TAXATION ISSUES IN ISLAMIC BANKING
SYED MOHAMAD HUSAIN
Islamic banking has made great strides in recent years as it has become recognised all over the world as an alternative to the traditional interest-based banking. Yet it is still engaged in a constant struggle in the area of tax treatment of its profits.
In all countries, regardless of whether Muslims are in a majority or in a minority, whether they are in power or not, the mainstay of the economy is the interest-based financial and banking system and this is reflected in the taxation laws.
Those Muslim countries colonised by European countries are still burdened with their economic philosophy, including their interest-based banking and taxation systems. In some Islamic countries, some taxation changes have been made to accommodate Islamic banking schemes within a primarily interest-based legal and taxation system, but they have been mostly of a cosmetic nature.
Thus, the taxation issues faced by Islamic banking are common throughout the world. Only in a few countries, such as Malaysia and Pakistan, have the governments recognised Islamic banking and made some changes in the taxation laws.
In Malaysia, the government has introduced parallel Islamic banking. That is to say that for income tax purposes. Islamic banking transactions are accorded the same tax treatment as that accorded to similar, interest-based banking transactions. The Malaysian Income Tax Act, 1967, was amended to accommodate the Sharia-based transactions as follows: “Any reference in this Act to interest shall apply mutatis mutandis to gains or profits received and expenses incurred in lieu of interest in transactions conducted in accordance with the principles of the Sharia”.
This clause of the Malaysian Income Tax Act 1967 provides comprehensive umbrella coverage and a level playing field to Sharia-based financial transactions. The implications of this clause in the Malaysian Income tax Act are as follows:
In the case of property financing or refinancing through an Islamic trading instrument, the gain on the sale of the property by the seller (for refinancing), or by the bank, will not fall within the ambit of the Real Property Gains Tax Act, 1967. The gains must be deemed equivalent to interest.
Technically speaking, in a trading transaction, the bank may lose as well as make a gain. According to the Sharia, when a bank buys a commodity or property, the bank must receive the delivery of the commodity or property before it can sell it to the customer under an agreement for sale.
If, through some circumstance, the customer is unable to buy or take delivery from the bank or the bank’s agent, the bank may make either a gain or loss on the outright sale of the commodity or property. In such a transaction, there is no similarity to interest, but we may presume that such gains or losses will be treated for tax purposes as a business gain or loss. This is where the risk factor in an Islamic trading transaction is greater than in an interest-based transaction.
The above example brings out the fact that Islamic finance cannot be compared with interest-based finance as they are totally different. According to the Malaysian Tax law, the gains paid to deposits on a Musharaka, or profit-and-loss-sharing accounts, will be deemed to be interest, and a tax of 5 per cent will be withheld.
Can the depositor offset such losses against his other income? Can he claim a negative withholding tax, in other words offset it against previous year’s tax withheld or claim a refund of tax?
It is clear from this that there is a mistaken idea that in Islamic banking, profit can be merely counted as interest. In other words, the law has failed to consider the true nature of Islamic banking and to provide for it. Similarly, for Mudaraba, or investment deposits, it is not clear whether the income, which belongs 100 per cent to the depositor, will be deemed to be interest and subject to a withholding tax of 5 per cent, or treated as business or investment income.
The following special cases have been exempted in the Malaysian Income Tax Act from withholding tax on interest: gains or profits (equivalent to interest) in respect of deposits up to RMIOOO placed with the Bank Islam Bhd; gains or profits in respect of monies deposited in an investment account (corresponding to interest from a fixed deposit account) for a period exceeding 12 months, with Bank Islam Malaysia Bhd; interest on savings deposits with Bank Simpanan Nasional (the national bank); finally, interest on fixed deposits placed for a period of 12 months or more with Bank Simpanan Nasional.
It would be simpler if uniform legislation were enacted for income on all Islamic deposit accounts. There is also a need to define Islamic financial institutions as well as banks.
If a bank or other financial institution, or an individual, extends a Sharia-based loan to a business in a Musharaka arrangement, is the share of the profits paid by the business to the lender to be treated as interest? Or as an allowable business expense, or even as a distribution of profits and therefore not claimable as a business expense?
Similarly, where a business obtains finance from a bank or other source on a Mudaraba basis, is the payment of the profit share to be treated as an expense or as profit? If a company issues a Sharia-based bond or convertible hand, is it to be treated, for tax purposes, as a share or as a debt instrument? If a business buys goods on a Mudaraba or Bai Muajjal basis, does it take the total amount as the cost of the goods (or sales), or does it separate out the profit and call it interest?
