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]

Do Islamic financial institutions care about Islamic microfinance?

The CGAP microfinance blog highlights the lack of progress in developing laws to facilitate microfinance since the Arab Spring. One point the post makes is that "The irony in all this is that only in Syria and Yemen, two countries still heavily affected by the uprisings, did the governments sanction savings mobilization by MFIs meeting minimum standards." 

It is interesting to me that in both these countries where microfinance was sanctioned by the governments there have been Islamic microfinance institutions, in Jabal al-Hoss in Syria and Hodeidah in Yemen.  There is still much to do in both countries, and in both countries there are more pressing needs with the departure of Ali Abdallah Saleh from Yemen and the continued fighting in Syria against Bashar al-Assad. 

However, despite the continued unrest in both countries, there have been examples of demand for Islamic microfinance which suggests that there is probably demand in other countries where the Arab Spring has run its course.  These countries should move forward on both conventional and Islamic microfinance development as a top priority.  Some may point out that there are more weighty concerns in the forefront today, but I would argue that the development of programs to provide economic opportunities should be at the forefront because the Arab Spring largely arose out of one man, Mohammed Bouazizi, very publicly died after setting himself on fire due to having his livelihood snuffed out by the police when they confiscated his fruit crates and electronic scale. 

It is fair to question whether Islamic microfinance is well developed enough to be moved to the top of the agenda alongside conventional microfinance.  However, with so many resources being devoted to developing the (macro) Islamic finance industry, there should be an equivalent commitment to developing Islamic microfinance.  Today, two of the biggest Islamic microfinance programs are being facilitated with funding for technical support from the US international aid agency USAID in Afghanistan and Iraq.  Where are the Islamic finance institutions who claim to embrace corporate social responsibility, ethical finance and a concern for the poor in laying the groundwork for Islamic microfinance to develop across the MENA region after the Arab Spring? 

Islamic securitization, other news

A lawyer from Patton Boggs has an article in Islamic Finance News about the requirements for Shari'ah-compliant securitization to develop in the Middle East. Securitization markets across the world have been restricted following the credit crisis, but the securitization if done in a Shari'ah-compliant way would allow Islamic banks to increase the diversification of their assets and would free up capital for additional financing.

Other News

• The Islamic Development Bank's $1.5 billion sukuk program and the first issue of $850 million in sukuk received a AAA rating from Fitch's and Standard & Poor's and a Aaa rating from Moody's Investor Services.
  
• Malaysian ports operator Pelabuhan Tanjung Pelepaas plans to raise MYR1.5 billion ($441 million) from sukuk issues with a maturity of up to 10 years.
  
• Standard & Poor's will be responsible for maintaining and calculating the National Bank of Abu Dhabi's NBAD UAE Listed Islamic Index.
  
• The fate of Islamic mortgage firms Amlak and Tamweel continues to be discussed as a UAE state panel oversees their restructuring.
  
• Swiss Re received approval to launch a retakaful unit in Malaysia. The takaful industry has been growing, but there is a shortage of retakaful firms forcing many takaful providers to use conventional reinsurance.
  
• France sees Islamic finance as a potential way to deal with the credit crunch, although Islamic finance is not immune from similar crises that began in the U.S. in 2007.
  

Islamic finance growing globally, particularly in the GCC and U.K., although the industry is not completely immune from the credit crisis

The rapid growth in Islamic finance has begun to receive interest from Western financial institutions and others like rating agencies (e.g. Moody's and Standard & Poors), consulting companies (McKinsey) and news organizations (Financial Times and Bloomberg). This is a credit to the industry's rapid growth and potential to emerge from being a niche industry to one that could become significant in the global financial system. The Islamic financial industry is also expanding into Europe, particularly the U.K. (although there are many other cities vying to become a hub in the global Islamic financial industry) The Independent newspaper in the U.K. has an interesting article on the different Islamic financial products available in the U.K. A recent event called 'Microfinance in the Islamic world' was held at the House of Commons and featured a presentation by Muslim Aid, a charitable organization which has done a significant amount of Shari'ah-compliant microfinance. The conservative nature of Islamic financial products has increased their attractiveness as more risky products have run into problems recently.

The first multi-asset class investment fund was launched on the AIM in London last Friday trading under the ticker FSF.

France is continuing the process of figuring out legislative, tax and regulatory changes needed to rival London for the center of Islamic finance in Europe. Despite having a Muslim share of the population many times that of the U.K., Islamic finance is still nearly nonexistent in France. Switzerland, although prominent in international finance, has lagged behind on Islamic finance.

AAOIFI is developing a governance standard for corporate social responsibility. This is a very important step because it will provide a way to monitor whether Islamic financial institutions are meeting their ethical responsibilities that are the core of their differentiation from most conventional financial institutions.

The Indonesian rupiah-denominated sukuk will be placed in mid-August with a listing expected on August 27th. Doha Bank has delayed their planned $1 billion sukuk to develop an exchange for carbon emissions trading in the Middle East because of poor market conditions. Thai property developers should finance their businesses using sukuk, according to the former head of the Islamic Bank of Thailand Dheerasak Suwannayos. Since 2006, the growth in sukuk has outstripped the growth in conventional bond issues in the GCC, and almost half of this has financed real estate projects.

The Netherland Antilles are exploring legal and regulatory changes needed to attract Islamic finance.

Islamic economist Humayon Dar is working with a group called Charity Bank to develop Shari'ah-compliant financing for non-profit organizations in the U.K.

Dubai Islamic Bank recently launched a Shari'ah consulting group, Dar Al Sharia, to provide research and development and consulting services in Islamic finance transactions.

