The German financial market offers growth potential for Islamic finance-compliant products and structures. Islamic finance products are not only appealing for foreign investors and around 5 million Muslims currently living in Germany, but also to non-Muslim investors who believe that investments must adhere to certain ethical standards.
The Federal Financial Services Supervisory Authority (BaFin) promoted two international conferences in 2009 and 2012 to outline the distinguishing factors of Islamic financial instruments and the potential economic benefits that Germany might gain from establishing an Islamic finance industry in the country.
II Legislative and regulatory framework
i Legislative and regulatory regime
The law in Germany does not differentiate between religious or ethical backgrounds.2 The German legal system differs fundamentally from the common law system of England and Wales, in which courts rely mainly on precedents. As opposed to relying on precedents, German judges apply the law according to the principles and standards set in various legal codes. The cornerstone of German civil law is the German Civil Code (BGB). Next to general rules such as legal capacity and conclusion of contract, it contains, inter alia, specific regulations regarding (1) typical contracts (such as sale and purchase agreements or renting agreements, (2) rights in rem and (3) torts. The laws concerning commercial, corporate and capital markets and banking law can be found mainly in five national codifications, comprised of the BGB, as well as the following codes:
- the German Commercial Code (HGB) containing regulations on merchants and regulations concerning commercial partnerships, such as general partnerships and limited partnerships;
- the German Act on Limited Liability Companies and the German Stock Corporation Act regulate the establishment and operation of the most common German corporations: limited liability companies and stock corporations; and
- the German Banking Act (KWG) covers, inter alia, the licensing requirements for banks, ownership control and the national regulation of banks and other investment institutions.
As Germany is an EU Member State, the national legislative and regulatory regime is complemented by certain EU regulations that claim direct application in Germany, which are also relevant to Islamic finance products:
- the Market Abuse Regulation (Regulation (EU) No. 596/2014) includes rules on ad hoc publicity, insider trading and market manipulation;
- the Single Supervisory Mechanism Regulation (Council Regulation (EU) No. 1024/2013) (SSM) confers the nature and scope of the European Central Bank's (ECB) duties and its cooperation with national competent authorities such as the BaFin; and
- the Capital Requirements Regulation (Regulation (EU) No. 575/2013) that sets certain capital requirements for credit institutions and investment firms.
Legal qualification of Islamic finance products under German law
Since Islamic finance products are not regulated separately in Germany, the corresponding structures will be legally assessed and qualified in accordance with the general rules of the applicable civil, commercial, corporate, banking and tax laws. Thus, the sharia-compliant structures have to be reviewed from a German law perspective, which applies to these structures accordingly.
This is a financial structure that enables immediate asset purchase but with deferred payment would legally be comprised of two purchase agreements. Thus, under German law, these would be subject to the regulations of the BGB covering sale and purchase agreements and the transfer of ownership in rem. If such agreement is concluded between business people and consumers, it could be qualified as financial assistance and thus be subject to the special consumer protection regulations set forth in the BGB.3
An istisnah is an agreement to manufacture an asset. One party engages another to develop or manufacture an asset, which the bank agrees to purchase. The engaging party then buys the manufactured asset from the bank with deferred payment. The istisnah is similar to the murabahah structure; however, it is not constituted of two sale and purchase agreements, but instead, a contract for development and a sale and purchase agreement.4
This is an arrangement under which two partners contribute to a partnership. While one partner contributes capital, the other partner contributes its know-how and work. Such an arrangement is comparable to a German silent partnership5 or a profit-participating loan6 and therefore falls under the corresponding regulation within the HGB.
Musharakah describes a partnership dedicated to achieve a joint purpose. Both or all partners provide cash or assets. Such arrangement would qualify as a joint venture in Germany. There are no specific rules applicable to joint ventures in Germany. The applicable law rather depends on the type of partnership or corporation that is used for the joint venture. Parties in general would use a limited liability company for such joint ventures; therefore, the rules on limited liability companies would apply.
Ijarah is similar to operating leasing, whereas an ijarah wa iqtina qualifies as financial leasing.7 Operating leasing agreements are qualified as rental agreements and are therefore directly subject to the relevant regulations in the BGB.8 Ijarah wa iqtina as a financial lease agreement could qualify as a financial instrument and therefore fall within the scope of the regulations of the KWG,9 or as financial assistance, and be subject to the consumer protection regulations.
Sukuk are asset-based certificates that differ depending on the asset they are based on. Sukuk are often referred to as Islamic bonds, owing to their resemblance to conventional bonds.10 In turn, sukuk would be subject to the regulations on bonds in the KWG.