The developed countries of Europe, America and Australia have some very sophisticated systems of taxation. These systems are, however, interest-based and do not recognise Islamic finance or Islamic banking schemes. This naturally raises serious taxation issues for Islamic banks. How will Islamic institutions or Islamic transactions be taxed? And are they to be regarded as financing transactions or trading transactions?
There are no clear guide-lines to be followed in any of the above-mentioned countries and Islamic banks and financial institutions in those countries are in a precarious tax planning situation. There is an urgent need for them to analyse this problem together, formulate a joint strategy and commence dialogue with their respective governments and regulatory bodies with a view to getting Islamic banking and finance recognised in their countries.
The question arises as to whether it would be possible for an Islamic institution to present a case to the US government regulators, that for tax purposes, their transactions were interest-bearing transactions, while, at the same time, accepting the fact that, under the Sharia, this was not so.
It might be said that Islamic financial institutions cannot have it both ways. Yet the Islamic financial institutions operating in Western countries and, for that matter, in most of the countries of the world, have taken the following position. If the internal revenue or tax authorities in any country put forward the case that a certain kind of transaction is an interest-earning transaction and is therefore entitled to whatever tax benefits interest payments are entitled to in that country, that does not necessarily mean that a correctly Sharia-based transaction is really interest-based.
Equally, if a Sharia adviser or committee says that a particular contract is, under the Sharia, providing legitimate trading income, we need not won-y how the tax authorities regard it. Islamic banks must just make sure that they get the proper Sharia advice and approval for their contracts.
Similar taxation issues exist in the case of a full Islamic lease contract, where the risk and reward remain with the lessor. Should one capitalise the lease or not, treat it as an operating lease or a finance lease?
In the case of international banking and transactions based on trading, there may be further taxation problems. It has to be considered where the contract was signed, and where the goods changed hands. For instance, it would be a very complex situation if there were a transaction between a Malaysian investor and an American company, where the goods were in Hong Kong and the money changed hands in France!
Such situations have not yet been fully thought through. There is no simple solution such as setting up a company in a particular country, as there is no one country in the world where all these tax problems have been solved. If the Channel Islands was the best place for a particular transaction, it could not be assumed that it would be the best place for another type of transaction, even if it were 90 per cent the same. One small change in the tax law could change the whole situation.
It is agreed that while any step to eradicate interest is welcome, it is necessary to formalise the whole concept of Islamisation and to introduce tax reform to achieve that object. A piecemeal approach poses a danger that the need for reform will remain mere lip service.
In 1980, Pakistan embarked upon the Islamisation of its financial system. Major institutional changes were embarked upon as the Government pursued policies aimed at meeting its declared goal of Islamisation of the economy. These changes, basic in nature and far-reaching in scope, were designed to radically alter the working of the economy and to bring it in line with Islamic thinking and practice.
One of the most fundamental measures introduced by the government so far has been the decision to replace, in phases, the interest-based system of banking with the Islamic profit-and-loss-sharing (PLS) system. The last phase of the switch-over was completed in July 1985, when it was officially declared that the entire banking system had been transformed to a non-interest-based system.
Very limited research work has so far been undertaken on the impact of interest-free banking on various elements of the tax system. This is due mainly to the lack of co-ordinated effort and strategies for the implementation of Islamic banking in Pakistan.
One theoretical-cum-economic model developed by three Pakistani economists has attempted to highlight the probable impact of this basic shift in the financial system. This model is based on some simplified assumptions. However, it has indicated areas that need more research in order to formulate a package of policy prescriptions. The main findings of the research are summarised below.
The model shows that in the fixed interest (FI) system, the complete elimination or evasion of taxes is not possible. However, the inducement to evade taxes is higher in the profit-and-loss system. This is due to the obligation of entrepreneurs to pay a share of the profits to the financing institutions.
The proportion of profits going to the financial institution and the tendency to evade are positively correlated. That is, the higher the share the greater the inducement to under-declare profits. This also implies that as the exposure of firms to credit increases, the tendency to evade taxes also increases.
In the FI system, declaration of profits by firms is not influenced by changes in rates of taxes. However, according to the findings of the study, in the PLS system, tax rates and the declaration of profits are positively correlated. Hence, in the latter regime, an increase in tax rate may result in less evasion. As interest will become a part of the aggregate profits, these profits would be larger than in the FI system and therefore a higher tax rate will imply a disproportionately absolute increase in the penalty for concealment.
