Islamic Finance and State Aid

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Thesis Submission

2017

Research Topic:

Special Tax Regimes for Islamic Finance

in the European Union

Research Question:

Do the Special Tax Regimes for Islamic Finance

enacted by some Member States constitute State Aid

as envisioned by Article 107(1) of the TFEU?

Submitted by: Neha Mohan

Student Number: 11366702

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Islamic financial instruments are generally undertaken to achieve the same economic outcomes as conventional financial instruments, while accommodating the principles of Islam that are applicable to finance. Circumventing the religious prohibitions (discussed in detail in Section 3.3) typically involves more constituent transactions, each of which is at a risk of attracting taxes on income or gains, as well as transfer taxes. These taxes, often referred to in literature as “excess tax costs” or “prohibitive taxes”, sometimes render Islamic financial instruments excessively expensive to carry out.

An analysis of taxation of Islamic Financial Instruments2_{in jurisdictions that follow an economic}

approach (or substance-over-form approach) towards taxation shows that this approach usually results in equal (direct) tax treatment for Islamic financial instruments when compared to their conventional counterparts, as this approach focuses on the intended outcomes of the financial instruments, rather than the constituent transactions or the legal structure of the instruments. However, in jurisdictions that follow a legal approach, it is more difficult to achieve equal (direct) tax treatment for economically equivalent Islamic and conventional financial instruments because there is no legal mechanism to look beyond the structure of the financial instruments and the terms of the contracts, at the economic reality or the substance thereof.

Hence, some jurisdictions (including the United Kingdom, Ireland, France and Luxembourg) have enacted special provisions for the taxation of Islamic financial instruments, in order to create a level playing field with the comparable conventional financial instruments.

However, since these provisions only apply to a certain category of financial instruments, in a European Union context, there may be a risk of these measures amounting to State Aid under Article 107(1)3_{of the Treaty for the Functioning of the European Union (‘TFEU’).}

The first half of this thesis deals with Islamic Finance, setting it apart from conventional finance and analysing the need for special tax regimes for Islamic Finance. The second half is dedicated to analysing the and special tax provisions for Islamic Finance enacted in some Member States of the European Union, in order to determine whether the special treatment afforded to the certain category of financial instruments under these legislations amounts to State Aid under Article 107(1) of the TFEU.

1 The three Islamic Financial Instruments discussed in detail herein (Murbaha, Mudaraba & Musharaka) are relatively simple, widely accepted and commonly used shariah-compliant structures; there are other (more complex) Islamic Financial Instruments, some of which resemble conventional derivative contracts (futures, forwards, options) that are not discussed herein because the special tax regimes for Islamic Finance in the European Union (United Kingdom, Ireland, France and Luxembourg) do not cover these instruments.

2A special issue (No. 5a) of the Derivatives & Financial Instruments Journal (Vol. 12), published in 2010, was dedicated to the Taxation of Islamic Financial Instruments. It discusses the taxation of Islamic Financial Instruments via country reports, including those for the United Kingdom, Ireland, France and Luxembourg. This thesis refers extensively to the country reports in this special issue.

3 Text of Article 107 of the TFEU:

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2. Introduction

This thesis is an attempt to address a very small part of the much larger and ubiquitous “debt-equity conundrum”4_{that has plagued the international tax system ever since there has been}

such a phenomenon as an international tax system.

The preferential treatment of debt, as compared to equity, is a common element in domestic tax systems. This preferential tax treatment, expressly, “treating interest on debt as a deductible expense and distributions on equity as wholly non-deductible”5_{, encourages}

taxpayers to finance their investments through debt, rather than through equity.

The “debt bias”6_{thus created, leads to economic distortions as well as significant}

complexities in tax systems, for example, the need for thin-capitalization rules. Businesses make use of the debt bias by maintaining high debt-to-equity ratios for which domestic thin-capitalization rules are enacted. In a cross border context, multinational businesses can restructure finances internally to shift debt between affiliates and use hybrid financial instruments in order to reduce tax liabilities in the various jurisdictions they operate in.7

As “an economist would maintain that there is no economic distinction between the flows on debt capital as opposed to equity capital”,8_{it may be argued, therefore, that the distinction}

between the tax treatment of debt and equity plays a large role in the financing decisions of businesses.

The debt bias, from a country perspective, gives rise to numerous policy questions, relating to the design of the tax system, revenue requirement and tax fairness.Every country thus, has a choice to treat, for tax purposes, debt favourably to a certain extent, in order to attract foreign investment but “by attracting debt capital the country may, on the other hand, be encouraging erosion of its tax base”.9

From the perspective of international taxation, the distinction between debt and equity is not as relevant as the allocation of risks and rewards.1011_{Moreover, the distinctions between debt}

and equity can be blurred by the use of a wide range of hybrid financial instruments, engineered to do precisely that – “make an equity position look like debt and vice versa”12_–

thereby, mitigating tax in cross-border situations13_.

4P.H. Blessing, Chapter 3: The Debt-Equity Conundrum, in O.C.R. Marres & D. Weber, A Prequel to Tax

Treatment of Interest for Corporations, 2012, Online Books IBFD

5ibid; Section 3.1 Background

6 M.H.J. Alink & V. van Kommer, Handbook on Tax Administration (Second Revised Edition), 2016, Online Books IBFD, Chapter 1: Taxation

7 ibid

8 See supra note 4; Section 3.1 Background

9 ibid; Section 3.1 Background

10 Inferred from: See supra note 4; Section 3.1 Background

11 Inferred from: OECD/G20 Base Erosion and Profit Shifting Project - Explanatory Statement (2015 Final

Reports), Annex A. Overview of BEPS Package, Section: Actions 8-10 – Assure that Transfer Pricing Outcomes are in Line with Value Creation, Page 18 http://www.oecd.org/ctp/beps-explanatory-statement-2015.pdf

12 R. J. Vann, Chapter 18: International Aspects of Income Tax, in Victor Thuronyi, Tax Law Design and

Drafting (Volume 2), 1998, IBFD Library, Page 790

13 Typically, “deduction / no inclusion schemes: arrangements that create a deduction in one country, typically a deduction for interest expenses, but avoid a corresponding inclusion in the taxable income in another country”.

