INSIGHT: Sharia Instruments of Financing—Tax Implications (Part 2)

This two-part article analyzes different Sharia financing instruments and their tax implications from a corporate tax and value-added tax (VAT) perspective. Part 1 discussed financing instruments such as Murabahah, Musharakah and Mudarabah. Part 2 considers Ijarah and Sukuk transactions.

Ijarah

Ijarah means “to give something on rent.” Under Islamic law, Ijarah is used in two situations: (i) hiring of human services, covering employment contracts, service contracts, etc., and (ii) hiring of usufruct properties for rent, which is similar to leasing.

This article will discuss the second type of financing transaction, i.e. a leasing transaction. The rules of Ijarah, in the sense of leasing, are quite similar to the rules of sale, because in both situations something is transferred to another person for consideration. The only difference between Ijarah and sale is that in a sale the corpus of the property is transferred to the purchaser, while in the case of Ijarah, the corpus of the property remains in the ownership of the transferor, but only its usufruct i.e., the right to use the property, is transferred to the lessee.

Hence, it can be said that Ijarah is not a mode of financing in its origin. It is a normal business sale transaction. However, various financial institutions use Ijarah as another mode of providing finance to businesses. Instead of giving a simple interest-bearing loan, institutions lease equipment to their customers. While fixing the rent of this equipment, the institutions calculate the total cost they have incurred in the purchase of these assets and add the stipulated interest they could have claimed on such an amount during the lease period. The aggregate amount so calculated is divided by the total months of the lease period, and the monthly rent is fixed on that basis.

These types of leases are generally known as “operating leases.” Ijarah financing transactions ending with transfer of ownership of the equipment to the buyer are commonly known as “finance lease” transactions.

Ijarah therefore replaces the traditional finance of equipment with “sale and lease” transactions. It is a mode of finance where the Islamic bank purchases an asset or equipment at the request of a client and leases it to the client at a price that includes a fair return for the bank. Ijarah is generally used by Islamic banks for financing consumer goods, equipment and vehicles, and home financing; it has also found its way into project and transportation financing and into asset-based financing in larger and more complex transactions.

When the client of an Islamic bank leases an asset under Ijarah, he pays lease rental to the bank in return for the right to use the asset for a specified period, at the end of which the asset may be sold to the business at nominal value. The client provides the bank with details of the asset required to be purchased, and enters into an understanding covering the overall structure of the lease contract with the bank as lessor and the client as lessee. The decision to provide Ijarah financing is based on the financial position of the client and the anticipated cash flow from the leased asset, in the same way as is done by conventional banks, but without involving interest.

To take an example:

Under tax law, the sale of equipment/asset to the bank would be subject to value-added tax (VAT) or similar other indirect taxes. Similarly, when assets are given on lease to the buyer, there would be VAT on lease rentals. The bank or financial institution makes profit on the transaction, which will be subject to corporate tax as normal business income.

Salam and Istisna

Salam is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future date in exchange for an advanced price fully paid at spot. Here the price is cash, but the supply of the purchased goods is deferred. For Salam to be valid the buyer must pay the price in full to the seller at the time of effecting the sale. This is because in the absence of full payment by the buyer, it will be tantamount to sale of a debt against a debt, which is expressly prohibited by Sharia.

Istisna is the second kind of sale, where a commodity is transacted before it comes into existence: an order is placed with the manufacturer to produce a specific commodity for the purchaser. The Istisna mode of financing is used to finance transactions in the housing sector and it can also be used for project financing.

Sukuk (Investment Bonds)—Sukuk means a joint pool wherein the investors contribute their surplus money for the purpose of its investment to earn a profit. In this case, instead of a fixed return tied to with their face value, investment certificates carry a pro rata profit actually earned by the fund. Neither the principal nor a rate of profit (tied up with the principal) is guaranteed. The investors enter into the fund on the basis that the return on their subscription is tied up with the profit earned or loss suffered by the fund. If the fund earns profits, the return on their subscription will increase to that proportion. If the fund incurs losses, the return on their subscription will decrease to that proportion.

Moreover, the amounts pooled together are invested in a business acceptable to Sharia principles.

