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Islamic and conventional banks face almost identical transfer pricing issues

The reason is that Islamic and conventional banks fulfil the same economic functions, and operate in very similar ways.


Posted 20 December 2017

The "Contact me" page of my website enables anyone in the world to send me an email.

Accordingly, I often receive questions about Islamic finance. Sometimes these provide the inspiration for one of my monthly columns in Islamic Finance News.

In July 2017 I helped a Muslim American researcher by completing a questionnaire about transfer pricing and Islamic banks, and used that as the basis for my August 2017 column.

You can read the column below, and then lower down some technical points reproduced from my questionnaire answers.

Transfer pricing and Islamic banks

Academics researching in Islamic finance often approach me with interesting questions. Most recently, an email came from a Muslim lawyer in the USA looking at transfer pricing issues.

“Transfer pricing” sounds esoteric, and many wrongly associate it with abusive behaviour by multinational corporations. In reality, all multinational corporations have to deal with transfer pricing.

If a multinational group consists entirely of companies that are 100% owned by the parent, directly or indirectly, then the ultimate shareholders, in principle, do not care which company makes the profits. Where goods or services are traded between wholly owned group members, the shareholders are indifferent (subject to the point below) to the prices that one group member charges to another group member.

The differentiator is that profits made in different countries may suffer different amounts of corporate tax and may suffer different amounts of withholding taxes before those profits can be paid to the ultimate shareholders as dividends.

The tax authorities of each individual country understandably seek to maximise that country’s tax revenues. Accordingly, they invariably argue that group companies based in that country should charge more when selling goods or services to group members located in other countries. Conversely, the tax authorities of the countries whose group members are buying those goods or services will argue that the companies concerned are overpaying, and should have paid less.

The serious risk that the multinational group faces is that the tax authorities of the selling / buying countries impose artificial prices for tax purposes which cause the underlying profits to be taxed twice, due to the tax authority imposed selling price being higher than the tax authority imposed buying price.

Fortunately, a growing number of countries have entered into tax treaties with dispute resolution mechanisms which ensure that the tax authority imposed selling / buying prices have to be the same. Obviously, to minimise disputes with tax authorities, multinational corporations always seek to start by using prices between group companies (transfer prices) which are as close as possible to those which would apply between arm’s-length third parties.

The researcher asked me a series of questions relating to transfer pricing within multinational Islamic banking groups.

The key point I made when responding was that, when attempting to calculate an arm’s-length price, there was no fundamental difference between an Islamic finance transaction such as murabaha and a conventional interest-bearing loan. Both have the effect of transferring money from a group bank company in one country to a group bank company in another country.

However, while there was no fundamental difference, there were many minor differences.

These logically should cause the pricing of the Islamic finance transaction to be different from that of a conventional transaction which might be used to assess arm’s-length comparability. For example, additional legal work is often required to create the Islamic finance transaction and the supplier of the funds needs to earn an extra return to compensate for these additional legal costs.

Furthermore, as occasionally seen in litigation, there is a risk that recoverability of the money in the Islamic finance transaction may be made more difficult by subsequent claims that the transaction was not Shariah compliant. These risks also need to be compensated by an extra return compared with a conventional transaction.

Some specific technical questions and my responses

I have edited the incoming questions below to make them easier to read.

Can an Islamic bank have a branch, a subsidiary, and/or affiliates ?

There is no reason why a properly run Islamic bank should not have branches, subsidiaries or affiliates. That is a commercial decision to be made in the light of the business objectives of the Islamic bank concerned.

What kind of intra-group loans or financial advances are used between affiliates of Islamic banks?

All of these kinds of advances can probably be found between affiliates of Islamic banks. I recall that there is a Shariah principle that interest bearing loans between wholly owned subsidiaries are permissible.

Have there been any transfer pricing issues for Islamic banks' intra-group financing transactions?

I am not aware of specific cases.

However my expectation is that country tax authorities would treat Islamic banks no differently to conventional banks when deciding whether to investigate the pricing of intra-group transactions.

How does a conventional bank own an Islamic bank?

This depends on the rules of the country concerned. Some Muslim majority countries now prohibit conventional banks having Islamic branches, while I believe some go further and prohibit them having Islamic subsidiaries.

How does a conventional bank lend to its affiliated Islamic bank?

In my view conventional interest bearing loans should not take place between a conventional bank and its Islamic affiliates. I would expect all of the others to be utilised, depending on circumstances.

Do intra-group loan contracts stipulate an interest rate or do they stipulate other Islamic financial tools without using an interest rate benchmark?

It is normal for intra-group Islamic financing transactions to be assessed against interest rate benchmarks to assess whether they are at arms length.

What is the service status for international transfer pricing purposes of the scholars on an Islamic bank's Sharia Board?

The scholars on the Shariah board are providing a service to the Islamic bank. For transfer pricing purposes, unless the scholar has a material shareholding in the Islamic bank, he or she would be treated as an arms length third party service provider.

Are Islamic banks comparable to conventional banks for international transfer pricing purposes?


Is an interest-based loan comparable to an Islamic financial transactions for tax purposes?

The broad answer is yes.

However one needs to take account of any differences in risks between the interest based loan and the Islamic financial transaction.

For example, if the payer in the Islamic financial transaction can suspend payments in specified circumstances, without similar suspension provisions applying in the case of the conventional interest based loan, then that is a material difference which I would expect to see reflected in a higher price being charged for the Islamic financial transaction.

Is an interest-based loan comparable an Islamic financial transactions for International Transfer Pricing purposes?

Yes. However see the answer to the question immediately above.


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