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Hence, the “debt bias”is especially problematic when it comes to the taxation of financial instruments both, domestically and cross-border. “Financial Instruments are not an exception to one of the general rules of domestic and international taxation: tax laws and practices cannot appropriately follow the development of rapidly developing businesses such as financial services. Taxation of financial instruments may therefore be unclear in one single jurisdiction as well as in transactions among different countries. Furthermore, the income classification may be vague. Instruments may produce interest income in one country and capital gains in another or they may generate both interest income and capital gains either in one or both countries”.14

Owning to the complexities that arise with cross-border taxation of financial instruments, taxation of financial instruments has been a topic of discussion at several annual conferences of the International Fiscal Association (‘IFA’), specifically in 1995 and 2000, resulting in IFA Congress Reports (comprising of country-wise reports of) “Tax aspects of derivative financial instruments”15_{and “Tax treatment of hybrid financial instruments in cross-border}

transactions” 16_{, respectively.}

Other, more recent, IFA Congress Reports (though not specifically on the topic of financial instruments) discuss some important issues arising out of the variances in accounting and tax practices across jurisdictions, which affect cross-border taxation of financial instruments. Some of these reports are titled, “New tendencies in tax treatment of cross-border interest of corporations” 17_{, “The Debt Equity Conundrum”}18_{, “Foreign exchange issues in international}

taxation” 19_{, “Tax treaties and tax avoidance: application of anti-avoidance provisions”} 20_.

Even among financial markets that are considered to be relatively well established and efficient, the IFA Reports show that there are variances in accounting and tax practices related to financial instruments.

In the cross-border context, the variations in accounting practices and the definitions of taxable income, deductible expenses, equity, debt and capital gains and losses, across different jurisdictions may easily cause double taxation, but on the other hand, also creates opportunities for tax avoidance.

The problems relating to the taxation of cross-border financial instruments can be classified in the three broad categories, “valuation, timing and unrealized gains”.21_{All these issues stem}

from the basic issue of classifying the relationship, underlying the financial instruments, as

OECD Report on Hybrid Mismatch Arrangements: Tax Policy and Compliance Issues, 2012, Chapter 1: Hybrid

Mismatch Arrangements, Page 7

http://www.oecd.org/ctp/aggressive/HYBRIDS_ENG_Final_October2012.pdf

14 A. Laukkanen, Taxation of Investment Derivatives, in IBFD Doctoral Series, Vol. 13, 2007, Online Books, IBFD; Chapter 1: Introduction

15 IFA Congress Report: Tax aspects of derivative financial instruments, Vol. 80b, 1995, IFA Cahiers, IBFD

16 IFA Congress Report: Tax treatment of hybrid financial instruments in cross-border transactions, Vol. 85a, 2000, IFA Cahiers, IBFD

17 IFA Congress Report: New tendencies in tax treatment of cross-border interest of corporations, Vol. 93b, 2008, IFA Cahiers, IBFD

18 IFA Congress Report: The Debt Equity Conundrum, Vol. 97b, 2012, IFA Cahiers, IBFD

19 IFA Congress Report: Foreign exchange issues in international taxation, Vol. 94b, 2009, IFA Cahiers, IBFD

20 IFA Congress Report: Tax treaties and tax avoidance: application of anti-avoidance provisions, Vol. 95A, 2010, IFA Cahiers, IBFD

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debt or equity (which can differ across jurisdictions based on the differences in accounting and tax practices). This thesis therefore, focuses on the issue of classification of the relationships underlying financial instruments as debt or equity relationships.

The inconsistency in tax treatment between two jurisdictions in this respect can potentially cause juridical and economical double taxation. Conversely, financial instruments also stand to gain from these inconsistencies. For instance, if the source jurisdiction classifies the outgoing recurring component of the financial instrument as interest, allowing the payer to deduct interest expenses, and the resident country of the receiver classifies the source as equity, with the effect that the income is tax exempt, instead of double or single taxation, this income totally avoids taxes, and the deduction reduces the overall taxable income in the source country. Multinational companies or cross-border related parties stand to make such “inconsistency gains”22_.

Since, Islamic Financial Instruments function much like conventional financial instruments (with the added requirement of being shariah-compliant or in accordance with Islamic Law), these arrangements, like their conventional counterparts, can also be used to make cross-border “inconsistency gains”.

However, Islamic Financial Instruments are inherently disadvantaged when compared to conventional financial instruments because, whereas anything is possible for conventional financial instruments, Islamic Financial Instruments need to abide by the shariah or Islamic Law.

In order to achieve the same economic outcomes as conventional financial instruments, Islamic Financial Instruments need to be structured differently, “meeting Islamic religious requirements, which include avoiding any charging of interest, avoidance of excessive uncertainty, avoidance of selling assets that are not yet owned”.23_{(The basic principles of}

Islamic Law applicable to finance are discussed in Section 3.3)

Circumventing the prohibitions laid down in Islamic Law makes the structuring of Islamic Financial Instruments far more complex and often involves a series of additional transactions that may or may not have additional tax implications, depending on which jurisdictions these transactions are taking place in.

Hence, proponents of Islamic Finance, political and academic, propose special tax regimes for Islamic Finance in order to create a level playing field with conventional instruments. However, in the European Union context, a special tax regime based on religious qualifications may amount to State Aid under Article 107(1) of the TFEU.

22 ibid, Chapter 6: Specific Tax Issues for Financial Derivatives

23 Qatar Financial Centre, Cross Border Taxation of Islamic Finance in the MENA Region, 2013

http://www.qfc.qa/Admin/Operate/TaxResources/Cross%20border%20taxation%20of%20Islamic%20finance %20in%20the%20MENA%20region%20-%20Phase%20One.pdf

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3. Islamic Finance

3.1 Relevance of the Islamic Finance Industry

Standard & Poor's Financial Services LLC estimated the Islamic Financial Industry's total assets to be USD 2 trillion at the end of the year 201624_{, which, though a significant amount,}

is but a small fraction of the assets held by the conventional financial instruments market and yet, Islamic Finance has been a topic for discussion among academics and policy makers because of its rapid growth over the past decade.

According to the International Monetary Fund (‘IMF’), the Islamic finance industry has seen a double-digit growth over a decade as assets held by industry have grown from about USD 200 billion in 2003 to an estimated USD 1.8 trillion at the end of 2013. (Ernst & Young 2014; IFSB 2014; and Oliver Wyman 2009)25

This rapid growth can be attributed largely to the savings accumulated in the major oil-exporting countries, from where investors are seeking to invest in shariah-compliant investment options. Many countries, having taken note of this opportunity to attract investment, have enacted special tax provisions to ensure that Islamic financial instruments are treated (for tax purposes) on par with or even favourably, when compared to the comparable conventional financial instruments.

The Islamic Finance Industry gained further popularity during the financial crisis of 2007-2008 as “Islamic finance products demonstrated superior stability compared to traditional financial products due to their linkage with tangible assets (as compared to derivatives created under the conventional finance system)”.26_{This is because Islamic Financial}

Instruments have to comply with the shariah (or Islamic Law), which prohibits certain high risk elements of conventional finance, like charging high rates of interest, inducing excessive uncertainty and dealing in assets that are not already in existence. (Basic Concepts of Islamic Finance are discussed in detail in Section 3)

The IMF reasons 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”.27_{In support of this argument, the IMF provides the}

following possible reasons: (i) asset-based financing (therefore, full collateralization), (ii) prohibition against speculation (therefore, reduced risk); and (iii) strong ethical principles, founded in religion (therefore, enduring).