Depending on the individual structure of each transaction, further legal regulations may apply. However, as a guiding principle, the freedom of contract applies to any of the aforementioned transaction structures, so that the parties are free – subject to the application of fundamental principles of German law – to agree and stipulate the specifics and details of their contractual relationship.
Islamic finance products are generally compatible with German law and can be structured to comply with the rules of German law as well as the requirements set by sharia. As sharia presents certain legal boundaries with regards to such transactions (e.g., based on Chapter 2, verse 276 of the Quran), taking interest is forbidden. Similarly, the German rule of law also stands, and as a result, German laws must be adhered to. In structuring the transaction, both legal systems must be aligned. In hindsight, it can be seen that this is possible:
- the sharia board must be compliant with standards set by German corporate law. If a German stock corporation, limited liability company or partnership is involved in a transaction, the principles concerning the authority of the management board should be observed. This means that the sharia board (internal or external) cannot have the power to make final management decisions, such as whether or not a certain product shall be issued. Although a sharia board may not take any managerial decisions, it may assess the extent to which products are compliant with the Islamic rules on finance.11 From our perspective and experience in dealing with such sharia boards, it is not its intention to take managerial decisions or roles, but it provides assessment advice and help in structuring transactions and monitors activities of the management board in order to qualify the transaction as sharia-compliant; and
- Islamic financial institutions should be aware of consumer protection law being integrated into general German civil law (Sections 305 et seq., 312 et seq., 355 et seq., 474 et seq., 491 et seq. and 506 et seq. of the BGB). The provisions of German consumer protection law are based on several European directives on consumer rights and are therefore regulated consistently throughout the European Union. Consumer protection law applies to contracts between customers and businesses (Section 310, Paragraph 3 of the BGB). This is not an Islamic finance specific issue, but applies to any international investor.
ii Regulatory and supervisory authorities
There is no special regulator in Germany dealing specifically with Islamic finance structures or products. Islamic and conventional financial institutions alike are supervised by (1) the ECB; (2) the German national central bank (Deutsche Bundesbank); and (3) the BaFin.
The ECB is responsible for banking supervision in the Eurozone under the SSM. Under such mechanism, the ECB aims to ensure harmony in the European banking system and consistency in the application of regulations and supervisory policies. The ECB is the competent authority to, in particular, (1) grant and withdraw banking licences, (2) conduct supervisory reviews and inspections and (3) supervise the institutions' compliance with the corresponding regulatory regime.
Despite the fact that many functions of the Deutsche Bundesbank have been taken over by the ECB, the Deutsche Bundesbank is, alongside the ECB, responsible for, inter alia, national supervision, drawing up the fiscal and monetary policies, foreign currency reserves and statistics regarding the market and its participants.
In addition to regulating the banking sector on a national level, the BaFin is also responsible for (1) regulating and applying the relevant applicable rules on the insurance market, (2) the offering of securities and (3) approving prospectuses. Depending on the specific circumstances of the transactions, either the BaFin or the ECB would be the competent authority to approve the issuance of sukuk and regulate the Islamic insurances and reinsurances known as takaful and retakaful.
III Common structures
The Capital Investment Act was adopted in 2013 for the creation of a unified standard for the management of investment funds, and provides the general regulatory framework that all financial products – regardless of whether they are structured to comply with sharia principles – must comply with.
i Islamic bank
In 2015, KT Bank was granted a banking licence by the BaFin and became the first bank in Germany to offer dedicated Islamic finance products.12 Since then, sharia-compliant financial products have been introduced to the German market and offer retail and investment banking solutions to both individuals and businesses alike.13
With regards to sharia-compliant insurance products, the most common structure is demonstrated by ForwardU AG (FWU AG), a financial services company based in Munich, which offers insurance solutions in the form of takaful. In accordance with sharia principles, FWU AG has allowed its customers to enjoy the benefits of life insurance.14
iii Investment funds
Sharia-compliant investment funds have been made available in recent times in Germany.15 Such funds provide investors with the opportunity to invest in an index that deals solely with businesses whose activities do not include activities that are forbidden in Islam, such as interest-bearing financial services or derivatives, or the sale of alcohol, pork, tobacco, arms or gambling products, among other things. As such, the certificates offered to investors in this index have been certified by the Central Council of Muslims in Germany as being sharia-compliant.16
KT Bank offers participatory accounts that involve investing in sharia-compliant products. These accounts are based on the principles of mudarabah. They operate on the basis of profit sharing, whereby the allocation of profits is dependent on the initial investment deposit and the duration of the deposit. The duration of the term varies between three and 36 months, whereas the investment size has a minimum requirement of €1,000.17
iv Consumer finance
