Taxation of Islamic Financial Instruments

TAXATION OF ISLAMIC FINANCIAL INSTRUMENTS

1. INTRODUCTION

In Malaysia, Islamic finance traces its history back to 1963, with the setting up of the Pilgrims Fund Board. This was a savings mechanism under which Malaysian Moslem set aside funds to cover the costs of performing the annual pilgrimage. These funds were in turn invested in syariah-compliance productive sectors of the economy with the objective to receive return uncontaminated by element of interest (riba ).

The first Islamic bank established in Malaysia was Bank Islam Malaysia Berhad (BIMB) which commenced operation on 1 st July 1983. BIMB carries out banking business similar to other commercial banks but are based on Syariah principles. In March 1993, in order to disseminate Islamic banking nationwide, the concept of Islamic window was introduced. This scheme allows conventional banking institutions to offer Islamic banking products and services using their existing infrastructure. On 1 st October 1997, a second Islamic bank in Malaysia, namely Bank Muamalat Malaysia Berhad commenced operations and carries out banking business similar to BIMB.

Currently, Malaysia has succeeded in implementing a dual banking system and has created a spill-over effect to the non-bank Islamic financial intermediaries which started to offer Islamic financial products and services. Besides financial institutions, non financial institutions also have adopted Islamic financing arrangement such as Islamic Securitization as an alternative to acquire fund for financing. All these financial Islamic instruments/products whether issued by Financial or Non Financial Institutions are to be approved by Syariah Council established by Security Commission or National Bank Of Malaysia.

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1.1 Malaysian Tax Legislation

1.1.1 In the context of banking and finance, the factor that distinguishes Islamic financing and conventional financing is the absence of interest-based transactions. Islamic financing transactions would have a ‘gain’ or ‘profit’ element instead of ‘interest’ element as in conventional financing transactions. Malaysian Income Tax Act (ITA) 1967 treats ‘gains’ or ‘profits’ in Islamic financing transactions to be similar to interest in conventional financing.

1.1.2 Under Section 2(7) ITA 1967, ‘gains’ or ‘profits’ received and expenses incurred, in lieu of interest, in transactions conducted in accordance with the Syariah principles are taxed in the same way as ‘interest’. Therefore, the taxability or deductibility of ‘gains’ or ‘profits’ would be similar to the treatment of ‘interest’ in conventional financing.

1.1.3 As ‘gains’ or ‘profits’ is treated as interest, it is an allowable expenses under paragraph 33(1)(b) ITA 1967 if funding has been used for business purposes or purchasing assets to generate income. It is treated as income that may be fall under subsection 4(a) {business income} or subsection 4(c){non business .income]. Similarly, all tax rules relating to ‘interest’, such as withholding tax and exemptions on ‘interest’ will equally apply on the ‘gains’ or ‘profit’.

1.14 Islamic financing transaction is not a debt-based transaction which the return is ‘interest’. Islamic financing transaction is a trade-based transaction which the return is ‘gain’ or ‘profit’. In order to facilitate financing in Islamic transaction, there will be an underlying transaction which the customer will sell an asset to an Islamic bank and repurchase the same asset or lease the same asset from the same Islamic bank. This underlying transaction would attract tax provision. This underlying transaction does not appear in conventional financing as in conventional financing, the bank will give loan to a customer and expect the customer to payback the loan plus interest.

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1.15 Subsection 2(8) ITA 1967 seeks to ignore the underlying transaction so that tax neutrality can be achieved in Islamic financing transaction. The sale of this under lying asset from the bank to customer is not a ‘true sale’ transaction. It is transacted to comply with the syariah principle. By using this section the Islamic bank will not be taxed twice on the profit from selling back the asset to the customer and on the ‘profit’ from the financing transaction.

1.16 Subsection 2(8) ITA is also applicable in the setting up of Special Purpose Vehicle to comply with Syariah Principle. The underlying asset transaction between originator and Special Purpose Vehicle (SPV) will be ignored for tax purposes. This special tax treatment is not applicable to the issuance of Asset Back/Based Securities in the Islamic Securitization.

1.2 Financing Operations & Tax Treatment

Financing operations adopted by Islamic banks and financial institutions are by no means new. They are only different from the traditional credit transactions undertaken by conventional banks and financial institutions. For example, Mudharabah is a type of investment trust or mutual fund and Musyarakah is a kind of joint venture which usually involves equity participation. Ijarah is leasing and Ijarah wa Iqtina is hire-purchase. All these modes of financing are recognized and undertaken by existing conventional banks and financial institutions.

1.2.1 Investment Financing

Investment financing is provided for a variety of profit-sharing arrangements. The concept of profit-sharing is fundamental to financing in Islamic banking. There are two types of profit-sharing arrangements adopted by Islamic banking and financial institutions.

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1.2.1 (a) Mudharabah

Mudharabah (trust financing) means a business in which a person participates with his money and another with his effort or skill or both of his effort and skill (entrepreneurship). The capital provider ( rab ul maal ) provides the entire funds and the Islamic banks and financial institutions ( mudarib ) supply the labour and management only. There is profit sharing between the capital provider and the entrepreneur.

The capital provider gets an agreed proportion of the profit actually realized but bears all the losses, if any. Losses sustained through negligence of the Islamic banks and financial institutions or breach of the terms of the agreement between the parties is borne by the Islamic banks and financial institutions. This mechanism can be seen in the operation of Mudharabah Current Accounts where the depositors will get their profit from the mobilized funds or it also can be seen in the unit trust activities or Real Estate Investment Trust (REIT)

The profit received or receivable by both capital provider and the entrepreneur are subjected to tax. The profit can be investment or business income in the hand of the capital provider depends on whether the person is merely investing his money or dealing in investment. Losses bear by the entrepreneur and the capital provider who deals in investment is tax deductible (except the fund is in the form of loan)

1.2.1(b) Musyarakah

Musyarakah (participation financing) is a form of joint venture or partnership for an agreed time under which both parties provide capital and either one or both may manage the business. The profits of the business are shared in a pre agreed ratio but losses, if any, are borne in proportion to the capital investment.

Although musyarakah is a form of joint venture or partnership, the parties are not taxed as partnership. They are taxed separately.

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Same as Mudharabah , profit from the participation financing will be taxed. This is similar to a loan syndication arrangement. Thus, the fundamental difference between Mudharabah and Musyarakah is that in the former, capital and monetary loss belongs to only capital provider whereas the latter, both capital and monetary loss are shared by the partners. Whether the profit is business or investment income depends on the fact of the cases. If both parties are banks, financial institutions or person dealing in investment then the profit is business income. Losses arises from business dealing is tax deductible.

1.2.2 Trade Financing

Trade financing generally consists of short-term placement of funds for trade purposes. The types of trade financing include cost-plus financing, lease financing and hire-purchase financing.

1.2.2(a) Bai bithamin Ajil / Bai Muajjal / Murabaha (cost-plus financing)

It involves the sale of goods at a mark-up price if payment by the purchaser is on a deferred basis. The financier arranges for the purchase of goods requested by the customer and sells them to him on the basis of cost plus agreed profit margin (mark-up) which can be paid lump sum or in installments over a specified time period. The mark-up element (profit) is a taxable income and tax deductible.

1.2.2(b) Ijarah (lease financing)

Customer will identify the good. The financier will acquire the good and lease the same good to the customer for fixed charge in term of leased rental payment by monthly installments. Legal ownership of the good still remains with the lessor (financier).The ownership of the leased good reverts to the lessee after a certain period. This is similar to financial lease as in conventional leasing. If the financier is carrying the business of leasing, Income Tax Leasing Regulation 1986 (ITLR) is applicable on the financier. The leased payment will be taxed in the hand of

The 5 th ATAIC Technical Conference - 67 MALAYSIA financier and is tax deductible (both principal and profit) for the lessee. The lessor is entitled for capital allowance on the leased asset.

