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Terrorism financing risks in the purification process of sharia-compliant funds

Authors:

Nicolas Marinier: Partner, Risk, Regulatory & Forensic, Deloitte Luxembourg
Marie-Astrid Dupuy: Director, Risk, Regulatory & Forensic, Deloitte Luxembourg
Andreas Schmitt: Senior Manager, Risk, Regulatory & Forensic, Deloitte Luxembourg
Mohamed Tarek Boubakar: Consultant, Risk, Regulatory & Forensic, Deloitte Luxembourg

Performance Magazine Issue 46 - Article 1

To the point

  • Due to Luxembourg’s political stability and efficient cross-border distribution through UCITS, it is an ideal location for hosting Sharia-compliant investment funds, which are anticipated to grow in the future.
  • Sharia-compliant investment funds adhere to Islamic principles, including the purification of non-permissible income, which involves channeling these funds to non-profit organizations.
  • Implementing comprehensive risk assessments and due diligence measures is crucial to safeguard against terrorism financing risks that may arise from non-profit organizations. This mitigates risks and further enhances ethical investment practices, which are inherently followed due to the nature of Sharia-compliant funds.

1. Europe’s Epicentre for sharia-compliant investing


The Luxemburg vibrant financial landscape is of astounding innovation, as the first European hub for environmental, Micro Finance Investment Vehicles and ethical investing. The country notably holds also another primate, as it hosts approximate 36 sharia-compliant investment funds (hereinafter “sharia funds”), mainly in form of sub-funds of open-ended investment companies with variable capital, qualifying as UCITS1. According to the brochure on Islamic Finance published by Luxembourg for Finance in July 2022, Luxemburg is the fifth largest domicile for shariah funds and the first taking into consideration only non-Islamic countries. It is widely known that the rationale is the political stability of Luxembourg and its unique cross-border distribution scale through the advantage of having UCITS that benefit from a European passport.

A sharia fund adheres to the principles of the Islamic law with the purpose to follow a social and ethical purpose (e.g., the prohibition of riba, being the interest on loans). These type of funds are set up under the Law of 17 December 2010 relating to the undertakings for collective investments or the Law of 13 February 2007 concerning specialized investment funds. There is no legal framework in force specifically applicable to sharia funds. Only the tax authorities had issued a circular in 2010 about the treatment of certain Islamic financial instruments such as murabaha, sukuk and ijara.

To summarize, Luxembourg finds itself in an optimal spot to market this type of investment funds, which is an important trait as Islamic Finance represented (worldwide) a market of around USD 3.37 trillion out of which USD 178 billion relates to Islamic funds. For the year 2025 an increase of Islamic finance to USD 4.94 trillion is anticipated.2

Probably due to the growth of this sector and Luxembourg’s position on the market, as well as the specifics surrounding sharia funds – as further elaborated below – these type of funds have been object of a thematic inspection by the CSSF in 2023. The results and insight have been published this year, in general anti-money laundering and counter terrorism financing (AML/CTF) controls for Luxembourgish sharia funds have shown “adequate and of good standard, despite some shortcomings”3 observed in key areas such as:

  • name screening against targeted financial sanction and politically exposed persons lists, and
  • failure on receiving and reviewing of the AML/CFT due diligence performed by third parties on different stakeholders including charities for purification (please note that the purification method will be further elaborated below).

Although the topic of Islamic finance is extensive, this article solely concentrates on those particular aspects surrounding sharia funds, which are potentially exposed to terrorism financing (TF) risks. This exposure to TF risk has also been highlighted by the CSSF in the context of the above-mentioned thematic inspection, requiring Sharia funds and Investment Fund Managers (IFMs) to exercise extra attention when using non-profit organizations (NPOs) for purification purposes.

2. Governance arrangements and the purification of investment income


A distinguishing element of sharia funds compared to non-sharia compliant investment funds is the additional attention to reputational risks, through regular monitoring of the fund’s portfolio. This control as a result could require the necessity to sell even profitable instruments in order to rectify non-sharia compliant positions, in the event of sharia non-compliant assets materializing. Of course, reputational risk, like its counterparts (e.g., credit, market, liquidity), is also consistently evaluated for non-sharia compliant funds. However, funds that necessitate adherence to Sharia bring an intensified focus to this reputation dimension. Ultimately, investors in these funds have a vested interest in ensuring compliance with Sharia principles.

