By Frank Obaro
From a tax perspective,one of the major challenges confronting Non Interest Banking (NIB) internationally is that tax laws generally cater for conventional banking products, which involve the charging of interest on monies lent which is not the same with NIBs.
While many Islamic products are structured to replicate the economic effects of conventional financial products, the legal form of these products is very different from conventional products. This may lead to differences in tax treatment that may potentially place Islamic banks and their customers at a disadvantage compared to banks with conventional products.
Tax neutrality has been accorded to Islamic finance instruments and transactions executed to fulfil Sharia requirements. Malaysia’s tax neutrality framework promotes a level playing field between conventional and Islamic financial products, hence reducing the cost of doing business in Islamic finance.
Tax neutrality, standardisation of accounting practices, legal contracts and favourable regulations seem on the surface to promote Islamic banking and finance; careful scrutiny reveals that they are all intended to bring Islamic banking and finance closer to the ethos of the conventional financial system.
Globally most tax incentives are provided to make Islamic finance competitive with conventional finance; these should eventually be phased out, so that Islamic finance focuses on its competitiveness and offering customers with a valuable product, rather than developing sophisticated political power to entrench the tax incentives.
On the other hand, incentives that place Islamic and conventional finance on equal footing should be maintained. For example, eliminating double taxation where the structure of an Islamic financial product would lead to extra taxation compared to a similar conventional product that would be subject to lower taxes.
The UK government took a lead in the west in revising its taxation law to include specific provisions for Islamic products and services. The key issue relate to the tax treatment of the Islamic deposit account that in theory paid a profit share to the depositor. The deposit account offered by Islamic Bank of Britain was based on the principle of Mudaraba, whereby the Bank shared the profits earned with the customer.
Normally,any interest payments made by banks to its depositors is deductible from gross income before tax is calculated. However in accordance with anti-avoidance rules in the UK, any “interest” payments made on deposits that were linked to the profit made by a bank was not allowed to be deducted from gross income but was considered as distribution of profit after tax. In other words, these were considered as dividend payments.
This high incidence of tax charge made the Bank economically unviable. To overcome this issue, the UK government established a Special Inland Revenue task force to review the taxation of Islamic products so as to ensure that there was a “level playing field” with the conventional market.
In a government paper, “Regulatory Impact Assessment for Sharia Compliant Products” that accompanied the Budget for 2005 it was stated that the key policy objective for taxation of Sharia compliant products is to ensure that such products are: “Taxed in a way that is neither more nor less advantageous than equivalent banking products.
The intended effect of the proposals is to allow providers to offer Sharia compliant products without facing commercial disadvantage and to enable customers to take up these products without encountering uncertainty or disadvantage over tax treatment”.
The solution that emerged from the task force and included in the Finance Act 2005 was to define Islamic products as “alternative Financial Arrangements” and to set out the key structures of the arrangements in the legislation. The profit payment on the deposits was termed as “Profit Share Return”. Islamic products are not specially mentioned in the Finance Act but only in the explanatory notes. Furthermore the Act is concerned not with principles but the specific structures of the products.
This was done to mitigate the risk of these structures being used to avoid taxation. In the explanatory notes it was clearly stated that the relevant legislative clauses relate to arrangements: “that involves profits and losses on sales of assets or profit share agreements that are economically equivalent to conventional banking products, but are not interest or speculative returns. The measure ensures that such arrangements are taxed no more or less favourably than equivalent finance arrangements involving interest”.
Prior to 2005, the government had already resolved the issue of double incidence of Stamp Duty on property financed using Islamic structures. Normally whenever property is purchased, the buyer has to pay a Stamp Duty. In case of Islamic finance where banks buy the property and then sell to the customer, there were two Stamp Duties payable, first by the bank and then by the customer. In 2003, the government had amended the Stamp Duty rules to charge only one Stamp Duty on such finance arrangements.
The UK government has also issued guidelines on the application of VAT to Islamic products. These guidelines have ensured that Islamic products are treated in the same way as conventional products. The lead taken by UK authorities to tax Islamic products should be intricately considered by Nigeria regulators and the Federal Inland Revenue Service (FIRS) as possible solution to help the Islamic markets to flourish.
Closer home, In Morocco, three Islamic banking products have been introduced; Ejara, Murabaha and Mucharaka. The first is essentially the equivalent of a leasing product, which typical is subject of a 20% VAT.
But in the Ejara case, the financing does not originate from a bank, meaning that it is not considered a credit with the conventional interest rates that apply to credit. Ejara is said to be financed by the own funds of the consumer credit company, i.e. own resources and not what it labels as credit. What the financing firm gets is a sort of profit margin generated during the lease period through monthly instalments, instead of an interest on financing. Nevertheless, the Moroccan tax authorities have decided to impose a 20% VAT on Ejara.
In contrast, Murabaha was defined by the tax authorities as bank loans and imposed a 10% VAT. They consider it as a form of credit, just as it is defined in mainstream banking. Where the difference occurs is in the way the transactions are defined. In mainstream banking, credits are subject to interest on the money loaned. In the Murabaha case, the creditor actually sells the “product” in question and earns a “legitimate” profit on that product. Even if the creditor never saw or took possession of the product, the money it gave its client means that implicitly it (the creditor) purchased that product and resold to its customers in exchange for a profit margin.
Summarily it is argued that the need for reform is driven by a combination of reasons of which the requirement for tax parity is a significant element. Given the complex issues involved, the reform process may be conceptualized through a framework that reflects the collective influence of local factors in line with best practices merging the key factors of meeting the national interest criteria, law, fiscal and regulatory, considerations. The rationale of such taxation framework is that faith-based considerations alone cannot determine changes to tax law—the necessity must be driven by a combination of core considerations based on ‘need and urgency and circumstances.’
Any reform of tax law must in the first instance meet the ‘national interest’ criteria, meaning that the reform must benefit the nation as a whole and not just a select group. The ‘legal compatibility’ driver advocates that proposed changes to tax law must be accomplished within the existing legal framework with minimal adjustments.
‘Fiscal’ considerations relate to reforms that do not result in revenue loss and that revenue-positive outcome may be achieved through increased economic activity. That is, the net effect of facilitating Islamic finance ought not to result in revenue leakage but carry the potential to raise additional revenue through competition and innovation. The ‘regulatory’ consideration argues for a ‘whole-of-industry’ approach in the sense that Islamic financial practices must conform to requirements administered by the FIRS, CBN and SEC.
It must be noted that the longer Islamic banking tax regulations take to put in place, the greater the probability that other jurisdictions may gain greater competitive advantage.