Can Sukuk Be Treated As An Equity Investment Rather Than A Debt Obligation?

1. Introduction

One of the most common misconceptions in capital markets is that a ṣukūk is simply the Islamic equivalent of a conventional bond. Both instruments can achieve a similar funding outcome for issuers, and both provide investment returns to investors. Yet this surface-level resemblance conceals a fundamental divergence in their legal and structural foundations. A conventional bond is generally a debt obligation: the investor lends money to the issuer and, in return, receives periodic interest payments and the repayment of principal over the life of the instrument. A ṣukūk, by contrast, is typically structured around ownership or beneficial interests in assets, usufructs, investments, or business ventures. Rather than representing a pure debt claim, ṣukūk structures are designed to comply with Sharīʻah principles by linking investors to an underlying asset or economic activity.

This distinction is not merely theoretical. It carries profound implications for how ṣukūk ought to be classified, regulated, taxed, and treated in the capital adequacy frameworks of financial institutions. If a ṣukūk genuinely embeds risk-sharing, links returns to the performance of real assets, and avoids guaranteeing the return of capital, then it may more accurately be characterised as an equity investment rather than a debt obligation.

Can ṣukūk be properly treated as equity investments? Drawing on the AAOIFI’s evolving standards, the proposed exposure draft SS ED 62, the International Accounting Standard 32 (“IAS 32”) classification framework, and recent proposals for mushārakah-based infrastructure ṣukūk in Malaysia, it does appear that certain ṣukūk structures—particularly those built on muḍārabah and mushārakah contracts—can and should be recognised as equity or quasi-equity instruments. The barriers to this recognition are institutional and behavioural, not technical or Sharīʻah-based.

2. The Debt–Equity Spectrum: Where Do Ṣukūk Sit?

Conventional financial taxonomy operates along a binary axis: instruments are either debt or equity. Bonds, loans, and notes sit firmly on the debt side; ordinary shares and partnership interests sit on the equity side. Ṣukūk, however, do not fit neatly into either category. They are, by design, hybrid instruments whose characteristics straddle the debt–equity divide.

A muḍārabah ṣukūk, for example, involves one party providing capital and another providing entrepreneurial expertise. The investor’s return is a share of the profits generated by the venture, not a fixed coupon. If the venture generates no profit, the investor earns nothing. If the venture incurs losses, the investor bears those losses to the extent of the capital contributed. This structure carries unmistakable equity-like features: residual, participatory claims on performance rather than a fixed, unconditional right to repayment.

A mushārakah ṣukūk takes this further. Here, multiple parties contribute capital to a joint venture and share both profits and losses in agreed proportions. The certificate holders become co-owners of the underlying venture or assets. Their returns are linked directly to the venture’s performance, and their exposure extends beyond the creditworthiness of any single originator.

Yet both muḍārabah and mushārakah ṣukūk also carry features associated with debt instruments. They typically have a defined maturity date, a terminal redemption mechanism, and—in practice—structures that provide investors with a degree of capital protection through purchase undertakings or liquidity facilities. The hybrid character of these instruments, combining features of both debt and equity, makes them susceptible to the agency problems associated with both financing forms simultaneously.

Some scholars have suggested that this taxonomic ambiguity could be resolved by adopting an alternative designation. The term “Islamic Investment Certificates” (IICs) has been proposed to signal that the instruments are fundamentally equity-like and risk-sharing in nature, rather than fixed-income obligations dressed in Islamic nomenclature.

It is important to note the regulatory context. Under Malaysian law, a ṣukūk is generally included within the statutory definition of a “debenture.” This means that, for certain legal and regulatory purposes, ṣukūk and conventional debt securities may be treated similarly. However, as the Securities Commission Malaysia has itself acknowledged, this regulatory treatment does not make a ṣukūk a conventional bond. The inclusion is a matter of administrative convenience and investor protection, not a determination of economic substance.

3. The Case for Equity Treatment

The strongest case for treating ṣukūk as equity investments arises from structures built on mushārakah (joint venture) contracts, particularly where the ṣukūk are deployed in infrastructure projects.

Academic proposals for Mushārakah-based sovereign sukuk structures suggest that equity characteristics can be embedded through the instrument's risk-sharing architecture and governance design, rather than through nomenclature alone.

3.1 Genuine Co-ownership, Not a Debt Claim

The proposed mushārakah structure establishes genuine co-ownership in infrastructure assets rather than a debt claim against the originator. Certificate holders acquire undivided proportional ownership interests in the underlying project assets—toll roads, power plants, water treatment facilities—and their returns flow from the economic performance of those assets. This is fundamentally different from a conventional bond, where the investor's claim is against the issuer's general creditworthiness.