Ijarah is adopted in some other Islamic financing (not only in leasing business) to comply with Syariah principle. If the financier is not carrying leasing business but adopts ijarah to raise the fund for business purposes, ITLR is not applicable.

1.2.2(c) Ijarah wa Iqtina (hire-purchase)

It is a mode of financing where the financier provides finance for the purchase of certain assets on the basis of an agreement under which the financier receives a payment of principal plus a share in nature of rental for the use of the assets. Legal ownership of the asset is transferred to the purchaser. This rental is a taxable income and similar to interest in the conventional hire purchase financing. Financier is not able to claim capital allowance.

2. FINANCING AND TRADING

Over the years Malaysian Islamic banking and financial institutions have operated as financiers as explained above. Some have argued that Islamic banking and financial institutions should operate more like traders as Kuwait Finance House and Al Rajhi Bank do in their home markets. The call to change the business operation is not new. Banking and religious scholars have raised concern that many of the retail banking facilities to credit cards and capital market products are mere duplication of the conventional products.

Malaysian financial products and services are Syariah compliant not Syariah based. With the participation of foreign Islamic banks in the Malaysian market and to compete with them, Malaysian banks will need to introduce new products and the banks must evolve to operate more like traders than lenders. Foreign Islamic banks like Kuwait Finance House and Al Rajhi Bank in their home markets actually buy/own products and sell to clients. These banks operate like a large supermarket offering cars, houses, electrical appliances and other consumer goods direct to

The 5 th ATAIC Technical Conference - 68 MALAYSIA their customers. As the banks face higher risk profile means that they make more returns.

3. TAX ISSUES

Taxation systems in Malaysia have developed over the years in a conventional financial environment’. Changes have been made to the tax law to accommodate the type of transactions undertaken in Islamic finance. Same as conventional financing, the law shall not tolerate to illegal tax planning. It is necessary for Islamic financiers to undertake careful and specific tax planning when implementing Islamic financial arrangements in Malaysia to ensure that they are within the tax law.

3.1 Ijarah Transaction (Islamic Lease)

Ijarah transactions are fundamentally financing transactions which incorporate leasing of an underlying asset in order to conform to Syariah principles. Most Islamic bank especially foreign Islamic banks provide banking facilities under Ijarah transaction. It is important to note that Ijarah for movable assets will trigger the application of the Income Tax Leasing Regulation 1986 (ITLR).

Under ITLR, the gross income from lease transactions shall be deemed as separate and distinct business source from other activities. In addition, the gross income which includes the capital portion of the lease will be subject to income tax. As gross lease income is taxed separately, there is a need to apportion common expenses including interest cost. This could increase the effective tax rate of the Islamic banks due to the apportionment formula being adopted. From Year Assessment 2006, interest expense has been excluded from common expenses with the intention to reduce the burden of tax on Islamic banks.

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3.2 Ijarah Transaction in Property Development Activities

Ijarah contract also can be used in financing property development activities. An Islamic bank can purchase a parcel of land and develop the land until it is completed. Then, rents the completed properties to any interested party and the interested party will make an undertaking or a promised that he will buy the property at the end of ijarah period with an agreed price. This sale and purchase agreement is not part of Ijarah contract. This transaction is called Al Ijarah Muntahia bit Tamleek.

Malaysia has issued Property Developer Income Tax Regulation 2006(PDITR). Since Islamic bank is not a developer, the issue is whether PDITR is applicable to Islamic bank. The rental income received from the property during the ijarah tenure is the funding income of the bank or merely rental income. Whether the rental income is taxed as funding income (interest) or rental income will not give any tax effect since all income for banking and financial institution is treated as one source.

3.3 Istisna (Manufacturing Contract) Transaction in Property Development Activities

Besides Ijarah contract, istisna contract also can be used in financing property development activities. The difference between ijarah and istisna is the latter is meant for properties which are under construction. Islamic bank will purchase a parcel of land and develop the land and will sell the properties under construction to any interested party. Should PDITR applicable to Islamic bank and should the profits on sale of the properties be taxed upfront or the profit will have to be apportioned according to the construction period because it is a funding transaction.

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3.4 Commodity Murabahah

Malaysia is establishing a new Islamic financial tool known as the Commodity Murabahah using crude palm oil (CPO) as the underlying commodity. The mechanisms using this type of transaction are as follows.

A customer wants to buy a machine valuing RM 100,000.00. To start this type of financing, an Islamic bank buys the CPO in a commodity market immediately paying, says RM 100,000.00 for it and transfers the ownership of the CPO to the customer at price of RM 105,000.00 payable in, say, 5 years time. The customer can then immediately sell the CPO in the same commodity market for a price of RM 100,000.00. This gives the customer cash equal to what the Islamic bank laid out to him, RM 100,000.00 and he has an obligation to pay the Islamic bank RM 105,000.00 in 5 years time. The extra RM 5,000.00 is the cost of the finance.

The principle issue under Malaysian tax law is that the customer may not be entitled to a tax deduction. The customer has purchased an amount of CPO at a price of RM 105,000.00 payable in 5 years time and sold that CPO for RM 100,000.00 with the price being payable immediately. Accordingly, the customer has suffered a loss of RM 5,000.00. Is this loss tax deductible? Unless the customer can argue under Malaysian tax law that he is trading in CPO, it will not be entitled to deduct RM 5,000.00 loss against his income.

3.5 Diminishing Musyarakah

This type of transaction often used by those who want to buy houses for owned occupation instead of using a conventional mortgage transaction. Diminishing musyarakah contract also can be used for the purchase of investment property.

Diminishing musyarakah is used when one party (eventual owner) wants to buy an asset, say a factory, but cannot settle the full selling price. For the first step, the bank buys, say 75% of the factory while the eventual owner buys the remaining

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25%. Under this type of contract, the eventual owner has immediate rights to sole occupation of the entire factory.

The eventual owner pays rent to the bank on the 75% of the property that he does not own. Then, over the tenure of the agreement, as well as paying the rent, the eventual owner will make additional payments to the bank to purchase additional part of the property. The bank will also have a put option to require the property to be purchased at specific time period.

The price for the additional part of the property will be stated in the diminishing musyarakah agreement. Any pricing method or formula can be used but the normal pricing mechanism will be as follows: i. The price is equal to the original cost to the bank. ii. The price is equal to the market value of each part of the property.

Referring to the above scenario, we would expect that the eventual owner to receive tax deduction for the rent he is paying to the bank. This rent is being paid to enable him to occupy the whole property even though he only owns 25% of the property.

With a thorough examination, tax deduction is not entirely certain as the eventual owner has the right to purchase the bank’s share of the property over a period of time by using the amount of rental paid.

If the purchase of the bank’s share is made at market value for the eventual owner to occupy the property, the rent is likely to be the same as the rent that is paid in conventional property rental transaction and is a tax deductible.

Different tax treatment will arise when the eventual owner is entitled to purchase the bank’s share of the property at a price equal to the original price paid by the bank. In this scenario, the rent paid by the eventual owner has two objectives: i. Entitlement to occupy the property

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ii. Preservation of the entitlement to purchase the property at the bank’s original cost

This preservation of the entitlement to purchase at original price appears to be a capital transaction which would not be tax deductible.

At the bank’s perspective, will the sale of the completed property and the rental of property be considered as separate business sources (financing business) and will the rental of property be seen as investment source.