Tax Treatment

Morocco

Under Moroccan income tax law, banks or financial institutions may be taxed on the profits generated out of a transaction as income. Should the transaction be recharacterized as a finance transaction, interest income is taxed in the hands of the bank or financial institution and interest expense in the buyer’s books. If the bank or financial institution are related parties, then interest charged should be at an arm’s length price. There is withholding tax of 20% on interest income and security lending transactions (Sukuk certificate).

From January 1, 2018, there is an exemption from withholding tax on income derived from Sukuk certificates (i.e. Islamic securities) held by:

• undertakings for collective investment in transferable securities;
• securitization mutual funds;
• collective investment undertakings;
• real estate collective investment vehicles.

There are no separate VAT rules for Ijarah or Sukuk financial transactions. VAT at 20% applies on leasing transactions and real estate transactions. A reduced rate of 10% may also apply to an Ijarah transaction that entails full transfer of ownership of the leased properties or assets, from the lessor to the lessee, at the end of the contract (after the last installment is paid).

Malaysia

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 issue 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, Securities Commission and the Labuan Financial Services Authority.

Malaysian tax law exempts from income tax the share of profit paid on Sukuk certificates originating from Malaysia in any currency other than Malaysian ringgit approved by Securities Commission and the Labuan Financial Services Authority, except if paid within the same group. Malaysian stamp duty law provides exemption from stamp duty on Ijarah transactions.

U.K.

Under U.K. corporate tax legislation Sukuk transactions are treated as “debt-like” Sukuk, which are referred to as “alternative finance investment bonds.” The assets are used to generate income, which is periodically distributed to the certificate holders. These periodic distributions are benchmarked against the prevailing rate of interest.

Sukuk where the investor is directly exposed to the performance of the underlying assets or business, and where the risks and rewards are not equivalent to a conventional bond, will not fall within the statutory definition. Such Sukuk may be treated as unauthorized unit trusts or offshore funds for tax purposes. CTA09/S518 provides that alternative finance investment bonds are securities for corporation tax purposes.

If alternative finance investment bonds are transferred by or to an individual or a trust, the accrued income scheme will apply (SAIM4000). If the bond or Sukuk are issued at discount or redeemed at a premium, rules on deeply discounted securities (SAIM3000) will be applicable. The capital gains tax rules relevant to a disposal of securities will apply to disposal of an alternative finance investment bond.

In Part 1 of this article we discussed other Sharia financing structures such as Murabahah, Musharakah and Mudarabah. If a taxpayer enters into an alternative finance arrangement, it is to be treated as if it had entered into a loan relationship (CTA09/S509) and therefore for corporation tax purposes all the loan relationship rules apply as they would do to conventional arrangements (CFM44040).

There may be stamp duty and stamp duty reserve tax on Sukuk certificates if these are issued from a fund set up in the U.K. There are no separate rules under U.K. VAT law to provide special treatment of Ijarah transactions, as under corporate tax law. Ijarah transactions are treated as lease transactions: for example, in the case of land and buildings, consideration for supplies made under this arrangement will be treated in the same way as other forms of leasing agreements.

Where the consideration is for a supply of services, other than property, it is taxable at the standard rate of VAT. Where the consideration is in regard to property, the liability will follow the normal rules for property.

Ijarah can be used for equipment leasing, which will be treated in a similar way as for hire purchase or conditional sale rules (VAT Notice 701/49 Finance). There are two supplies being made by the bank, the first one of the goods, and the second one the facility to defer payment. Consideration for supply of the goods will follow the normal liability rules. The additional charge above the price of the goods will be treated as consideration for a deferred payment facility and thus exempt (VAT Act 1994, Schedule 9, Group 5, item 3).

Planning Points

Taxpayers should undertake detailed analysis of the tax implications of Ijarah or Ijarah–Sukuk Sharia financial structures.

Most transactions that are undertaken in Sharia finance seek to achieve an economic outcome that is similar to the economic outcome achieved by conventional financing. Sharia financing structures are always at risk, as there may be taxes applicable on them which will make the financing of the 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. 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.

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