Islamic finance

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Islamic finance

Posted 10/12/2010 by Paige Darby

In October 2010, the Board of Taxation published a discussion paper on the Review of the Taxation Treatment of Islamic Finance. This discussion paper was in response to the Australian Financial Centre Forum (AFCF) which recommended in its November 2009 report that the impediments to Islamic finance in Australia be considered by the Board of Taxation. The AFCF was established in September 2008 by the then Assistant Treasurer to discuss options for positioning Australia as a leading financial services centre. This post presents some of the key characteristics of Islamic finance and the opportunities for reform in Australia.

Islamic financial products are different to other financial products in order to be compliant with Sharia law. The AFCF describes the key characteristics of Islamic financial products as the following:
  • the payment or receipt of interest is prohibited
  • speculation or uncertainty is prohibited
  • investment in some sectors is not allowed (such as gambling, pornography, and alcohol)
  • both parties to a financial transaction must share the risk, and
  • financial transactions should be underpinned by an identifiable and tangible underlying asset.
Such limitations have led to the development of unique financial products. An Austrade publication on Islamic finance from January 2010 lists the following Islamic financial products:
  • Murabaha: A form of asset financing where an Islamic Finance Institution (IFI) purchases an asset and then sells it to its client at a higher price (ie mark-up sale) with deferred payment terms. The interest that would ordinarily be paid by the client in a conventional loan – and which would constitute the bank’s profit — is replaced by the difference between the purchase price and the sale price 
  • Mudaraba: A form of limited partnership where an investor (the silent partner) gives money to an entrepreneur for investing in a commercial enterprise. The profits generated by the investment are shared between the partners in a predetermined ratio. The losses are borne only by the investor
  • Musharaka: Unlike a Mudaraba transaction, both partners in Musharaka must contribute capital to the partnership. Both partners or one of them may manage the venture or alternatively both may appoint a third party manager to manage the investment. While profits may be shared in a pre-determined ratio, losses are shared in proportion to the capital contributed
  • Ijara: Similar to a hire-purchase, the IFI purchases the asset and allows the customer to use it for an agreed period and for an agreed rent
  • Sukuk: Sharia-compliant financial certificates of investment that are similar to asset-backed bonds; and
  • Takaful: Similar to a mutual insurance arrangement, a group of individuals pay money into a Takaful fund, which is then used to cover payouts to members of the group when a claim is made.
According to a paper by Beng Soon Chong and Ming-Hua Liu on the website ‘Islamic Economics and Finance Pedia’ the first modern Islamic bank was the Mit Ghamr Savings Bank in Egypt in 1963, but it has since grown in practice to more than 50 countries worldwide. Specifically, Islamic banking is practised in, but not limited to, the following countries: Albania, Algeria, Australia, Bahamas, Bahrain, Bangladesh, British Virgin Islands, Brunei, Canada, Cayman Islands, North Cyprus, Djibouti, Egypt, France, Gambia, Germany, Guinea, India, Indonesia, Iran, Iraq, Italy, Ivory Coast, Jordan, Kazakhstan, Kuwait, Lebanon, Luxembourg, Malaysia, Mauritania, Morocco, Netherlands, Niger, Nigeria, Oman, Pakistan, the Palestinian territories, Philippines, Qatar, Russia, Saudi Arabia, Senegal, Singapore, South Africa, Sri Lanka, Sudan, Switzerland, Tunisia, Turkey, Trinidad & Tobago, United Arab Emirates, United Kingdom, United States and Yemen. In August 2004, the first bank licensed by a non-Muslim country commenced Islamic banking in Britain. More information on the arrangements in other countries is provided in Chapter 5 of the Board of Taxation's discussion paper.

However, due to the profit-and-loss sharing characteristics of Islamic finance and the subsequent structure of financial products (such as Sukuk or Islamic bonds), there can be disadvantages placed on such products in the Australian system. The AFCF report provides the following example:

... at the Commonwealth level, there are issues about the eligibility for withholding tax relief on widely distributed Sukuk bonds (available for conventional bonds) and the possibility that capital gains tax could inappropriately apply to the disposal or transfer of assets (an essential feature of a sukuk). At the state level, there is potential for stamp duties to be inappropriately applied to those transfers. 
The AFCF argues that reforming withholding tax arrangements for Islamic finance would 'improve Australia’s access to offshore pools of savings at competitive rates, so as to provide more diversified and cheaper funding for Australia’s investment needs'. The report recommends that the regulatory barriers to Islamic finance in Australia be removed in order to create a 'level playing field'.

The Board of Taxation discussion paper identifies eight case studies in which Islamic financial products are comparatively disadvantaged or lead to substantial uncertainty. These case studies include cost plus profit sales (such as a residential property mortgage), Islamic bonds and interbank finance.

Submissions to the Board of Taxation's Review of the Taxation Treatment of Islamic Finance Products close on 17 December 2010.

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