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Changing finance in changing times - Islamic finance and Irish tax Back  
Brian Daly asks if it is time to seriously consider introducing tax rules to deal with Islamic financing products and to position ourselves at the forefront of the inevitable emergence of related products on the secondary financial markets?
Islamic finance consists of the conduct of commercial and financial arrangements in a manner which complies with Shari’a law. Since I last wrote about this in 2005, the Islamic financing market has continued to expand. As retail markets have grown, corresponding secondary products, such as Sukuk, the Islamic finance equivalent of securitisation, have emerged. According to the Islamic Finance Information Service, estimated Sukuk issuances this year will be US$50billion compared to US$336million seven years ago.

The UK Inland Revenue recently focussed on clarifying the tax treatment of Sukuks. They have been introducing rules to govern Islamic Finance since 2003 however. There are likely to be several areas, including securitisation, where our existing financial services expertise could provide us with an excellent base from which to become a niche player if we can get the framework in place. This has prompted me to revisit the case as to why consideration should be given to introducing tax rules to deal with these arrangements in Ireland.

Its origin
The modern banking system emerged in the 18th century. It penetrated Muslim countries in the late 19th century but was not welcome as interest is considered haraam (forbidden) in Islam. The most pronounced difference between Islamic financing and the existing equivalent products relates to the prohibition on interest. This is based on the view that it is unacceptable in and of itself for money to increase in value merely by being lent to another person. This belief was shared by Aristotle, the famous Greek philosopher, who maintained that money should not breed money.

The worldwide growth of the financial sector provoked Muslim scholars to introduce a parallel system that gave rise to various types of Islamic finance products. Fundamentally, the system is based on the principle of sharing risks and rewards. Shari’a law does not prohibit the making of a return on capital if the provider of the capital is willing to share in the risks of a productive enterprise. Thus profit and loss sharing arrangements are considered acceptable, provided there is risk sharing.

The products
The major Islamic finance products are simplified below. There can be variations to these models.

Musharaka is a type of partnership or joint venture. While profits can be shared in any agreed ratio, share in loss must be proportionate to the amount invested. Diminishing Musharaka is used in the mortgage market. The customer (mortgagee) acquires the property in partnership with the financier. The periodic payment comprises rent for use of the property and part purchase of financier’s equity in the partnership by the customer. The customer’s equity in the partnership increases with a corresponding decrease in the financier’s equity until the equity (and thus the property) is eventually transferred to the customer.

Mudaraba is a venture between two parties where one (financier) participates with funds and the other (entrepreneur) with skills, expertise and labour with agreed profit sharing ratios. The entrepreneur also receives a fee for services provided. If a loss is sustained, the loss is borne by the financier and the entrepreneur takes no remuneration for his efforts and skill. If there are many financiers, an intermediary may take deposits of funds and finance projects put forward by entrepreneurs. In this scenario, the financier is essentially a sleeping partner who provides capital and then shares the profit or absorbs the loss. This product is akin to a type of share or a deposit with a return dependent on the results of the investment or use of the money.

Murabaha is a form of finance whereby the financier purchases an asset for cash and sells it to the customer on a deferred payment basis adding an agreed profit margin. The customer pays the sale price either in instalments or in one lump sum at the end of the period. This is somewhat similar to a finance lease.

Ijara is a form of operating lease. The financier buys and then leases the equipment to the customer for an agreed rental over a specific period. A specific form of Ijara (Ijara-wa-iktana) is similar to finance lease / hire purchase as it provides for a promise from the customer to buy the equipment at the end of the lease term at an agreed (generally token) value.

Wakala is a form of agency agreement. The financial institution promises a return to the investor and keeps any excess return as their agency fee.

Sukuk is essentially a certificate that evidences a share in the beneficial ownership of particular assets, somewhat akin to a security. The holders’ return is their share of the income generated by the assets. The issuer obtains funding and can ‘securitise’ the assets.

