In practice, there are likely to be guarantees in place to reduce this risk to a minimum.

From Z’s perspective, the arrangements have features in common both with a covered bond issue and with a conventional securitisation. In all three cases, assets are removed from the generality of Z’s business (thus reducing or eliminating any claims that other business creditors might have on them). But, whereas in covered bond issues or securitisations, the ‘removal’ is accomplished by transferring the assets to a separate company, sukuk accomplish it by putting the assets into a trust or a trust-like arrangement.

Thus the sukuk holders have an interest in the underlying assets, which holders of conventional secured debt will not have - even though, in practice, their rights are restricted to receiving a pre-arranged rate of return and getting their capital back at the end of the bond term.