The significance to comply with Sharia principles and hence mitigate reputational risks introduces also an unique element in terms of the governance of a sharia-compliant investment fund. The appointment of Sharia Boards constitutes one of the key differences compared to other type of investment funds. Depending on its function, this board may possess the authority to make impactful decisions or may exclusively provide advisory support. Often the competences and functions of Sharia Boards are described in the investment fund prospectus. The Sharia Board is usually entrusted to monitor and approve investment guidelines, issue annual reports and to assess compliance of investment products and transactions. From an AML/CTF perspective, it is pertinent to point out the competency of the Sharia Board to advice on the methodology of purification of non-permissible income (e.g. interest gain) or the review of the investment funds purification activities.

In 2023, foreign investment surged in India, flowing in from a variety of jurisdictions. The year also saw a spate of regulatory developments that underscored India’s unwavering commitment to fostering economic growth, streamlining investment processes, enhancing transparency, and nurturing a favorable environment for foreign investors.

As the global economy continues to intertwine with India’s financial markets, it’s increasingly essential for foreign investors to understand the country’s regulatory framework and keep abreast of its changes.

This article summarizes the different routes available to foreign investors, taking a closer look at the regulations governing foreign portfolio investments (FPIs) and alternative investment funds (AIFs) in India. It also breaks down the Securities and Exchange Board of India’s (SEBI) rules and compliance requirements for these avenues.

Purification is the deduction of a portion of income generated by an investment which is related to non-permissible activities. Subsequently, any purified income is given away to charities. In short the gains to be purified are:

  • those deriving from non-permissible activities and,
  • those deriving from the divesting of assets that become non-permissible.

In the first scenario a sharia fund could hold shares in a company whose income is linked to the selling of alcohol or performance of lending activities, however, usually it is not allowed to invest in shares of companies whose income exceeds 5% of non-permissible activities. Any income deriving from the non-permissible activities of a company would need to be purified.

In the second scenario, the Sharia Board would initiate the selling of an entire position due to the sharia fund surpassing (for a certain time period) the 5% threshold, or the prescribed 33% indebtment ratio. For instance, a tech company might opt to invest in the retail banking sector, which could result in a scenario where the majority of profits are derived from interest-related activities (riba), which is not compliant with Islamic law.

The process of purification of this type of gains translates into the donation to charitable causes. The amount is based on specific calculation methods, defined by the Sharia Board, following common international best practices (e.g. Accounting and Auditing Organization for Islamic Financial Institutions or AAOIFI).

3. The purification of investment income and potential terrorism financing risks


Depending on the preference of the sharia fund, either the investors themselves or the IFM can have the responsibility to carry out the purification process and hence, the selection of the NPO. In the first mentioned scenario, the investment fund would provide the percentage of earnings to be purified to the investor. Either way, the charitable distribution might pose an inherent risk of TF which would need to be addressed and prevented accordingly, as further elaborated below.


3.1. NPOs exposure to terrorism financing risks

Already in 2014, the relevance to protect NPOs against TF risk have been highlighted by the Financial Action Task Force (FATF)4. Moreover, in November 2023, the FATF also issued their best practices to support countries and professionals in their efforts to protect NPOs from TF abuse5.

In their publication, the FATF has emphasized the importance of NPOs and state that they play an important role by providing support to economies, communities or individuals in need. In fact, this may also lead to the prevention of radicalization which otherwise could lead to terrorism. At the other hand, the FATF has recognized that NPOs are frequently abused for the funding of terrorist groups or extremist in different ways (non-exhaustive):

  • The public trust which NPOs enjoy could be exploited by terrorist groups as donators would contribute considerable amount of funds without further considerations. Furthermore, potential exploitation is not limited to donated funds. Human resources, for example, may also be at risk, as they could be utilized for purposes of radicalization and recruitment for terrorist organizations.
  • Due to the global nature of some NPOs, including in areas or close to areas which are exposed to terrorist activities, transactions might appear in line with the activity of an NPO, while funds might be misused for financing non-legitimate purpose. NPOs could be abused as legitimate front for a terrorist group or the management could be infiltrated by terrorists, which in turn would be able to make fundraising and -distribution decisions.

As a result, it is pertinent to understand the characteristics and activities of an NPO. The FATF urges to conduct a TF risk assessment and to apply risk-based due diligence measures on charitable organizations. Thus, prior to any donation of purified gains, the NPO receiving the donation has to be examined in regard to their ML/TF risk profile and mitigation measures should be enforced.

