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Tax impact Ignorance of Sharia finance transactions troubling

Islamic finance is a “baby dragon” growing exponentially. Ignoring the tax consequences will result in future global problems equivalent to today’s debate on how to tax the digital economy, panellists at the IFA Congress warn.

There is a lack of government guidance in non-Muslim countries on how to tax financial transactions structured to comply with Sharia law.

“So many countries are just turning a blind eye to Islamic finance for the time being,” said Monia Naoum, international tax and transfer pricing consultant from the Netherlands. She warned that this ignorance is going to cause significant problems for taxpayers, governments and advisors as the trend of undertaking Sharia transactions continues to grow beyond traditional Muslim countries and communities.

Islamic finance is growing faster than conventional finance. Approximately 6% of global finance now applies Sharia principles. Although almost all tax professionals will be touched by Sharia-compliant finance in the coming years, the tax community is still largely unprepared, said panellists at the IFA 2019 Congress.

Issuers are using Islamic finance to access additional customers and capital, explained Peter Barnes, of counsel to Caplin & Drysdale in the US, during a panel discussion.

“If you are a large company that wants to tap the capital markets – yes, today, there is plenty of cash around ­– but there is an enormous amount of cash available through investing in Islamic finance. The big issuers – General Electrical, Goldman Sachs, the UK government – want to be able to access that cash,” Barnes said.

Issuers want to signal an interest in Muslim-depositor markets and the market goes beyond the Middle East to include Malaysia, Singapore, Indonesia, Morocco, and others.

“Unless the big institutions are engaged with the Muslim-depositor markets, they’re missing out on a big chunk of the financial world - and people want to build expertise for the future. This is an area of growth,” said Barnes.

Islamic banking constitutes a form of finance transactions compliant with Sharia Law and Islamic economics. It is interchangeably referred to as Sharia finance, Islamic finance and Sharia-compliance finance and often includes transactions such as Mudarabah, Wadiah, Musharaka, Murabahah, and Ijara. Transactions include a multiple of additional transfer taxes when compared with traditional finance arrangements. The financing structure is most commonly used in property, but there are four key principles of all transactions that make Islamic finance different to traditional methods:

Interest and unacceptable profits are prohibited. Most property transactions will involve a form of rent or lease-buyback to ensure it complies with Sharia law. No documents or contracts are allowed to refer to interest. However, for tax, the ‘rent’ is often equal to interest when applying tax treaty benefits;

  • There is an assumption and sharing of risk (e.g. no risk-free participation);
  • There must be no excessive uncertainty or speculation; and
  • All investments must be ethical. No investments are allowed in unethical goods or activities such as gambling, alcohol, pornography, conventional interest, arms, etc.

Cross-border and transfer pricing troubles ahead

Sharia finance transactions are often domestic, but panellists said that as more countries enable a legal structure for these transactions, cross-border transactions will happen and will become far more complex.

“When we first started talking about BEPS Action 1, this was just something that was silent for quite some time, and in the last couple of years, everyone is freaking out about the digital economy and the taxation of the digital economy and then we see all these unilateral measures. I truly hope we don’t get that in Islamic finance because it’s not a sleeping dragon, said Naoum.

“It’s a baby dragon, but it is growing exponentially; so, I believe it is time to start thinking about unilateral measures, but also cooperative measures. Hopefully, under the OECD or the UN, but something needs to be done.”

Developing global guidance now would ensure certainty and avoid the risk of transfer pricing disputes emerging when tax authorities question the benchmarks used or the application of the arm’s-length principle.

“In the context of these cross-border deals, if we were to take it from a transfer pricing perspective, I can easily see HMRC or other revenue authorities in the functional analyses of the employees of the bank saying ‘so, how do you guys benchmark this? Do you see yourself as being in the business of buying and selling properties? How do you determine your return? Can you show me the CVs of the guys who really know about property?” noted Osman Mollagee, senior international tax and transfer pricing partner at PwC South Africa.

“So, on the question of looking at this simply from one jurisdiction, I don’t think the transfer pricing aspect is going to permit us to do that for much longer,” warned Mollangee, who chaired the session.

‘Toxic topic’

Although Islamic finance transactions are growing, there is a severe lack of guidance on how tax law treats Sharia-compliant transactions in most non-Muslim-majority countries.

In the US, there is no information whatsoever on the Internal Revenue Service (IRS) website.

“If you go on the website for the IRS, and you search for either the words ‘Sharia’ or Islamic finance’, what you get it: ‘your search returned no results’ – there is no guidance,” said Barnes. “Even though Goldman Sachs, General Electric, and others, had done these transactions, there is zero guidance in the US on how these transactions should be treated.”

“It worries me because US taxpayers are doing these transactions, either directly or through their subsidiaries,” continued Barnes. “Some subsidiaries are reporting transactions on their 5471 forms to some level, and I’m not sure the US tax leaders of these companies even know these transactions are occurring, or have thought about the consequences of these transactions for 5471.”

Barnes quoted a 2017 article written by Virginia La Torre Jeker, international US tax specialist, who said that while “[guidance] from the IRS or the courts on the application of Sharia law to US tax matters would be helpful, it simply does not exist and is unlikely to materialise soon. This is especially so in today’s political climate, given that Sharia law is a hotly contested topic in the United States”.

However, Barnes said La Torre Jeker understated the problem, describing Sharia law as a “toxic topic in the US”. States have tried to pass laws to prevent the use of Sharia principles when dealing with legal matters.

The problem is “almost identical” in India too, according to Mukesh Butani, a guest speaker during the session. “This is a sensitive subject in India and also [a] politically charged debate,” he said, despite Sharia law operating in the country before its constitution was enacted.

However, countries like the UK and Hong Kong SAR are ahead of the curve, with a host of guidance on its legal and tax applications already in place.

Nevertheless, each country’s guidance is unique to its own tax structure and there is need for a global approach. However, the OECD has its hand full with the digital tax debate and there is little hope of unified guidance from an authoritative organisation any time soon. This may be good news for the UK, according to David Saleh, corporate tax partner at Clifford Chance in the UK. He said global guidance could mean the UK loses its competitive edge in attracting Islamic finance transactions and investment opportunities.

For now, governments would benefit from establishing strong domestic guidance, tax advisors should ask their clients about their engagement and reporting under Sharia law, and taxpayers need to scrutinise their transactions to unearth any links to Islamic finance structures.

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