INSIGHT: Sharia Instruments of Financing—Tax Implications (Part 1)

According to capitalist theory, capital and entrepreneur are two separate factors of production. The former receives interest while the latter is entitled to profit. Interest is a fixed return for providing capital, while profit can be earned only when there is a surplus after distributing the fixed return to land, labor and capital.

Sharia law does not recognize capital and entrepreneur as two separate factors of production. Every person who contributes capital (in the form of money) to a commercial enterprise assumes the risk of loss and therefore is entitled to a proportionate share in the actual profit. “Capital” has an innate element of “entrepreneurship,” as far as the risk of the business is concerned. Therefore, instead of a fixed return as interest, it derives profit. The more the profit of the business, the higher the return on capital.

Most Sharia financing is asset-backed while conventional banks deal in money and monetary papers. The profit earned through money itself is treated as “interest” and therefore prohibited, while profit earned through assets is allowed.

Another principle of Sharia financing is that there is no excessive uncertainty or speculation and that investments are not made in unethical goods such as alcohol, or activities such as gambling.

Musharakah and Mudarabah

Musharakah literally means “sharing.” In the context of business and trade it means a joint enterprise in which all the partners share the profit or loss of the joint venture or partnership. Interest predetermines a fixed rate of return on a loan advanced by the financial institution irrespective of the profit earned or loss suffered by the debtor, while Musharakah does not envisage a fixed rate of return. Rather, the return in Musharakah is based on the actual profit earned by the joint venture.

Financial Institutions or banks in an interest-bearing loan cannot suffer loss while the financier in Musharakah can suffer loss, if the joint venture fails. In this case, business (buyer) and bank come into partnership for purchase of the asset. The business contributes say 20% of the total value of the asset, while 80% is funded by the bank. The buyer will make periodic “rental” payments to the bank to reduce the bank’s share and increase its own share in the asset.

Mudarabah is a special kind of partnership where one partner gives money to another for investing in a commercial enterprise. The difference between Musharakah and Mudarabah can be summarized as follows:

• The investment in Musharakah comes from all the partners, while in Mudarabah, investment is the sole responsibility of the First Partner (financial institution).

• In Musharakah, all the partners can participate in the management of the business and can work for it, while in Mudarabah, the First Partner has no right to participate in the management which is carried out by the Mudarib (other partners).

• In Musharakah, all the partners share the loss to the extent of the ratio of their investment while in Mudarabah any loss is suffered by the First Partner only, because the Mudarib does not invest anything.

In Mudarabah, the First Partner may specify the particular business for other partners (Mudarib), in which the First Partner is willing to make investment. The First Partner leaves it open for the Mudarib to undertake whatever business they wish; the Mudarib shall be authorized to invest the money in any business they deem appropriate.

Distribution of profit would be decided at the beginning of the project itself. Parties can share the profit in equal proportions, and they can also allocate different proportions for the First Party (financier) and the Mudarib. However, it is not permissible under Sharia law to allocate a lump sum amount of profit for any party, or to determine the share of any party at a specific rate tied up with the capital invested.

The combination of Mudarabah and Musharakah presumes that First Party (financial Institution) will fund the project while other parties will manage the project. In a Mudarabah arrangement, if financial institution wants to exit the project, then the other partners will purchase the share of the financial institution, at an agreed price.

Murabahah

Most Islamic banks and financial institutions use Murabahah as an Islamic mode of financing projects. Murabahah is particular kind of sale wherein the seller agrees with the purchaser to provide a specific commodity on certain profit added to his cost. The basic principle of Murabahah is that the seller discloses the actual cost incurred in acquiring the commodity, and then adds some profit on it. It is quite similar to the cost plus concept defined under transfer pricing regulations.

Under Murabahah, the sale of a commodity can be done either at spot price or deferred price which includes an agreed profit added to the cost. Being a sale, and not a loan, the Murabahah should fulfil all the conditions necessary for a valid sale. Murabahah cannot be used as a means of financing except where the purchaser needs funds to actually purchase a commodity.

According to Sharia law, the bank or financial institution itself purchases the commodity which it keeps in its own possession, or purchases the commodity through a third person appointed by it as agent, before selling it to the customer at a profit. The taxpayer and the financial institution sign an overall agreement whereby the financial institution promises to sell and the taxpayer promises to buy the commodities from time to time on an agreed ratio of profit added to the cost.

