VAT and Islamic finance transactions: a discussion of the policy issues

About five years ago, I spent a fair amount of time considering how Islamic finance should be treated from a VAT (value added tax) perspective. I also looked at the approach the UK and three other countries, South Africa, Singapore and Malaysia, had taken.

The report was never published. I have decided to make it available here for educational purposes. As well as my usual disclaimer in the page footer and within the report, please remember that there will have been many changes around the world since the report was written in November 2015.

I have not updated it, as that would be very time consuming, and I have other priorities.

Executive Summary

Most discussion of the tax treatment of Islamic finance focuses on direct taxation. To help address this imbalance, this report looks at the VAT treatment of Islamic finance transactions.

The report was written by Mohammed Amin, who is a taxation specialist, in November 2015 as part of a wider research project. The research project did not complete, and the report was never published. Accordingly, Mohammed Amin is making it available in July 2020 for educational purposes only. It should not be relied upon for any other purpose. Apart from any other factor, the law in many of these jurisdictions may have changed.

The goal of publication is purely education for those who are interested in the conceptual challenges that Islamic finance presents for a VAT system.

Indirect taxes fall into several categories such as excise taxes, customs duties, sales taxes and value added tax (VAT) often also called a goods and services tax (GST). VAT is conceptually a tax on value added, but functions as a consumption tax on final consumers. The global VAT pioneer is the European Union which has the largest and most complex VAT regime.

The EU VAT regime has detailed provisions for conventional financial services which are generally treated as exempt for VAT purposes. The consequence is that consumers of such services are not required to pay VAT, but financial services companies are unable to recover VAT on most of their costs since the overwhelming majority of their supplies are exempt supplies. Alternatively, a jurisdiction may choose to make some financial services zero rated, as New Zealand permits banks to do for financial services supplied to non-exempt business customers.

Without seeking to be comprehensive, the report lists some of the most common transactions used in Islamic finance and carries out a “first principles” VAT analysis of those transactions. This VAT analysis is not based upon the tax laws of any particular country, but rather considers how a tax on value added might apply to such transactions taking into account the general principles of VAT.

The report does not seek to survey the large number of countries that have some form of VAT or GST. However, it looks at the VAT regimes of four jurisdictions, South Africa, Singapore, Malaysia, and the United Kingdom to consider how those countries have addressed the question of Islamic finance transactions within their VAT regime. It finds that South Africa, Singapore, and Malaysia have specifically modified their VAT law for Islamic finance transactions.

Conversely the UK has made no amendments to the VAT law applicable but has published guidance materials which explain how the existing VAT law should be applied in the context of Islamic finance transactions. Despite the UK not having modified its VAT law for Islamic finance, the report concludes that, by and large, it is possible to conduct Islamic finance transactions within the UK without incurring significant additional VAT costs.

After reviewing South Africa, Singapore, Malaysia and the UK, the report then proposes a method for classifying Islamic finance transactions into three categories:

For each of these categories it considers whether a VAT regime is likely to give rise to additional VAT costs compared with the equivalent conventional financial transactions.

In the final section, the report makes some general recommendations for governments which are legislating for a VAT regime that are intended to assist in achieving parity of treatment for conventional finance and Islamic finance. The report does not propose any specific legislative language but rather sets out a methodology for approaching the subject.