Islamic financial institutions are considered to be good platforms for increasing financial inclusion, “including access to finance for SMEs, thereby supporting growth and economic development”. 28

24 Standard & Poor's Financial Services LLC Global Ratings, Islamic Finance Outlook (2017 Edition), September 2016 https://www.spratings.com/documents/20184/0/Islamic+Finance+Outlook+2017/5abbe572-c826-4622-bd13-1aba725281fc

25IMF Staff Discussion Note, Islamic Finance - Opportunities, Challenges and Policy Options; SDN/15/05; April 2015 https://www.imf.org/external/pubs/ft/sdn/2015/sdn1505.pdf

26 D. Yun & F. Chan, The Development of Islamic Finance in Hong Kong, No. 4, Vol. 19, Asia-Pacific Tax Bulletin, 2013, Journals IBFD, Section 1: Introduction

27 See supra note 25

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Statistics show that enacting special tax regimes, whether to treat Islamic financial instruments on par with or favourably, when compared to the comparable conventional financial instruments, has benefited countries like the United Kingdom and Malaysia, which are now hubs for the Islamic finance industry, in Europe and Asia-Pacific, respectively. Hence, Islamic finance has the potential to boost the economy as well as induce stability. 3.2 Brief History of Islamic Finance

One can say that the basic principles of Islamic finance are as old as Islam itself, dating back to the 7th century. Documented history reveals that Muslims have practiced some version of Islamic finance since the advent of Islam and that the modern Islamic Finance Industry that we see today is an evolved version of financial practices of the people of Mecca during the time of the Islamic Prophet, Mohammed.

Islamic Finance was at its peak from the 8th_{century to the 13}th_{century, what is known by}

historians as the golden age of Islam, and though it saw a decline with the decline of the Islamic empire and colonization by European nations between the 13th_{century and the 19}th

century, it has seen a steady revival over the last century.

The re-emerge of Islamic Finance in the 1970 can be attributed to the increase in liquidity in the oil-exporting countries, most of which practice some form of Islamic finance, as well as to 20th-century Muslim economists who continually envision and popularize modern alternatives to conventional financial instruments because it is believed that some concepts of conventional finance violate Islamic law.

Key events in the short history of the modern Islamic finance industry29_:

 1963: Establishment, in Egypt, of the first modern Islamic bank on record, called the “Mit Ghamr Savings Bank”

 1963: Launch of the “Pilgrims Saving Corporation of Malaysia” (not a bank, but an institute or authority to advise and help Muslims invest savings in compliance with Islamic Law, in order to be able to afford the hajj or the Islamic pilgrimage to Mecca)  1975: Opening of the “Islamic Development Bank” in Saudi Arabia, giving the

Islamic finance industry an international presence

 1979: Establishment of the first Islamic insurance company, the “Islamic Insurance Company of Sudan”

 1986: Creation of the world’s first Islamic mutual fund, the “Amana Income Fund”, in Indiana

 1990: Creation of an international autonomous body, called the “Accounting and Auditing Organization for Islamic Financial Institutions” (AAOIFI), for setting standards for the Islamic Finance Industry with respect to accounting, auditing, governance, ethics and shariah-standards,

 1990: Issuance of the first tradable sukuk (Islamic alternative for a conventional bond) by Shell MDS in Malaysia

 1996: Establishment of the “Citi Islamic Investment Bank”, in Bahrain (Start of Islamic banking services by Citibank)

29 Jamaldeen F, Islamic Finance For Dummies, 2012, For Dummies (A Wiley Brand); Chapter 3: History of

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 1999: Establishment of the first mainstream benchmark for the performance of Islamic investment funds, called the “Dow Jones Islamic Market Index” (DJIMI)  2002: Establishment of an international standard-setting body for Islamic financial

institutions in Malaysia, called the “Islamic Financial Services Board” (IFSB)

 2004: Establishment of the “Islamic Bank of Britain”; the first Islamic commercial bank, outside the Muslim world

Since 1970, more than 500 Islamic financial institutions have been established worldwide, about 300 of these being commercial banks offering shariah-compliant banking services (or financial services in accordance with Islamic law; discussed in detail in the next section). 3.3 Basic Concepts of Islamic Finance

Islamic Finance can be understood to be the structuring of financial transactions in order to mobilize funds, in conformity with the principles of Islamic Law. For a particular transaction to be in accordance with Islamic Law, it must not involve any of the following “evils”30_:

 riba (usury/interest)

 gharar (uncertainty/speculative risk)  akl al-mal bil-batil (unjust enrichment)  ghubn (damage, injury, fraud, lesion)

The key principles relevant to structuring a financial transaction in accordance with Islamic Law can be summarized as31_:

 The charging or receiving of “riba” or interest is prohibited

Depending on one’s own understanding of the shariah, this could mean a prohibition on interest of all kinds or only on interest at usurious rates. A commonly accepted interpretation of this prohibition is that “an investor should realise no profit or gain merely for the employment of money”.32_{Accordingly, earnings should only be linked}

to effort or risk undertaken. Therefore, an investor must make a profit/loss participating investment in an enterprise, assuming some degree of risk as well as ownership in the underlying assets of the enterprise, from which he may reclaim his initial investment in case of losses suffered by the enterprise. However, some shariah scholars go as far as to a denounce the accounting concept of time-value-of-money because it implies that the same sum of money has a different value in the present and in the future, merely owing to the passage of time.

 The enterprise and underlying assets must be shariah-compliant

The general prohibitions, for example on gambling, alcohol and pork, laid down in the Quran apply to Islamic finance as much as they do to the conduct of life, in general33_.

Hence, no investment must be made in enterprises engaging in any of the items or practices prohibited by the Quran.

30 Hegazy W, Islamic Finance – A Tax Perspective, Pages 342-348, No. 10, Vol. 3, Asia-Pacific Tax Bulletin, 1997, IBFD Publications BV, IBFD Library

31 Latham & Watkins LLP; The Sukuk Handbook: A guide to Structuring Sukuk; 2015

https://www.lw.com/thoughtLeadership/guide-to-structurings-sukuk-2015 32 ibid

33 IMF Working Paper, An Overview of Islamic Finance, WP/15/120, 2015, Sub-Section A. Key Principles of

Islamic Finance, in Section II The Framework of Islamic Finance, Page 5

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 Prohibition on uncertainty (gharar), speculation (maysir) and exploitation of ignorance (jahl)

Islamic Law prohibits “gharar”, which can be translated to “intentionally induced uncertainty or unnecessary risk”34_{; “maysir”, which translates roughly to speculation;}

and “jahl”, which is ignorance. Hence, a liberal understanding would imply that all parties to a contract should fully understand and be aware the expected outcome. However, a strict interpretation would mean a prohibition on any sort of uncertainty, for example, a contract wherein the repayment terms reflect market-linked interest rates (like LIBOR) or accommodate for currency fluctuations.

