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HMRC internal manual

Corporate Finance Manual

Deemed loan relationships: alternative finance: investment bond arrangements: conditions: reasonable commercial return

‘Reasonable commercial return’

Additional payments under the sukuk arrangements (which will include both ‘interest’ and ‘discount’) must not exceed a reasonable commercial return on a loan of the capital. Where the return is not fixed at the outset, it is the maximum possible amount of the additional payments that must be considered.

Thus, in the example above, the issue terms of the sukuk impose no upper limit on the amount of the periodic distributions - a sukuk holder subscribing £100 may, in a year, get back £20 or even £200 if the bull sires particularly valuable calves (although equally, they could get nothing). The maximum return is clearly in excess of a reasonable commercial return on a loan of £100, and the sukuk would therefore not be an alternative finance investment bond within the legislation.

In applying the ‘reasonable commercial return’ test, the sukuk should be compared to a hypothetical loan on similar terms and carrying similar risks. For example, a conventional security convertible into shares will normally carry a lower rate of interest because the conversion right has a value. The return on an ‘exchangeable’ or ‘convertible’ sukuk should be measured against the return on an equivalent exchangeable or convertible debt security.

However, investment in a sukuk will generally carry a slightly greater risk than investment in a conventional security, because investors have recourse only to the ‘bond assets’ - they cannot sue the issuing company for return of their capital. So the ‘reasonable commercial return’ for a sukuk is likely to be higher than the return were the same company to issue a conventional security.

As with any financial instrument, the pricing of sukuk will depend on the issuer’s view of the market at the time of issue, and ‘reasonable commercial return’ may vary within quite a wide range. HMRC staff should bear in mind that the purpose of the test is to exclude sukuk where the return is blatantly above what would be reasonable and commercial for a debt security, or where the return is linked to profits.