As a result of the implications mentioned above, firms may try to economise on the use of outside finance. This tendency is also strengthened by the fact that in the FI system, interest is deductible from the income of the firm as an element of the cost of production, whereas in the PLS system, it becomes a part of the taxable income.
To the extent that banks’ share in profits are linked to firms’ profitability, banks will have to decide whether to confine their lending to larger firms, which are more profitable but which have a higher tendency to under-declare profits, or to disperse their finance widely amongst smaller firms, which are less profitable but have a low tendency to under-declare profits.
The total tax yield in the PLS system will include normal income tax paid by firms and banks and penalties which companies would ordinarily have paid under the FI system, and additional tax revenue, if any, from banks on their share of the profit.
The four determinants of the aggregate tax yield in the PLS system were found to be: rates of taxes; extent of detection of evasion; penalties for evasion; and fourthly, the formula for sharing profits between firms and financing institutions.
Because of the uncertainties in the PLS system, the model concludes that the total impact of a shift to the PLS system on the aggregate tax yield is not very certain. Only if the probability of detection of evasion and the rates of penalties were higher might the total tax yield be higher than in the FI system.
As financing institutions have a high stake in the profits declared by firms, they have to make some arrangement to monitor the performance of the enterprise financed. They must also require them to keep prope r accounts. Effective monitoring will exercise a check on the tendency of firms to under-declare profit.
However, as monitoring is not a cost-free activity, banks will have to compare its costs against its benefits. In the case of large borrowers, banks may ask for representation on their Board of Directors. Although the borrowers have a greater inducement to conceal profit in this system, their need to borrow in subsequent periods will exercise a check on this tendency because credit will be disbursed on the basis of an expected rate of return, and not on the credit-worthiness of borrowers. On the whole, the monitoring activity of banks will supplement the detection efforts of the tax department.
There are several policy implications of the change of the financial system on the taxation system. Firstly, although the economic model discussed earlier postulates that the impact of an increase in tax rates on total tax yield in the PLS system is not certain, the issue should be given careful consideration.
After the implementation of the budgetary proposal of 1985-1986, Pakistan has become a relatively under-taxed country. Further, the model indicates a positive correlation between changes in tax rates and the tendency towards fuller declaration of profits in the PLS system. Hence, the advisability of an increase in tax rates in the PLS system is indicated.
Secondly, the maximum rate of monetary penalty in Pakistan for tax evasion, relatively speaking, is also not very high. Unlike the situation in many other countries, the possibility of imprisonment for concealment of income and evasion of taxes in Pakistan exists only on paper. On the other hand, the model has shown that in the PLS system, higher rates of penalties have the potential of increasing total tax receipts. Hence the advisability of examining higher penalties for concealment.
Thirdly, evaders’ names should be published regularly and promptly while honest tax payers should be rewarded through rebates.
Finally, professionals who help in the concealment of true income should be temporarily banned from continuing their practice while the auditing of profits of firms by chartered accountants of good repute should be encouraged.
In 1981, the Islamic Ideology Council of Pakistan gave the following recommendation to the Government. “The council wishes to stress that with a view to ensuring the success of the new banking system, it is of paramount importance that the Government should carry out a thorough reappraisal of the tax system, focusing in particular on the need for greatly simplifying the system of income tax.
“The need for this measure was earlier underscored by the council, when submitting its report on the introduction of Zakat, and it was pointed out in this context that proper collection of Zakat would be difficult to achieve so long as the income tax system was not simplified and made sufficiently easy for the assesses.
“Regrettably, however, this recommendation of the Council has yet to be put into effect. In submitting its present report, the Council wishes to express its deep concern in this regard once again, particularly in view of the fact that a thorough-going reform of the income tax system is a sine qua non for the success of an interest-free banking system.
“This is because under the new system, the income of the banks would depend upon the profits of the business firms that received financial assistance from them. If the existing system of income tax remains as it is, business firms will continue the malpractice of concealing their profits and maintaining multiple sets of accounts, which will deprive the banks of their concerns and thus adversely affect the earnings of the banks”.
Over thirteen years have elapsed and the Council’s recommendation on tax reforms to implement the Islamic banking system has not been acted upon by the Government.
