There are two key principles to make a financial transaction Sharia (compliant with Islamic law, Islamic banking | Islamic finance and principles)
- The transaction musn’t involve businesses that are in markets that are inherently forbidden (so, no investing in gambling houses or pork butchers.)
- The transaction mustn’t charge ‘Riba’, which is in practice ‘interest.’
A general principle is one of balance – that the bank should share in the risk (and reward) rather than just charging money for the sake of money.
Obviously, modern Islamic economies want the benefits of entrepreneurs being able to borrow, and Moslems who want to live in countries where interest-based financing is common want to be able to, say, buy houses without needing to come up the entire price up-front!
So there are a number of different ways of structuring a deal that means that no interest is charged, but the transaction ends up (over a certain period of time) looking similar.
So, for instance, if someone wants a Sharia mortgage according to Islamic banking, on a $100,000 property, they can enter into a transaction where the bank buys the property from the vendor (for $100,000), immediately sells it to the purchaser for, say, $200,000, but allows the purchaser to repay that amount, interest-free, for $10,000 a year for 20 years. (This is often called a Murabaha contract.)
The problem with this sort of mortgage under UK tax law was one of transaction taxes – if the bank buys the property and then re-sells it (same day) to the ultimate purchaser, that’s techically two transactions, and SDLT (stamp duty – land tax) needs to be paid on each. In 2003, the UK Government passed a law to allow such contracts to only be taxed once.
Another type of mortgage is structured as a joint purchase – the bank and the buyer purchase the property jointly, and the bank gradually sells out their share to the buyer (who has exclusive use of the property.) The buyer pays the bank according to a pre-determined schedule, part of which is repayment of an interest-free loan on their portion, and part of which is rent on the bank’s. This kind of arrangement is called a Musharaka contract.
Of course, in some places, there’s a tax benefit to having some costs classed as interest – in 2005, the UK government passed some laws allowing both the contract types above to be taxed as if they were ‘conventional’ mortgages.
When it comes to corporate finance, there are similar ways of structuring things – rather than an investor buying an interest-bearing corporate bond, they might bear a zero-coupon bond at a discount.
I can’t handle the ‘religious, ethical and legal’ nuances… but hopefully this is an adequate starter for 10.