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]

ICD head gives interview to Arab News

Arab News had an interview with the CEO of the Islamic Corporation for the Development of the Private Sector, Khaled Al-Aboodi.  The ICD is the private sector arm of the Islamic Development Bank (similar to the relationship between the International Finance Corporation and the World Bank).  Here are a few sections that I thought were interesting: 

"While lack of access to finance by the private sector has opened new opportunities for ICD to support private sector development in a number of member-countries, a combination of factors such as social unrest in some member-countries, increased cost of funding and lingering effects of financial crisis has made it very difficult for ICD to operate as planned."

 ....

"ICD managed to approve 18 new projects and capital incease for three existing equity projects totaling 372.26 million in 1432H/2011. This was 58 percent higher than the previous year (2010), which reflects ICD's continuing robust support to private sector development in the member-countries. Equity investments accounted for the bulk of ICD's 1432H/2011 approvals, representing 38 percent of the total, followed by the line of finance (35 percent), long-term financing (22 percent), and short-term murabaha (5 percent). In terms of sectoral distribution, the three main beneficiary sectors were finance, industry and real estate, jointly attracting 85 percent of the total approvals. The financial sector accounted for the biggest allocation, totaling 201.26 million, or 54 percent of the 1432H/2011 approvals. In terms of regional composition, 31 percent of ICD's approved projects during 1432H were allocated to the Middle East North Africa (MENA) region, followed by South Asia (23 percent), Sub-Saharan Africa (16 percent), East Asia and Pacific (14 percent), and Europe and Central Asia (10 percent). In terms of recipient countries, ICD approvals were extended to 13-member countries, including three new countries - Algeria, Gabon and Turkmenistan. "

...

"In the past year, ICD successfully closed the fund-raising for Tunisia and Saudi Arabia SME funds, and also for the Central Asia Renewable Energy Fund. Furthermore, ICD has approved establishment of a Food & Agriculture Fund and Fixed Income Fund, and successfully secured some mandates in Tunisia and Cameroon for capacity building and creation of Islamic windows within conventional banks."

...

"To fulfill our mandate, we support the private sector through the following ways: First, we assist them alone or in collaboration with other financing institutions the establishment and expansion of enterprises. Second, we can make direct investment, through Islamic instruments, in the subscription and purchase of their share capital. We also promote with participation of other sources of financing, including the structuring of syndication deals, underwriting of securities, joint ventures and other forms of association. Moreover, we can get involved in issuing mudharba, leasing and istisna'a bonds and other financial instruments. At the top of these, private sector firms may benefit from our advisory services and technical assistance programs."

 ...

"ICD's accumulated approvals since it began operation reached 2.17 billion by the end of 1432H/2011, which has been allocated to 218 projects. The corporation approved about 60 percent of its investments through two main modes of finance - equity and murabaha. The cumulative gross approvals of ICD by mode of finance include 766.07 million of equity, 535.77 million of murabaha, 526.5 million of ijara, 223.13 million of installment sale, and 119.14 million of istisna'a. "

"The financial sector accounted for the largest share, amounting to 783.7 million, or 36 percent of the accumulated gross approvals since inception. The industrial sector had the second largest share with a total approved amount of 596.1 million, representing 27 percent of the gross approvals. This was followed by real estate, with a total approval of 276.2 million (13 percent)."

One thing I think is notable is that the ICD is becoming involved with both SME financing and renewable energy financing, which I have mentioned as important areas for Islamic finance several times.  One question that arose for me when comparing the inception-to-date statistics with the 2011 data was what the breakdown in terms of structure used by the ICD.  The inception-to-date numbers break down by equity, murabaha, ijara, installment sale and istisna'a, but the 2011 data show equity, line of finance, long-term finance, short-term murabaha. The data are not comparable without making some perhaps heroic assumptions about what structure is used for "line of finance" and "long-term finance" (which may be murabaha and ijara, respectively, but could combine a number of different structures in each category). 

Click through to the full article to read the rest of the interview. 

Will Saudi Hollandi return with another mudaraba sukuk

The news that Saudi Hollandi Bank is planning a SAR1.4 billion ($373 million) sukuk to raise the bank's capital levels could serve as a 'tell' on the future for sukuk markets, depending on the structure.  If SHB returns with another mudaraba sukuk (it issued one of the first using that structure after AAOIFI issued a ruling significantly limiting some of the features used in mudaraba sukuk that made it more 'fixed income'-like). it could indicate that the structure may see a resurgence in the future.

