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Looking back at 15 years of Islamic finance tax law changes around the world

This retrospective shows just how much the UK has been a global pioneer regarding the taxation of Islamic finance


Posted 21 February 2020

The magazine "Islamic Finance News" recently celebrated 15 years of operation with a special 151-page anniversary book "Celebrating 15 Years of Islamic Finance Coverage 2004 — 2019".

I have been writing for the magazine since 2006, originally with occasional articles and since September 2015 as a monthly columnist. Accordingly I was asked to contribute two pages on taxation.

The anniversary book is only available to subscribers, but my article is reproduced below with the magazine's permission.

15 years of tax law changes around the world

15 years is a relatively short amount of time. However, it exceeds my entire Islamic finance career which, as a result of some UK tax law changes, began in 2005.

Illustration of the tax issues Islamic finance gives rise to

Taxation, particularly when international, is often very complex. The table below illustrates how even relatively simple Islamic finance transactions give rise to complex tax questions.


Some illustrative tax issues

A man’s private residence is purchased from a third party using a diminishing musharaka transaction

  • Is real estate transfer tax charged on both the sale from the third party to the bank, and the later sale by the bank to the customer who has been financed?
  • If the customer rents part of the house, is part of the rent he pays to the bank deductible from the rent he receives for sub-letting?

A bank provides finance to an overseas customer using a commodity murabaha (tawarruq) transaction

  • Is the bank’s mark-up taxable in the period when its sale takes place, or is it spread over the life of the murabaha agreement?
  • Are the successive sales of the commodity subject to any sales or transfer taxes?
  • Does the customer’s jurisdiction give it a tax deduction for the financing cost it suffers?
  • Does carrying out the transaction cause the bank to have a taxable presence (permanent establishment in tax jargon) in the customer’s jurisdiction?

A company raises finance by setting up a special purpose vehicle (SPV) in an offshore jurisdiction,  selling real estate to the SPV and leasing it back, with the SPV paying for the real estate by issuing sukuk to international investors.

  • If the real estate is worth more than original cost, does the sale to the SPV give rise to a taxable gain?
  • Does the company receive tax relief for the rent that it pays to the SPV?
  • Is any tax withheld from the rent, since the SPV is offshore?
  • Are there any withholding taxes on income which the SPV pays to the sukuk investors?
  • Are later sales of sukuk certificate by investors to new holders subject to any transfer taxes?

Why does Islamic finance cause taxation problems?

The fundamental difficulty is that tax laws were developed in an environment when all finance was conventional. That applies not only in European and North American countries, but also for Muslim majority countries in the Middle East and North Africa, South and Southeast Asia.

Accordingly, when Islamic financial institutions carry out transactions which are structurally quite different from those of conventional finance, albeit with virtually identical economic consequences, the tax system often gives rise to additional tax costs that do not arise with conventional finance transactions.

Do all countries face similar taxation challenges?

See "The Taxation of Islamic Finance in Major Western Countries" published in Issue 138, 2007 First Quarter, of "Arab Banking Review", the journal of the Union of Arab Banks.

This document is not provided on my website for copyright reasons. Although I was the lead author, PwC colleagues from several other countries also contributed parts of the text, and it is not logistically feasible to obtain reproduction permission from all of the copyright holders.

After carrying out my first international survey on Islamic finance in 2007, [when I was a tax partner in PricewaterhouseCoopers] I concluded that countries fall into two broad categories.

For many countries, profits and the deduction of costs from profits are primarily determined by analysing the transactions undertaken using economic principles.

When it comes to computing the taxable profits of Islamic financial institutions, and computing the tax deductions which the party being financed should receive, such countries have few or no problems coping with Islamic finance. The USA and Germany are two such countries. Economic analysis of the transactions normally gives a sensible answer. (Transfer taxes on assets are a separate issue.)

However, some countries require taxable profits and allowable deductions to be computed using rules that are explicitly set out in tax law, with only limited reference to the accounting or economic analysis. What such countries regard as critical is the “legal form” of the transactions. The best example of such a country is the UK.

