U.S. Editor Abed Awad examines the implications of the 6th Circuit’s decision in September regarding the financing of an Islamic Center through ijāra.
Case: Islamic Center of Nashville v. Tennessee, et al., 872 F.3d 377 (6th Cir. 2017)
Established in 1979, the Islamic Center of Nashville is a religious not-for-profit that operates both a mosque and a religious school in Nashville, Tennessee. With the rapid growth of the Muslim community since 1979, the Islamic Center (ICN) had undergone numerous expansions. By early 2007, the community had again outgrown the Islamic Center’s facilities. To meet the needs of their congregants, ICN needed to upgrade their facilities, including the Islamic School. Because Islamic law prohibits the taking or charging of interest, the Islamic Center was unable to accept a conventional interest-bearing loan to finance the expansion. The sharīʿa compliant finance options they had available included ijāra.
Ijāra is a standard lease agreement, and has become the most common instrument for sharīʿa compliant real estate financings in Western jurisdictions as well as Muslim majority jurisdictions. Certain modern ijāra finance instruments are similar to a rent-to-own scheme:
- The lender (or a special purpose vehicle, such as a subsidiary created by the lending bank) purchases a property for the prospective purchaser.
- The lender or special purpose vehicle is the title owner of the property during the lease period.
- The lender or special purpose vehicle enters into a lease agreement with the purchaser/lessee allowing the purchaser/lessee to occupy and control the property. The lease rent is usually exactly equal to the debt service that would exist had the purchaser/lessee obtained a conventional interest-bearing loan.
In some cases, an interest-bearing loan is made by the lender to the special purpose vehicle, and the latter leases the property to the purchaser lessee. Here, again, the lease rent is exactly equal to the debt service on the loan. When the lease period concludes, ownership will be transferred from the lender or the special purpose vehicle to the purchaser/lessee. Essentially, in each structure, the lender’s security for the loan is title ownership of the property. The rent constitutes an installment payment arrangement in which the lender would earn a profit rather than a fixed interest rate.
The Islamic Center of Nashville utilized such ijāra structure to finance their Islamic school expansion.
The Islamic Center owned a specific real property. They transferred title of this property to the lender, the local Devon Bank, during a lease period that would conclude in the transfer of title back to the Islamic Center of Nashville. According to the lease agreement, “no ownership other than by [the Islamic Center] is anticipated at the conclusion of the term of the Ijāra Agreement, and the Terms specify that no ownership is anticipated by any other than [the Islamic Center].” The objective of the finance structure was clear: “[t]he transaction is intended to finance the acquisition of properties by persons who abide by religious limitations against borrowing money at interest.” See Complaint.
These types of ijāra transactions are common and routine; the Islamic Center’s status as a tax-exempt not-for-profit religious organization is the only uncommon factor in this ijāra transaction. Once title to the property was transferred to the Lender, the Nashville tax authorities returned the property on the Tax Rolls. The Islamic Center objected to the taxation arguing that nothing had changed, as the property continued to be exclusively occupied by the Islamic Center and continued to be utilized exclusively for the Center’s tax-exempt religious purposes.
From 2008 through 2013, the Islamic Center’s property was titled in Devon Bank’s name. After 2013, the title was returned to the Islamic Center. After the title to the property was returned to the Islamic Center, the Islamic Center asked the Tennessee State Board of Equalization to apply its tax exemption retroactively to cover the period when Devon Bank had held title to the property[1]. While sympathetic to the Center’s religious circumstances, the Tennessee State Board denied the Islamic Center’s request. They appealed to the State Board’s Assessment Appeals Commission, which similarly denied the Islamic Center’s request. The basis for both denials was simple: title ownership for the period in question was nominally vested in lender/bank, a commercial for-profit entity, which is not exempt from real estate taxes.
The Islamic Center then commenced a lawsuit against the tax authorities in federal court. The Complaint alleged that the Islamic Center had suffered “the disparate impact of the application of the tax laws of the State of Tennessee, which caused it to suffer harm as a direct result of compliance with the terms of its indisputably sincerely held religious beliefs.” The Islamic Center’s Complaint relied on several legal theories all with a common theme: the State of Tennessee had substantially burdened the Islamic Center’s exercise of religion by making them pay real estate taxes otherwise exempt because the Islamic Center was prohibited under religious law to take a conventional loan.[2]
Dismissing the Islamic Center’s Complaint, the Tennessee District Court concluded that it lacked subject matter jurisdiction because the Tennessee statute governing tax appeals expressly states that the state chancery court as the appropriate next step for obtaining judicial review.
The Islamic Center appealed to the 6th Circuit. The 6th Circuit affirmed the District Court’s dismissal because the federal Tax Injunction Act (TIA), 28 U.S.C. § 1341, bars a federal court from hearing Islamic Center’s claims. The TIA states: “The district courts shall not enjoin, suspend or restrain the assessment, levy or collection of any tax under State law where a plain, speedy and efficient remedy may be had in the courts of such State.” 28 U.S.C. § 1341.