3.6 Profit Equalisation Reserve (PER)

Islamic banks are required to have PER to reduce the fluctuation of dividend rates arising from the fluctuation of income generated, provisioning, total deposits etc and to ensure their competitiveness with conventional banking. PER is appropriated from gross income before arriving at the net distributable income. PER will be built up when a guaranteed rate of return is achieved and is written back when the guaranteed rate of return is not achieved. This is to meet the objective that the required rate of return to depositors can be achieved at all times. A question arises whether PER is an incurred liability or contingent liability in order to satisfy tax law.

3.7 Islamic Asset Back Securitization (IABS)

The difference between IABS and Islamic financing is that the sales of underlying asset in IABS represents true sale. This means the legal ownership is transferred to SPV. The originator will not entitle to capital allowance even though the asset is normally will still be used by the originator. SPV is set up to facilitate the securitization but does not carry on business.

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4. TAX INCENTIVES FOR ISLAMIC FINANCIAL INSTITUTIONS

Malaysian financial landscape is gradually changing with the participation of new international players. This paper looks at the incentives for Islamic banking sector and some of the important factors to be considered to ensure that investors would fully benefit from the incentives given by the Government of Malaysia.

4.1 Income Tax Exemption for Islamic Banking

Income tax exemption will be given for a period of 10 years from 2007 to 2016 for Islamic banks and Islamic banking units licensed under the Islamic Banking Act 1983 on income derived from Islamic banking business conducted in international currencies including transactions with Malaysian residents.

An Islamic bank refers to a new conditional license under Islamic Banking Act 1983 issued to foreign or local financial institutions to conduct a full range of Islamic banking business in international currencies. The new entities will be referred to as licensed International Islamic banks (IIB). Whereas, Islamic banking unit refers to Malaysian Islamic banks that are offering Islamic financial services to set up an International Currency Business Units (ICBU) within the institutions itself.

IIB and ICBU can carry out a wide range of Islamic banking business in international currencies such as commercial banking business, investment baking business and other banking business approved by Central Bank of Malaysia.

4.2 Tax Issues for Islamic Banking

There are some issues to be taken into account from a practical view point so that these IIBs or ICBUs of Islamic banks would fully benefit from the tax exemption. However, as far as IIBs are concerned, they primarily conduct transactions in international currencies and the issues below may not be that noticeable as compared to ICBUs within existing Islamic banks.

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4.2.1 ICBUs of Islamic banks can carry out a wide range of banking businesses. As the Islamic banks would carry out businesses in both local and international currencies, there will be a need for legislative framework to clearly define the scope of “banking business conducted in international currencies”. This will determine the type of income of the Islamic banks that would be exempted. Financial transactions and products evolve over time to meet to the changing need of the public. A good example for this issue is the treatment for banking transaction in dual currencies. Therefore, a clear legislation is needed to avoid dispute with the tax authorities.

4.2.2 ICBUs of Islamic banks would likely share common resources and assets with business activities of the Islamic banks carried out in local currency. This leads to the issue of allocation of common expenses and capital allowances to the businesses carried out in local and international currencies.

4.2.3 The income of the ICBUs of Islamic banks is exempt is at statutory income level. If the business in international currencies were in a loss, could such losses be utilized to offset income from the other business, and vice versa? In addition, would the losses be entitled to be carried forward to offset future income of the Islamic banks after the expiry of the 10 year exemption period?

4.3 Tax Exemption – Profit paid by Islamic Banks to Non- Residents

Profit paid by Islamic banks to non-resident customers will be exempted from tax. This is in lieu of interest income received from conventional banks.

4.4 Musyarakah Financing – Tax Neutrality

The definition of partnership in Malaysian Income Tax Act 1967 is to exclude any arrangement which is established under a scheme of financing in accordance with the Syariah principles. Therefore, no separate partnership tax return is required to be submitted to the tax authorities.

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5. SUKUK (ISLAMIC BOND / ISLAMIC SECURITIES)

Sukuk have become extremely important in Islamic finance. The objective of sukuk transaction is to give investors an undivided ownership share in the income flows from the assets, so that there is no debt obligation to them. Whereas, a conventional bond is a contractual debt obligation whereby the issuer is contractually obliged to pay to bond holders interest and principal. In short, sukuk are monetary denominated participation certificates of equal unit value to be issued to investors to represent their proportionate share in the ownership of the underlying assets and a pro rata share in the income generated by those assets.

Sukuk structures are developed based on the existing laws of a particular jurisdiction. However, the legal relationships are not about lending and borrowing but about sale, purchase, construction and investment which are operated under banking and securities laws. Therefore, it is extremely important to fine tune tax laws that govern sale, purchase, construction and investment. Besides any guidelines or orders issued, Section 2(7) and 2(8) of the Malaysian Income Tax Act 1967 have given the tax neutrality treatment in this aspect.

5.1 Tax Incentives for Sukuk Transaction

5.1.1 A deduction will be allowed until the year 2010 on expenses incurred on issuance of Islamic securities approved by the Securities Commission based on: (a) The principle of mudharabah, musyarakah, ijarah and istisna’ (b) Any other principle in accordance with the Syariah principle approved by the Minister

5.1.2 Tax exemption on income of a Malaysian resident Special Purpose Vehicle (SPV) established to ensure compliance with Syariah requirements for the issuance of Islamic Securities.

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5.1.3 The cost of issuance Islamic securities ( mudharabah, musyarakah, ijarah and istisna ’) incurred by the SPV can be claimed by the Malaysian resident company which establishes the SPV.

5.1.4 Remission of 20% of stamp duty imposed on principle or primary financing instruments made according to Syariah principles.

6. CONCLUSION

We should refrain ourselves from making a direct comparison between Islamic banking and conventional banking (apple to apple comparison). The key difference is that Islamic banking is based on Syariah foundation. Thus, all dealings, transactions, business approaches, product features, investment focus and responsibility are derived from Syariah laws which lead to the significant difference in many parts of the operations as of the conventional banking system.

The demand for Islamic banking and finance is growing and leads to the establishment of new banks and to a number of others offering Islamic products alongside conventional ones through windows in branches. The system of Islamic banking and finance is based on the principle on interest-free financing. As such it is different from the conventional banking system. Islamic banks must operate to the highest ethical and moral standards and this includes the principle of fairness to all. In turn, this leads to the practice of neither giving nor receiving interest. In addition, Islam states that there can be no gain without sharing in risk; therefore many deposit-like products have investment-like characteristics as depositor share not only in the profits but also the losses, either of the bank itself or of the SPV in which their funds are placed.

Malaysia has succeeded in implementing a dual banking system by having a full- fledged Islamic system operating side-by side with the conventional banking system. Nevertheless, there is an uphill task that lies ahead for the authorities. The challenge would be for the authorities to come up with a clear and administratively simple regulatory and supervisory framework within a short span of time and

The 5 th ATAIC Technical Conference - 77 MALAYSIA ensure that the frameworks achieve the Malaysian government’s intention of spurring the growth of the Islamic banking in Malaysia. To achieve this, nurturing human resources and the availability of proper training are essential to sustain the growth of Islamic banking in Malaysia. Lastly, Islamic banking business in Malaysia is not just about tax exemption. The uphill tasks for it is to define clearly the target segment, the products that can be delivered and the capability in delivering the products.

