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VAT and Islamic finance transactions

Summary

Posted 19 December 2015

On 9 December the magazine Islamic Finance News published my fourth monthly column.

In November I had spoken at the Sixth Middle East / North Africa (MENA)Tax Forum in Doha, Qatar on how countries' systems for Value Added Tax (also often called Goods and Services Tax) should deal with Islamic finance. This is a project I have been researching for two years on behalf of the International Tax and Investment Center in Washington DC, USA, which is the body that organises the MENA Tax Forum.

Accordingly I based the article below on the presentation I gave there. I am also making available the slides of the PowerPoint presentation VAT and Islamic finance - Challenges and policy approaches that I delivered in Doha. (This downloads as a Microsoft PowerPoint file.)

Letter from Amin - 9 December 2015

Since late 2011, I have assisted the Washington based International Tax and Investment Center in researching the taxation of Islamic Finance in the Middle East and North Africa (MENA) region, supported by the Qatar Financial Centre Authority.

The first output was a survey of the direct tax (taxes on income) treatment of Islamic finance transactions. Afterwards I was asked to look at how value added tax (VAT), also often called goods and services tax (GST), impacted on Islamic finance transactions. Just as most financiers regard tax as arcane, I suspect that most direct tax advisers regard VAT as an esoteric part of the tax universe!

After its early adoption by the European Union, an increasing number of countries around the world have brought in VAT systems for a variety of reasons. Being normally broadly based, VAT generally raises revenue more efficiently and with less distortion of economic activities than a traditional sales tax. It also has no adverse impact upon exports. In my view the record keeping requirements of VAT can boost the general quality of tax compliance in adopting countries.

Last month I found myself presenting the project’s findings on VAT to the Sixth MENA Tax Forum in Doha, to an audience containing many senior MENA region tax administrators as well as representatives from private sector multinational companies and professional services firms.

The key challenge Islamic finance presents for VAT is that Islamic finance transactions often have more steps than equivalent conventional finance transactions. For example a commodity murabaha transaction involves three sales of a commodity (from the market to a bank, from the bank to its customer, and from the customer to the market) whereas nothing is bought or sold in the case of an interest bearing bank loan. Each of these sales may require VAT to be charged. That is a minor nuisance if the purchaser can recover the VAT but a crippling cost if the purchaser cannot recover the VAT.

I explained that both Malaysia and South Africa have legislated specifically for the VAT treatment of Islamic finance transactions. Meanwhile the UK has relied on the operation of its general VAT rules; these work satisfactorily most of the time, but serious problems sometimes arise, particularly when one of the parties (such as a private individual) is not registered for VAT.

I advised the tax administrators in the audience to cater specifically for Islamic finance if their countries were planning to introduce a VAT system. In particular since most Islamic finance transactions involve a regulated entity (e.g. a bank or a takaful operator) the compliance risks can be minimised by requiring the regulated entity to report on the transactions it has with its (non-regulated and possibly unregistered) counterparties.

 

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