The Tennessee statute clearly vested the chancery court with subject matter jurisdiction to review the Islamic Center’s claims. But the Islamic Center argued that there is an exception to this rule when a federal right “might otherwise be lost”. Colonial Pipeline, 474 F.3d at 218 (quoting Tully, 429 U.S. at 73, 97 S.Ct. 219) (“A federal district court is under an equitable duty to refrain from interfering with a State’s collection of its revenue except in cases where an asserted federal right might otherwise be lost.”). The 6th Circuit disagreed, holding that the Islamic Center’s claims are barred from federal court in as much as the Supreme Court in California v. Grace Brethren Church, 457 U.S. 393, 102 S.Ct. 2498, 73 L.Ed.2d 93 (1982) “has explicitly rejected the idea of a special exception to the Tax Injunction Act for First Amendment claims.” In Grace Brethren, the Supreme Court explained that “[c]arving out a special exception for taxpayers raising First Amendment claims . . . would undermine significantly Congress’ primary purpose ‘to limit drastically federal district court jurisdiction to interfere with so important a local concern as the collection of taxes.’ ” Id. at 416–17, 102 S.Ct. 2498 (quoting Rosewell v. LaSalle Nat’l Bank, 450 U.S. 503, 522, 101 S.Ct. 1221, 67 L.Ed.2d 464 (1981)).
After establishing that the First Amendment is not an exception to the Tax Injunction Act, the 6th Circuit Court confirmed the obvious: the Islamic Center has “a plain, speedy and efficient remedy” available in Tennessee state court. With the remedy available in Tennessee chancery court where they would have a full hearing and are able to raise any federal constitutional objections to the tax, the federal court lacked subject matter jurisdiction to review the Islamic Center’s claims, held the 6th Circuit.
Finally, the 6th Circuit addressed the Islamic Center’s argument that the District Court should have provided the Islamic Center with leave to amend its complaint. Noting that the Islamic Center never filed a motion to amend nor had it filed a proposed amendment with the District Court, combined with the clear lack of subject matter jurisdictional in federal courts, the 6th Circuit concluded their “review indicates that any anticipated amendment would likely be fruitless, we cannot say that the district court abused its discretion.”
To summarize, the Islamic Center’s Complaint relied primarily on the First Amendment. In light of the Supreme Court’s decision in Grace Brethren, such reliance seems clearly misplaced and unpersuasive.
The Moral of the Islamic Center of Nashville v. Tennessee Story
This decision should serve as a cautionary note to the Islamic finance industry in the United States. Islamic finance is a trillion-dollar-industry worldwide. It has been gaining momentum in the United States, especially in financing mosques and Islamic Schools around the country. With the prohibition on interest, these Islamic institutions have limited access to lenders who can finance the massive national growth of the community. The ijāra finance structure is currently the most frequently used sharīʿa-compliant instrument used in real estate financing. While the ijāra structure is legally sound and workable in commercial transactions, in a religious not-for-profit setting, it may expose religious institutions to substantial tax liability, from which they are otherwise exempt.
Be that as it may, there are other sharīʿa-compliant options to finance not-for-profit religious organizations without risking an organization’s tax exemption status. Michael McMillen, a partner with Curtis, Mallet-Prevost, Colt & Mosle, LLP, who is a prominent internationally recognized American-based Islamic finance practitioner and scholar, agrees. McMillen explained that there were and are many structural alternatives available to the Islamic Center, even within an ijāra scheme, that would not require the transfer of title to the lender, and that there are other available financing structures, such as murabha, istisna and mudarba. He emphasized that the finance structure must be carefully tailored to state and local law, taking into account whether that tax law determines exemption status based on economic substance or mere form. [3]
There are organizations all over the United States like the Islamic Center of Nashville in need of financing for legitimate tax-exempt purposes. To make sure they are not denied tax exemptions for transactions that are within the intended scope of the tax exemption, but structured to comply with their religious beliefs, practitioners should conduct more due diligence. In any transaction involving a tax-exempt organization, practitioners should consider discussing the nature of the transaction with the local and state tax authority to avoid any misunderstanding and adjust the finance structure accordingly. For example, it is prudent to explain to the tax authorities that the transaction was structured to avoid sharīʿa prohibitions on the payment of interest, that the title transfer (if any is involved) is exclusively for the purpose of providing the lender with collateral security, and that at the conclusion of the transaction (assuming no default) all economic benefits and indicia of ownership (including title) will revert to the lessee.
While the 6th Circuit did not address the underlying tax issues in Islamic Center of Nashville v. Tennessee, the case strongly suggests that practitioners should exercise care in structuring these transactions. Post Islamic Center of Nashville, Islamic finance practitioners must exercise caution in using the standard ijāra structure to the extent that it entails transfer of title to the lender—at least in states like Tennessee, where tax exemption status is exclusively based on the identity of the title holder.
[1] The complaint notes that Devon Bank did not pay any taxes on the property during the period in which it held the title. I suspect that the financing deal was based on the Center being exempt from real estate taxes. The Lender was most likely not liable for any real estate taxes. For that reason, Lender never paid the real estate taxes or took advantage of depreciation for tax purposes. Even though strictly speaking the Lender would be responsible to pay the real estate taxes because title was held in Lender’s name, a standard commercial lease generally passes the real estate tax liability onto the tenant/lessee. That being said, in the end the Center was on the hook for the unpaid real estate taxes during the period the title was in the Lender’s name. That is why the Center asked for retroactive tax exemption date to cover the period the title was held in Lender’s name. Once title returned to Center, the tax exemption status kicked in.
[2] The Islamic Center alleged causes of action under the federal Religious Freedom Restoration Act (RFRA); the federal Religious Land Use and Institutionalized Persons Act (RLUIPA); the federal Elementary and Secondary Education Act of 1965; and the First Amendment’s Establishment Clause. R. 1 (Compl. ¶¶ 5.1–5.21).
[3] Michael McMillen (Partner, Curtis, Mallet-Prevost, Colt & Mosle, LLP), interviewed by Abed Awad at Hasbrouck Heights, NJ, November 2017.