If, however, SHB abandons the mudaraba structure in favor of, for example, an istithmar sukuk backed by receivables (ijara, salam, istisna'a and murabaha), it will be more support for that structure.  Istithmar has become more common with issuance by the Islamic Development Bank and the ability of financial institutions--which tend to have few physical assets to base sukuk on--to raise money through sukuk issuance (istithmar can include up to 67% in debt-based receivables like murabaha, although most istithmar sukuk limit this percentage to 50%). 

Only time will tell. 

Should Islamic banks use mudaraba and musharaka?

A while ago, I started a series of posts about how Islamic financial institutions work, looking at their products one by one, and I got distracted from it by other things I was working on.  However, I was looking through the financial statements of a large Islamic bank and I had a few thoughts.  Hopefully I'll get to that series of posts again at some point, but this was still interesting to me.  Here's the breakdown of assets by the types of contracts used (excluding cash and non-financing assets):

	30-Jun-12	30-Jun-11
Murabaha	84.8%	83.1%
Ijara	0.3%	0.3%
Salam	1.0%	0.8%
Istisna'a	0.2%	0.3%
Mudaraba	4.4%	6.2%
Musharaka	3.4%	3.5%
Ijara Muntahia Bittamleek	5.8%	5.8%

The breakdown should be relatively expected to most people, since the Islamic finance industry has used murabaha because it is the easiest to use by banks that are trying to (or forced to by regulations) keep the same business model as in conventional banking.  It also conforms to rough estimates that pop up in articles every now and then that 90% or thereabouts of Islamic finance is based on murabaha.

It shouldn't be surprising either that most of the ijara contracts are ijara muntahia bittamleek (leases that end in ownership transfer from the lessor to the lessee), since it is a bank, not a leasing company (which would have a different breakdown between financing and operating leases). 

What is a little surprising is how much of the non-murabaha contracts are mudaraba and musharaka. To see if the last few years were outliers, I pulled up the total share for east as a percentage of the bank's assets going back to 2008. 

	2008	2009	2010	2011	2012
Mudaraba/Musharaka	8.3%	7.2%	7.0%	9.8%	7.9%

While these seem like small amounts, their absolute amount is larger since this is a large bank with about $17 billion in assets (the latest total mudaraba and musharaka assets were $859 million).  This is still very small relative to the total size of Islamic finance which is itself a small part of the global financial industry, but it is still there as a portion of Islamic banks' balance sheets.  There is also the chance that these contracts are used to replicate conventional financial lending arrangements (with anticipated profit rates that determine periodic payments), but that cannot be gleaned from the financial statements. 

Regardless of whether the share of mudaraba and musharaka is large or small, there remains the question of whether a bank should be engaged in taking equity positions at all (for example, banks in the US are not allowed to make equity investments so musharaka-based products are offered only by non-bank financial institutions).  Within Islamic finance, the practical answer to that question is 'no', and a resounding 'no'.  But the theoretical answer is 'yes' since the first model for an Islamic bank is based on a two-tier mudaraba, where the bank provides capital to businesses and shares in the profits and absorbs any losses. 

This probably is not the best system for banking because when people put money into banks as deposits (rather than investing as shareholders), they expect to be able to use that money for transactions or for savings, and are not expecting to recognize losses of capital (or else they would find a better destination, like a mutual fund, where they would fully get the profits from investments (Islamic banks pay out returns to depositors in a way to compete with conventional banks so returns are based on the prevailing interest rates on deposits). 

This conflicts with the idea that Islamic banks should use a model as close as possible to a two-tiered mudaraba.  Islamic banks do use the mudaraba structure for deposits (this bank had profit-sharing investment accounts nearly 3 times the value of current accounts), but shelter depositors from losses to the greatest extent possible by reserve funds that build up profits in excess of the profits paid out (based on prevailing interest rates on deposits) and shareholders will likely be expected to give up profits to meet the prevailing rate of return if there were ever a shortfall. 

On the issue of banks engaging in mudaraba, Dr. Zubair Hasan at INCEIF wrote a post recently that discussed the profit sharing model and agency problems.  In his post is a diagram which shows the potential to inject mudaraba financing into an operating business where the firm's profits are separated in a way from the mudaraba profits (since the mudaraba is funding a portion of the business and its profit share is dependent only on this portion of the business). 