These basic principles of Islamic Finance are rather broad and open to interpretation because they are derived from various interpretations of the Quran and the Hadith (which are accounts of the words, actions and habits of the Islamic Prophet, Muhammad, by his relatives and companions; comparable to the Gospels), originally written in Arabic. These texts only lay down general prohibitions on certain things, like pork, alcohol and usury, without detailed descriptions or context. For instance, the Quran imposes a prohibition on the consumption of pork, except for those who are driven by necessity. It does not clarify what circumstances qualify as necessary or whether dealing in pork is also prohibited.

Similarly, there is a prohibition on “riba”, which can be translated either as “usury” or as “interest”. It has been mentioned and condemned in several verses of the Quran (2:275-2:280, 3:130, 4:161, 30:39) and is also mentioned in many hadith.

The term “usury” is defined in the Oxford Dictionary as “the action or practice of lending money at unreasonably high rates of interest”.35_{“Interest”, on the other hand, is money paid}

for the use of money or for the purpose of delaying the repayment of debt.

Due to the lack of consistency in translations from the original texts, it is unclear whether interest of all kinds is prohibited or only interest at usurious rates. Umar ibn Al-Khattāb, the second of the Islamic caliphs (sometimes referred to as Umar I by historians of Islam), is often quoted to have said that, among the three things he wishes the Prophet had made clear,

“riba” is one.

Historically, the charging of interest on loans has been regarded as sinful in many cultures, including Christianity (in medieval Europe). The Catholic Church in medieval Europe banned the charging of interest altogether, though the Roman Empire eventually allowed the earning of interest at controlled rates. Many nations, from ancient Rome and Greece to ancient China, have, at different points in time, outlawed the earning of interest from loans. The earliest known prohibitions on usury can be found in ancient Indian texts, like the Vedas36_{. Similar}

prohibitions can also be found in ancient Buddhist and Jewish texts; “the term is riba in Arabic and ribbit in Hebrew”.37

35https://en.oxforddictionaries.com/definition/usury

36 L. C. Jain, Indigenous Banking In India, 1929, Macmillan and Co. Ltd, Chapter 1: Early History of

Indigenous Banking, Page 1 - 26

https://archive.org/details/in.ernet.dli.2015.1055

37S.A. Karim, The Islamic Moral Economy: A Study of Islamic Money and Financial Instruments, 2010, Brown Walker Press http://www.bookpump.com/bwp/pdf-b/9425394b.pdf

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Hence, the prohibition on usury is not, historically, exclusive to Islam. However, the belief that usury is sinful has lived on in the Islamic world and therefore, the practise of avoiding usury has permeated into modern day Islamic Finance.

However, “not all shariah scholars equate riba with all forms of interest”,38_{and among those}

who do, “there is also disagreement over whether it is a major sin and against Islamic law, or simply discouraged (makruh)”.39

Mohammad Taqi Usmani40_{, in paragraph 62 of the ‘Historic Judgment on Interest’}41_{, states}

that a deeper study of the hadith reveal that the authors of the hadith were only doubtful about certain types of “riba”, whereas Muhammad Akram Khan42_{, in his book, ‘What is}

wrong with Islamic Economics?’43_{, gives a list of “possible meanings of the term riba”, some}

of which are: “interest on any kind of loan; interest on consumption loans but not business loans, compound interest but not other kinds of interest, exorbitant rates of interest; interest on loans to the poor and needy”.

Therefore, while there may be a consensus on “riba” being prohibited, there is no consensus on what constitutes “riba”, or “whether it should be punishable by humans”44_.

An article titled, ‘An Introduction to Islamic Banking’ 45_{, by Richard Iferenta, Johan Bain and}

Kelly Eland of KPMG, published in 2005, attempts to decode the principles of Islamic Finance for the understanding of modern day tax professionals as follows:

 Prohibition on interest or riba - based on the belief that it is unacceptable for money to increase in value, in and of itself, merely by lending to another person. Hence, the parties to a contract must only enter into economic transactions, which involve the buying and selling of goods or buying and hiring of goods or services.

 Equity of relationship between the parties to a contract – that is, the sharing of ownership and risks, without exploitation.

 There should be no investment in companies or sectors that are involved in activities which are incompatible with the Muslim faith - for example, pork products,

38 O. Roy, The Failure of Political Islam, trans. Carol Volk, 1994, Harvard University Press, Page 132

39 M. A. Khan, What Is Wrong with Islamic Economics? Analysing The Present State and The Future Agenda, 2013, Edward Elgar Publishing, Pages 134 and 35

40 Muhammad Taqi Usmani is a Pakistani shariah scholar, who served as a judge on the Federal Shariat Court of Pakistan from 1981 to 1982, and the Shariat Appellate Bench of the Supreme Court of Pakistan between 1982 and 2002. He is an expert in the fields of Islamic Jurisprudence (fiqh), hadith and economics.

41 M.T. Usmani, The Historic Judgement on Interest – Delivered in The Supreme Court of Pakistan, 2007 Idaratul Ma’arif

(On 23rd December 1999 the Shari'at Appellate Bench of the Supreme Court of Pakistan announced its historic judgment declaring interest as unlawful according to Islamic Law. This book is the work of Justice Taqi Usmani that was influential in that decision and the full text of the judgment is available at:

https://archive.org/stream/Document1_201501/Document%201_djvu.txt)

42 Muhammad Akram Khan (born in 1945) is a fellow of the Canadian Comprehensive Auditing Foundation. He is presently Director General (Training) in the Department of Auditor General of Pakistan. His published works include “Issues in Islamic Economics”, “Economic Teachings of Prophet Muhammad”, “Glossary of

Islamic Economics” (a two-volume Annotated Bibliography of Islamic Economics) and “Economics of the Qur'an: Economic Teachings of Surah al-Ma'idah and Surah al-Nahl”.

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arms/ammunitions, alcohol, gaming and financial services/products requiring payment or receipt of interest.

Whereas, a working paper of the IMF on Islamic Finance,46_{outlines three principles}

governing Islamic Finance - Principle of Equity, Principle of Participation and Principle of Ownership.

Clearly, even among shariah scholars and tax experts, there is no consensus on the meaning of the term “riba” and therefore, on what arrangements are shariah-compliant (or in accordance with Islamic Law).

