The great argument about Islamic finance is that it is taxed unfairly. After nearly 30 years of work in the shadows and in the guts of this business, I feel that this is often a fact, and, too often, an excuse. As a general presumption, the world system has a bias towards interest. Let’s examine that bias and then determine where there may be other challenges, for instance, historical inefficiencies or industry biases.

Following the Second World War, the planet had a very simple problem. The industrial, transportation and commercial infrastructure of the developed world was destroyed. Most countries were also broke financially as well. The exception was the US. And now, a very simple set of fears arose. If the Americans have the money and we need it, then they will simply buy everything we have.

Over the next 10 years, international tax treaties evolved to protect the equity of the devastated nations. To assure that capital moved successfully to rebuild Europe and Japan, loans were given tax protection and interest was not penalized. To assuage European and Japanese fears of American vulture capitalism, both national ownership laws and aggressive taxes on capital gains and dividends were tolerated.

Lest you think this analysis is off the mark, let’s examine the simple concept of an asset backed security (ABS). If we took any of the pooled vehicle transactions of the last 25 years, then we would see the following steps:
Manufacturer builds 10,000 cars.
Unable to sell them, Manufacturer leases them to a captive leasing company.
Captive leasing company enters into medium-term fleet leases.
Manufacturer sells beneficial title to a special purpose vehicle (SPV).
SPV issues units to the public.
At maturity, the cars are sold (auctioned to the public, sold to the leasing company or bought back by the Manufacturer).

Debt or Equity? If you said equity, that is the fact. If you said debt, that is the generic treatment in multiple jurisdictions. Interpreting and legislating (depending upon jurisdiction) ABS into the debt family allowed everyone to avoid changing many more tax laws and treaties.

Even in the Islamic finance space, the American bank regulators have interpreted Ijarah Muntahia be Tamleek (IMBT) to fit under a bank’s mortgaging powers. Even if the bank has apparent equity risk in real estate, the interpretation allows IMBT to generate mortgage risk weighting for a bank as well as an “interest” deduction for the “profit” element of the rental flow. Similar interpretations apply to Murabahah and declining balance partnership (in the UK only for banks).

There you have it. On the one hand, the system is globally biased against equity. On the other hand, the system up until the financial crisis has allowed for flexible interpretations to cram “equity” into “debt” for tax or regulatory purposes. Curiously, this ambiguity can only be tolerated in a non-harmonized or oblique accounting environment. As you know from prior commentaries, I have a great concern that globally, legislators and regulators will throw the good securitization rules out with the bad securitization behavior in their revisions of accounting, securities and banking rules. We have seen this starting in early 2009 in the US.

Conversely, these problems really don’t matter with Islamic private equity and listed equity investing. With the exception of debt (which nobody can find now), the fundamentals don’t change and the Islamic and conventional sectors have a level playing field under the current global tax regime.

It’s true. From the Islamic perspective, we are looking for tax parity. But the ongoing reality of offshore jurisdictions providing tax simplicity for traditional investors is evidence that taxes are not the enemy of Islamic finance, but a business reality. Taxes are a fact to be managed in a lawful manner via structuring and choice of domicile, sometimes by lobbying, and by paying up what is due when it is due. And, every now and again, we need to be careful about what we ask for.