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THE 5 TH ATAIC TECHNICAL CONFERENCE

TOPIC III

TAX TREATMENTS ON SHARIA FINANCIAL INSTRUMENTS

Presentation

Prepared by:

MALAYSIA

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5TH ATAIC TECHNICAL CONFERENCE BALI, INDONESIA – 2008

PRESENTATION ON TAX TREATMENT ON ISLAMIC FINANCIAL INSTRUMENTS

PRESENTED BY

HALIJAH BT BULAT INLAND REVENUE BOARD MALAYSIA

History Of Islamic Banking In Malaysia :

1963 – Setting up the Pilgrims Fund Board Saving mechanism to perform pilgrimage Funds were invested in Syariah-compliance sector

1983 - Establishment of Bank Islam Malaysia Berhad (BIMB) First Islamic bank in Malaysia

1993 - Islamic window was introduced by the conventional banks Offer Islamic banking products & services

1997 - Establishment of Bank Muamalat Malaysia Berhad (BMMB) Second Islamic in Malaysia

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History Of Islamic Banking In Malaysia :

1963 – Setting up the Pilgrims Fund Board Saving mechanism to perform pilgrimage Funds were invested in Syariah-compliance sector

1983 - Establishment of Bank Islam Malaysia Berhad (BIMB) First Islamic bank in Malaysia

1993 - Islamic window was introduced by the conventional banks Offer Islamic banking products & services

1997 - Establishment of Bank Muamalat Malaysia Berhad (BMMB) Second Islamic in Malaysia

Banking Institutions In Malaysia

Islamic Banks (11) Kuwait Finance House (Malaysia) Berhad Saving & Development Financial Institutions (5) Al Rajhi Banking & Investment Corporation (Malaysia) Berhad Bank Simpanan Nasional Asian Finance Bank Berhad Bank Pembangunan Bank Islam Malaysia Berhad Bank Pertanian Bank Muamalat Malaysia Berhad SME Bank Affin Islamic Bank Berhad Bank Rakyat AmIslamic Bank Berhad CIMB Islamic Bank Berhad EONCAP Islamic Bank Berhad Hong Leong Islamic Bank Berhad RHB Islamic Bank Berhad

Islamic Windows (7) Citibank Berhad HSBC Bank Malaysia Berhad OCBC Bank Malaysia Berhad Standard Chartered Bank Malaysia Berhad Maybank Berhad Public Bank Berhad Alliance Bank Berhad

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Similar Treatment

Section 2(7) Income Tax Act (ITA) 1967;

Any reference in ITA 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 Syariah”

Interest is not allowed under Syariah principles, Islamic transactions would have a profit element

ITA treats profits similar to interest

Taxability or deductibility of profits would be similar to the treatment of interest in a conventional financing

Tax Neutrality

Section 2(8) Income Tax Act (ITA) 1967;

Any reference in ITA to the disposal of an asset or a lease shall : “ exclude any disposal of an asset or lease by or to a person pursuant to a scheme of Financing approved by Central Bank, Securities Commission or Labuan Offshore Financial Services Authority, as a scheme which is in accordance with the principles of Syariah where such disposal is strictly required for the purposes of complying with those principles but which will not required in any other schemes of financing ”

Section 2(8) ITA 1967 seeks to ignore the underlying asset transactions for tax purposes

Section 2(8) ITA 1967 allows Islamic financing to continue without any tax issues relating to assets transfer or lease

Applicable if transactions have been approved by the relevant authorities

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Conventional Financing Arrangement

(1) Pay principle & interest

(1) Obtain loan Customer Financiers

(2) Provide fund

Islamic Financing Arrangement

(4) Provide fund

(1) Sale of assets

Underlying disposal of asset & Customer repurchase of asset / lease Islamic Bank

(2) Asset repurchase / Ijarah (Lease)

(3) Pay Profit & Principle Section 2(7) ITA 1967 Profit similar to the treatment of interest

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Islamic Financing Arrangement

(4) Provide fund

(1) Sale of assets

Underlying disposal of asset & Customer repurchase of asset / lease Islamic Bank

(2) Asset repurchase / Ijarah (Lease)

(3) Pay Profit & Principle Section 2(8) ITA 1967 Ignore the underlying transaction

Islamic Financing Arrangement In Capital Market

(1) Provide fund

(1) Sukuk issuance (1) Sale of assets

Issuer Underlying disposal of asset & SPV Investors repurchase of asset / lease

(2) Asset repurchase / (2) Provide funds Ijarah (Lease)

(3) Return to investors

(2) Considerations / ijarah payments (3) Pay Profit & Principle Section 2(8) ITA 1967 Section 2(7) ITA 1967 Ignore the underlying transaction Profit similar to the treatment of interest

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Islamic Asset Back Securitization

(1) Provide fund

(1) Sukuk issuance (1) Sale of assets (true sale)

Issuer Underlying disposal of asset & SPV Investors repurchase of asset / lease

(2) Asset repurchase / (2) Provide funds Ijarah (Lease)

(3) Return to investors

(2) Considerations / ijarah payments (3) Pay Profit & Principle Section 2(8) ITA 1967 is not Section 2(7) ITA 1967 applicable Profit similar to the treatment of interest

Malaysian Islamic banking & capital market are structured under 2 main concepts:

A.Contract of Exchange - deferred sale (Bai Bithaman Ajil) - mark up sale (Murabahah) - leasing (Ijarah) - sale & buy back (Bai Inah) - progressive sale (Istisna)

B. Contract of Participation - trust partnership (Mudarabah) - partnership (Musyarakah)

Bai Inah & Bai Bithaman Ajil are used for cash line facilities & credit card

Bai Bithaman Ajil is used extensively in consumer financing of houses & cars in Malaysia

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The rise of foreign Islamic Institutions in the Malaysian banking landscape :

1. Kuwait Finance House (Malaysia) Berhad (KFH) – Kuwait based

2. Al Rajhi Banking & Investment Corporation (Malaysia) Berhad (ARB) - Kingdom of Saudi Arabia based

3. Asian Finance Bank Berhad (AFB) – Qatar based

Change Business Model

- until today, Malaysian Islamic banking institutions have operated as ‘financiers’ but pure Islamic banks should operate more like ‘traders’ as KFH & ARB do in their home markets.

- foreign Islamic banks like KFH & ARB actually buy/own products and sell to clients

- these banks operate like a large supermarket offering cars, houses, electrical appliances & other consumer goods direct to customer

- the banks higher risk profile means they make more return

- by going to manufacturers, pure Islamic banks get products at cheaper prices & then mark up the price & sell to potential customers

- for property projects, the banks become the owners or joint venture partners & taking active participation in the development of the project or sometimes hiring the contractors & suppliers & selling the properties themselves 14

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Change Business Model

- the bank then provide financing which is another source of income.

- making more money than the Malaysian Islamic business model approach.

- Malaysian Islamic banks may have to change their business model to remain competitive?

- operating like pure Islamic banks will help Malaysia to become a regional Islamic financial centre & products & services gain universal acceptance.

TAX ISSUES

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Acquisition & holding of vehicles as inventory

Islamic Bank Customer ijarah Purchase vehicles & hold as inventory

Sell or lease motor vehicles Issues :

Ijarah transaction be treated SAME AS lease transaction i. Apportionment of Cost: Gross income from lease deemed as separate & distinct business source ii. Deemed as sale transaction: option to purchase the asset at the end of the lease 17

Issues :

Ijarah transaction be treated SAME AS lease transaction

Apportionment of Cost: Gross income from lease deemed as separate & distinct business source

Consideration :

Ijarah transaction by Islamic bank - financing income if ijarah is adopted to comply with Syariah principles. - Ijarah is part of leasing business ref: Income Tax Leasing Regulation 1986 – separate & distinct business source)

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Issues :

Ijarah transaction be treated SAME AS lease transaction ii. Deemed as sale transaction : option to purchase the asset at the end of the lease

Islamic banks will be taxed upfront even though funding income & cash flow is received periodically when customer makes lease payments.