The primary structures used for consumer finance in line with Islamic finance principles are based on murabahah lil amri bi-schira, whereby a contract between the customer and the bank is entered into that gives the customer authority to purchase the good to be financed in the name of the bank. It is imperative that the good conforms to the principles of Islamic finance and is deemed halal. Subsequently, the contract of purchase between the customer (signing in proxy in the bank's name) and the seller of the good is signed, and the purchase price is paid to the seller. The bank will then have ownership and good title over the good, and sells the good in question to the consumer, having calculated a profit margin on top of the original purchase price.18
v Home financing
Customers seeking sharia-compliant home financing are able to do so in accordance with both the principles of Islamic finance and the general provisions under German law. KT Bank provides such financial products by utilising the musharakah structure.19
vi Other areas
In 2004, the state government of the German federal state of Saxony-Anhalt issued a sharia-compliant bond in the form of a sukuk for €100 million. The federal state allocated the legal rights of use of some of its real estate to a trust and the trust released the legal rights of use back to the federal state. The issue was traded on the Luxembourg Stock Exchange and was fully subscribed.20 The structure involved the use of a leasing rate, as opposed to receiving interest in order to maintain compliance with sharia principles. Subsequently, the ijarah sukuk structure became the most common form of Islamic finance structure used with regards to German real estate transactions.21
The German tax system applies to all taxpayers equally. The guiding principle of German taxation is the ability-to-pay principle as a specific expression of the general principle of equality stipulated in Article 3, Paragraph 1 of the German Federal Constitution.22 Accordingly, the tax burden is measured on the basis of income of the respective taxpayer (i.e., on purely economic factors).23 Although social aspects and responsibilities are considered,24 there is in principle no special treatment on the basis of ethnicity or religion. As such, the tax burden of a transaction is determined based on the merits of the individual transaction. This might result in disadvantageous taxation of certain structures used for Islamic finance compared to the taxation of a conventionally structured transaction. Below are two summarised examples of such potential taxation issues that need to be taken care of when doing such transactions:
- Islamic finance ijarah and murabahah structures require, in principle, at least a two-step acquisition of the underlying asset, first by the financial institution and then by the customer.25 In the case of a real estate transaction, such structure may trigger real estate transfer tax twice, for each case of acquisition of the underlying real estate asset. In contrast, a conventional product would only result in one taxable acquisition,26 and thus, real estate transfer tax would be triggered once. At first glance, the structure of murabahah products is seen to give rise to double taxation issues in Germany, as the transaction is comprised of two distinct purchase agreements, and therefore each respective transaction may be liable for taxation under German real estate transfer tax laws. However, KT Bank suggests a solution with regards to the tax implications by electing to constitute a civil law partnership with the customer.
- The term 'interest' might be interpreted differently under German law compared with sharia. Under murabahah, the profit of the bank – being the surplus between the amount paid to the seller and the amount received from the customer – would not qualify as income from interest, but as commercial income. That is to the disadvantage of the bank as the tax rate for trading and commercial income is higher in Germany than that of income derived from interest. For the customer who has paid an extra amount as surplus to the bank, such surplus would be qualified under German tax law as interest expenses, irrespective of the qualification under sharia. The customer would therefore be treated equally as any taxpayer in a conventional structure.
Thus, Islamic finance products are not subject to tax (dis)advantages in general. Nevertheless, they have to be structured carefully and with a special view on German tax law to minimise the risk resulting from German taxation.
There is no separate insolvency regime for Islamic finance products in Germany, making them subject to the German Insolvency Act (InsO). Within an insolvency proceeding, all creditors are generally treated equally.27 After the application for insolvency has been filed, the court passes a resolution to commence insolvency proceedings. The creditors are then required to file their claims. The insolvency administrator now has administrative authority over the debtor's assets, and subsequently the debtor's disposals of insolvency assets are generally invalid.28
Individual enforcement of a ruling in favour of the creditors is not permitted, as the revenue of the liquidation is divided among the creditors pro rata. However, some creditors are favoured, such as creditors who are entitled to have specific property released from the bankrupt's estate and creditors who are entitled to separate satisfaction. A right to release a certain property requires a personal right or a right in rem concerning the property, such as a right of ownership.29
VI Judicial Framework
Courts in Germany have jurisdiction over disputes arising out of Islamic finance-related transactions, unless there is an arbitration clause or a contractual clause that gives jurisdiction to any other courts.
To our knowledge, there have been no recent (publicly known) litigation cases in German courts that are related to Islamic finance matters.
Germany offers an open market for Islamic finance that provides a solid foundation for growth. Additional development in the regulatory framework will further facilitate Islamic finance products and enhance both inbound and outbound investment streams with investors caring for sharia-compliant or ethical products in general. Owing to the fact that the BaFin is in charge of the oversight of the financial sector, potential customers would always be protected by a supervisory authority, which ensures that the respective law is followed in light of potential developments.30 Although sharia-compliant products are still relatively rare in the German financial market, the existence of the KT Bank proves that it is possible to successfully embed them into the German legal framework.