Tax Treatment

Musharakah is a relationship established by the parties through a mutual contract, and therefore all the relevant elements of a valid contract must be included.

Under conventional financing, the buyer will borrow from the bank to purchase an asset from the seller. The buyer will capitalize the asset and claim capital allowance as per the capital allowance rules. The buyer pays interest to the bank which is a tax-deductible expense. Under Musharakah, the buyer will pay rental to the bank, which would comprise of interest and principal. There may not be any tax relief for the rental payment to the financial institution in Musharakah or Mudarabah.

Should the transaction be re-characterized as an interest payment to the bank, relying on the “substance over form” concept, only the interest part in the rental would be claimable as a tax-deductible expense. Businesses should ensure that the contractual arrangement carries the necessary clauses to satisfy the substance over form test. It is highly likely that the tax authorities can challenge the tax treatment and disallow deductibility of interest expense. The bank can again be taxed on rental received from the Musharakah or Mudarabah transaction.

In Mudarabah, when the financial institution exits from the project at an agreed price, and if the agreed price is more than the amount invested, it will result in a capital gain which will be taxable in the hands of the financial institution. In Murabahah financing, the transaction will be treated as purchase and sale of the commodities at a price determined under the cost plus method. As such, the financial institution will pay corporate tax on the net profits made on the trading transaction.

The value-added tax (VAT) treatment will be driven by the clauses of the agreement executed between the bank and the business. It is highly likely that rental payment may be subject to VAT.

In the U.K., the rules regarding deduction of input tax are covered by sections 25 and 26 of the Value Added Tax Act 1994. It is a fundamental principle that deduction is only allowed to the extent the goods or services purchased are used to make taxable supplies. If the equipment is used in providing taxable supplies, then businesses can reclaim the input credit of VAT paid on rental; otherwise, it would become a cost for the business.

There is another option where, if rental payments are re-characterized as a loan transaction, the interest payment to the banks would be exempt from VAT. However, it is highly unlikely that the tax authorities will re-characterize the transaction. It is therefore advisable for the taxpayer to agree in advance with VAT authorities on the treatment of VAT.

In Murabahah, VAT will be charged on sale and purchase of the transaction as per the VAT law.

Egyptian Income Tax Law (Law 91 of 2005) indicates specifically that interest expenses on loans used in the course of business are allowed as deductible expenses. The tax treatment of Sharia financing structures is not specifically defined under Egyptian tax law. The tax authorities in Egypt generally scrutinize the Sharia financing structure to ensure that this is not excessively advantageous to taxpayers and complies with the interest deductibility rules. There may be VAT implications on the rental payments to the bank. It is also possible to claim exemption from VAT if the rental payments are classified under a banking transaction exclusively executed with banks.

Moroccan income tax law does provide for Musharakah and Mudarabah financial instruments to claim the deduction of a portion of rental payment as interest. The law covers interest paid to partners on amounts lent by them to the company for use in running the business, provided that the authorized capital is fully paid up. However, the total amount on which deductible interest is payable may not exceed the amount of authorized capital, and the rate chargeable on deductible interest may not exceed the base rate fixed each year by the Minister of Finance. The maximum rate of deductible interest payable to shareholders for the year 2019 is 2.19%.

Malaysian tax law allows the underlying sale of assets to be ignored for tax purposes so that any additional tax as a result of the underlying transaction would not arise. It enables Sharia financing to continue without any tax issues relating to asset transfer, placing the Sharia financing on the same footing as conventional financing. Approval for the Islamic financing has to be obtained from Bank Negara Malaysia, the Securities Commission and the Labuan Financial Services Authority.

Planning Points

Taxpayers should undertake detailed analysis of tax implications of Musharakah, Mudarabah or Murabahah Sharia financial structures. Most transactions that are undertaken in Sharia finance seek to achieve an economic outcome that is similar to the outcome achieved by conventional financing.

Sharia financing structures are always at risk, as there may be tax applicable to them which will make the financing of a project expensive. Taxpayers should try to obtain advance rulings based on substance over form principles from tax authorities in order to achieve certainty in their tax position.

Rajeev Agarwal is Head of Global tax with Qatar Navigation QPSC based out of Qatar. He may be contacted at: rajeagar2012@gmail.com.

Disclaimer: The content of this article is intended for general information purposes. You should always seek professional advice before acting. No responsibility is taken for any loss because of any action taken or refrained from in consequence of its contents.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.