Sheer excuse or a real hindrance? NAZNEEN HALIM questions the validity of the claim that tax issues have hampered the growth of the Islamic finance industry and sees how much influence it has had on the landscape of Islamic finance as we know it.

“It’s just such that when the original laws were written, they did not take Islamic finance into consideration. Islamic banks are not looking for a subsidy from the regulators. All we’re asking for is a level playing field and clarity of regulations so we can write and execute a business plan for the benefit of our customers in that economy.”

Regulators have begun to see the urgency in amending global tax laws to allow Islamic finance to participate in the real economy. At a seminal stage now, the spread of Islamic finance throughout the globe has uncovered several roadblocks which need to be addressed, such as the double taxation and value added tax components on Islamic finance transactions.

Countries such as Malaysia which have not only injected Islamic finance into mainstream transactions but also offer 0% tax incentives to Islamic banking institutions, have been rewarded with phenomenal growth within the industry. Emerging markets have picked up on this and intend to replicate Malaysia’s regulatory system. The question is: How far must they go and how long will it take?
“It’s not a tax break — people keep talking about tax breaks. It’s a leveling out, tax neutrality,” a Dubai-based banker stated. The reason for the current tax implications, simply put, is because Islamic finance does not recognize loans — which are ubiquitous in conventional finance. Islamic finance transactions are seen as straight up financing which involves buying and leasing, which are seen as a sale and purchase, therefore naturally implying withholding and capital gains tax.

However, the banker was quick to add: “We (Islamic banks) are not asking regulators to make Islamic financing cheaper than conventional finance. We are happy to compete within the conventional space. It’s the clarification of tax rules that we need to mobilize the sector.”

What’s the story?
Indonesia is set to pass a new law any time now which will remove the value-added tax (VAT) on Murabahah transactions. The incorporation of this new law into the system is expected to dissolve the issue of withholding tax on margins and distributions, thus creating a level playing field between Islamic and conventional institutions, as well as attract foreign issuers and investors into the country, alongside foreign banks.

However, could this really be the panacea to the republic’s late entry into the international markets? A senior banker from Indonesia thinks not entirely: “This new law sort of resolves VAT issues when there is a certain transfer of goods between the supplier and institution and the end customer. Therefore, structures such as Murabahah will be in the clear, but there are many other Islamic products that are not as explicitly regulated under this new law.

“There are different interpretations — some see it as leveling the playing field and resolving many tax issues, but some are not convinced yet,” he added. Margie Margaret, partner at PricewaterhouseCoopers Indonesia tax services, explained: “The law is not intended to address the VAT implication for transactional basis. As such, we suggest that corporations and investors still need to consider specific tax implications for the underlying transactions. In general, the VAT implications shall be the same with conventional transactions.

“Perhaps it is not merely about the legislative framework but rather to what extent Islamic finance products can be more, or at least, as competitive with conventional products,” she said.

Other countries such as Korea have also been stuck in a catch-22, uncertain of its future in Islamic finance despite its desire to diversify its investments. Korea’s main area of focus however is Sukuk — the quickest and almost surefire way to penetrate the market. Currently, under the Special Tax Treatment Control Act in Korea, no corporate income tax is imposed on interest received by a foreign entity in relation to foreign-currency denominated bonds.

However, due to the nature of Sukuk issuances, which involve the creation of a special purpose vehicle (SPV), the Koreans question the excess income gained over the original investments, and whether it can be treated as interest income from the bonds.

This, coupled with Korea’s lack of familiarity with Sukuk structures, has posed as a hindrance to the nation’s Sukuk debut, with its government seeing bifurcation in terms of its stand on the current tax laws. According to Yong-Jae Chang (caricature), partner at law firm Lee & Ko, and also a member of the Ministry of Strategy and Finance’s (MOSF) task force on Islamic finance, which is passionately pushing for tax amendments for Islamic finance, the tax amendments which have been proposed to the government encompass granting tax exemptions from corporate income tax for investment returns gained by the offshore SPVs from the Sukuk, and tax exemptions for acquisitions and registrations which occur during multiple transfers of the underlying assets in a Sukuk Ijarah transaction.

Chang also revealed that the MOSF is in the process of meeting with the relevant legislators in parliament, with much pressure from corporates and institutions which want to see the bill passed as soon as possible. “We don’t want there to be a dip in momentum, and we’re hoping to see Korea achieve tax neutrality soon. If there is a lapse in momentum, Korea’s image risks being tarnished,” Chang said.

Perception also plays a part in Korea’s resistance in passing the Islamic finance tax laws. Chang stated: “There is lack of awareness among the members of parliament, with some citing terrorist money laundering as a top concern with regards to this issue. Certain Christian groups have also expressed their unease with the proposed bill. However, the Korean president himself seems keen on this initiative to amend the existing tax laws.”

In Thailand, political uncertainty has also prompted a delay in the approval process with regards to a change in its current double taxation regime, which many see as a hindrance in the country’s bid to issue a sovereign Sukuk. “The revenue department has to change its tax regulations because the current system would make it more expensive to issue Sukuk than conventional bonds.”

“Sukuk are subject to high tax costs in Thailand due to double transfers of underlying assets. Laws and regulations related to land transactions would also need to be changed to accommodate Islamic finance structures,” explained Rhengrit Pooprasert, partner of Zaid Ibrahim & Co (Zico) in Thailand.

Change is inevitable
Such debate however has not plagued European countries such as the UK and Ireland which almost immediately reacted to the tax implications on Islamic finance products. Recently, Ireland’s Finance Bill introduced new rules to support the development of Islamic finance by extending the tax treatment applicable to conventional financial products to Shariah compliant products.

According to Irfan Butt (caricature), senior tax partner at PricewaterhouseCoopers in the UK, the existing tax legislation covers “alternative finance arrangements” as well as structures such as Murabahah, Diminishing Musharakah, Ijarah and Sukuk. Butt added that this push has come from the retail and institutional side: “Jurisdictions such as Ireland and Luxembourg are typically used to retaining institutional types of funds. However, investments such as real estate are rarely done in those jurisdictions.

“London is fully aware of the importance of Islamic finance and it has been quick to act on the matter of establishing itself as an Islamic finance hub in Europe. UK tax treatments used to depend on general tax principles, but this has changed to accommodate Islamic finance,” Butt added.

Not just in Asia but across the globe as well, countries have begun to acknowledge the promise of diversity and transparency which Islamic finance brings. However, regulatory changes can only come about with sound justification from those proposing such change, and sufficient political will.