[This point is explained in more detail on my page "Islamic financial products and their challenge to taxation systems."]

In such countries, unless there is specific tax law, Islamic finance can give rise to  nonsensical results. For example, a party providing finance using a murabaha transaction might be taxed instantly on the financing profit (even if the murabaha extends over many years) while the party receiving finance might not be entitled to any tax deduction at all! (Transfer taxes on assets also remain an issue.)

The UK as a global pioneer

No country has done more to address the tax law challenges of Islamic finance than the UK. This is despite it having a Muslim minority of only about 5% now, and even smaller 15 years ago.

The UK’s pioneering status was evident from the number of foreign government representatives who visited me at PricewaterhouseCoopers to learn how the UK was adapting its tax law for Islamic finance. From memory, I recall visits from representatives of Singapore, Hong Kong, France, and South Korea as well as paying a visit to the Australian government.

I still remember a comment in 2009 by a member of staff at the central bank of Indonesia when I gave a presentation there on the taxation of Islamic finance. The person pointed out that the UK, with a small Muslim minority, had done more to address the real estate transfer tax consequences of Islamic mortgages than had  the world’s largest Muslim majority country!

Why was the UK such a global pioneer?

In my view it comes from the importance of the financial services industry in the UK, the availability of highly capable civil servants, and the absence of preconceptions. The absence of any official Islamic religious authorities in the UK was probably an advantage, as it enabled the tax authorities to proceed unbound by traditional thinking.

From the very beginning, the UK has followed a fundamental principle: tax law and regulatory law should be religiously neutral. Indeed, they should not mention religion at all, so whether a transaction is, or is not, Shariah compliant should never affect its tax or regulatory status.

Other Muslim minority countries have found these principles attractive to follow.

They are less important for Muslim majority countries which are often happy to specify that a particular tax treatment applies to a transaction only if the transaction is ruled to be Shariah compliant by, say, a national Shariah supervisory body.

A quick tour of the world

It is not practical to do a global survey of the current status without the resources of an international consulting firm. Furthermore, the status quo keeps changing.

Countries with Muslim majorities

Paradoxically, Muslim majority countries have often been relatively slow at accommodating Islamic finance within their tax systems. For example, I surveyed the Middle East and North Africa for a taxation report published by The Qatar Financial Centre Authority in 2013. This found some adaptation of tax law for Islamic finance in many of the responding countries but at the same time there were many tax impediments remaining.

A particular issue in some Middle East countries has been political stability which often means that the refinement of tax law becomes a very low priority.

Countries where Muslims are minorities

Countries where Muslims are a minority have shown a surprisingly high level of interest in Islamic finance.

Many see this as a competitiveness issue. For example, in Europe countries such as France, Luxembourg, Ireland and Malta compete as locations for financial services businesses, especially in asset management. Accordingly, all have taken a strong interest in adapting their tax systems to facilitate Islamic finance. Furthermore, some countries such as France and Germany have very significant Muslim minorities, with meaningful Muslim minorities in many other European states. They want to ensure that their Muslim citizens are not excluded from accessing financial services, which was one of the key drivers for legislative change in the UK.

Similarly, the Australian government was interested in Australia becoming an international hub for financial services and wealth management for South East Asia, where its long-term political stability could give it a competitive advantage.

Where next?

I expect the pace of change in Muslim minority countries to be slower, since many have dealt with the basics. However, many wrinkles still need to be addressed. For example, I have written in Islamic Finance News about the tax problems when refinancing appreciated real estate in the UK.

Tax law changes will continue to be needed in Muslim majority countries. The key issue for many of them is achieving the political and economic stability required for Islamic finance to expand. Many still have high levels of poverty, and drawing more of their Muslim citizens into a reliable, low-cost, financial system should be a key priority. Once all citizens have bank accounts, many more government policy options become possible.


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