Islamic Finance: Integration into the Financial Mainstream Adapting Western Tax Systems to Accommodate Islamic Finance Mohammed Amin 28 May 2008.

Islamic Finance: Integration into the Financial Mainstream

Adapting Western Tax Systems to Accommodate Islamic Finance

Mohammed Amin28 May 2008

Slide 2 PricewaterhouseCoopers LLP

28 May 2008

Mohammed Amin

Mohammed Amin is a tax partner at PricewaterhouseCoopers LLP and leads their Islamic Finance practice in the UK.

He is:

• a Council member of the Chartered Institute of Taxation

• a member of the Policy & Technical Committee of the Association of Corporate Treasurers

• a member of the Business & Economics Committee of the Muslim Council of Britain

• a member of HM Treasury’s Islamic Finance Experts Group, set up to advise the Government on Islamic finance strategy

Many of Amin’s previous articles and presentations on Islamic Finance can be found on his Islamic Finance blog at:

pwc.blogs.com/islamicfinanceTel: 020 7804 6703Fax: 020 7804 1001Mob: 07802 788 357

Email: [email protected]

Web: www.pwc.com

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Agenda/Contents

Why Western tax systems can be challenged by Islamic Finance

The Swiss position

How the UK tax system has been adapted for Islamic Finance

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Why Western tax systems can be challenged by Islamic Finance

Slide 5 PricewaterhouseCoopers LLP

28 May 2008

Assumed tax system

Assume equipment expenditure amortisable over equipment life on straight line basis.

When does amortisation start?

- When machine purchased

- After payment made

What constitutes a finance cost

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Illustrative transaction

Conventional purchase

-Machine delivered, cost 1,000

-Pay immediately by borrowing bank loan

-Two year bank loan @ 5% simple interest payable on repayment.

-Five year machine life

Islamic purchase

-Machine delivered now

-Payment due after two years

-Machine price 1,100

-Five year machine life

Identical cash flows

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Conventional purchase

Goods obtained Cost 1,000Finance cost 100

Bank

Goods supplier

Customer

1,000

Sale for immediatepayment

Cash loan 1,000

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Loan repayment 1,100

Pay 1,000

Slide 8 PricewaterhouseCoopers LLP

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Conventional purchase tax deductionsAmortise from purchase, interest on accruals basis

Year Amortisation Interest Total

1 200 50 250

2 200 50 250

3 200 200

4 200 200

5 200 200

Total 1,000 1,100

Slide 9 PricewaterhouseCoopers LLP

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Islamic purchase

Goods obtained Cost 1,100Bank

Goods supplier

Customer

1,000Sale for

immediatepayment

Sale for 1,100. Payment deferred

by two years

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Payment 1,100.

Implications of tax system type

Slide 10 PricewaterhouseCoopers LLP

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Legal evaluation of Islamic purchase

There is no cost of finance

The machine cost 1,100

Machine is paid for two years after delivery

Implications of tax system type

Slide 11 PricewaterhouseCoopers LLP

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Islamic purchase tax deductionsFollowing legal analysisAmortise from payment, no finance cost

Year Amortisation Interest Total

1 0 0 0

2 0 0 0

3 366 366

4 366 366

5 367 367

Total 1,100 1,100

Implications of tax system type

Slide 12 PricewaterhouseCoopers LLP

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Economic evaluation of Islamic finance purchase

Machine value on delivery 1,000

Agreed price 1,100

Excess 100 price must be finance cost

Payment due after two years

50 per year finance cost

Implications of tax system type

Slide 13 PricewaterhouseCoopers LLP

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Islamic purchase tax deductionsFollowing economic analysis

Year Amortisation Finance cost Total

1 200 50 250

2 200 50 250

3 200 200

4 200 200

5 200 200

Total 1,000 1,100

Implications of tax system type

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Tax systems classified

Implications of tax system type

Legal approach Economic approach

USA NetherlandsUK

Specific tax law needed for Islamic finance

Zero or limited need for specific tax law

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The Swiss position

Slide 16 PricewaterhouseCoopers LLP

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Tawarruq or Commodity Murabaha

Party A (Bank)

Commodity seller Commodity buyer

Party B

100Sale for

immediatepayment

Sale for deferredpayment

110

Sale for immediate paymentSale 100Cost 110

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Tawarruq – basic Swiss tax questions

Can Party B deduct loss? – Yes if for business purposes.

Party A’s income may be treated as trading or financial income.

No automatic Permanent Establishment if Party A non-Swiss.

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Diminishing Musharaka

Bank Eventual Owner

75% share, diminishing

Asset

25% ownership share, increasingSole occupier

Payment to vendor for 25%

Payment to vendor for 75%

Payments to increase ownership

Rent on bank’s 75% (diminishing) share

Slide 19 PricewaterhouseCoopers LLP

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Diminishing musharaka – Swiss tax questions

Rent deductible if for business purposes.

Rent taxable in Switzerland due to Swiss real estate, even if bank foreign.

Real estate transfer taxes on each transfer.

Slide 20 PricewaterhouseCoopers LLP

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Sukuk (Diagram 3)

$50,000 share capitalXYZ Sukuk

Ltd

$500mInvestorsCharity

Shareholders

XYZ TradingCompanyMudarabah

Agreement

Trust

SukukCertificates

Periodic Paymentslimited to

6%

Purchased Assets used in XYZ Trading Company’s business

$500m to buy assets

Mudarib 1%

Rab al-maal 99%

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Sukuk – Swiss tax questions

Legal form for sukuk transaction needs review. No Swiss law of trusts.

35% withholding tax if over 10 investors.

No automatic permanent establishment.

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The UK tax system’s approach to Islamic finance

Religion neutralDeeming approachOverride of specific obstacles

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Religion neutral

• No mention of Islamic finance• Key concepts

- Purchase and resale- Deposit- Profit share agency- Diminishing shared ownership- Alternative finance investment bond

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The UK tax system’s approach to Islamic finance

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Deeming approach

• “Equate(s), in substance, to the return on an investment of money at interest”

• If within statutory definitions- Customer’s expense treated for tax purposes in the same

way that interest is treated- Same for financial institution

• Tax definitions are precise

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The UK tax system’s approach to Islamic finance

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Override of specific obstacles

• Anti-avoidance rules to stop equity finance being disguised as debt- ICTA 1988 s.209(2)(e)(iii) “securities under which... the

consideration given… is … dependent on the results of the company’s business”

- interest treated as “distribution” ( = not tax deductible)• Specific override in “Islamic finance” legislation

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The UK tax system’s approach to Islamic finance

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The extent to which a tax system needs to be adapted for Islamic finance depends upon the extent to which it taxes the economic reality or the legal form of transactions.