Elimination of Tax Bars for Islamic financing

colomboby Suresh R. I. Perera

Islamic financing is the ‘in thing’ in the world of financial services. ‘Murabaha, Mudaraba, Ijara’ are some of the ‘buzz’ words. The latest financial instrument to enter the Islamic financial services sector is the ‘Sukuk’, an Arabic term, – the plural of SAKK – the origin of the English word cheque. The list is not exhaustive. ‘Musharaka, Ististina, Tawarruq, Salam’ are some of the other buzz words.

The cross – cultural penetration of Islamic finance is manifesting it’s impact in the largely non- Muslim markets too. Whilst Islamic financial products are being expanded to cover non – Muslim customers, there are many non- Muslim financial institutions venturing to offer these products that comply with Shari’ah principles. Whilst amendments to relevant statutes would further the cause of development of Islamic financing, tax considerations would be the determinant for monetary benefits to be in parity to its conventional counterparts.

Interest v profit

The basic tenet of the Islamic value proposition is the prohibition on the paying and receiving of interest (riba), and a fundamental belief in the sharing of profit and risk in the conduct of business.

The Qur’an Sura Al Baqara, verse 275 states that the Creator allowed trade but prohibited Riba, which is typically translated as interest. While interest is a I passive I income, profit is an earned income which is treated differently for tax purposes. Profit is considered an after tax item for the profit creator and a fully taxable item for the profit receiver. Herein lies one of the principal tax barriers for the smooth progression of development of the Islamic financial service sector. The growth of the current tax systems in most of the countries over the last century has been to address issues of a conventional financial environment and the system naturally poses many issues for Islamic financial instruments.

The concept of instrument is intrinsically embodied in tax statutes around the globe and the international treaties between countries for avoidance of double taxation. Income Tax Statutes in countries that follow the ‘source doctrine’ such as Sri Lanka, recognise interest as a separate source of income and contains specific provisions for the tax deductibility thereof, reliefs such as lower rates or exemptions. Invariably income statutes also impose withholding tax burden on the person paying interest as a collection mechanism by deduction at source.

As interest is considered haram, Islamic financial products avoid the payment or the receipt of interest by adopting sharing of risks & rewards or cost plus profit mechanisms. As opposed to providing interest bearing loans, the financier obtains the return by way of a share of profits for his equity finance which is intrinsically related to success of the venture.

Musharaka & Mudaraba are profit & loss sharing instruments whilst Murahaba is based on cost plus profit basis. Thus the critical tax issue that these instruments are exposed to is whether the profit element or the share of profits world be treated as interest for tax purposes and the application of the tax rules including the tax deductibility of the payments.

Battle between substance and form

The success and the viability of Islamic financial instruments as an alternate mode of financing in a particular jurisdiction would depend on adoption of the doctrine of substance over form by the tax authorities.

These instruments would flourish and appeal to the populace in a country in the same manner of its conventional counterpart where the tax authorities are governed by the economic reality and the substance of a particular transaction. In countries where the hands of the tax authorities are bound by the shackles of the legal form of the transactions, unless the tax systems are adapted for Islamic instruments by requisite amendments to the tax statutes, the two competing product-lines would experience inconsistent results. – More often than not to the detriment of Islamic financial instruments. – Whilst the Netherlands and Switzerland are examples of countries that analyse transactions by the substance and economic reality for tax purposes, UK tax authorities weigh heavily in favour of the legal form for ascertaining the tax consequences.

Murabaha (trade finance)

This is the alternative Islamic financial instrument available for a person who wishes to acquire an asset by obtaining a conventional interest bearing loan which is considered haram according to Shari’ah principles

This instrument is a means’ to fund a variety of acquisitions such as motor vehicles, computers, furniture, televisions, residential & commercial property etc. The financier purchases the asset identified by the customer, say at 1M euros and sells to him at a premium for 1.2M euros to be settled on deferred installment basis or the total price to be paid at a specified future date. The profit of 0.2M Euros made by the financier corresponds to the interest earned under a conventional loan. At the time of the commencement of the arrangement the title passes from the financier to the customer.