It is also possible for every individual to have a different interpretation of the term, “riba” and therefore, of “shariah-compliance”; for some people, even a small shade of debt renders the arrangement not in accordance with Islamic Law, while others may regard all arrangements as shariah-compliant as long as one party is an Islamic Bank. Hence, the question is (ultimately) more moral and personal, rather than legal or juridical.

Whether one has a strict or a liberal interpretation of the prohibitions in Islamic Law, the USD 2 trillion47_{Islamic Finance Industry thrives on the widely accepted belief that certain}

aspects of conventional financing are not compatible with Islamic Law.

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4. Accounting and Tax Implications of Islamic Finance

In order to circumvent the prohibitions laid down by Islamic Law, Islamic Financial Instruments need to be structured differently from conventional financial instruments, making them significantly more complicated, usually involving many constituent transactions.

For instance, rather than lending money to a customer at a pre-decided rate of interest, an Islamic bank would have to enter into a profit and loss sharing partnership with the customer by investing in the customer’s business and taking part ownership of the underlying assets of the business, until such time that the bank’s initial investment and the pre-agreed mark-up are paid off from the bank’s share of profits. (Example of a typical musharaka arrangement, further discussed in Section 6.)

A better example would be sukuk arrangements where, in many cases, a series of transactions are carried out and later reversed, the cumulative effect being comparable to the issue of bonds or securitization. (Sukuk arrangements are not discussed in detail in this thesis.)

There is also, in practice, a general consensus that Islamic Law is opposed to the concept of time-value-of-money, that is, the accounting concept of discounting future cash-flows at a particular “discount rate” in order to determine the present value of that cash-flow. Those who follow a strict interpretation of Islamic Law believe that “money is only a tool for measurement and has no intrinsic value” 48_{. Hence, since the concept of time-value-of-money}

indicates that the same amount of money may have a different value in the present than it does in the future, merely due to the passage of time, a strict interpretation of Islamic Law would render the concept non-shariah-compliant. However, in practice, it is impossible to ignore the concept for accounting purposes and is common (in the Islamic Finance Industry) for present and future values of cash-flows, assets and commodities to differ; though this is often justified in literature by reasons other than time-value, for instance market conditions, demand and supply, depreciation, etc.49

From an economic standpoint, the main distinction between Islamic Finance and conventional finance would be the distribution of risk. Since interest is prohibited, parties should, ideally, contribute to the capital and share the risks of the business as well as the ownership of the underlying assets; not just in form or contractual terms, but also actually, in substance. However, in practice, it is the form of the financial instruments that is structured around the prohibitions in Islamic Law, often masking the substance that lies underneath. Though this divergence might not have any implications on taxation in jurisdictions that follow an economic approach, it is likely to have grave implications on taxation in jurisdictions that follow a legal approach.

However, before discussing the difference in taxation of Islamic Financial Instruments under the two approaches, is important to note that income qualifying as “riba” in accordance with the shariah has a completely different meaning and implication from income qualifying as “interest” in the conventional sense or with respect to taxation.

49 M. F. Khan, Time Value of Money and Discounting in Islamic Perspective, No. 2, Vol. 1, 1191, Review of Islamic Economics, Pages 34 and 35

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Income from a financial instrument qualifying as “riba” is prohibited for religious reasons and hence, an investor looking for shariah-compliant investment opportunities will not invest via such an instrument. Such an investor is only concerned with the structure of the financial instrument being shariah-compliant in accordance with his/her own understanding of Islamic Law and is not concerned with the qualification of the income from that financial instrument as “interest” under conventional tax laws. The qualification as “interest” under tax law does not have any implications on shariah-compliance.

Income from Islamic Financial Instruments qualifying as “interest” under tax law, relates to the deductibility of interest expenses and withholding taxes (if any), in the same way as income from conventional financial instruments.

An analysis of various country approaches towards the (direct) tax treatment of Islamic Financial Instruments shows that “all countries (whether they follow the economic approach or the legal approach), do wish for there to be similar tax treatment of similar tax treatment of Islamic finance and traditional, similar finance products”50_.

To achieve this result, however, countries choose one of two approaches; while some countries lack special rules and treat Islamic Financial Instruments in accordance with laws applicable to the conventional financial products with equivalent characteristics (the United States, the Netherlands, Belgium, Germany, Hong Kong, Indonesia), other countries (the United Kingdom, Ireland, Malaysia, Singapore) have created Special Tax Regimes for Islamic Financial Instruments.

4.1 Jurisdictions with Economic Approach

Jurisdictions that follow the economic approach (or the substance-over-form approach) towards accounting and taxation look beyond the form and structuring of the financial instruments and the terms of the contracts, to focus on the underlying substance or the intended outcome of the transactions.

Therefore, usually, an Islamic Financial Instrument and a conventional financial instrument intending to achieve the same economic end would be taxed in the same way, irrespective of their structuring. (Some examples of this are discussed in Section 5 and 6.)

Therefore, there is no pressing need for special tax reforms for Islamic finance in these jurisdictions (for example: the United States, the Netherlands, Germany).

4.2 Jurisdictions with Legal Approach

Jurisdictions that follow the legal approach (or form-based approach) towards accounting and taxation tend to follow the letter of the law and the terms of the contracts, as opposed to the substance or the intended aims of the financial instruments, unless there is a specific legislation to that effect.

Hence, Islamic Financial Instruments, while structuring around the prohibitions laid down in Islamic Law, may run into what academics and tax practitioners sometimes refer to as “excess tax costs” or “prohibitive taxes” as they sometimes render Islamic Financial

50M.J. Peters, Islamic Finance, Editorial to 5a/Special Issue, Vol. 12, Derivatives & Financial Instruments, 2010, Online Journals, IBFD

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Instruments “prohibitively expensive to carry out”51_{when compared to the conventional}

financial instrument intended to achieve the same economic outcome.

For instance, the musharaka and sukuk instruments (briefly described in the beginning of this Section) would likely be taxed at every step under the legal approach, unmodified for Islamic Finance, while trying to achieve the same overall outcome as the comparable conventional financial instrument, which would only be taxed once.

Hence, in order to reach a level playing field, with respect to direct taxes, there is a need for special tax regimes for Islamic Finance in jurisdictions that follow a legal approach towards taxation, with no legal provisions for deviating from the terms of the contract.

Accordingly, some countries have enacted special tax regimes for Islamic Finance (the United Kingdom, Ireland, Malaysia) in order to accommodate Islamic Financial Instruments and to ensure that these instruments are not heavily taxed when compared to the comparable conventional financial instruments.

These regimes may encompass income tax, VAT, stamp duties, administrative exemptions, etc. However, the scope of this thesis is limited to direct taxation.