The AAOIFI's proposed exposure draft, SS ED 62, reinforces this distinction. Clause 2/1 defines ṣukūk as:

Equal-value investment securities representing undivided common ownership interests in underlying assets, whether tangible assets, usufructs, rights, debts, cash, or any combination thereof, that give rise to rights and obligations for certificate holders arising from their proportional ownership share.

This definition places ownership—not lending—at the centre of the ṣukūk relationship.

3.2 Five Distinguishing Characteristics

SS ED 62 Clause 3 enumerates five characteristics that distinguish ṣukūk from conventional bonds:

• Not based on interest-bearing lending (Clause 3/1). Ṣukūk returns derive from asset ownership or venture participation, not from the time value of money lent.
• Principal and profit are not automatically obligations of the originator (Clause 3/2).Unlike a bondholder, a ṣukūk certificate holder does not have an unconditional right to demand repayment of capital or a guaranteed return.
• Certificate holders share both the rewards (ghunm) and the burdens (ghurm) (Clause 3/3).The Sharīʻah maxim of al-ghunm bi al-ghurm mandates that entitlement to profit must be accompanied by exposure to loss.
• Issued pursuant to Sharīʻah contracts (Clause 3/4). The governing contracts determine the nature and extent of the certificate holder’s rights, which may differ materially from conventional fixed-income instruments.
• Risks are not confined to the originator's credit risk (Clause 3/5). Certificate holders are exposed to the performance risk of the underlying assets or venture, not merely to whether the originator can service its debts.

3.3 Elimination of Fixed Financial Obligations

A defining feature of the proposed mushārakah structure is the elimination of fixed financial obligations. There are no fixed profit payments. There is no guaranteed return of principal. Returns are linked entirely to the actual performance of the underlying infrastructure project.

SS ED 62 Clause 11/2/3 prohibits separating the profits of the ṣukūk from the returns of its underlying assets, reinforcing the requirement that ṣukūk returns must be genuine and performance-linked rather than predetermined.

The structure further provides that any purchase undertaking must be at fair market value determined at the time of the transaction, and must not be mandatory. This avoids the capital guarantee mechanisms that have historically rendered many ṣukūk debt-like in substance. The government's in-kind contribution—land, concession rights, or existing infrastructure—constitutes a capital contribution to the mushārakah venture rather than collateral securing a debt obligation.

3.4 Quasi-Equity Recognition

The AAOIFI has recognised the quasi-equity nature of these instruments in its accounting standards. Both muḍārabah and mushārakah ṣukūk should be understood as quasi-equity instruments: their returns are linked to the performance of real underlying assets rather than to a contractual obligation to pay a fixed amount. They do not fall within the category of fixed-income securities.

AAOIFI has introduced a quasi-equity classification in financial reporting, acknowledging that these instruments integrate characteristics of both debt and equity. This classification is significant because it provides a formal accounting framework that recognises the hybrid nature of risk-sharing ṣukūk without forcing them into the binary debt-or-equity taxonomy of conventional finance.

4. The IAS 32 and Accounting Perspective

The accounting classification of a financial instrument as equity or liability is governed by IAS 32, Financial Instruments: Presentation. Critically, IAS 32 requires classification based on the economic substance of the contractual arrangement, not its legal form. The label attached to an instrument—whether “ṣukūk,” “bond,” “note,” or “certificate”—is irrelevant to its accounting treatment. What matters is the nature of the rights and obligations created by the contract.

The key test under IAS 32 is whether the issuer has a contractual obligation to deliver cash or another financial asset to the holder. If such an obligation exists, the instrument is classified as a financial liability. If it does not, the instrument may be classified as equity.

In the context of the proposed mushārakah-based ṣukūk, three features are determinative:

• No fixed repayment obligation. The government does not contractually undertake to return the investors' capital at a fixed amount. Redemption, if it occurs, is at fair market value.
• No fixed return obligation. Returns to certificate holders are a share of the project's actual performance, not a predetermined coupon.
• Non-binding purchase undertaking. Provided the purchase undertaking is drafted as a non-binding option rather than a binding obligation, the issuer is not contractually compelled to repurchase the ṣukūk at maturity.

If these conditions hold, the instrument may be classified as equity or as a hybrid instrument without a liability component under IAS 32. The IFRS classification decision tree confirms this analysis: where there is no contractual obligation to deliver cash, the instrument falls on the equity side of the classification.

The government's in-kind contribution—land, concession rights, or existing infrastructure asets—should be recognised as an equity investment inthe mushārakah venture rather than as a debt obligation. This treatment reflects the economic reality of the arrangement: the government is contributing capital to a joint enterprise, not borrowing money that must be repaid.

Classification as equity rather than debt directly affects the government's balance sheet, its debt-to-GDP ratios, its fiscal headroom, and the capital adequacy treatment of institutions holding the ṣukūk. If the instrument is properly classified as equity, it does not increase the sovereign debt burden—a significant advantage for governments seeking to finance infrastructure without expanding their liabilities.