This is a way that a mudaraba could be incorporated into more business financing in the same way that mudaraba sukuk are used to fund aspects of businesses (for example, an expansion of a bank's Islamic banking business).  The new (post-AAOIFI ruling) way mudaraba sukuk work is that the funds are invested and an anticipated profit-rate is paid periodically with the final redemption based on the market value of the assets (less any shortfall in the actual profits for the rabb ul-maal over the life of the sukuk). 

This is a nice solution for a sukuk issuer that wants debt where its payments are predictable and the redemption value is based on the underlying value of the business being financed, but from the financier's perspective (assuming that is a bank for this discussion) it is not a good way to operate since it gets limited upside and assumes the risk in cases of loss.  There are likely ways to make it more like a conventional loan, but that further muddies the water of the underlying structure in order to make it a banking product. 

This complexity subtracts value because it transforms what is fundamentally supposed to be a relationship that is equity-based not debt-based.  There are much better ways for equity investment that don't require such complicated modification, like, well, equity mutual funds.  If an investor wants to take advantage of a professional manager and is willing to take losses and wants to have daily liquidity, why change how banks work and why not just go invest in a mutual fund that selects Shari'ah-compliant equities where all of the losses are borne by the investor and it takes a proportional share of equity corresponding to the dividends and capital gains paid out. 

It is perfectly possible to design Islamic banks to incorporate mudaraba and musharaka contracts, but it doesn't seem fundamentally useful when there are more functional, simple ways to use those contracts and depositors are generally not prepared to risk principal. Maybe the debate should be more about why the other forms of non-murabaha debt financing like istisna'a and salam (not to mention asset-based or asset-backed financing using ijara) are not used more and murabaha less. 

Gov. Zeti tells it (mostly) like it is

An article in Arab News describes the prospects for Islamic finance as seen by Zeti Akhtar Aziz, the governor of the central bank of Malaysia, Bank Negara.  Included in the article is a quote from Gov. Zeti which I think does an admirable job at describing the ways in which Islamic finance is affected by the global financial crisis and the recession which followed.  She said:

"The Islamic finance industry was insulated from the first round of the crisis (the global financial crisis). Islamic financial institutions (IFIs) are more resilient because they are closely linked to the real economy, with in-built checks and balances such as profit-sharing and risk-sharing. As such, there are greater elements of responsible lending. As economies slow down and financial markets experience a correction, these will impact financial institutions including IFIs. That is why it is important to have capital buffers, risk management and governance practices that are sound. We are continuing to develop mechanisms, institutional arrangements and financial infrastructures such as greater liquidity management and more so that the Islamic finance industry would continue to be resilient."

There are some things I think are not necessarily true.  IFIs do have some elements of responsible lending because they cannot move risk off balance sheet quite as easily (and in opaque ways) as conventional banks through credit default swaps (which the FT Alphaville blog described in two posts earlier today).  But, I am not sure that IFIs are any more linked to the real economy than conventional banks (with the exception of situations like before the credit crisis when some banks were loaded up with CDOs created (synthetically in many cases) from subprime MBS.  Most (smaller) banks didn't participate in these instruments, but were still hurt because of tightening credit, falling real estate prices and a slowing economy.

However, she is absolutely correct that IFIs are susceptible to a slowdown in the economy, which necessitates a similar level of regulation as other financial institutions.  Gov. Zeti is usually a good source for clear statements on the Islamic finance industry and this quote is a good example.

A couple other things in the article caught my eye.  First, the 3 applications for Islamic mega banks are not from Western institutions, and are reportedly backed by GCC-based investors, which continues the trend of convergence between the GCC and Malaysia.  Second, Governor Zeti is quoted saying: ""The IILM [International Islamic Liquidity Management Corporation] is currently obtaining the required rating, as well as fulfillment of all other parameters for the issuance including high quality underlying assets".  This to me suggests that the sukuk will be more likely an istithmaar sukuk, backed by Shari'ah-compliant financial assets from the central banks that are the members of the IILM.  Under standard practice, fewer than 50% of these assets will be murabaha and istisna'a if the sukuk are going to be tradable (though I think AAOIFI rules stipulate a cutoff of 33%).