Moving towards a tax level playing field for Islamic finance

The review of tax treatment of Islamic Finance products is one of the main tax recommendation of the Report on Australia as a Financial Centre.

One of the main tax recommendation of the Report on Australia as a Financial Centre prepared by the Australian Financial Centre Forum chaired by Mark Johnson (the Johnson report) was the review of the tax treatment of Islamic finance products to ensure parity of tax treatment with conventional finance products.

The Board of Taxation has been asked by the Federal Government to undertake a review to ensure that Australia’s tax laws do not inhibit the expansion of Islamic financing and investment products in the Australian market. The Board will provide its report and recommendations to the Assistant Treasurer by June 2011. The Board of Taxation recently issued a discussion paper seeking views on any tax impediments.

The Middle East and South East Asia Islamic region has emerged as a potential source of funding for Australian financial institutions and market for investment products offered through Australian intermediaries such as funds managers. The Islamic finance market has been experiencing rapid growth with funds flowing into global bond, managed funds and insurance markets.

Islamic finance and investment products are governed by certain Sharia law principles. This has created considerable uncertainty about the taxation consequences of various products offered to Islamic financiers and investors by Western or conventional issuers and counterparties. For example, Sharia law principles prohibit the payment of interest, require the sharing of profits and losses, require an underlying tangible asset, prohibit financing of certain industries such as gaming, alcohol and tobacco, and investments must be certified Sharia compliant.

The Australian tax consequences of Islamic financing and investment products that involve profit mark ups, or pre-agreed profit splits or that produce gains or profits that are not interest in legal form are uncertain. The Board of Taxation’s discussion paper includes several case studies using Islamic financial arrangements which highlight various uncertain Australian tax outcomes for issuers and investors.

These arrangements may be characterised as debt or equity for tax purposes. The existing regime for the taxation of financial arrangements generally applies to debt products and, in limited circumstances, to equity products. Certain timing elections may affect the timing of the recognition of gains and losses under this regime. Many of these elections require various conditions to be satisfied. If the arrangements are treated as hire purchase arrangements they may be taxed as a notional sale and loan with a component of the payments treated as a finance charge. If the arrangements involve cross border payments which include a finance charge or a profit component these may be subject to interest withholding tax. However, it is uncertain as to whether they would be able to qualify for the interest withholding tax exemption available for interest paid on conventional debentures and bonds issued in wholesale funding markets.

Where the arrangements involve the transfer of underlying tangible property the possible application of certain transaction related taxes such as capital gains tax, goods and services tax, stamp duty and land tax will need to be considered.

The Board of Taxation will need to consider whether it is possible to rely on an administrative response involving the issue of interpretative guidance by tax authorities on the application of existing tax law to Islamic products. This may not provide sufficient certainty for issuer and investors given the variation of products available in the market and the development of new products. It may be possible for amendments to be made to the existing tax law to address some of the uncertainties. This may, however, not go all the way. Therefore, the alternative may be the development of a legislative code which will cover the tax treatment of such products for both issuers and investors. This response would need to be consistent with the policy objective of ensuring that Islamic finance and investment products are treated in the same way as conventional economically equivalent products.