For direct tax purposes, the effect of these special tax regimes is to treat the relationship underlying the Islamic Financial Instrument as loan relationship (if it is so in substance; ignoring the form) and the profit-linked income thereof as interest income, whereas “payments under Islamic finance transactions generally do not qualify as interest within a strict legal definition of interest”. 52

Special tax regimes for Islamic Finance (with respect to direct taxation) may apply by adopting a general principle, that is, applying to all shariah-compliant arrangements (example: Malaysian Special Tax Regime for Islamic Finance) or by using specific legislation, that is, by defining exactly what kind of arrangements qualify (example: United Kingdom).

Before discussing the general and specific approaches of special tax regimes (and the implications thereof in the European Union context), discussed in Sections 5 and 6 are three relatively simple and widely-used shariah-compliant financial instruments and their treatment under the economic approach, in order to justify special tax regimes for Islamic finance in jurisdictions that follow the legal approach.

52N. Muller, Islamic Finance and Taxation: A Level Playing Field in Sight?, 5a/Special Issue, Vol. 12, Derivatives & Financial Instruments, 2010, Online Journals, IBFD, Section 1 – Introduction

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5. Murabaha: Shariah-complaint Arrangement - 1

“Murabaha” is a term of fiqh (Islamic jurisprudence) for a cost-plus-profit purchase of assets or commodities53_{. The buyer, in a murabaha arrangement, agrees to pay, at a future date, a}

certain “mark-up” (or “profit”) 54_{, over and above the seller’s cost price.}

Murabaha arrangements are typically used for short-term trade financing of assets or

commodities. Instead of lending money to the customer in order to purchase an asset or commodity, the Islamic financier (“seller”) purchases the asset or commodity, holds it (“often only briefly, but it is important that the financier take a degree of commercial risk in the asset”)55_{and then sells it to the customer, usually on deferred purchase terms, for a set price}

which includes an agreed mark-up. 5657

Though murabaha arrangements have a variety of applications, for example, “financing arrangements for receivables and working capital financing”, the most commonly occurring are the “commodity murabaha contracts”, typically “contracts for the deferred sale of assets or commodities at cost plus an agreed profit mark-up under which a party (the seller) purchases goods at cost price from a supplier and sells the goods to someone else (the buyer) at cost price plus an agreed mark-up”. 58_{A typical commodity murabaha arrangement is}

illustrated in figure 1 below. Figure 159

Other important aspects of a murabaha arrangement are that the buyer must be aware of the sellers purchase-price, the terms of repayment (amount and date) must be certain and the asset or commodity being traded must already exist at the time of signing the contract. “Although the seller may charge an administration fee when payment is delayed, he may not charge a penalty interest”. 60

53 M. T. Usmani, An Introduction to Islamic Finance, Arab and Islamic Law Series, 1998, Kluwer Law International, Chapter 5: Murabaha, Page 65

http://muftitaqiusmani.com/en/books/PDF/An%20Introduction%20To%20Islamic%20Finance/An_Introduction %20_to_Islamic_Finance.pdf

54H. Irfan, Heaven's Bankers, 2015, Overlook Press, Page 135

55 Pinset Masons LLP, Back to Basics - Shari’a Finance, No. 978, 2009, The Tax Journal – Croydon, Pages 17-19 https://www.pinsentmasons.com/PDF/ShariaFinance.pdf

56 ibid

57J. Dabner, Islamic Finance in Australia: Interest or not Interest?, No. 1, Vol. 18, 2012, New Zealand Journal of Taxation Law and Policy, Pages 12-31

58 N. Schoon, Islamic Finance: An Overview, 5a/Special Issue, Vol. 12, Derivatives & Financial Instruments, 2010, Online Journals, IBFD

59 ibid

60 H. Pijl, Chapter 6: The Concept of Interest in Tax Treaties, in O.C.R. Morres and D. Webber, Tax Treatment

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5.1 Taxation of Murabaha (Economic and Legal Approaches)

In substance, a typical muarabaha arrangement is the Islamic equivalent of a conventional contract for a deferred-credit-sale. Hence, in a jurisdiction that follows an economic approach to taxation of financial instruments, a murabaha would likely be taxed in the same manner as a deferred credit sale. Some examples of this are mentioned below.

Belgium

Income, that is not referred to as “interest” but has a due payment date of more than one year, is to be discounted61_{for accounting and tax purposes (in order to determine the present value,}

and thereby determine how much of it is to be treated as “interest”).

As a result, the gain, over and above the purchase price of the seller will be split into “capital gain” component, which is immediately taxable and an “interest” component, which is taxed over time (based on the time-value calculation or “discounting”). 62

The Netherlands

Income over and above the cost of the asset price from a murabaha arrangement with deferred payment terms, would be taxed on the same deferred basis, that is, “straight-line basis over the period of the deferred payments, rather than upfront when initiating the

murabaha” 63_{. This deferred taxation is based on “goed koopmansgebruik” (or “the principles}

of sound business practice”), in particular the matching principle, which stipulates that profits and losses must be allocated to the tax year in which they are realized.64

Hence, economic approach jurisdictions would look through the terms of the murabaha contract to tax the substance of the transaction, which is a single deferred-credit-sale, wherein the repayments are deferred but the ownership of the asset passes (from seller to buyer) at once, when the entire agreed sum has been paid.

However, a purely legal approach would see two consecutive sale contracts and hence, in a legal approach jurisdiction, unmodified for Islamic Finance, a murabaha arrangement is likely to attract tax on income or gains (as well as transfer taxes) twice because “a murabaha legally rests on two sales agreements: first, a purchase of the goods by the seller, then a purchase by the buyer with deferred payment, where a cost-plus satisfies the seller for the deferred receipt of the payments by the buyer”. 65

61 “Discounted” refers to the accounting concept of determining the net present value of a future cash-flow based on market interest rates (like LIBOR)

62 J. van den Berg et al., Tax Treatment of Islamic Finance Products - Benelux, 5a/Special Issue, Vol. 12, Derivatives & Financial Instruments, 2010, Online Journals, IBFD

63 ibid

64 ibid

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Figure 266_{shows a murabaha arrangement from a legal perspective, wherein the seller is an}

“Islamic Bank” and the buyer is referred to as “customer”.

Hence, in legal approach jurisdictions, in order to achieve equality with respect to direct taxation of murabaha arrangements and the economically equivalent conventional arrangements, there is a good case for adjusting the domestic tax treatment afforded to

murabaha arrangements.

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6. Musharaka and Mudaraba: Shariah- compliant Arrangements 2 & 3

Musharaka and Mudaraba arrangements, according to sharia scholars, in the broadest sense,

resemble partnership contracts. In Mudaraba arrangements, “investment is the sole responsibility of the investor (rab-al-mal) and the management of the business is the responsibility of the customer (mudarib)”. 67_{In musharaka arrangements, all the parties to the}

contract can invest in the business as well as participate in the management of the business. Therefore, in a musharaka arrangement, the losses are to be borne by all parties (depending on the ratio of their individual investments), whereas in a mudaraba arrangement, the losses are borne by the investor (rab-al-mal). Accordingly, the liability of the investor (rab-al-mal) in a mudaraba arrangement is limited to his investment, whereas in a musharaka arrangement, the liability of all parties may be unlimited.

