March 13 Luxembourg's plan to issue an Islamic bond faced its first test this week as a proposal to securitise assets to back the transaction was scrutinised by the Council of State, a body which advises the national legislature.
AAA-rated Luxembourg could pip Britain's ambitions to become the first Western country to issue sovereign sukuk, as both countries look to boost their Islamic finance credentials to attract more business from cash-rich Gulf countries.
In a filing on Wednesday, the Council raised issues including the economic rationale for issuing sukuk, a need for greater clarity on tax treatment, and whether the sukuk could be bought only by Muslims.
The questions underscored both the progress which Islamic finance has made in winning acceptance in Western markets, and the challenges which it still faces in presenting its business proposition to policymakers.
Luxembourg's proposed bill would allow securitisation of three properties for a sukuk issue worth 200 million euros ($275 million).
The filing by the Council's secretary-general Marc Besch and president Victor Gillen listed several issues not addressed in the plan, including technicalities relating to Luxembourg law.
"Will there be a banking syndicate in the classical sense or will the mode of marketing be different? What are the "coupons"? Who will be entitled to buy? Only Muslim investors or institutional investors or also Luxembourg individuals?"
"The State Council finds that the project is entirely silent on the tax treatment of sukuk."
The Council said answers to such questions were not essential for the bill to be approved, but would be useful background given the innovative character of the proposal.
It is unclear if the questions could delay the bill's passage; an upcoming vote on Luxembourg's budget could potentially extend the sukuk approval process by up to five months.
The Council requested a "convincing explanation" for why sukuk financing was more appropriate than a conventional bond, citing the additional costs of establishing a sharia board to oversee the transaction's adherence to Islamic law.
"First, in the world of finance, many experts including Muslims argue that, in principle, funding via sukuk is more costly for the issuer than a classic bond financing."
Extra costs are also partly due to the way certain Islamic finance contracts can attract double or even triple tax duties, because they require multiple transfers of title of the underlying asset.
Luxembourg tax authorities, however, have clarified the tax treatment of Islamic finance transactions in circulars dating back to 2010, which is expected to ensure that the tax treatment of sukuk is similar to that of conventional bonds.
Besides justifying the added value of using a sukuk, the project needs to clarify the end purpose of the money raised, the Council said.
"What is missing in the project is to establish a link between the selected instrument (sukuk) and legislative requirements of public spending."
The finance ministry, which would issue the proposed sukuk, has provided documents supporting the project but the Council said it had not received an opinion from the Chamber of Commerce, which would have been "very useful".
Cost considerations led the British government to shelve its own sukuk plans in 2008, although it has since revived them under a downsized scheme to sell a 200 million pound ($335 million) sukuk issue as early as this year.
The British government has mandated HSBC to advise on the deal. (Editing by Andrew Torchia)