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Sukuk - taxation of legal form or economic substance? The role for tax incentives?

Summary

2 April 2014

I was recently interviewed by email by the magazine Islamic Finance News about the taxation of sukuk. They had a number of questions. The most thought provoking was about whether taxation should be based on form or substance. I was also asked about the role of tax incentives.

I gave quite detailed responses, which I have shared below.

The magazine condensed the 969 words in the questions and answers below into an article of appropriate length, 424 words. However the text of that article, "Sukuk taxation: Legal form or economic substance?" on page 19 of the issue dated 26 March 2014, is only available to subscribers. The full answers given below are of course more detailed than the published article, which conveys the same messages more concisely.

Full text of questions and answers

In your opinion, which country/region has the most efficient tax regulations for Sukuk issuances?

I cannot claim knowledge of every country’s tax regulations for sukuk. Accordingly I am unable to say which country has the most efficient tax regulations.

However from my research I am aware of several countries that have put significant effort into designing a tax regime for sukuk which aims to ensure, as far as possible, that issuing sukuk does not entail worse tax treatment than the issue of conventional bonds. The United Kingdom, Malaysia, Turkey and the Qatar Financial Centre are four jurisdictions which were identified in the study "Cross border taxation of Islamic finance in the MENA region Phase One" as having a specific set of taxation rules for sukuk. This study was published on 13 February 2013 by the Qatar Financial Centre Authority (QFCA) and I was the principal researcher. The full report can be downloaded from the QFCA website or via my website.

Taxation is based either on their legal form or their substance. Shouldn’t this be standardized? What are the advantages and disadvantages of it being based on one rather than the other? In relation to this, what would be your suggestion for a proper mode of taxation?

Countries have differing approaches to tax law because they have differing approaches to law generally, and have differing legal and constitutional philosophies. Accordingly it is unrealistic to expect standardisation between countries regarding the different level of emphasis they give to legal form or economic substance.

There is no country which purely looks at legal form when applying tax law and no country which purely looks at economic substance when applying tax law. All countries fall at different points on the continuum between these two theoretical extreme positions. For example the USA and the Netherlands are closer to the economic substance end of the continuum while the United Kingdom is closer to the legal form end of the continuum.

The great advantage of paying significant respect to the legal form of a contract when applying tax law is that it gives greater certainty. The parties entering into a contract can ensure by careful attention to the legal terms of the contract how it will be treated for tax purposes. There is much greater scope for disagreement when attempting to identify economic substance than there is for deciding what is the legal form of a contract.

The drawback of following the legal form too closely is that it can create scope for tax avoidance. Ingenious and somewhat artificial use of particular contractual forms can enable the taxpayer to be taxed on the true economic return at a rate which is much lower than the legally published tax rate. Examples can be found by looking at many tax cases from the United Kingdom, particularly cases heard 30 or 40 years ago, where the result, to most observers, would look unfairly generous to the taxpayer.

Accordingly, certainly in the UK and probably globally, there appears to be a trend towards paying greater attention to the economic substance of a transaction and paying less attention to the legal form.

The greatest disadvantage of paying greater attention to the economic substance is that it can make the application of tax law depend to a great extent upon the opinions of the tax administrator. As noted above, there can be genuine disagreement regarding what is the economic substance and the taxpayer is exposed to the risk that the tax administration will act arbitrarily in determining the taxable amount.

To protect the taxpayer there needs to be a strong system of independent courts to which taxpayers can appeal against the capricious application of economic substance taxation by the tax administration.

How efficient are tax incentives in bringing issuers into the market?

The primary goal of a government should be to ensure that the tax system does not distort commercial decisions. Accordingly the starting point should be to ensure that Islamic finance transactions do not suffer a greater tax burden than economically equivalent conventional finance transactions.

Some governments, particularly in Muslim majority countries, may choose to go beyond the achievement of neutrality by giving a specific tax privilege to Islamic finance transactions compared with conventional finance transactions. For example, the government may choose to tax the economic return to an investor in Islamic finance at a lower rate than the tax that would be charged on the same economic return from a conventional finance transaction.

Incentives given directly to issuers (for example allowing an Islamic finance cost a more generous tax deduction than a conventional finance cost) will of course encourage issuers to issue Islamic financial instruments such as sukuk rather than issuing conventional bonds, if they have the ability to issue sukuk. (Some issuers, for example those engaged in activities prohibited by Shariah such as producing alcoholic drinks will not have the ability to issue sukuk even if they would wish to do so for economic reasons.)

However, even where incentives are given to the investor, (for example by taxing the investor’s return at a lower rate) the existence of the incentive is likely to mean that the benefit of the incentive is shared between the investor and the issuer for competitive reasons. For example if the economic return on sukuk is known to be taxed at a lower rate than the economic return on conventional bonds, then issuers are likely to reduce the rate of return that they offer on sukuk, compared with the return on conventional bonds, so that the tax privilege is shared between the investor and the issuer.

To summarise, if tax incentives are created to encourage the issue of sukuk, then I would expect the issuance of sukuk to increase above the level that would exist in the absence of the tax incentives.

 

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