Sub-Saharan Africa is taking to Islamic finance in a big way, with many governments racing to amend or introduce new legal regimes. Governments, financiers and customers often neglect and ignore the potential tax issues in Islamic finance, but they can be complex and intriguing. And the tax solutions that some jurisdictions have set up in view of the challenges of Islamic finance mean that even non-Islamic finance transactions may fall within the regime and be taxed differently. Why is Islamic finance a challenge for taxation? What Islamic finance structures are commonly used? And what are the options for African governments?

Islamic finance involves using classical Shari’ah-compliant investment techniques and structures to create arrangements that work in a similar way to modern conventional finance. One key Shari’ah principle is to prohibit “riba”, which is generally viewed as a prohibition on interest or usury. Shari’ah law also forbids gambling or speculation and prevents financing for commodities such as alcohol and pork. It also prohibits elements of uncertainty in a transaction and is also invariably backed by an asset or commodity.

Why should Islamic finance pose a challenge for tax systems? One reason is that, while interest is prohibited, an Islamic finance structure can enable a financier to receive a return that is interest-like. Similarly, the customer under the arrangement can suffer an interest-like finance cost.

Some tax systems, like that of the United States, look at the economic substance of a transaction rather than its form and, therefore, may tax Shari’ah and non-Shari’ah compliant transactions in a similar way without significant difficulty.

However, systems such as those of the UK and many African countries that generally tax the form rather than the substance of a transaction, may not relieve or tax interest-equivalent amounts as interest. The financier may be subject to tax on its finance receipts in a different way to that of the conventional financier who has lent money at interest. The customer may not obtain relief for the finance that it pays to the financier. It is not just the financier and the customer who face uncertainty. Withholding taxes may not apply to the payment made by the customer to the financier, thus depriving a government of revenue.

Tawarruq

Tawarruq is a common Islamic finance structure. The Tawarruq structure is suitable where a customer needs liquidity.

The financier buys freely tradable Shari’ah-compliant commodity such as copper (gold and silver are regarded as currency and cannot be used) for, say, $90 million and on-sold to the customer on deferred terms for, say, $100 million. Although the practice varies from one Islamic financial institution to another, the customer will often appoint the financier as its agent to sell those commodities, which it does so at a cash price of $90. The result is the customer has obtained money today ($90 million), for more money to be paid tomorrow ($100 million).

Tax challenges

Tawarruq is a relatively simple structure, but illustrates many tax problems, for example, the direct tax position of the financier. The financier pays $90 million for goods, which it then on-sells for $100 million. It needs to ensure that it can deduct the $90 million cost of goods from the $100 million sale price. Issues include whether the transaction is on capital or trading account, whether the financier can get relief if the customer fails to pay all or some of the $100 million sale price, whether the profit (or loss) on the transaction can be set against losses (or profits) incurred on other transactions, and when the financier has to bring the profit on the transaction into account. These issues may involve a combination of legal, accounting and factual analysis.

From the point of view of the customer, the main tax issue is whether it gets relief for the “finance” element of the price it pays for the goods. It has purchased goods worth $90 million for $100 million. It may be difficult, without a specific tax regime, for the customer to get relief for the $10 million. This relief would not be guaranteed and may not be as useful to the customer as an equivalent deduction for interest.

Finally, there are also VAT and stamp duty issues on the supply of the goods. For example, if the goods are subject to stamp duty there may be three charges to stamp duty and, if subject to VAT, the broker, financier and customer may need to register for, charge and recover VAT on three supplies.

Tax reliefs

As a result of these issues, which would add difficulty and uncertainty to a Shari’ah-compliant transaction, the UK government introduced a regime to allow Shari’ah-compliant and traditional financings to be taxed in a similar way. It is called the “alternative finance regime” and is relevant where either or both of the financier and the customer are subject to UK corporation tax.

How does it apply to Tawarruq?

If certain conditions set out in the Corporation Tax Act 2009 are met, then the transaction between the financier and the customer will be treated as a loan for direct tax purposes. The amount of the loan will be the original cost of the asset for the financier and the payment made by the customer in excess of that amount is treated as interest for UK tax purposes. Broadly, the conditions are:

• arrangements are entered into between two people, one or both of whom are “financial institutions”; and
• under the arrangements:
(i) the first purchaser purchases an asset and sells it to the second purchaser;
(ii) the sale occurs immediately after the purchase or the first purchaser is a financial institution and the asset was previously purchased by the first purchaser for entering arrangements within the section;
(iii) all or part of the second purchase price is not required to be paid until a date later than that of the sale;
(iv) the second purchase price exceeds the first purchase price; and
(v) the excess equates, in substance, to the return on an investment of money at interest.

As can be seen, the conditions are not straightforward. A non-Shari’ah compliant arrangement may (intentionally or not) satisfy the conditions. A Shari’ah-compliant arrangement may fail to satisfy the conditions. For example, the difference between the purchase and resale prices may not be equivalent to the return on an investment of money at interest. The UK’s approach to taxing Shari’ah-compliant transactions has its critics, but practitioners have generally been encouraged by its willingness to engage with the issues, and the legislative framework generally works well.

Options for African governments seeking to introduce Islamic finance successfully
Ignoring potential tax issues is not an option. A change in the tax statutes will almost certainly be necessary, and the tax authority will need to devise and publish a policy to give certainty to financiers and customers alike. Without such a change, it is unlikely that Islamic finance will be able to flourish in a country.  
An African government introducing Islamic finance will need to consider several issues in determining the nature of its tax regime, including:
• whether it wishes for Islamic finance to be taxed in an identical way to non-Islamic finance;
• whether it wishes to legislate on a structure-by-structure basis (which is what the UK has done);
• whether it wishes explicitly to introduce Shari’ah concepts into the statutes (which is not what the UK has done);
• whether the regime should be optional, i.e. whether the parties must elect to be taxed under the Islamic finance regime even if they satisfy the conditions; and
• the extent to which there should be an anti-avoidance rule, preventing an abuse of the Islamic finance regime.

While African governments need to be aware of the challenges and time involved in introducing an Islamic finance tax regime, the UK statutory regime, although not perfect, provides an invaluable precedent.

Jeremy Cape, tax partner, Denton Wilde Sapte LLP and Sophie Radford, trainee, Denton Wilde Sapte LLP
jeremy.cape@dentonwildesapte.com
+44 (0)20 7320 3845

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