Changing the UK tax system for Islamic finance is challenging

Since around 2001, the UK tax system has been slowly adapted to enable Islamic finance transactions to take place without extra tax costs beyond those faced by conventional finance. I have written about this on many occasions.

However UK tax law does not yet present a "level playing field" for Islamic finance and conventional finance.

In my November 2018 column for the magazine "Islamic Finance News" I explained just how difficult it is to change the UK tax system without the risk of making mistakes and creating new anomalies.

Why is the taxation of Islamic finance still unequal?

Because tax is country specific, the article’s heading is wrong to generalise. However, in the UK and many other countries, even when Islamic banks and takaful companies can operate, Islamic finance is treated less favourably than conventional finance.

For example, the UK has legislated a tax regime for murabaha transactions (called purchase and resale), but it only applies where at least one of the parties is a financial institution as defined. Accordingly, if two individuals, or two non-financial-institution companies enter into a murabaha transaction, none of the law enacted to facilitate Islamic finance applies. Instead, the party being financed is likely to be unable to claim tax relief for its finance cost.

Why have such issues not been resolved, almost two decades after the UK first started looking seriously at the additional tax burdens faced by Islamic finance compared with conventional finance?

The answer is that it is very difficult to change a tax system which developed over almost 200 years in an environment where all finance was conventional. Every change requires immensely painstaking legal analysis, and every change risks inadvertently creating opportunities for tax avoidance.

At its simplest, what should any revised tax regime apply to? “Islamic finance” is not an acceptable answer, because the government of the UK (or of most other non-Muslim majority countries) does not want to hold itself out as the arbiter of what is Islamic and what is not. That is why the term “Islamic finance” is not used anywhere in the UK’s tax legislation enacted to enable Islamic banking, even though the words “Islamic finance” are used in explanatory materials.

Instead, the law uses purely secular language to define certain transactions, such as “purchase and resale”, which replicate transactions used in Islamic finance such as murabaha. The law then specifies the tax treatment of the parties to a purchase and resale transaction.

Unfortunately, tax law is so complex that mistakes are easy to make, even when experts do the drafting.

For example, in Finance Act 2006 Parliament legislated for something called “profit share agency” which was intended to replicate wakalah. The key part of the definition is that a person (“the principal”) appoints a financial institution as his agent; the agent uses money provided by the principal with a view to producing a profit; the principal is entitled, to a specified extent, to profits resulting from the use of the money; and the agent is entitled to any additional profits resulting from the use of the money (and may also be entitled to a fee to be paid by the principal).

If these requirements are met, “The principal shall not be treated for the purposes of the Tax Acts as entitled to profits to which the agent is entitled.” However, FA 2006 was silent regarding whether the agent was taxable on the profits which the agent was entitled to retain. UK tax law is incredibly prescriptive, and it was perfectly arguable that, in the absence of clear legislation, the agent was not taxable on anything.

Parliament took this concern sufficiently seriously that the following year FA 2007 had to fix the legislation by stipulating “and the agent is treated as entitled to the profits specified.” [I actually spotted the problem when I was reviewing FA 2006 and notified HMRC of the potential loophole so that it could be fixed.]

The overall message from the UK’s experience of legislating is that specific incremental tax law changes are possible, when clearly needed for the development of Islamic finance. However, we are unlikely to see complete equality between the taxation of Islamic and conventional for many decades, if at all.