IMF: Tax Policy Challenges for Islamic Finance

IMF: Tax Policy Challenges for Islamic Finance

Thu 09 Apr 2015

The International Monetary Fund published a Staff Discussion Note on Islamic Finance focusing on opportunities challenges and policy options on 6 April 2015. The Discussion Note highlights that Islamic finance raises a number of tax policy issues as well.

Islamic finance has grown rapidly over the past decade, and its banking segment has become systemically important in a dozen countries in a wide range of regions. According to the BBC website,  Prime Minister David Cameron announced that the UK would become the first non-Muslim country to issue an Islamic bond and plans for a new Islamic index on the London Stock Exchange at the World Islamic Economic Forum (WIEF) in London in October 2013.

The growing reach of Islamic finance promises a number of possible benefits. For example, it is often argued that Islamic finance is inherently less prone to crisis because its risk-sharing feature reduces leverage and encourages better risk management on the part of both financial institutions and their customers.

It is also argued that Islamic finance is more stable than conventional finance, because: (i) Islamic finance involves prohibitions against speculation; (ii) financing is asset-based and thus fully collateralized; and (iii) it is founded on strong ethical precepts. Moreover, Islamic financial institutions (IFIs) are considered to be a good platform for increasing access to financial inclusion, including access to finance for SMEs, thereby supporting growth and economic development. Nonetheless, Islamic finance faces a number of challenges.

Tax Policy

To level the playing field between conventional and Islamic finance, a number of issues will need to be addressed in the context of domestic and international tax systems.

These relate primarily to the treatment of Islamic finance under income taxes, sales taxes (for example, value added taxes), specific transaction taxes, and bilateral tax treaties. They may arise in the context of intermediation, portfolio investment, brokerage activities, insurance, and so on. Whereas some issues can be easily addressed at the national level, others may require international cooperation.

Among these issues, those arising from differences in the notion of debt and equity between Islamic and conventional finance (and the tax treatment of related returns) stand out. Conventional tax systems (and in particular corporate income taxes) recognize the return to debt (but not equity) as a deductible cost for income tax purposes. This so-called debt bias can, in principle, disadvantage Islamic finance since Shari’ah does not recognize interest. In practice, however, most modern tax systems can deal with this apparent disadvantage by treating the economic substance of Islamic instruments similarly to conventional instruments. Experience shows that this may or may not require changes to countries’ tax legislation. In this context, changes to regulations or application rules may be sufficient to provide transparency and certainty regarding the tax treatment of the main Islamic finance instruments.

Differences in the treatment of Islamic and conventional finance, if unchecked, can create cross-border spillovers and international tax arbitrage opportunities. Multinational enterprises exploit differences in tax systems in many different forms, one of which is to treat a transaction as debt in one country and equity in another. It is important that countries collaborate on minimizing these opportunities, both within existing bilateral tax treaty networks, and perhaps more globally.

The tax implications of certain differences between Islamic and conventional finance are less clear cut. For example, Islamic finance may generate higher transactions costs than conventional finance, especially due to the necessity in some cases to set up additional intermediaries between suppliers and demanders of funds, as well as more complex transaction structures. This means that some Islamic financial instruments can be disadvantaged in the presence of transaction taxes (for example, stamp or similar fees). Although it is possible to mitigate such a disadvantage by ignoring certain elements of a transaction for tax purposes, it is preferable to shift away from distortionary transaction taxes and toward more neutral profit-based taxes—not only for the benefit of Islamic finance, but for financial intermediation in general.

International standards can facilitate tax reforms toward leveling the playing field between Islamic and conventional finance. Accounting and auditing standards for Islamic finance are particularly important, especially for ensuring Shari’ah consistency within and across jurisdictions (Hurcan, Mansour, and Olden 2015).

Source: IMF

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