Example : Ijarah tenure : 5 years ( Yr. 2006 to 2010) Cost of asset : RM 100,000.00 Profit : RM 25,000.00 (5 % per year) Lease transaction contracted with customer : RM 125,000.00 Yearly payment received : RM 25,000.00 (Cost : RM 20,000.00 & Profit : RM 5,000.00)

Tax upfront : RM 25,000.00 as it is the profit in Yr. 2006 because it is deemed as sale transaction

Property development activities

Islamic Bank Customer Istisna

Purchase land

Develop land

Sell or lease properties to locals & foreigners

Uncompleted properties, the bank & the customer enter into istisna contract.

The 5 th ATAIC Technical Conference - 89 MALAYSIA

Issues [uncompleted properties & istisna contract] : i. as the Islamic bank sell the asset under construction to customer, profit has been determined upfront or ii. revenue recognized either through percentage of completion method or completed contract method

COMMODITY MURABAHA OR TAWARRUQ

The 5 th ATAIC Technical Conference - 90 MALAYSIA

Central Bank of Malaysia Securities Commission Bursa Malaysia ( Stock Exchange)

3 Foreign-owned banking institutions •Kuwait Finance House (Malaysia) Berhad •Al Rajhi Banking & Investment Corporation (Malaysia) Berhad •Asian Finance Bank Berhad

5 Local banks. •Bank Muamalat Malaysia Berhad •Bank Islam Malaysia Berhad •RHB Islamic Bank •CIMB Islamic Bank •EONCap Islamic Bank

Sale for deferred payment (RM 105) Islamic Bank Customer

Sale for immediate Sale for immediate payment (RM 100) payment (Sale RM 100) (Cost RM 105)

Commodity Seller Commodity Seller

Using Crude Palm Oil (CPO) as the underlying commodity

The 5 th ATAIC Technical Conference - 91 MALAYSIA

Diminishing Musyarakah

Payment to Payment to Increase ownership vendor for 75% Payment to Islamic Bank Eventual Owner vendor for 25%

Rent on Islamic Bank’s 75% share (diminishing)

75% share; 25% ownership share; DIMINISHING INCREASING Sole Occupier

Asset

The 5 th ATAIC Technical Conference - 92 MALAYSIA

Ratio RM 75k RM 25k Yr. 0 75 : 25 Yr. 1 RM 7.5k 67.5 : 32.5 RM 15k Yr. 2 60 : 40 Yr. 3 RM 22.5k 52.5 : 32.5

Yr. 4 RM 30k 45 : 55

Yr. 5 RM 37.5k 37.5 : 62.5 RM 45k Yr. 6 30 : 70 Yr. 7 RM 52.5k 22.5 : 77.5 Yr. 8 RM 60k 15 : 85

Yr. 9 RM 67.5k 7.5 : 92.5

Yr. 10 RM 75k 0 : 100

Contribution Ratio (RM 7.5k per year)

Scenario 1: Payment to occupy the property (no arrangement for the tenant to purchase the property) Equivalent to rental expenses = tax deductible

Scenario 2: Payment to occupy the property and preservation of the entitlement to purchase Capital transaction ?

The 5 th ATAIC Technical Conference - 93 MALAYSIA

Profit Equalisation Reserve (PER)

- primarily to support the application of mudharabah (profit sharing) contract in the Islamic banking institution (IBI) deposit taking activities.

- conventional banking is based on ‘lender-borrower’ relationship, the mudharabah (profit sharing) contract is based on ‘investor-entrepreneur’ relationship. (depositors assume the role of the capital provider while the IBI assume the role of the entrepreneurs)

- the depositors’ fund are utilised for the financing, investment & trading activities undertaken by the IBI & the profit generated from these activities are shared between the depositors & the IBI based on the PSR.

- any losses will be borne solely by depositors unless it is proven that the loss is due to the negligence of the IBI.

The 5 th ATAIC Technical Conference - 94 MALAYSIA

- IBI may be under market pressure (fluctuation of profit rate, provisioning & total Mudarabah deposits) to pay a return that exceeds the rate that has been earned on assets financed by Investment Account Holder when the return on assets is under performing as compared with competitors’ rate (conventional banks).

- mechanism to enable the IBI to mitigate the undesirable fluctuations of income & to to remain competitive, particularly in terms of Islamic deposit rates offered to the depositors.

- PER refers to the amount appropriated by the IBI out of the total gross income, before distributing to the depositors, in order to maintain a certain level of return for the depositors.

Income Statement Presentation : ‘000 Income derived from investment of depositors’ fund & others 53,751 Income derived from investment of shareholders’ fund 7,815 Allowances for losses on financing, advances & other loans 242 Profit Equalisation Reserve (PER) ------ (1,622) Total distributable income 60,186 Income attributable to depositors (32,574) Total net income 27,612 Personnel expenses (3,262) Other overhead & expenditures (20,800) Profit/(loss) before zakat & taxation 3,550 Zakat (20) Taxation (1,610) Net profit / (loss) for the financial year 1,920

The 5 th ATAIC Technical Conference - 95 MALAYSIA

Question :

PER : Incurred Liability or Contingent Liability ?

To reduce mismatch in the accounting profit & tax adjusted income, PER should be given a tax deduction : whether this reason acceptable?

Tax Incentives for Islamic Financial Institutions

The 5 th ATAIC Technical Conference - 96 MALAYSIA

Income Tax Exemption For Islamic Banking

Islamic Bank

International Currency Business Unit (ICBU) Income Tax Exemption Conventional bank For 10 years (Islamic banking business) (2007-2016) International Islamic Bank (IIB)

Note : This Incentive also be given to Takaful Operators

Current issues :

1. Meaning of “banking business conducted in international currencies” - banking business in dual currencies (meet the definition?)

2. Allocation of common expenses and capital allowances to the businesses carried out in local & international currencies. (separate account)

3. Losses : can it be utilized for other business & can it be carry forward to offset future income after the expiry of exemption period.

The 5 th ATAIC Technical Conference - 97 MALAYSIA

Other Incentives :

Tax exemption on profit paid by Islamic Banks to Non-Residents (equivalent to interest from conventional banks) with effect 2 nd September 2006

Musyarakah financing will not be taxed as a partnership in Malaysian tax law (exclude any association which is established pursuant to a scheme of financing in accordance with the principles of Syariah)

Tax Incentives for Sukuk Transaction

The 5 th ATAIC Technical Conference - 98 MALAYSIA

A deduction will be allowed until the year 2010 on expenses incurred on issuance of Islamic securities approved by the Securities Commission based on: (a) the principle of mudharabah, musyarakah, ijarah and istisna’ (b) any other principle in accordance with the Syariah principle approved by the Minister

Tax exemption on income of a Malaysian resident Special Purpose Vehicle (SPV) established to ensure compliance with Syariah requirements for the issuance of Islamic Securities.

The cost of issuance Islamic securities (mudharabah, musyarakah, ijarah and istisna’) incurred by the SPV can be claimed by the Malaysian resident company which establishes the SPV.

Remission of 20% of stamp duty imposed on principle or primary financing instruments made according to Syariah principles.

Conclusion :

Do not make a direct comparison between Islamic banking & conventional banking

Clear and administratively simple regulatory and supervisory framework

Develop human capital in Islamic finance

The 5 th ATAIC Technical Conference - 99 MALAYSIA

Thank you.

