Value added tax ("VAT") was pioneered by the European Union, but is gradually spreading worldwide. Saudi Arabia recently tripled its rate of VAT. While VAT in Saudi Arabia is only a couple of years old, the Saudi VAT law follows widespread international precedent by also exempting financial services. Accordingly, all financial institutions will suffer a hit to their profit and loss account. All purchases of goods and services which are subject to VAT increase in cost by 9.5%. This may lead to an increase in bad debts in the Saudi banking sector. Islamic financial services are not expected to suffer more (or less) than conventional financial services.
Making moral and religious investment decisions is right, but does not change the world. Shariah compliant screening of stock market investments enables investors to invest in accordance with their religious beliefs, but that is all it does. To combat the harm from alcohol, for example, requires other policies. Divestment campaigns do achieve one thing. That is to increase publicity about the issue concerned, whether that is climate change in the case of oil companies, or deaths from smoking in the case of tobacco companies. The ethical and religious reasons for divestment should not be ignored, since they matter to the individual shareholder. However ethical investors should not deceive themselves to believing that divestment will result in change in circumstances when it will not.
The Shariah compliant index generally under-performs its conventional analogue before the global financial crisis years of 2007 and 2008, outperforms during the global financial crisis and then under-performs again afterwards. A conventional equity investor should perform better than a Shariah compliant investor, simply because the the conventional investor can pick from the entire universe of shares, while the Shariah compliant investor cannot.
During the global financial crisis many experts pointed out that Shariah compliant shares had performed much better than those which were not. However, once the world emerged from the crisis, the Shariah All-World index has consistently underperformed its conventional counterpart. A conventional investor who is selecting shares from the complete universe of shares will, on average, outperform a Shariah compliant investor who selects shares only from the Shariah compliant subset of the universe. The conventional investor is always free to buy high quality Shariah compliant shares, but the Shariah compliant investor can never buy high quality non-Shariah compliant shares. This is simply a fact of life to be accepted.
For well over a decade, the UK has been amending its tax laws for Islamic finance. The goal is to ensure that Islamic finance transactions are not taxed more heavily, or more lightly, than their conventional finance equivalents. In a diminishing musharaka transaction a property is being sold twice, once by the individual to the bank and then by the bank back to the individual. Countries that charge tax on transfers of real estate will typically do so for both sales. Furthermore, the individual has sold for $750,000 a property that cost him $100,000, so if the country taxes gains arising on the sale of property, the individual can expect to be taxed on the $650,000 gain. In the United Kingdom, the real estate transfer tax charges were eliminated. However, the capital gains tax charge triggered by the sale remains in the case of sales to Islamic banks. The UK’s Chartered Institute of Taxation has now proposed that the gain on the Islamic financing transaction described above should not be taxed.
In this article Mohammed Amin discusses a structure which sidesteps Shariah rules but nevertheless was approved by Shariah scholars. He encountered this structure at a recent conference and the paper was titled "The Doomsday Fatwa". The "total return swap" structure would allow Muslims to achieve the same economic returns as investing in any identified asset. For example, a Muslim could achieve the economic results of investing in brewery shares without ever owning them. The "Shariah conversion technology" underlying the transaction appears to violate any purposes which underlie Islamic finance.
The Dana Gas sukuk case illustrates the dangers of local country courts favouring domestic companies. Wherever possible, international investors should avoid local law. The most commonly used is English law, even for commercial arrangements that have nothing to do with the UK, because English law is well-developed and English courts have a deserved reputation for legal competence and impartiality. Dana Gas raised money from international investors by issuing sukuk. The money so raised was invested in a mudarabah agreement with Dana Gas, written under UAE law. Dana Gas also entered into a purchase undertaking, written under English law. Under UAE law, sukuk investors would have been sunk, having to litigate about whether the commercial arrangements were or were not Shariah compliant. However, they were saved by the purchase undertaking being under English law.
For an Islamic bank, Shariah compliance is a foundation attribute, not a leverage attribute. Islamic banks need to give an impression of strength and stability. They also need to be accessible for customers. Historically, a physical branch network was needed, but today Islamic banks compete by providing electronic access, remote deposit facilities and smart phone apps. The key leverage attribute of any bank is accurate credit assessment, so that the bank can charge appropriately for the risk of customer default. A further leverage attribute is to have bankers whose connections in the business community are so strong that they can create deals, such as corporate takeovers or partnerships. It is a leverage attribute for Islamic banks to be able to innovate and devise new Shariah compliant offerings not provided by competitors. The challenge is both in devising those offerings and in preventing their intellectual property being copied by competitor Islamic banks.
Because Shariah compliance is essential for all Islamic banks, it does not distinguish one Islamic bank from another. Hence it is a foundation attribute. About 25 years ago, Price Waterhouse made a distinction between foundation attributes and leverage attributes. Foundation attributes convey no competitive advantage. Al Rayan Bank is the only Islamic bank in the UK which targets ordinary retail customers. The bank's homepage gives very prominent coverage to its Shariah compliance. That is because Al Rayan is not competing against other retail Islamic banks but rather seeking to create a retail Islamic finance market where none has existed before.
Transfer pricing sounds esoteric and many wrongly associate it with abusive behaviour by multinational corporations. In reality, all multinational corporations have to deal with transfer pricing. Profits made in different countries may suffer different amounts of corporate tax and may suffer different amounts of withholding taxes before those profits can be paid. The tax authorities of each individual country understandably seek to maximise that country’s tax revenues. The serious risk that the multinational group faces is that the tax authorities impose artificial prices for tax purposes. This can cause the underlying profits to be taxed twice. Fortunately, a growing number of countries have entered into tax treaties to solve this problem.