5. Regulatory and Capital Adequacy Challenges

Despite the strong Sharīʻah and accounting arguments for equity treatment, regulatory frameworks remain stubbornly debt-centric. In Malaysia, once an instrument is labelled a “ṣukūk,” it is often automatically treated as debt or fixed income, regardless of the nature of the underlying contract. This regulatory presumption creates a self-reinforcing cycle: issuers structure ṣukūk to behave like debt because regulators classify them as debt, and regulators classify them as debt because issuers structure them to behave that way.

Capital adequacy requirements compound the problem. Under the standards issued by the Islamic Financial Services Board (IFSB), capital requirements of 300 to 400 per cent are imposed on mushārakah exposures under certain approaches. These charges are disproportionately high relative to the actual risk profile of well-structured, revenue-generating infrastructure partnerships. The result is that financial institutions face a punitive capital cost for holding risk-sharing ṣukūk, which in turn depresses demand and discourages issuance.

Bank Negara Malaysia (BNM) assigns a credit risk weight of approximately 150 per cent to certain mushārakah and muḍārabah exposures. However, BNM’s Capital Adequacy Framework for Islamic Banks (CAFIB) also provides for a supervisory slotting approach, under which the risk weight is determined by the quality of the underlying exposure rather than its contractual label. A well-structured, revenue-generating sovereign infrastructure partnership could credibly attain a “strong” or “good” slotting classification, attracting a risk weight of 70 to 90 per cent—significantly lower than the standard mushārakah charge.

Importantly, BNM’s CAFIB requires the regulatory capital treatment of any ṣukūk to follow its economic substance and actual risk profile rather than its legal form. This is a critical principle. It means that, in theory, a mushārakah ṣukūk structured with genuine risk-sharing and backed by revenue-generating infrastructure assets need not attract the punitive capital charges that deter banks from holding such instruments.

The regulatory challenge, then, is not one of principle but of practice. The principle of substance over form is well-established in both accounting and prudential regulation. The difficulty lies in translating that principle into consistent regulatory practice, particularly when the default taxonomy treats all ṣukūk as debt. As the IERIF report observes, regulatory classification as “debt” is a matter of regulatory taxonomy rather than economic substance. From both Sharīʻah and accounting perspectives, what is determinative is the underlying structure and allocation of risk, not the terminology applied by regulators.

6. Market Resistance and Behavioural Barriers

Even where the legal, Sharīʻah, and accounting arguments for equity treatment are compelling, market practice has consistently resisted the shift. The barriers are deeply embedded in the institutional culture of Islamic capital markets.

The entrenched mindset that equates ṣukūk with debt is perhaps the most formidable obstacle. For decades, market participants—issuers, arrangers, investors, rating agencies, and regulators—have operated on the assumption that ṣukūk are the Islamic equivalent of bonds. Pricing conventions reflect this: ṣukūk are typically priced off a benchmark yield curve, with a fixed or floating "profit rate" that mirrors a conventional coupon. Purchase undertakings at fixed redemption amounts are commonplace, providing investors with effective capital protection that renders the instruments debt-like in economic substance, whatever their Sharīʻah characterisation.

Investor preferences have been shaped by decades of experience with capital-guaranteed products. Institutional investors—pension funds, insurance companies, sovereign wealth funds—are mandated or accustomed to investing in instruments that provide predictable cash flows and capital preservation. A genuinely risk-sharing ṣukūk, where returns fluctuate with project performance and capital is at risk, does not fit comfortably within these investment parameters.

Historical episodes have reinforced these behavioural patterns.

A frequently cited example is the pre-2008 generation of Mushārakah sukuk, many of which incorporated purchase undertakings requiring the originator or managing partner to repurchase the sukuk assets at face value upon maturity or dissolution. Although labelled as Mushārakah and therefore ostensibly equity-based, the fixed-price repurchase mechanism effectively guaranteed investors' capital and substantially reduced their exposure to partnership losses, leading scholars and the AAOIFI Shari'ah Board to criticise such structures as debt-like in economic substance

A notable example is the US$1 billion 2007 sukuk issued by Dana Gas PJSC, which utilised a Mudarabah structure accompanied by a purchase undertaking requiring the obligor to acquire the sukuk holders' interest upon dissolution for a predetermined exercise price. Although the instrument was structured as a profit-sharing investment, the purchase undertaking substantially mitigated investors' exposure to capital loss and rendered the transaction economically closer to a debt instrument than a true risk-sharing venture. The structure exemplifies how the legal and economic substance of a sukuk may diverge from its formal characterisation as an equity-based instrument. The Dana Gas ṣukūk required a Sharīʻah ruling acknowledging non-compliance after payment difficulties emerged, highlighting the tension between stated Sharīʻah structures and actual market practice.