The 5 th ATAIC Technical Conference - 100 MALAYSIA

THE 5 TH ATAIC TECHNICAL CONFERENCE

TOPIC III

TAX TREATMENTS ON SHARIA FINANCIAL INSTRUMENTS

Working Paper

Prepared by:

SUDAN

The 5 th ATAIC Technical Conference - 101 SUDAN

TAX TREATMENTS ON SHARIA FINANCIAL INSTRUMENT

INTRODUCTION

Generally speaking, the financial systems in most of the Islamic countries can be classified under major categories; the Islamic financial system, the conventional financial system, and the dual financial system (where both the Islamic and conventional ones coexist).

The Difference between Islamic Finance and Islamic Financial System

As far as the Sharia financial instruments are concerned, it would be worthful to distinguish between two concepts that are being used interchangeably. The first concept is the Islamic financial, while the second one is the Islamic financial system. The former concepts (i.e. Islamic finance) was being practiced predominantly in some Moslem countries throughout the middle ages, while the latter one is a relatively new concept which came to existence in the 20 th century.

Although Islamic Financial System started as an idea only in the early 1960s, it has grown since then and fledged as a world-wide financial system. According to year 2003 statistics by the General Council for Islamic Banks and Financial institution of Bahrain, there are more than 250 financial institutions in over 50 countries involved in Islamic Financial system, with annual growth rate of 15% and market share around U$300 billion. The core principles of this Islamic financial system are; potential capital, forbidden of speculative behavior sanctity of contracts, and Sharia approved activities.

Both the Islamic finance and financial system in Sudan traces their history back to the very beginning of the 1977 when Islamic banking commenced with establishment of Faisal Islamic Bank (with initiative of Sudanese and Saudi founders along with other nationals of Islamic countries. However, the bank

The 5 th ATAIC Technical Conference - 102 SUDAN commenced its operations in May 1978 with the objective of conducting all forms of banking and financial activities disseminated all-over Sudan, dealing in different types of financial instrument under either the profit and loss sharing mechanism (PLS) (i.e. Mudaraba and Musharaka) or the fixed return for the financier (e.g. Murabaha, Bai Al salam, Ijara, Istisna and their parallel, etc).

The juristic-based understanding for forbidding usury (i.e. Riba), stands on the point that Islamic finance has to be "asset-based” (i.e. no rented money). As Holy Quran says :"Those who devour usury, (Riba), will not stand except as stands one who the Evil One by his touch has driven to madness, that is because they say: Trade is like usury, but God has permitted trade and forbidden usury" (2.275).

Pertaining to the Sudanese financial system, we are going to review some types of financial instrument.

Mudaraba (Trust Financing)

It is an investment contract in which the Islamic bank (investor) provides all the capital and the investment manager (entrepreneur) carries out the investment activities in a specific project or trade for a defined period profit is shared on the basis of a pre-agreed ration and the loss is borne by the bank in the case of no negligence or violation by the partner to the terns and conditions of the contract.

Musharakah (Partnership)

The bank enters into a partnership contract with another party in existing or new investment project or in the ownership of an asset. Each party provides some amount and entitled to participate in management-profit is shared among partners in a pre-agreed ratio while losses are borne pro-rata.

The 5 th ATAIC Technical Conference - 103 SUDAN

Murabaha (Cost-plus financing)

This is a sale contract in which an Islamic bank first purchases good from an independent supplier and acquire a valid little and possession thereof. Goods are then sold by the bank to the clients at an agreed differed price which includes the bank profit.

Bai Al Salam (Advance Payment)

A contract in which the bank (the buyer) pays upfront a price for the purchase of goods from the customer and the commodity is to be delivered to the by at a specified future date.

Ijara (Leasing)

It is a contract in which the bank purchase an asset and leases the same asset to the customer at a pre-agreed lease rent on a financial leas basis whereby upon successful completion of the term, the asset title is transferred to the customer.

Istisna (Forward sale of and asset)

It is a sale contract whereby the bank sells non-existing asset to the customer, which is required to be built and delivered on a future date by the bank as per the customer's specifications. The sale price and terms are pre-agreed, which includes the bank's profit.

THE IDENTIFICATION OF SHARIA FINANCIAL INSTRUMENT RELATING TO TAX ISSUES

Unlike the conventional financial and banking system, the Islamic system treats the Sharia financial instruments as modes of finance and investment, therefore, the profit is determined ex-post, which symbolize successful entrepreneurship and

The 5 th ATAIC Technical Conference - 104 SUDAN creation of additional wealth, whereas in the conventional system interest, determined ex-ante, is a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are losses. Therefore the Sudanese Income Tax Act does not tax those financial instruments as transactions or modes of finance (i.e. raising funds). But letter on, upon fruitful business outcomes, the profit of each partner may be taxed along with his other income. (i.e. it is similar to Iranian System).

Pertaining to other types of Sudanese taxes, it would be better off if we mention how both the Value Added Tax Act (VAT) and the Stamp Duties Act deal with the financial instruments. However, according to provision of the VAT Act, 1999, all financial services have been exempted from VAT (i.e. financial services rendered by the banks, companies of funds, financial funds, and sales of shares, bonds and stocks).

Concerning the Stamp Duties Acts, the financial instruments shall be taxed in a percentage manner by 0.5% of the principle amount.

THE MOVEMENT FROM ISLAMIC FINANCIAL SYSTEM TO A DUAL FINANCIAL SYSTEM

The financial system in Sudan, up-to- year 2005, was completely being ruled by Sharia laws (i.e. no usurious financial transactions). However, the signing of Comprehensive Peace Agreement (CPA) necessitates the movement from a purely Islamic financial system to a dual financial one. As a result, the Islamic financial system prevails in Northern Sudan while the conventional financial system has been introduced in the Southern part of the country. This compelled most of the Islamic bank to withdraw from the Southern Sudan, paving the way for other conventional banks (i.e. Nile Bank).

The CPA has entitled Southern Sudan to have its own tax laws and regulations, but still the same tax laws and regulation rules both the Islamic financial system in the North and the conventional one in the South.

The 5 th ATAIC Technical Conference - 105 SUDAN

The stamp duty proceeds levied from the conventional banking system in south Sudan on financial instrument is insignificant figure that spent locally.

MONITORING AND AUDITS OF SHARIA FINANCIAL INSTRUMENT

All banks and financial instruments have tax files with tax authorities. Depending on the nature of the withholding tax of the stamp duty, these institutions have to pay the stamp duty proceed on monthly-basis. Over and above, the tax authorities always send seasonal auditing teams to check that stamp duties are levied correctly and accurately.

THE HARMONIZATION OF SHARIA TAX TREATMENT WITH EXISTING LAWS AND REGULATIONS

One of the most controversial issues that have been raised recently among the Sudanese taxpayers on one hand, and tax officials on the other hand, is the imposition of stamp duties as percentage of the concerned transaction. The taxpayers suspect that rate is assumed to be of a usurious nature since it is similar to profit realized from transaction, while the tax officials says that most Islamic countries resort to stamp duties for its easy calculation. Therefore this issue found an obvious cause for concern in the recommendations of tax reforms committees, 2006.

As the core principles of Islamic finance are concerned, the Sudanese Islamic financial system in the North is restricted to those concepts.

CONCLUSION

This paper elaborates the major Islamic financial instruments prevailing in Sudan, and how they relate to Sudanese tax laws and regulations (i.e. income tax, value added tax, and stamp duty).

The 5 th ATAIC Technical Conference - 106 SUDAN

The paper also reviews how the Islamic financial system ruled the financial transactions in Sudan up to year 2005, when the conventional financial system introduced in the southern part of the country.

The paper also highlights some controversial points concerning the way-how the Sharia financial instruments and taxed (i.e. stamp duty). In addition to, the paper shows that financial instruments, as transactions and finance modes, are exempted from both the income tax and VAT.