1 Murad M Daghles is a partner at Allen & Overy LLP.
2 Casper/Allali, 'Islamic Finance Made in Germany – A Case Study on Kuveyt Türk (KT Bank): Germany's First Islamic Bank', Preprints and Working Papers of the Center for Religion and Modernity (2017), p. 6, at www.unimuenster.de/imperia/md/content/religion_und_moderne/preprints/crm_working_paper_15_casper_allali.pdf.
3 Becker, RNotZ 2014, 22, 30, 32.
4 Becker, RNotZ 2014, 22, 26.
5 Gehrlein, in Ebenroth/Boujong/Joost/Strohn, HGB, 3rd edition, 2017, Section 230, recital 2 et seq.; Roth, in Baumbach/Hopt, HGB, 38th edition, 2018, Section 230, recital 1 et seq.; Karsten Schmidt, in MüKo HGB, 3rd edition, 2012, Section 230, recital 3; Wedemann, in Oetker, HGB, 5th edition, 2017, Section 230, recital 1 et seq.
6 Gehrlein, in Ebenroth/Boujong/Joost/Strohn, HGB, 3rd edition, 2014, Section 230, recital 77; Roth, in Baumbach/Hopt, HGB, 38th edition, 2018, Section 230, recital 4; Karsten Schmidt, in MüKo HGB, 3rd edition, 2012, Section 230, recital 57 et seq.; Wedemann, in Oetker, HGB, 5th edition, 2017, Section 230, recital 36, 37.
7 Becker, RNotZ 2014, 22, 26.
8 Koch, in MüKo BGB, 7th edition, 2016, financial leasing, recital 5; Alexander Scheuch/Ina Ebert, in Schulze, BGB, 9th edition, 2017; introduction to Sections 535 to 580a, recital 11; Weidenkaff, in Palandt, BGB, 77th edition, 2018, introduction to Section 535, recital 38, 40; Zehelein, in BeckOK BGB, 45th edition, 2017, introduction to Section 535, recital 68.
9 Gramlich/Manger-Nestler, WM 2009, 1634.
10 Grieser, WM 2009, 592.
11 Sorge, ZBB 2010, 366.
12 Meijer/Vizcaino, 'Kuveyt Turk preps July launch of Germany's first Islamic bank', 2015, at www.reuters.com/article/islam-financing-germany/kuveyt-turk-preps-july-launch-of-germanys-first-islamic-bank-idUSL6N0WO0UW20150322.
13 See footnote 2.
17 Footnote 2, p. 5.
18 Footnote 2, pp. 24 et seq.
19 Footnote 2, p. 34.
20 Footnote 2, p. 5.
21 Fawzy, VuR 2009, 39, 40.
22 BVerfGE 105, 73, 125; Hey, in Herrmann/Heuer/Raupach, EStG and KStG, 2017, introduction to EStG, recital 42.
23 Hey, in Herrmann/Heuer/Raupach, EStG and KStG, 2017, introduction to EStG, recital 44.
24 Hey, in Herrmann/Heuer/Raupach, EStG and KStG, 2017, introduction to EStG, recital 45.
25 Klein, in Islamic Finance Tax Considerations Around the World, 2012, pp. 26–27.
27 Ganter/Lohmann, in MüKo InsO, 3rd edition, 2013, Section 1, recital 52; Madaus, in Fridgen/Geiwitz/Göpfert, BeckOK InsO, 10th edition, 2018, Section 1, recital 3; Pape, in Uhlenbrock, InsO, 14th edition, 2015, Section 1, recital 12.
28 Mock, in Uhlenbrock, InsO, 14th Edition, 2015, Section 81, recital 25; Ott/Vuia, in MüKo InsO, 3rd edition, 2013, Section 81, recital 5; Riewe, in Fridgen/Geiwitz/Göpfert, BeckOK InsO, 10th edition, 2018, Section 81, recital 7.
29 Brinkmann, in Uhlenbrock, InsO, 14th edition, 2015, Section 47, recital 10; Ganter, in Kirchhof/Eidenmüller/Stürner, MüKo InsO, 3rd edition, 2013, Section 47, recital 37; Haneke, in Beck InsO, 10th edition, 2018, Section 47, recital 26.
30 Kloft, 'Geld anlegen nach Scharia', 2017, at www.faz.net/aktuell/finanzen/finanzmarkt/muslimische-kt-bank-arbeitet-als-erste-ohne-zinsen-15220758-p2.html.