Tax neutrality for Islamic Finance needs refinement

For countries wanting to enable Islamic finance within their borders, a key requirement is tax legislation to provide for tax neutrality. The objective being to provide a fair playing field for Islamic finance. The need for such legislation has to do with the fact that Islamic finance, being real asset based, requires the financing to transact in an underlying asset. When the financing is made through the sale and repurchase of an asset, usually real estate, the applicable stamp duty and tax implications can be onerous. Without a waiver on at least one leg of the transaction, Islamic finance would incur costs that would render it prohibitive. The need for a real underlying asset applies to both Islamic banking and capital market transactions. For example, in a typical Ijarah sukuk, the obligor would transfer ownership of an asset to an SPV (Special Purpose Vehicle) which then uses that asset as the underlying for a sukuk issuance to investors. On receipt of the proceeds from the sukuk issuance, the obligor, in continuing to use the asset, pays Ijarah or lease payments periodically to the sukuk holders. These lease payments go on until maturity, at which point the underlying asset is resold to the obligor. Proceeds of the resale are then used as the final redemption amount for the outstanding sukuk. It is obvious that without tax neutrality, the sale and resale of the asset would make the entire transaction far too expensive.

While tax neutrality has indeed been helpful to Islamic finance by levelling the field, vis-a vis conventional finance and current tax regulation appears to have caused an imbalance within the Islamic finance space. While the debt like contracts of Islamic finance, contracts such as Ijarah, Murabaha, Bai Bithamin Ajil (BBA), Salam and the like have prospered and now dominate Islamic finance, the risk sharing contracts like Mudarabah and Musyarakah remain unused. Yet, it is the risk sharing contracts that truly provide the value added of Islamic finance. Today, whether it is Islamic banking or Islamic capital market products, the debt based contracts account for 80-90 percent of the transactions. The reason for this acute imbalance is again the tax regime. As is the case in conventional finance, where debt provides a tax shelter but equity doesn’t, the debt-based contracts of Islamic finance have the same tax advantage, but the risk sharing ones, being classified as equity for tax purposes, do not. As a result, the same debt bias that we see in conventional finance is as prevalent, if not more acute, within the Islamic finance space. This is ironical as the Shariah upon which Islamic finance is to be practised, abhors interest-based lending but requires the taking of risk in order to justify a return.

Policymakers of the Muslim world, while being cognizant of the need to avoid “double” taxation, by way of tax neutrality, appear to have missed the bigger picture of the need to discriminate in favour of risk sharing contracts in keeping with the spirit of maqasid shariah. In any case, defining Mudarabah and Musyarakah contracts as equity for tax purposes is slipshod. While these contracts have the risk sharing features of equity, they are terminal like debt. Furthermore, unlike equity, they do not have a claim on all of the issuing firm’s assets but only on the specific financed asset. Thus, they are truly quasi equity instruments that should not be treated as equity but should have different tax treatment. There are several reasons why policymakers would be well advised to treat the risk sharing contracts the same way they do with the debt based contracts, that is, provide tax exemption on the dividends paid.

First, the existing bias within Islamic finance for the debt based contracts due to tax advantage would be eliminated. Second, the recently seen slowdown in the growth rate of Islamic banking and finance could be turned around. It is obvious that much of the slowdown is due to the seeming convergence with conventional finance. The cash flow and leverage impact of debt is the same, regardless of whether it is Shariah compliant or not. Removing the tax impediment to risk sharing contracts can help rejuvenate both Islamic banking and capital markets. Third, to governments, there will be no loss in tax revenue. This is because there is very little use of risk sharing contracts now and it is likely that as their use will be in lieu of the debt contracts. On a net basis, therefore, there will be no loss in tax revenue to governments. Finally, the biggest advantage to the movement away from debt to risk sharing at the micro level is the macro level benefit of reduced vulnerability. Reductions in the aggregate domestic debt reduce susceptibility to external shocks, contagion, interest rate risk and the like. For emerging countries, these are distinct benefits. If there is much to be gained and little to be lost in terms of tax revenue, the policy choice should be obvious.