Unfriendly tax laws stunt sukuk growth

Taxation is one of the critical areas that can hinder the progress of Islamic finance and this needs to change, says Malaysia’s RAM Ratings.

The implementation of "friendly" tax legislation and initiatives for sukuk is vital for the growth of Islamic finance but some countries still lag in this regard, according to Malaysia’s RAM Ratings.

This is either due to the complexity of legal documentation or lack of comprehension for sukuk instruments and structures, highlights the rating agency in a report released on March 10.

However, the eagerness shown by various countries including Japan in terms of attracting more investments and liquidity bodes well for the global Islamic finance market, according to RAM.

“The introduction of more tax incentives and the decision to abolish tax would add to the appeal of sukuk and provide a level playing field with its conventional counterparts,” wrote Zakariya Othman, head of Islamic ratings in the report. “Typically, this would lead to the respective countries opening a gateway for sukuk and Islamic finance.”

“Meanwhile, individual investors have the extra option of investing in a shariah-compliant vehicle that is competitively priced, knowing that equal taxation treatment has been granted,” he added.

In sukuk – and Islamic finance in a broad sense – the movement and transfer of assets are integral to the principles and concepts of most Islamic finance contracts as the shariah law prohibits the fixed or floating payment or acceptance of specific interest or fees.

As a result, the process of asset transfer will inevitably attract tax, which could then result in costlier Islamic finance transactions when compared to conventional bonds.

In such cases, there would also be some detailing of what taxes may be charged on the sale of these assets. For example, this may include local taxes or stamp duty or other documentary taxes, which will be linked to the value of the assets, says RAM Ratings.

Varying tax laws

Sukuk can be exposed to direct and indirect tax hurdles, depending on certain jurisdictions’ tax laws.

As a result, the fact that tax implementation may add extra cost to the transaction will inevitably hinder the growth of the sukuk market as the complexity of tax laws will make both issuers and investors more cautious, notes RAM Ratings.

“When it comes to taxation, certain terms and conditions need to be clarified,” wrote Othman. “For instance, the treatment and range of tax exposures need to be defined in terms of the nature of payment classification to the sukuk holders, where it may come in the form of dividends or profit payments plus the principal.”

“In addition, there will inevitably be issues even on the nature of the transactions – and whether it should be classified as an equity- or debt-based investment,” he added. “In relation to this, the legal documents accompanying the contract would have to be crystal clear to reflect the exact nature of the structure involved, and how the assets are transferred from one party to another.”

For Malaysia – the largest Islamic hub in the world, accounting for over 60% market share of shariah-compliant debt – the government has shown its determination to turn the Southeast Asian nation into a hub for Islamic financial services, as reflected in its tax-friendly legislation and initiatives for sukuk.

For example, the government has introduced measures to eliminate tax altogether and also offered additional tax incentives to both issuers and investors.

Such friendliness has led to the growth of Malaysia’s market with Moody’s noting strong Middle East and Asia participation in both the Malaysian ringgit and US dollars. Total issuance is likely to exceed $100 billion for the third year in a row if yields remain attractive for issuers, adds the rating agency in a report on February 5.

Ambank’s Islamic banking arm, AmIslamic Bank, on February 28 issued a RM200 million ($60.94 million) Basel III Tier 2 subordinated sukuk – Malaysia’s first ever. The note, with a maturity of 10 years and can be called at the end of five years, carries a semi-annual profit payment of 5.07% per annum.

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