Furthermore, in regard to Luxembourg,  the recent mutual evaluation report of the FATF6, published in September 2023 subsequent to their on-site inspection, pointed out that Luxembourg must strengthen the understanding of TF across public and private sector stakeholders. Despite Luxembourg’s capacity to identify non-governmental organizations potentially exposed to a higher risk of TF abuse, it was emphasized that the sector’s understanding of TF is still low.

It is by now commonly known that NPOs are increasingly targeted by terrorist organizations to raise funds, either through effective fraud schemes or in some occurrence through indirect exploitation. As a result this might cause professionals to refrain from business relationships or transactions when NPO are involved. However, the so-called de-risking of an entire group of actors undermines the effectiveness of NPOs which are crucial in certain areas of the world. Indeed, it is common that charities operate in high risk areas and undoubtedly in geographic closeness to terrorism treats or in the proximity of areas of conflict the TF risk is stronger. Nevertheless, this does not imply that de-risking should be the immediate course of action. Instead, considerable thought should be given to enhancing the risk assessment and due diligence procedures.
 

3.2. Prevention of terrorism financing risks when dealing with NPOs

Related to the above mentioned outcome of the FATF on-site inspection, the CSSF has issued Circular 23/842, complementing CSSF Circular 21/782 relating to the implementation of the revised EBA guidelines on customer due diligence and material risk factors. The complementing Circulars focal point was to indicate relevant ML/TF risk factors for NPOs for the professionals ML/TF risk assessment.

From a broad prospective the risk assessment methodology has to include an evaluation of TF risks relevant to NPOs, which would be targeted in framework of the purification process. Both, CSSF Circular 23/842 and the best practices issued by the FATF (as referred to above), provides the professional with sound guidance on typical ML/TF risk factors related to NPOs. These usually focus around the following and should be reflected in the respective procedures of the sharia fund on the selection of NPOs (non-exhaustive):

  • type of activity, funding methods and category of beneficiaries,
  • governance and legal structure,
  • exertion of controls in place,
  • size of the organization and location of the activities,
  • reputation and adverse media findings

With respect to the geographic ML/TF risk, it should be highlighted that even if located in a low risk jurisdiction, NPOs likely have operations in countries with a high risk of TF. Consequently, the country risk of the NPO should encompass the country of their activity as well.

The questions stated within CSSF Circular 23/842, relating to each of the above criteria listed, should be considered when modifying or enhancing the existing risk assessment methodology, or alternative, to draft a dedicated risk assessment methodology for NPOs. The latter is particularly sensible if you are a professional frequently working with NPOs. In the context of sharia funds, this might often be the case.

The CSSF Circular 23/842 does not describe due diligence measures which are specifically limited to NPOs, however, IFM should take risk-based due diligence measures, focusing on the pillars of the Law of the 12th November 2004 on the fight of ML and TF, as amended. Those bear a beneficial aspect for the due diligence process towards NPOs.

In their risk assessment and application of due diligence measures, professionals should keep in mind that the aim is not to burden NPOs but to establish a comfort level with the relationship, ensuring trust, safety, and adherence to legal and sharia standards.

4. Conclusion


Sharia  funds are encouraged, by their intrinsic nature, to engage in sustainable and ESG finance. Exercising AML/CTF controls in line with FATF’s expectations and CSSF Circular 23/842 does not obstruct the development of this industry but rather constitutes an enhancement of the primary scope of Islamic finance; that is to say fostering a fair and ethical economic environment.

It is important to emphasize that de-risking of NPOs is not advocated. On the contrary, the aim is to promote risk-based assessments and precise risk mitigation. By taking into account the results of the thematic inspections on the sharia funds published by the CSSF in their annual report, the best practices published by FATF as well the ML/TF risk factors highlighted within CSSF Circular 23/842, professionals should be adequately prepared to identify and mitigate the TF risks existing in the process of purification of investment income handled by sharia funds.

 

1 “List of UCI and SIF having a sharia-Compliant policy”, CSSF, 27 January 2025
2 pg. 1 “Innovation in Islamic Finance”, March 2023, Islamic Development Bank
3 CSSF Annual Report 2023
4 FATF – Risk of terrorist abuse in non-profit organisations, June 2014
5 FATF – Combating the terrorist financing abuse of non-profit organisations, 16 November 2023
6 FATF – Mutual Evaluation Report on Luxembourg's measures to combat money laundering and terrorist financing, 27 September 2023

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