The 5 th ATAIC Technical Conference - 107 SUDAN

THE 5 TH ATAIC TECHNICAL CONFERENCE

TOPIC III

TAX TREATMENTS ON SHARIA FINANCIAL INSTRUMENTS

Presentation

Prepared by:

SUDAN

The 5 th ATAIC Technical Conference - 108 SUDAN

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0 The major classification of financial systems. The difference between Islamic finance and Islamic financial system. Islamic financial started in the early 1960s. The core principles of Islamic financial system. Both Islamic finance and financial system trace their history back to the establishment of Faisal Islamic Bank, in 1977.

The 5 th ATAIC Technical Conference - 109 SUDAN

The Sudanese Islamic financial system is working under either profit & loss sharing mechanism (PLS) (e.g. Mudaraba & Musharaka) or Fixed return for the financier mechanism (e.g. Murabaha & Ijara, etc). The juristic-based understanding for forbidding usury (i.e. Riba), stands on the concept that Islamic finance has to be asset-based.

1% 0

Under PLS mechanism. Mudaraba (Trust financing). Musharaka (Partnership). Under FRF mechanism. Murabaha (Cosi-plus finance) Bai Alsalam (Advance Payment). I gara (leasing). Istisna (forward sale of an asset).

The 5 th ATAIC Technical Conference - 110 SUDAN

2 0 The financial system treats these instrument as modes of finance & investment. In the convential system, the interest rate is the cost of finance. The Sudanese Income Tax Act does not tax those instruments. The VAT act exempted them as a part of financial services. The stamp duty is levied at a rate of 0.5% of the principle amount.

3 1 0 The signing of CPA necessitated the introduction of a convential system in the southern Sudan. The CPA entitled the south of Sudan to have its own law & regulations.

The 5 th ATAIC Technical Conference - 111 SUDAN

4 5 6 5 2 6 0

Some controversial issues among Sudanese taxpayers and tax officials. The recommendations of tax reforms committees, 2006. The financial system in the north, is restricted to the core principles of Islamic finance.

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The major Islamic financial instruments in Sudan and how they are taxed. The movement from a pure Islamic to a dual financial system. The controversial points about the way they are taxed.

The recent financial crisis and its effects upon the Sudanese Islamic financial system.

The 5 th ATAIC Technical Conference - 112 SUDAN

THE 5 TH ATAIC TECHNICAL CONFERENCE

TOPIC III

TAX TREATMENTS ON SHARIA FINANCIAL INSTRUMENTS

PRESENTATION

Prepared by:

TURKEY

The 5 th ATAIC Technical Conference - 113 TURKEY

INSTRUMENTS OF PARTICIPATION BANKING IN TURKEY (INTEREST-FREE BANKING) AND TAXATION

Timur ÇAKMAK Turkish Revenue Administration Head of Department (EU & Foreign Relations)

INTEREST-FREE BANKING IN TURKEY/HISTORY

Historical backround of interest-free banking, which is based on profit and loss sharing, is very old.

But, requirement of interest-free banking in the modern meaning has arisen because of industrialization improvements of Islamic countries in 20th century and boom in 70s of petroleum prices.

The most important model of interest-free banking is Islamic Development Bank in which also Turkey has a membership. Turkey has also a permanent member at the chamber of this Bank.

The 5 th ATAIC Technical Conference - 114 TURKEY

INTEREST-FREE BANKING IN TURKEY/HISTORY

Savings could be invested interest-free in the Special Finance Institution (SFI) by decree No.83/756 at16.12.1983

Special finance institutions has been covered by the Bankings Law with the Law No.4491 dated 19.12.1999

By the application of Special Finance Institutions; It is targeted to encourage the low amounted private savings in Turkey especially to bring unemployed money (because of the islamic rules) in economy.

In that time, the rate of persons who hadn’t deposited into classical banks by reason of islamic principles was %15.

Source: “PIAR Banking Paper” Kuveyt Türk, www.kuveytturk.com.tr) 3

INTEREST-FREE BANKING IN TURKEY/HISTORY After publishing decree numbered 83/7506 concerning to the establishment of special financial institutions and additional communique, six private financial institutions have been established in Turkey since 1985. With the Law of Banking numbered 5411 that was put into effect in 01/11/2005, the title “Special Financial Institution” has been changed into “Participation Bank” and for the first time these institutions have obtained the title “Bank”. Participation Banks have been considered of equal statue with Deposit Banks within the Law of Banking in terms of legislation. In the scope of this law, the term of banks include deposit banks, participation banks and development and investment banks. By today, there are four participation banks having operations in Turkey 4

The 5 th ATAIC Technical Conference - 115 TURKEY

INTEREST-FREE BANKING IN TURKEY/HISTORY

Participation Banks are established based on the decision of Council of Ministers, have operations in accordance with the Banking Law and undertake significant functions in order to bring the unemployed money into economy for 25 years.

Participation banks that are in the form of Venture Capital Institution, provide serious contributions to the economy by using the unemployed funds (under pillow money) for collecting in the supply of raw materials, semi-manufactures,manufactures and investment goods which are needed directly by Turkish industrialists and entrepreneurs.

INTEREST-FREE BANKING IN TURKEY AND WORLD Worldwide amount of Savings at Interest- Free Banking reached to 300 billion $ Kuwait 22% Rank on the system of Egypt interest-free banking at 17% some countries

Malaysia 11,00% Bahrain 8,40%

Turkey 3,65%

Source : Union of Turkey Participation Banks, “Participation Banks in Turkey Finance System”, www.tkbb.org.tr 6

The 5 th ATAIC Technical Conference - 116 TURKEY

Main Financial Numbers of Participation Banks (USD) (31.03.2008) General Sum General Sum (March 2008) (December 2007) Change (%) Financial Topics Quantity Quantity Turkish Money 10.649.802.000 9.532.566.000 12 Foreign Money 9.186.962.400 8.399.119.200 9 Collected Funds SUM 19.776.764.400 17.931.685.200 10 USED FUNDS 20.768.017.200 18.399.528.000 13 CREDITS TO BE LIQUIDATED (NET) 309.882.000 277.108.800 12 TOTAL ASSETS 25.785.564.000 23.322.098.400 11 NET ASSETS 2.943.933.800 2.836.573.200 4 NET PROFIT 146.114.400 122.688.000 19 THE NUMBER OF PERSONNEL 9898 9215 7 THE NUMBER OF BRANCHES 441 422 5 * The number of net profit has been compared with March 2007. (1 YTL=1.2 $)

Source: Turkish Financial Participation Bank “ The Vision of Participation Banking”,www.albarakaturk.com.tr 7

Methods of Interest-free Banks For Collecting Fund In Turkey

1- Private Current Accounts: These are accounts that can be drawn out partly or completely when it is required and are not paid any return to account holder and are subscribed payment of capital.

2- Participation Accounts: These are the accounts that give the results of sharing profit or loss which occured while yielding the fund,are not paid any previously identified return to account holder and are not guarenteed to pay the money back.

The 5 th ATAIC Technical Conference - 117 TURKEY

INSTRUMENTS OF INTEREST-FREE BANKING 1) MURABAHA A)Institutional Financial Support Sums of any commodities, real estate or immovable properties and service participation needed by the company (Credit Customer) are paid to the seller by the partcipation bank on the behalf of the company and the company is charged with those sums in return. It’s to meet the demand for the capital.It’s been implemented as institutional financial support since 1985 in Turkey.

B)Personal Financial Support Sums of goods or services directly purchased for personal needs such as vehicles,dwellings are paid to the seller by the Participation Bank on behalf of the customer and the customer is charged in return.