The crucial issue that arises from, a tax perspective with regard to the aforesaid Murabaha structure is whether the tax authorities would adhere to the doctrine of ‘substance over form’ to accept it as a financing arrangement for tax purposes or insist on the application of the tax laws based on the strict legal form. Most of the countries that follow English Legal Tradition would find the mechanics of Murabaha falling within a statute akin to ‘Sale of Goods Act’.

An interesting observation in this regard was made in a case decided by the District Court of Sri Lanka. The defence taken up by a company sought to be wound up, that the action was prescribed under the Prescription Ordinance, as the Murabaha structure was governed by the rules pertaining to sale and delivery of goods, was rejected in favour of it being a financing transaction. The relevant extract from the Order of the court in Case No. 92/ Co., where an application under the Companies Act was, made by Amana Investments Limited to wind up Greenwood Growers (Pvt) Ltd. is reproduced below.

It is stated in the Affidavit, filed on behalf of the company sought to be wound up, that since the relevant loan transaction is one of sale and delivery of goods, it has been prescribed in terms of the provisions of the prescription Ordinance. The Petitioner has submitted that the said transaction was not one of sale and delivery of goods, but a transaction to provide a financial facility.

The Petitioners have further stated by their written submission that the loan amount claimed to be owned to them has been accepted as a loan payable by the company sought to be wound up in its final accounts according to the report of the provisional liquidators. The report of provisional liquidators confirms that the final accounts of the company sought to be wound up has been prepared as at 31.03.2001, and that it states the amount of the loan and the interest thereon as an amount payable therein. Therefore the company sought to be wound-up has admitted that the loan was payable as at 31.03.2001. It is evident ex facie that since it has to be treated as an acknowledged debt it would be governed by Section 12 of the Prescription Ordinance and that it is not governed by the provisions relating to sale and delivery of goods. Therefore it cannot be stated that the debt claimed by the Petitioner has been prescribed.

Would tax authorities in Sri Lanka be sufficiently liberal to accept a fundamental principal of taxation -’substance should override the form’ to allow the development of this mode of financing still in it’s infant stage ?. To date the issue remains controversial in Sri Lanka as the authorities concerned have not clearly ruled on this.

If the authorities opt to look at the form over the substance, some of the fiscal consequences of this alternate mode of financing would differ from an interest bearing loan; its conventional counterpart. As the title transfers twice – initial purchase by the financier and then the onward sale to the customer – the indirect tax implications could impact the profitability due to the existence of two tax points.

If buy – sell operations are not excluded under the VAT / GST statute in a particular Jurisdiction and the statute imposes input tax recoverability, the cost to the ultimate consumer of a product provided under a Murahaba arrangement could be higher than obtaining a conventional loan. To eliminate this impediment, Singapore for instance has permitted the financial institution to claim the GST attributable to the purchase in full, whilst exempting the mark-up on selling price.

The exclusion of wholesale or retail sale of goods from transactional VAT under Sec.3 of Value Added Tax Act No. 14 of 2002 may provide relief whilst denying the input tax claim to the financier, provided the transaction does not involve an importation, whilst exposing it for the turnover tax levied by the Provincial Councils in Sri Lanka. Though the above would be the tax consequence if form takes precedence over the substance, if Sri Lankan tax authorities accept the structure as a pure mode of financing, the profit derived by a bank would be subject to a profit VAT at 20% only.

The liability of a bank carrying out a conventional loan transaction is restricted to the interest element for the purpose of ‘Economic Service Charge’ (ESC) levied under Act No. 13 of 2006. However a Murabaha arrangement exposes it on the total sales proceeds, if the ESC Act follows the form of the transaction. i.e. 1.2M euros as opposed to the mere profit element of.0.2M euros. If the entity does not have sufficient income tax payable to set off the incremental ESC, this would turn out to be a cause to deplete the competitive edge of Murabaha. On the other in the battle between substance and form, substance emerging victorious could wipe out the disadvantage.

Diminishing Musharaka

Whilst a Sharl’ah compliant alternative of conventional housing finance could be carried out using Diminishing Musharaka, Murabaha or Ijara, where these arrangements involve two transfers of’ title, i.e. execution of two transfer deeds, where the financing entity is required to purchase the asset and sell it to the customer, the liability to stamp duty twice becomes unavoidable as most countries levy stamp duty on transfer of immovable property. This impediment has been successfully removed in UK by providing specific relief from stamp duty and land tax.

source: island lk