Islamic banks in the GCC are planning expansion into North Africa and Asia to find new opportunities to grow.

NPR has an article on Islamic home finance in the United States.

IBF Net is launching an institute studying Islamic microfinance in the state of Orissa in India. I have had the pleasure of speaking with one of the founders of the Institute of Microfinance and Development, Dr. Mohammad Obaidullah who is also a Senior Economist at the Islamic Development Bank, and I anticipate that they will make a very positive impact.

Islamic credit cards are becoming more available, although they differ little from conventional credit cards. Usually, the either offer a line of credit with a fee based on the amount used, a murabaha structure where the card issuer 'owns' the goods purchased for an instant when they are purchased and charge a markup, or a lease-buyback where they own the goods until they are paid for and 'lease' usage. They seem to be virtually indistinguishable from conventional credit cards in impact, more so than other Islamic finance transactions where there is a chance for the Islamic finance company to take ownership.

Sukuk, India, France, Kenya, growth in Shari'ah-compliant equity investing

North Africa is beginning to see more growth in Islamic finance, although the higher cost of Islamic finance products is proving to be a greater hurdle than in the GCC countries, where consumers were less sensitive to cost initially. However, like the GCC where consumers are becoming more sensitive to the cost of Islamic financial products, some banks in Tunisia and Morocco have begun to offer Shari'ah-compliant products which are cost competitive with similar conventional financial products.

During the recent worldwide boom in equities, Islamic finance was seen to be underperforming conventional alternatives, but the credit crunch and slump in equity prices has led to changing opinions about the relative performance and riskiness of Shari'ah-compliant versus conventional investments says Jahangir Aka, senior executive of SEI in the Middle East. The avoidance of the financial sector is just one reason these funds have been more stable than conventional alternatives over the previous year. The greater due diligence and 'buy and hold' investment approach, along with the avoidance of highly leveraged companies, has led to more robust returns in periods of instability in the financial markets. Gartmore, a UK-based investment company, has also pointed out that investors see greater safety in Shari'ah-compliant methods of financing due to the recent volatility and Islamic finance's reliance on 'real assets' to underpin financing.

The lack of market makers in sukuk has slowed the development of a secondary market and made it difficult to determine current value of outstanding sukuk issues. The lack of qualified professionals, as well as scholars, is still currently threatening the sustainability of current growth rates in Islamic finance. This shortage has spurred the development of new academic and professional training schools for Islamic finance professionals. One group of professionals who are entering Islamic finance rapidly is lawyers.

Islamic banking advisor Lahem Al-Nasser argues that many of the new products offered by Islamic banks are nothing more than new marketing methods, like a credit card in Saudi Arabia that earns airline miles. Instead, Islamic banks need to encourage more creativity by not focusing too much on expenditure for new product development or dismissing those who develop unsuccessful products, which he believes "cripples creative thinking". The growth in Islamic finance products and development of new products, however, is not entirely without controversy.

A contributor to CPI Financial discusses the different ways to replicate short selling in Shari'ah-compliant ways.

Despite having great potential for developing a market for Islamic finance, France has been slow to encourage growth in the industry, says a special comment from Moody's Investors Service. In contrast, Kenya has seen its Islamic financial industry growing rapidly as banks begin to offer a growing range of Islamic finance products. India's Islamic finance industry is just beginning to start growing rapidly and some companies like Reliance Money, have begun expanding into the GCC offering Islamic financial products.

EPF makes offer for RHB stake, Abu Dhabi starts Islamic bank, Singapore attracts Middle Eastern banks

EPF enters battle for RHB

Utama Banking Group announced that the Employees Provident Fund (EPF) offered RM2.2 billion (US$636 million) for Utama's 32.8% stake in Rashid Hussain Bhd (RHB), which slightly tops the Kuwait Finance House offer of RM2.16 billion (US$615 million) for the same stake in RHB. If Utama Banking Group accepts the EPF offer, the Fund will extend the same offer to all other shareholders of RHB, as well as offer RM4.80 (US$1.37) per share of RHB Capital.

Abu Dhabi to start $1 billion Islamic bank

The Government of Abu Dhabi announced plans to start a $1.1 billion Islamic bank called Al Hilal Bank.

Singapore attracts Middle Eastern Banks

Senior Minister Goh Chok Tong announced that eight Middle Eastern banks have opened branches in Singapore. He was speaking at the Singapore International Waqf conference.

KFH ups bid for RHB, GFH announces European private equity fund, Islamic banking in Pakistan

Gulf Finance House announces European private equity fund

Gulf Finance House, the Bahrain-based Islamic investment house which opened in 1999, announced the creation of a European private equity fund. The bank, which claims to have raised $1 billion in new private equity in 2006, also has a Middle East and North Africa regional fund.

Kuwait Finance House ups bid for RHB and RHB Capital

Kuwait Finance House one of two bidders for control of Rashid Hussain Bhd and RHB Capital, competing with EON Capital, has set a minimum price it will pay for shares of RHB and RHB Capital. Previously, KFH offered RM2.16 billion ($618 million) for Utama Banking Group's 32 percent stake in RHB, which owns 65% of RHB Capital. The new offer is RM2 ($0.57) per share of Rashid Hussain Bhd, RM1.8 ($0.52) per call warrant of RHB Capital and RM4.8 ($1.37) per share of RHB Capital.

KFH plans to invest $3.4 billion in RHB to turn it into a mega Islamic bank. The current EON Capital bid is $2.86 billion for RHB.

Islamic banking in Pakistan

The monthly magazine Newsline in Pakistan has an interesting article about the development of Islamic banking in Pakistan.