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Islamic Financing: Adaptation Of The Income Tax Act

Wednesday, 01 September 2010   (0 Comments)
Posted by: Author: Wouter Scholtz
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Islamic Financing : Adaptation Of The Income Tax Act 

The draft Taxation Laws Amendment Bill, tabled on 10 May 2010, incorporates proposed amendments dealing with the tax (and VAT and transfer duty) consequences of various forms of Islamic financing. Islamic financing implies financial services, transactions and agreements which comply with the precepts of Shar’ia or Islamic law.

The offering of Shar’ia-compliant products by banks is still something of a novelty.The more common products on offer include the following:

•Mudurabah – A form of deposit where clients invest with the bank and, in turn, the bank invests their deposits in Shar’ia-compliant enterprises or products.The profits are shared in a predetermined ratio between the bank and its clients, who bear the risk of a loss on the investments.The bank earns management fees and bears the risk of operational losses arising from the administration of the arrangement.

•Murabaha – A form of asset financing.The bank purchases the asset, and pays the provider.The asset is resold to the client by the bank at a mark-up and the client pays the bank in instalments.The bank’s margin on the transaction is calculated by reference to the interest that would have been raised on a conventional transaction.

•Diminishing Mushasaka – A form of partnership commonly used in the context of project financing. The client and the bank jointly purchase project assets; the bank’s share in the assets is divided into units, and the units are progressively purchased by the client.For as long as the bank retains ownership of the units, the client pays the bank rent on the unsold units.The rent will diminish as ownership of the units passes to the client.

Shar’ia Products From a Tax Perspective

In the draft Taxation Laws Amendment Bill, the principle of ‘substance over form’ has been adopted as the basis for the analysis and regulation of Shar’ia-based financial transactions.In terms of this approach, an amount will (for tax purposes) be taken to be interest if it replaces interest under conventional transactions.The explanatory memorandum accompanying the draft bill gives examples illustrating how and when components of a transaction will be treated as interest.

Application of Substance Over Form to Mudurabah

Any profit derived by the client in consequence of the investment in the deposit account will, for tax purposes, be taken to be interest.

The Substance Principle and Murabaha

As explained, Murabaha transactions involve the acquisition of assets by the bank, and their resale (at a mark-up) to the client.The bank’s margin on the resale of the asset to the client will, for income tax purposes, be treated as interest.For VAT purposes, the client will be taken to have purchased the asset directly from the supplier, at the price imposed by the supplier.(The purchase of the asset by the bank, and its resale to the client, will accordingly be ignored for VAT purposes.) A similar approach – a deemed direct acquisition of the property by the client, without intermediation by the bank – will also be applied for transfer duty purposes.Transfer duty will accordingly be levied only on the original purchase price, and not upon the mark-up imposed by the bank.

The Substance Principle and Diminishing Musharaka          

As previously explained, Diminishing Musharaka turns around a joint purchase of assets by the client and the bank.The bank’s units (ownership interests) in the asset are leased to the client, pending the progressive purchase of the units by the client. The rent paid on the bank’s units will, for income tax purposes, be taken to be interest.For VAT purposes, the client will be taken to have acquired the assets at the outset, and directly from the supplier, at the supplier’s price.A similar approach will be adopted for transfer duty purposes.

While the treatment of transaction amounts as interest for tax purposes might be construed as offensive given the deliberate avoidance of interest under Shar’ia precepts, it should be appreciated that if the amounts in question were not to be treated as interest for tax purposes, the client might be deprived of the right to claim a tax deduction, even where a deduction would have been claimable pursuant to a conventional financing transaction.For example, if you were to borrow money to acquire business assets, interest on your borrowings would be deductible. You should not be deprived of that right because, in observance of Shar’ia, you cast the transaction into a compliant form.The amendments are accordingly about extending equal rights to those who observe Shar’ia. 

Source: By Wouter Scholtz (TaxTALK)



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