There is joint ownership of the assets of the business in a musharaka arrangement, where as in a mudaraba arrangement, the assets are owned by the financier (rab-al-mal), until the repayment of the initial investment, at which time the ownership can pass to the customer (mudarib). A typical musharaka and a typical mudaraba arrangement are illustrated in Figures 3 and 4, respectively.

Figure 368

Figure 469

67 M. T. Usmani, An Introduction to Islamic Finance, Arab and Islamic Law Series, 1998, Kluwer Law International, Chapter 4: Musharaka and Mudaraba as Modes of Financing, Pages 37 - 64

http://muftitaqiusmani.com/en/books/PDF/An%20Introduction%20To%20Islamic%20Finance/An_Introduction %20_to_Islamic_Finance.pdf

68 R. Bhupalan, Tax Treatment of Islamic Financial Products - Malaysia, 5a/Special Issue, Vol. 12, Derivatives & Financial Instruments, 2010, Online Journals, IBFD

69 M. Amin and I. Suleman, Islamic Finance: The Tax Adviser’s Role, September 2008, in Tax Adviser, Pages 18 – 20, Source: IBFD Tax Research Platform

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Even according to tax experts, musharaka and mudaraba contracts, broadly defined, are partnership arrangements in which, “either one (mudaraba) or more (musharaka) parties provide capital and/or skills and expertise to a sharia-compliant project or business”.70

Though the profits generated are distributed between the parties based on a pre-agreed ratio that reflects a return on capital as well as the effort put into management of the business, the losses, however, are distributed between the partners only on the basis of the ratio of the capital contribution. Hence, in a mudaraba arrangement, where only the rab-al-mal provides the capital, 100% of the loss is borne by the rab-al-mal, unless negligence is proved on the part of the mudarib, in which case, the mudarib bears 100% of the loss.71

6.1 Mudaraba and Musharaka (Economic and Legal Approaches) Belgium

Only musharaka and mudaraba arrangements structured as legal entities would be recognized as partnerships under the Belgian corporate law. For legal and tax purposes, the contributions made by the party (or parties) would qualify as equity investments, and the payments made on shares and profit participating certificates (sukuk certificates) would qualify as dividends for both corporate and tax purposes.72_{These payments would therefore,}

be subject to a 30%73_{withholding tax, which might be reduced or exempt under domestic}

provisions or tax treaties.

If additional financing is provided by the parties to a musharaka or mudaraba arrangement (after the date of the initial contract), in the form of registered profit participating securities (sukuk certificates), the payments made on these profit participating securities would qualify as interest despite the equity features of this instrument.

The income, at the level of the musharaka or mudaraba, might be fully subject to tax or benefit from the Belgian participation exemption74_{, provided certain conditions are met.}

The Netherlands

Musharaka and mudaraba arrangements can be structured in any of the several recognized

forms of partnerships under Dutch law. The same tax treatment that would be afforded to a conventional partnership of that chosen form will be afforded to the Mudaraba or musharaka arrangement. 75

Hence, in economic approach jurisdictions musharaka and mudaraba arrangements would assume the characteristics of an equity-based partnership and be taxed accordingly, provided the underlying relationship is, in substance, a risk and reward sharing relationship.

Though there may be slight variances in the tax treatment of the same instrument in two economic approach jurisdictions (owing to the slight variances in accounting practices)76_{, an}

70See supra note 58

71ibid

73 ibid, “15 or 25%” in this article from 2010, but new top rate (applicable from 2017) is 30%

74 The Belgian participation exemption provides for a 95% exemption of dividends received (provided the quantitative conditions are met as well as the condition that the subsidiary is subject-to-tax is satisfied) and for a 100% exemption of the capital gain realized (provided that the subsidiary is subject-to-tax)

76 The difference in tax treatment is more evident with respect to more complex financial instruments, like certain types of sukuk, which are not discussed herein.

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economic approach would ensure that two equal instruments are taxed equally within the same jurisdiction.

With regard to legal approach jurisdictions, musharaka and mudaraba arrangements would have the legal shape of a partnership, and be taxed accordingly. However, in a legal approach jurisdiction, unmodified for Islamic Finance, there is no mechanism to look beyond the structure of these instruments to check whether the underlying relationship between the parties is actually an equity-based, risk and reward sharing partnership.

Though musharaka and mudaraba arrangements are “typically applied to private equity investments or to asset management-type instruments”77_{(as seen above), they may also be}

used for simply acquiring an asset or creating an agency relationship, where the underlying relationship is, in substance, not an equity-based, risk and reward sharing partnership. In legal approach jurisdictions, such musharaka and mudaraba arrangements would also be treated as equity relationships, where as, under the economic approach, these arrangements would be treated as debt relationships, considering the substance and intended aim of the arrangements. For instance, an entrepreneur, who lacks sufficient funds for purchasing an asset required for his business, approaches a financier, who partly invests in that asset, such that it is owned jointly (by the entrepreneur and the financier) till such time that the entrepreneur pays the financier the agreed amount (investment plus an agreed mark-up), at which time the ownership of the asset passes to the entrepreneur. Such arrangements, though resemble, conventional hire-purchase arrangements (which are not, in substance, equity-based, risk and reward sharing partnerships), would also be called a musharaka arrangements because the Arabic term “musharaka” loosely translates to “shared interests” or being “invested in”. An agency relationship, where the rab-al-maal appoints the mudarib to invest funds on his behalf and the mudarib agrees to pay the rab-al-maal a certain share of the profits thereof, (keeping the rest of the profits for himself, perhaps as fees for his services), would also fall into the broad description of mudaraba arrangements described above. Here too, the underlying relation is not an equity-based, risk and reward sharing partnership.

Hence, in legal jurisdictions, there is a good case for altering the domestic tax legislation in the case of certain musharaka and mudaraba arrangements, in order to ensure the equal (direct) tax treatment of equal financial instruments.

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7. Murabaha, Musharaka & Mudaraba: Prescribed OECD & UN Approach

Since, the special tax regimes for Islamic Finance (discussed in the following sections) are applicable, not only domestically, but also cross-border, it is pertinent to discuss the approach, with respect to tax treatment of Islamic Financial Instruments, recommended by the Model Tax Conventions on Income and Capital of the Organisation for Economic Co-operation and Development (“OECD”) and the United Nations (“UN”), with regard to Double Taxation Avoidance Agreements (“Tax Treaties”) based on these Model Conventions.

