Tuesday, February 19, 2013

Should tax competition be between countries or focus on harmonizing taxation of Islamic/conventional finance?

The Qatar Financial Centre Authority report on the taxation of Islamic finance products seems to be getting most of the attention for the conclusion that Qatar Financial Centre and Turkey are the most favorable from a tax perspective for Islamic finance.  However, this misses a glaring omission in the report’s coverage: Bahrain, the United Arab Emirates and the Dubai International Financial Centre are excluded.  According to the report's principal author, Mohammed Amin, the report covers all the jurisdictions that responded to the questions which were distributed by Ernst & Young. 

As a result, the report is a valuable reference guide to how different transactions may be taxed—if the five situations analyzed are representative of the entire universe of Islamic finance products, which is not entirely unrealistic.  The products that are reviewed are commodity murabaha/tawarruq, salam, istisna’a, and sukuk (with either an onshore or offshore SPV).  But again, there are significant gaps in the analysis caused by the exclusion of Bahrain, the UAE and the DIFC, all of which have a large presence in the MENA region’s Islamic banking and finance market.

However, a more pertinent conclusion is to discount the way the report is being covered (i.e. what is the most “Islamic finance tax friendly” country?). There is not likely to be anywhere near as much competition between countries within their treatment of Islamic finance products in comparison with the impact of tax differences between Islamic finance and conventional finance within each country. 

Fortunately, the structure of the report does highlight the comparison between conventional and Islamic financial products.  In preparing the report, the authors created templates for Islamic finance products with economically similar outcomes to conventional loans or bonds (see below for an example, a murabaha-based mortgage) and then asked tax consultants and the countries’ taxation authorities whether the expected treatment of equivalent loans/bonds would apply for a given Islamic finance structure.

Source: QFCA, p. 18


Where there may be competition based on ‘friendliness to Islamic finance’ between jurisdictions is in attracting foreign investors, either regionally (banks and investors within MENA or within the GCC) or global institutional investors through sukuk issuance.  However, taxation will remain only one factor and will more likely affect pricing for the issuer depending on the allocation between different investors (domestic or foreign) and the structure used (asset-based ijara versus structures where there is no real estate transfer that could attract taxation).  

One way to interpret the study’s result that is not affected by the exclusion of several Islamic finance centers within the GCC region is to focus the analysis on comparing the tax treatment of Islamic finance and conventional finance.  And the authors do reach a conclusion on this topic:

For relatively simple Islamic finance transactions […], the application of the general tax laws of the countries concerned, unmodified for Islamic finance, appear to give results for the taxable income of the parties which broadly correspond with the results expected from an analysis of the transaction economics [although], transaction taxes can arise which would not be payable in the case of a conventional finance transaction which had similar economic consequences.

In the case of more complex transactions such as sukuk, the application of the general tax laws of the countries concerned, unmodified for Islamic finance, leads to prohibitive tax costs which can make the transaction wholly uneconomic to carry out.

The end result is that the report provides an interesting, although strikingly incomplete look at the MENA region’s tax treatment of Islamic finance. There are still interesting conclusions that can be reached, but they are mostly applicable within each country such as why a transaction that is economically equivalent to a sale-and-leaseback finance lease would be treated differently from a loan with equal principal amount and rental payment amounts and schedule equivalent to interest payments on the equivalent loan. 

By highlighting these types of differences between the tax treatments of conventional and Islamic finance, the report should lead to greater pressure for harmonization in countries that are opening up to Islamic finance or trying to encourage its development. 

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More Information

Qatar Financial Centre Authority. 2013. Cross border taxation of Islamic finance in the MENA region: Phase One. [PDF]

1 comment:

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