There are three possible explanations to the question why innovation might be slower in Islamic finance than in the conventional finance industry. These are the size of the industry, cultural factors and religious conservatism. First, the industry is tiny compared with conventional finance, Islamic finance assets are only 1.07% of total financial assets. Culturally, Muslim majority countries display much more respect for age and seniority than do locations like Silicon Valley or London. Finally, there is the question of religious conservatism. The rules of traditional Islamic law have always been derived from the original sources of Quran and hadith, and from past judicial rulings. Requiring all legal developments to be based on prior sources limits the scope for innovation. Mohammed Amin states that fintech can only transform Islamic finance if Shariah scholars are sufficiently agile in developing traditional Islamic law to accomodate innovation.
The UK Government has been thinking about the possibility of introducing Shariah compliant student finance since 2011. The Higher Education and Research Bill is currently before Parliament. However, the Bill contains no time-scale for when a Shariah compliant system is likely to be in place. When the Bill was reviewed in the House of Lords, Lord Sharkey proposed an amendment to give a deadline of the 2018-2019 academic year for the introduction of such a scheme. This proposal was rejected by the Government. Lord Sharkey instead proposed an amendment requiring quarterly progress reports from the Secretary of State. The final outcome is that the Bill will proceed forwards and once it has completed all stages, the Secretary of State for Education will have the power to implement a Shariah compliant student finance system.
The principal reasons are the small size of Islamic banks, and the additional legal transactions involved with Islamic mortgages. In the UK, Muslims are often surprised to find that Shariah compliant Islamic mortgages are noticeably more expensive than conventional ones. A conventional mortgage is a reasonably simple transaction to document legally. Conversely, a residential Islamic mortgage involves both the bank and the new owner occupier purchasing the property jointly. The contracts used are less standardised and there are simply more pieces of legal paperwork involved in an Islamic mortgage. Furthermore, the stand-alone Islamic banks in the UK are very small compared with the very large conventional banks. All these costs must ultimately be borne by the customers and are reflected in the higher prices Islamic banks charge for Islamic mortgages.
Unless tax systems properly accommodate Islamic finance transactions, prohibitive tax costs can arise. The legislation in South Africa, Singapore and Malaysia explicitly refers to Islamic finance transactions. Strictly speaking, this introduces a religious test into secular tax law, which may not be acceptable to other countries. The UK takes a different approach. UK tax law proceeds by only looking at the economic implications of the transaction, without any concern for whether it qualifies religiously as Islamic finance or not, so religious tests do not enter into the UK tax system. UK law already operates to avoid additional VAT costs. In other countries specific legislation will be needed to create parity of tax treatment between conventional finance and Islamic finance.
Where UK based students are led to take Islamic finance masters' degrees as a route to an Islamic finance career, mis-selling may be taking place. In world rankings, many UK universities rank relatively highly, and such a UK degree can enhance the promotion prospects of foreign students in their home country. However, many UK origin students are persuaded to take a master's degree in Islamic finance immediately after graduating. Unfortunately, the number of available positions in Islamic finance in the UK is very limited. Also UK Islamic financial institutions are too small to train people, and typically only hire experienced Islamic bankers.
Mohammed Amin wrote a chapter for the "International Wealth Management Report 2016" published by Edbiz Consulting Ltd. The chapter titled "Taxation Issues in Islamic Wealth Management" outlines some generic taxation issues that need to be taken into account in the provision of Islamic wealth management services, and provides specific illustrations of how they are dealt with in one jurisdiction with a relatively advanced system for taxing Islamic finance, the United Kingdom, to provide some pointers as to how other jurisdictions should treat those issues. However it does not attempt to survey the tax treatment in other jurisdictions.
An interview on Islamic Finance by Algeria International Radio took place on Monday 6 April and is now available on Youtube. The interview provides a short introduction to Islamic finance for those who have not come across it before. Mohammed Amin was asked several questions about Islamic finance, including: What definition would you give to Islamic Finance? What are the benefits of Islamic finance? Which countries apply this financial system? Has there been a historical evolution of Islamic Finance? How do you describe today’s Islamic Finance? What would be the challenges for Islamic finance?
Countries gain or lose economic competitiveness not by one or two major decisions, but by the steady drip feed of political decisions that either enhance or weaken their competitiveness. While Islamic finance is only a small part of the financial scene in the UK, the way that the UK government has facilitated its grown illustrates the above point very well. Competitiveness is rarely lost by a single dramatic mistake. Similarly, success in increasing competitiveness is often achieved by having a large number of “micro-policies” affecting particular parts of the economy. Promoting Islamic finance as the government has done is clearly in the best interests of the economy and therefore of all British citizens and taxpayers.
Looking back at Islamic finance in the UK over the last eight years is rather like looking at a roller coaster, with peaks of excitement and troughs of depression. On the one hand, in 2006 Gordon Brown MP, announced the ambition for Britain to be the global gateway to Islamic finance and trade. However, the excitement of these early developments was followed by a trough. The UK is already the world’s pre-eminent centre for international conventional finance. It also has a very strong position in international Islamic finance. These developments pose an important competitive challenge to Islamic finance centres such as Kuala Lumpur, Bahrain and Dubai. Each has a very strong domestic Islamic finance market, and a significant level of international reach, but lacks the overall scale and credibility of London.