Irish opportunities
So, why should we follow the UK’s lead and bring these products on a par with conventional banking in our tax laws?

Ireland’s reputation for sensible regulation and its low corporate tax regime could encourage foreign banks offering Islamic finance products to base some of their operations here while targeting expanding Islamic EU markets. The advent of refinancing and derivative products may provide particular opportunities, for example in the area of ‘securitisation’ of Islamic finance assets using the concept of Sukuk.

In addition, it may be interesting to note that the tax changes would be relevant to any investors interested in a financing system based on sharing of risks and rewards, such as ethical investment funds, for example. Facilitating such a system would offer alternatives to everyone and lead to increased competition. However, the tax anomalies currently existing are unlikely to encourage this.

Tax impediments
Applying the Irish tax law as it currently stands to Islamic finance products gives rise to inconsistent results since the tax treatment does not always reflect the economic purpose of the transactions. For example, a return paid to a ‘deposit maker’ under certain Shari’a compliant investment schemes, such as Mudaraba, could be considered as a dividend instead of interest under Irish tax law. As such it would not be regarded as a tax deductible expense and would give rise to dividend withholding tax. An individual ‘deposit maker’ would be subject to the marginal tax rate of 41% instead of the 20% rate which normally applies to deposit interest.

Diminishing Musharaka (mortgage), Murabaha and certain Ijara transactions potentially involve two transfers of title where the financier is required to purchase the asset and sell it on to the customer. This could give rise to an additional charge to stamp duty, at rates up to 9%. Also, the current rules may not allow isolation of interest income from principal recovered in all cases, which could accelerate tax payments. A financial institution engaged in Diminishing Musharaka (mortgage) transactions may be considered as deriving non trading rental income (Islamic substitute for interest) and thus exposed to tax at 25% instead of 12.5%. Furthermore, the treatment of capital allowances in Ijara (mortgage) transactions needs to be clarified.

The VAT position can also pose an impediment as in some cases, the purchase-sale elements may be considered as taxable supplies from a VAT perspective. A VAT charge will increase the product’s cost to the end customer thereby making it less attractive compared to conventional banking products.

If we do not have the tax and regulatory framework to deal with the basic products, we will not be in a position to fully participate in any emerging market in associated securities or derivatives equivalents. For example, the securitisation of conventional mortgages is critical in enabling financial institutions to expand their lending capacity and the issuing of Sukuk can have the same economic effect with respect to Islamic finance. Ireland is already a key player in the securitisations industry. Early entry into this market could surely yield long term benefits.

The way forward
If we take no action, the risks, uncertainties and inconsistencies set out above will remain, disadvantaging those who wish to utilise financing based on the principle of sharing risks and rewards. As Islamic banking grows in importance, tax barriers will restrict the competitiveness of institutions based in Ireland to compete in this market.

Alternatively, we can make specific provisions in our tax law to ensure that Islamic finance products are not taxed less favourably than traditional financial transactions. The experience of the UK could be drawn upon. The Inland Revenue removed the possible double imposition of Stamp Duty Land Tax on property purchased using Shari’a compliant products. Broadly, the UK legislation labels the return on Islamic finance arrangements as alternative finance return, profit share return or additional payments. The amounts are not deemed to be interest although they are treated in the same way as interest for UK tax purposes. Legislation was not tied to the Qu’ran or the Islamic faith, but used intrinsic features of the underlying contracts under the UK law to define the transactions to which the rules apply.

In summary, not only primary but secondary aspects of the Islamic finance market are likely to have far reaching potential for jurisdictions that are in a position to participate. At a time when we need to explore new industries in the face of tough tax competition, this would seem to be an area worth serious consideration. The required changes in tax laws should not be too cumbersome and are not likely to have any adverse revenue impact. Rather, they may enable us to use some of our existing skills to tap into growth areas in this emerging market, such as Sukuk and other secondary products and facilitate any domestic Islamic financing.

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