C)Financing the securities of the commodity It’s to provide funds for securities representing the goods under the foreign trade and stock exchange legislation.

INSTRUMENTS OF INTEREST-FREE BANKING 1- Murabaha and Taxation

De ds Participation ma oo er nd g m fo or to r t f s Bank 1 G Pu en Cu Pa o rc m y ym od ha ay b 0 e s se P ed 10 4 nt o ed $ fo f e $ r G N 11 oo 2 0 ds

Delivery to Customer Seller Customer 3

Taxation When the bank pays 100 $ for the goods which is bought from seller, gets 110 $ from customer. The difference will be taxed as bussines profit for the banks

The 5 th ATAIC Technical Conference - 118 TURKEY

INSTRUMENTS OF INTEREST-FREE BANKING 2) IJARA (Financial Leasing) Movables and immovables are provided and leased by the participation bank under the financial leasing law Payment of Leasing(6) Bank

Purchase of Payment for the Contracting the commodities(3) Customer sum of the leasing (2) commodities(4) The selection of commodities (1)

Seller The delivery of commodities(5)

Taxation Banks get income for the movables or immovables which they leased.The leasing contracts and the guarantees for these contracts are exempted from all kind of tax,levies and charges.The VAT rate is applied on leased equipments which they are subject to. Besides,the profit shares paid under the leasing cost might be indicated as expense 11 For the bank; leasing income-cost of purchased goods: business income

INSTRUMENTS OF INTEREST-FREE BANKING

3) MUSHARAKA (Profit and Loss Investment) It’s the transaction to provide ,the natural and legal persons which are in need of funds, with funding on condition that they participate in profit or loss born by their all activites or certain activities or purchase and sell of certain consignment of goods.The musharaka method is usually applied on funding of industry. Permanent Musharaka: The partnership between the bank and the customer lasts in the term that the Project is applied. Diminishing Musharaka: The partnership share of the bank stipulates that the shares are to be purchased by customer in determined terms and transferred to the possession of the customer completely when the Project is over.

Taxation There is a partnership between the bank and the customer. The customer gains the profit share at the end of the term .The profit share is taxed with withholding tax according to the Income Tax Law. The income of the bank is business income (commercial gain).

The 5 th ATAIC Technical Conference - 119 TURKEY

INSTRUMENTS OF INTEREST-FREE BANKING 4) MUDARABA (Labor-Capital Patnership Investment)

The term refers to a form of business contract in which one party brings capital and the other personal effort.

It’s a contract in which all the capital is provided by the islamic bank while the business is managed by the other party.

Customer who uses the fund performs his labor and mastery.

The proportionate share in profit is determined by mutual agreement.

The loss, if any , is borne only by the owner of the capital not by entrepreneur.

The bank passes on this loss to the depositors.

INSTRUMENTS OF INTEREST-FREE BANKING 4) MUDARABA (Labor-Capital Patnership Investment)

Loss Depozitors

Profit/Loss Money

Person who manage Labor&Mastery Bank who Provide Money The business % 100 Capital Runnign Business (Mudarib) (Financier-rabbal-maal) Profit/Loss

Share of Profit Share of Profit

Bank is not active partner. All business managed by Entrepreneur

Taxation •Depositor puts money in the bank for purpose of gaining profit. Bank uses this and in case of getting profit the bank pays share of profit.Share of profit is taxed according to Income Tax Law and is not declared. •The entreneprenuer’s share of profit is business income. •The bank’s share of income is also business income. 14

The 5 th ATAIC Technical Conference - 120 TURKEY

INSTRUMENTS OF INTEREST-FREE BANKING

5) Salam and Istisna’a SALAM; • Salam, is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future date in exchange for an advanced price fully paid on the spot. • Here the price is paid in cash, but the supply of the purchased goods is deferred • Salam was beneficial to the seller, because he received the price in advance, and it was beneficial to the buyer also, because normally, the price in Salam used to be lower than price in spot sales. • It is necessary for the validity of Salam that the buyer pays the price in full to the seller at the time of effecting the sale. • The things whose quality or quantity is not determined by the specification cannot be sold through the contract of Salam. • Income is a markup over the cost of a commodity. • The subject of trade, price and delivery date is duly considered with the agreements.

INSTRUMENTS OF INTEREST-FREE BANKING

5) Salam and Istisna’a ISTISNA’A; Istisna’a is basically same with the salam. In isnisna’a transaction instead of commodities are traded construction, manufacturing take place. Difference between Istisna and Salam:

The subject of Istisna is always a thing that needs manufacturing, while Salam can be effected on anything, no matter whether it needs manufacturing or not.

It is necessary for Salam that the price is paid in advance, while it is not necessary in Istisna.

The contract of Salam, once effected, cannot be cancelled unilaterally, while the contract of Istisna can be cancelled before the manufacturer starts the work.

The time of delivery is an essential part of the sale in Salam while it is not necessary in Istisna that the time of the delivery be fixed.

The buyer may stipulate in the Istisna contract that the commodity shall be manufactured or produced by a specific manufacturer, or manufactured from specific materials. This is not permitted in the case of Salam sale.

Source:http://www.islamic-world.net/economics/instrument_bank_finance.htm 16

The 5 th ATAIC Technical Conference - 121 TURKEY

INSTRUMENTS OF INTEREST-FREE BANKING 5) Salam Transaction

Pay 8 me 00 Bank o nt 2 2 n 1 for ug on Ma cot A /t rch ton 3 50 $ 1 20 le 1 00/ 08 Sa $ ton n ice tto pr o e S C th al At e P 3 C rod om uc m ts o 1 odi r ties Seller Buyer x Delivery of Cotton 4 3 August 2008

Taxation: The difference between bank’s payment to seller and buyer’s payment to the bank for the goods is operating income.

INSTRUMENTS OF INTEREST-FREE BANKING

6) SUKUK (ISLAMIC BOND)

One of the most important tools for the growing interest-free banking at the international market is launching sukuk. Sukuk can be described as a bond without interest. Sukuk basically is the investment certificates which have the possesion right at their existence.

Issuing Sukuk is not allowed in Turkey by the Banking Law

The 5 th ATAIC Technical Conference - 122 TURKEY

TAXATION OF INTEREST-FREE BANKING INSTRUMENTS TAXATION BASE OF ISLAMIC FINANCIAL INSTRUMENTS IN TURKEY

According to Article 75 of The Income Tax Law; The dividend, interest, rental and similar incomes gained by the owner via its capital consisting of cash or assets represented by money except for its commercial, agricultural or professional undertakings are incomes from movable capital.

Also share of profit paid to those which loans money interest-free, share of profit paid against the certificate of profit and loss sharing and shares of profit paid by the special finance institutions against the profit and loss sharing account (share of profit paid to participating certificates of mutual funds) ,irrespective of their source, is considered as incomes from movable capital.

Shares of profit paid by the special finance institutions (participation banks), based on the profit and loss sharing account shall not be declared irrespective of their amounts under the provisional article 67 of Income Tax Law. 19

TAXATION OF INTEREST-FREE BANKING INSTRUMENTS

According to the Provisional Article 67 of Income Tax Law;

As of January 1 2006 ; Withholding tax at a rate of 15% is applied on the share of profit paid to those which loans money interest-free, share of profit paid against the certificate of profit and loss sharing and shares of profit paid by the Special Financial Institutions based on the profit and loss sharing account. And annual declaration shall not be submitted for this incomes.

In the witholding application, it is not important whether the income owner is fully or limited liable taxpayer and the income derived is tax free or taxable.

The 5 th ATAIC Technical Conference - 123 TURKEY

Thanks you for attention …

The 5 th ATAIC Technical Conference - 124 TURKEY