7.1 Relevant Provisions

Article 11 of the OECD and UN Model Conventions deals with the allocation of taxing rights, with respect to income qualifying as “interest”. Article 11(3) states that “the term ‘interest’ as used in this Article means income from debt-claims of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtor's profits, and in particular, income from government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures. Penalty charges for late payment shall not be regarded as interest for the purpose of this Article”. Therefore, the definition of “interest” for the purposes of the Tax Treaties based on the OECD and UN Model Conventions is quite comprehensive, covering “income from debt-claims of every kind”, even those that “carry a right to participate in the debtor's profits”. However, as clarified by Paragraph 18 of the Commentaries to Article 11 of the OECD and UN Model Conventions, Article 11 covers income from only those debt-claims, which although carry the right to participate in the debtor's profits, “are nonetheless regarded as loans if the contract by its general character clearly evidences a loan at interest”.

With regard to providing equal tax treatment to Islamic Financial Instruments, when compared to the comparable conventional financial instruments, this paragraph is not very helpful because it requires that the contract terms of the financial instrument “evidence a loan at interest”. As seen in the previous sections, the legal form (or the contract terms) of

Murabaha Musharaka and Mudaraba arrangements does not evidence loans at interest, even

when the underlying relationship is, in substance, is a loan relationship (owing to the contracts being structured around the religious prohibitions discussed in Section 3.3)

Further clarifications in Paragraph 18 may however, shed some light on the recommended treatment for income from certain Islamic Financial Instruments. For instance, the sentence in Paragraph 18 that states that “mortgage interest comes within the category of income from movable capital (revenus de capitaux mobiliers), even though certain countries assimilate it to income from immovable property”, may help in categorizing income from certain ijara arrangements (Islamic mortgage arrangements) as “interest” under Article 11.

However, this Paragraph doesn’t provide sufficient clarity with regard to income from the Islamic Financial Instruments discussed in the previous Sections. The problem is compounded by the fact that Murabaha, Musharaka and Mudaraba arrangements can only be broadly defined and the terms of each of the specific arrangements can vary to a great extent. Depending on the specific terms of the contracts, the income from a murabaha arrangement may qualify, in a legal sense, as “capital gains” under Article 13, even though, in substance,

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the benefits and risk related to the asset remain with the same party throughout (or as “income from immovable property” under Article 6, if the asset is immovable property). Another question that may arise, at a Tax Treaty level, with respect to income from these arrangements is whether, “Article 7 competes with Article 11”,78_{that is, whether the income}

from these arrangements should be treated as “business profits” or as “interest”.

Hence, there is a need for the interpretation of Article 11 provided in the commentaries to allude to the substance, rather than the form or contract terms, of these financial instruments. Paragraph 21 in the Commentaries to Article 11 of the UN and OECD Model Conventions thus states that the term “interest” in Article 11 covers “all the kinds of income which are regarded as interest in the various domestic laws”, and Paragraph 21.1 clarifies that “the definition shall apply to the extent that a loan is considered to exist under a substance-over-form rule, an abuse of rights principle, or any similar doctrine”, but will not apply to “payments made under certain kinds of non-traditional financial instruments where there is no underlying debt (for example, interest rate swaps)”.

Hence, Paragraph 21.1 might help in providing equal treatment to Islamic Financial Instruments, when compared to the equivalent financial instruments, “to the extent that a loan is considered to exist under a substance-over-form rule”. However, Paragraph 21 requires that the domestic tax system of the legal jurisdiction re-characterizes and recognizes income from these instruments as “interest in the various domestic laws”.

This clearly implies that, for legal approach jurisdictions to be able to treat (for direct tax purposes) Islamic Financial Instruments on par with the comparable conventional financial instruments, the OECD and UN recommend that they re-characterize, as “interest”, for domestic tax purposes, income from certain Islamic Financial Instruments that would not qualify under the legal approach as “interest” but is, in substance, “interest”.

The Commentary to the UN Model Convention goes a step further and refers specifically to income from certain Islamic Financial Instruments.

In Paragraph 19.1 thereof, it recognizes that a number of legal approach countries (like the United Kingdom, Ireland, Malaysia), assimilate “certain non-traditional financial arrangements” to debt relationships under their respective domestic tax law regimes, “although the legal form is not a loan”. The paragraph further prescribes that the definition of “interest” for the purposes of Article 11 shall apply to the payments made under these “non-traditional financial arrangements”.

Paragraph 19.2 provides examples of these non-traditional financial arrangements, “where the economic reality of the contract underlying the instrument is a loan (even if the legal form thereof is not)”, specifically mentioning the following Islamic Financial instruments: “murabaha, istisna’a, certain forms of musharaka and mudaraba (i.e., profit-sharing deposits and diminishing musharaka) and ijara (where assimilated to finance lease), as well as sukuk based on such instruments”.

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Paragraph 19.3 suggests that both, economic approach countries and legal approach countries may “refer expressly to such instruments in the definition of interest in the treaty” by adding the following sentence to the definition of “interest” in Article 11(3):

“The term also includes income from arrangements such as Islamic financial instruments where the substance of the underlying contract can be assimilated to a loan”.

Paragraph 19.4 clarifies that the definition of “interest”, for the purposes of Article 11, “does not apply to Islamic financial instruments the economic substance of which cannot be considered as a loan”.

7.2 Conclusion

The OECD and the UN do recognize the existence of certain “non-traditional financial instruments” wherein the underlying economic substance is a loan, even though the form or the terms of the contract suggest otherwise.

For the purposes of Article 11, which deals with interest income, the OECD and UN recommend treating these instruments based on the substance, rather than the form.

To jurisdictions that do not follow an economic approach (substance-over form approach), the OECD and UN Commentaries (Paragraphs 21 and 21.1) recommend amending domestic tax laws with respect to such instruments, so that income from these instruments is treated as interest as per the domestic laws. This would qualify such income as interest for the purposes of Article 11 of its Tax Treaties, since the definition in Article 11 covers “all the kinds of income which are regarded as interest in the various domestic laws”.

The UN commentary (in Paragraph 19.1) to Article 11 specifically mentions Islamic Financial Instruments, in the context of non-traditional financial instruments wherein the underlying economic substance may be a loan, even though the legal form of the instrument is not. It also provides (in paragraph 19.2) some examples (including “murabaha” and “certain forms of musharaka and mudaraba”) of such Islamic Financial Instruments that may need to be treated based on substance, rather than form.

It further suggests (in Paragraph 19.3) adding the words, “income from arrangements such as Islamic financial instruments where the substance of the underlying contract can be assimilated to a loan”, to the definition of “interest” under Article 11 of the Tax Treaties. However, it warns (in Paragraph 19.4) that contracting countries should be careful not to include, for the purposes of Article 11, income from “Islamic financial instruments the economic substance of which cannot be considered as a loan”.