Unlike Malaysia, Pakistan did not promulgate any over-riding legislation giving blanket coverage for a financial scheme that would put Sharia-based transactions at least on the same footing as similar interest-based transactions. Pakistan has instead incorporated interest-based schemes into the taxation law item by item.
This creates a constant problem, as there are many areas, particularly in the case of foreign finance and finance from non-banking entities or individuals, where Sharia-based transactions are not accorded the same treatment as similar interest-based transactions.
The twelve Islamic modes of finance introduced by the state are only partly accommodated in the Income Tax Ordinance, 1979. Subsequent amendments were made affecting leasing, interest and payment to depositors.
Leasing: any sum paid on or after the first day of July 1985 to a schedule bank, a financial institution or such Mudaraba or leasing company, as is approved by the Central Board of Revenue for the purposes of the Third Schedule, by way of lease money in respect of an asset taken on lease by the assesses and used for the purposes of any business or profession carried on by him.
Any interest paid in respect of capital borrowed by business or the professionals is deductible as a business expense. This means that any Islamic modes of finance such as Murabaha, and other forms of Bai Muajjil, Mudaraba or Musharaka, between banks and other companies, will not be allowed as a deductible expense, whereas interest on such types of transactions is an allowable expense.
Tax authorities have taken a liberal view of Islamic modes of financing declared by the State Bank and they have been allowing the payment to banks, deeming it interest. However, lately there has been a case where the amount payable to the Faysal Islamic Bank of Bahrain by a government agency for Murabaha was disallowed because it fell outside the purview of clauses 75-77A of the Second Schedule to the Income Tax Ordinance, 1979.
Clause 75 refers to any interest payable to a non-resident in respect of such private loan to be utilised on such project in Pakistan as may be approved by the Federal government for the purposes of this clause, having regard to the rate of interest and the terms of repayment of the loan and the nature of the project on which it is to be utilised.
Clause 76 refers to interest payable by an industrial undertaking in Pakistan, firstly on monies borrowed by it under a loan agreement, entered into with any such financial institution in a foreign country, as may be approved in this behalf by the Federal Government by a general or special order; and secondly on money borrowed or debts incurred by it in a foreign country, in respect of the purchase outside Pakistan of capital plant and machinery in any case where the loan or debt is approved by the Federal Government, having regard to its terms generally and in particular to the terms of its payment, from so much of the tax payable in respect thereof, as exceeds the tax or taxes on income paid in such interest in the foreign country, from which the loan emanated or in which the debt was incurred (hereinafter referred to as the ‘said country’).
Provided that, where the amount of such tax or taxes paid in the said country exceeds the amount of the tax payable in Pakistan, no refund of the amount paid in excess shall be allowed. If the said country exempts such interest or allows credit against its own tax, for the tax which would have been payable in Pakistan, if the said interest were liable to tax in Pakistan, no tax shall be payable in Pakistan in respect of such interest.
Clause 77 concerns income of an agency of a foreign Government, or other foreign national (company, firm or association of persons) approved by the Federal Government for the purposes of this clause, from interest paid on money borrowed by the Federal Government or by any other person in Pakistan under a loan agreement approved by the Federal Government.
Clause 77A concerns any interest payable to a non-resident being a foreign individual, company, firm or association of persons in respect of a foreign loan, as is utilised for industrial investment in Pakistan provided that the agreement for such loan is concluded on or after the first day of February 1991, and is duly registered with the State Bank of Pakistan.
With regard to payment to depositors, any sum paid or credited to any person maintaining a profit-and-loss-sharing account or deposit with a scheduled bank by way of distribution of profit by the bank in respect of the deposit is deductible as an expense by the Bank.
Pakistani tax laws do not fully provide for Islamic banking and most of the profit from banking transactions continues to be treated as interest. Th e Faysal Islamic Bank of Bahrain’s case is an example whereby, owing to a lack of specific definition, the tax authorities may hold that the profit from trading or investment transactions of Islamic banking products is not interest but trading income and therefore is not provided for in this tax law, a very precarious situation.
The conclusion can only be that more comprehensive work needs to be done on this subject. In almost all countries of the world. Islamic and non-Islamic, the income from Islamic banking products continues to be treated as interest and no provision is made for any losses suffered.
Until Islamic banking and finance is fully defined and a method of implementing changes in the tax laws world-wide is formulated, we shall continue to suffer mere piecemeal reforms. There is an urgent need for Islamic banks and institutions to formulate a joint plan to get Islamic finance recognised and fairly catered for by tax authorities world-wide.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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