Absence of Saudi Arabia, Bahrain deprives IILM of key markets but peripheral Islamic markets should benefit

The absence of Bahrain and Saudi Arabia from the IILM deprive the institution of entry to key markets for Islamic finance, and may have cost the institution its top rating. While the reason for Saudi Arabia’s withdrawal, it could be due to concern over the possible use of IILM sukuk in Islamic repo transactions, or fears that the IILM sukuk program might curtail commodity murabaha participants profits. Even Qatar, which is more involved in the IILM as a result is showing signs it may not be confident in the IILM’s ability to succeed where others have failed by announcing its own plans for regular sovereign sukuk issuance.

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Saudi Arabia exits IILM, clouding the prospects for sukuk issuance

The withdrawal of Saudi Arabia from the IILM is an ominous development for the body which said in March that it was in the “final stage” of launching a $300 to $500 million sukuk.  It would be hoped that, for the good of the Islamic banking industry which needs additional liquidity management tools, no further delays will occur to the IILM’s maiden sukuk, but the withdrawal of Saudi Arabia could just be the first storm cloud gathering above that institution’s prospects, following several previous delays.

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Qatar’s sukuk issuance to remain robust, but may disappoint optimists

The continued rapid economic growth in Qatar, despite the suspension of new hydrocarbon-based projects until 2015, has led analysts to suggest that Qatar—and in particular Qatari banks—will be significant sources of new issuance during 2013.  The IMF recently concluded an Article IV consultation with the Qatari government and one area of focus was the development of a domestic yield curve, which was a government priority in the wake of the global financial crisis. 

The shift away from the hydrocarbon sector in the economy represents a drag on the country’s extremely rapid growth rate in recent years, but continued growth in the non-hydrocarbon segment of the economy as well as investments in advance of the 2022 World Cup—primarily from public enterprises and the private sector—could represent a growing source of sukuk issuance either directly or indirectly.  However, the total issuance is unlikely to spike as dramatically as optimists predict, which may lead to disappointment even if there are many positive developments for sukuk in 2013.  

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Islamic Finance is More Susceptible to Regulatory Arbitrage

Regulatory arbitrage provides clever bankers and lawyers with a way to exploit different jurisdictions’ regulatory structure—most often those with strict rules-based systems where form is placed above substance—to their advantage.  Because many of the countries where Islamic finance operates are classified as emerging and frontier markets, and because Islamic finance itself is underdeveloped relative to conventional finance, there are likely to be more opportunities for regulatory arbitrage in Islamic finance.  

There are many ways that regulatory arbitrage can be used by institutions of all varieties, and that includes within Islamic finance.  However, there are concrete first steps being made on a country-level (specifically in Indonesia and Qatar) that will remove some of the opportunities for regulatory arbitrage, but there will need to be globally accepted, mandatory regulatory standards like the Basel accords in order for Islamic finance to significantly reduce industry- and  world-wide regulatory arbitrage, although the three Basel accords have demonstrated that more work will remain even once standards are in place.  

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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]