These examples illustrate a persistent pattern: ecosystem pressures consistently push issuers, arrangers, and rating agencies towards fixed-income conventions even where contracts are nominally structured as profit-sharing. The result is a market in which the form of Islamic finance is maintained—mushārakah contracts are used, assets are identified, Sharīʻah boards provide approvals—but the substance remains indistinguishable from conventional debt.

Rating agencies contribute to this dynamic. Their methodologies are calibrated for fixed-income instruments, assessing the issuer's ability to make scheduled payments and repay principal. A genuinely equity-like ṣukūk, where the certificate holder’s return depends on project performance rather than the issuer's credit strength, does not map well onto existing rating frameworks. Without a credit rating, many institutional investors cannot or will not invest, regardless of the instrument's underlying quality.

7. The Path Forward

If ṣukūk are to fulfil their potential as genuine equity or quasi-equity instruments—and if the Islamic capital markets are to move beyond the replication of conventional debt—a coordinated programme of policy and market reform is required. This could include:

• A formal national framework recognising risk-sharing ṣukūk as non-debt financing. An explicit regulatory classification that distinguishes risk-sharing ṣukūk (built on mushārakah and muḍārabah) from asset-backed or debt-replicating structures could be introduced. This framework could recognise that instruments with genuine risk-sharing, no capital guarantees, and performance-linked returns are equity or quasi-equity instruments, not debt obligations.
• Pilot implementation with brownfield infrastructure projects. Initial deployment should prioritise brownfield and upgrade-type projects—existing toll roads, power plants, or utilities with established revenue histories. These projects offer observable cash flow track records, reducing the information asymmetry that deters equity investors and enabling more confident valuation.
• Recalibration of capital adequacy charges. Regulators should ensure that the supervisory slotting approach is applied consistently to well-structured mushārakah ṣukūk, so that capital charges reflect the actual risk profile of the instrument rather than the punitive default weights for equity exposures. A sovereign infrastructure mushārakah with stable revenue streams should not attract the same capital charge as a speculative equity position.
• Tax neutrality between debt and risk-sharing instruments. Tax asymmetries that favour debt—such as the deductibility of interest payments but not profit-sharing distributions—must be corrected. Without tax neutrality, issuers will continue to prefer debt-like structures for purely fiscal reasons, regardless of Sharīʻah considerations.
• Introduction of an "Islamic Investment Certificates" classification. The adoption of a new classification, such as Islamic Investment Certificates, would signal to the market that these instruments are fundamentally different from conventional bonds. Nomenclature matters: as long as ṣukūk are labelled and categorised alongside bonds, the market will treat them as bonds.
• Phased implementation roadmap. Reform should proceed incrementally. A pilot programme with a limited number of well-structured issuances, supported by regulatory guidance and investor education, would build the evidence base and market confidence needed for broader adoption.

These reforms are not utopian. Each builds on principles already embedded in law, AAOIFI standards, and international accounting frameworks. What is required is the institutional will to apply those principles consistently and to resist the gravitational pull of debt-centric conventions.

8. Conclusion

A ṣukūk built on a mushārakah or muḍārabah contract, with genuine risk-sharing between issuer and investors, no capital or return guarantees, returns linked to the performance of real underlying assets, and natural exit mechanisms at fair market value, possesses the essential characteristics of an equity or quasi-equity instrument. The AAOIFI's proposed SS ED 62 standards confirm this. The IAS 32 classification framework supports it. The Sharīʻah principles of al-ghunm bi al-ghurm (reward accompanies risk) and the prohibition of ribā demand it.

The barriers to equity treatment are not technical. The legal structures exist. The accounting frameworks accommodate them. The Sharīʻah scholarship supports them. The barriers are institutional and behavioural: entrenched market conventions, debt-centric regulatory taxonomies, misaligned capital charges, tax asymmetries, and investor preferences shaped by decades of capital-guaranteed products.

Malaysia, as the world's largest ṣukūk market and a leader in Islamic finance innovation, is well-positioned to lead this transition. By introducing a formal framework for risk-sharing ṣukūk classification, piloting mushārakah-based structures in brownfield infrastructure projects, recalibrating capital adequacy requirements, and restoring tax neutrality, Malaysia can demonstrate that ṣukūk are not merely bonds with an Arabic name—they are a distinct class of investment instrument, capable of delivering the risk-sharing, asset-backed, real-economy financing that Islamic finance has always promised.

The shift from debt replication to genuine equity participation will not happen overnight. But every regulatory reform, every successful issuance, and every investor who accepts performance-linked returns over guaranteed coupons moves the market closer to what ṣukūk were always intended to be: instruments of shared enterprise, shared risk, and shared reward.

This article is for general informational purposes only and does not constitute legal advice. Please contact us if you require advice on how these developments may affect your business.