It is with great interest that the introduction of tax legislation dealing with Islamic finance has been noted in the Taxation Laws Amendment Bill, 2010 (the Bill) that was released for comment recently. In this context South Africa is thus following countries such as the United Kingdom and France that have introduced similar legislation and have attracted substantial investments following from the regularisation of these types of investments from a tax perspective.
Should one consider the entering into of financial transactions from an Islamic law perspective, one of the key issues is that the derivation of interest is prohibited. In the draft legislation that is to be promulgated as section 24JA of the Income Tax Act, three forms of Islamic finance will be recognised, namely -
- diminishing Musharaka
Mudarabah is mostly used as an investment or transactional account offered to clients. Essentially funds are deposited with the bank and the anticipated profit from the funds so deposited is divided proportionately in terms of an agreement that is concluded between the bank and the client. The client bears all the risk of loss in relation to the funds deposited or contributed in terms of the arrangement. Mudarabah acts like a partnership in form and substance in circumstances where the profits are economically comparable to interest. From a tax perspective, any profit so derived by the client shall be deemed to be interest. In order to qualify for this criteria, the parties must share in the profits on a pre-agreed basis and the client must incur the sole risk of loss in respect of the deposit. The profit sharing ration may not be varied during the life of the arrangement.
Murabaha is in turn a mark-up financing transaction that is offered by a bank so that the client can obtain funding for the acquisition of various assets. A bank would typically purchase an asset from a third party and then sell the asset thereafter to the client at a pre-agreed price. The bank will retain a right to take possession of the asset from the client to the extent that the client defaults on any payment in terms of the arrangement. The client will settle the "purchase consideration" to the bank by way of the payment of regular instalments that will not vary over the lifetime of the arrangement. The mark-up of the bank is essentially determined with reference to the time value of money. From a tax perspective -
- the bank will not be deemed to be involved with the purchase or sale of the asset;
- the client is deemed to have acquired the asset directly from the seller for a purchase consideration equal to the amount paid by the bank to the seller;
- the mark-up by the bank is deemed to be interest;
- the client is deemed to have acquired the property from a value added tax perspective (VAT) for an amount equal to the consideration paid by the bank whilst the difference is deemed to be interest;
- the client is liable for any transfer duty that may be payable and is deemed to have acquired the asset at the date that the seller disposes of the property to the bank.
In order to qualify for this treatment, the asset must be purchased by the bank from the seller based on the terms and conditions agreed upon between the client and the seller. The client will effectively pay the purchase price in regular instalments on the basis that the so-called profit mark-up may not be varied during the life of the arrangement.
The last form of Islamic funding dealt with in the draft legislation is diminishing Musharaka. In terms of this arrangement the bank and the client will acquire joint ownership of an asset on the basis that the client will purchase the bank's interest in the asset over a period. The purchase consideration payable by the client is equal to the consideration paid by the bank to acquire the ownership interest in the asset on the basis that the client will pay "rent" to the bank in respect of the bank's ownership interest in the asset until such time as the client becomes sole owner of the asset. Essentially a form of a partnership arrangement is thus entered into on the basis that the bank's interest in the asset is diminished over time whereas the client's interest increases until such time as he owns 100% of the asset. From a tax perspective -
- the bank is deemed not be involved with the purchase or sale of the asset;
- the client is deemed to have acquired the bank's proportionate interest in the asset directly from the seller for a purchase consideration equal to the amount paid by the bank to the seller;
- the rent payable by the client to the bank is deemed to be a premium and thus falls within the concept of interest in terms of section 24J;
- from a VAT perspective, the rent is deemed to be interest on the basis that the client is liable for the VAT payable in respect of the original acquisition of the asset from the seller;
- equally the client is liable for any transfer duty payable in respect of the acquisition of the asset.
In order to qualify for the envisaged tax treatment, a number of general requirements must be met, amongst others -
- the product must be offered by a bank to the general public;
- the product must be advertised to the general public as an arrangement that is compliant with Shari'a law.
From a tax perspective, the question arises whether the premium or rent payable by the client would not in any event have fallen under the definition of "interest" contained in section 24J of the Income Tax Act. In particular, the question is whether the difference between the amount paid by the bank and the amount receivable by the bank can be said to be a premium or discount payable in respect of a financial arrangement. To the extent that one argues that one is not dealing with a simulated transaction and where an asset is acquired and sold for a different price, the counter argument is that one is only dealing with a difference in purchase price and that it does not fall under the concept of a premium from a tax perspective. That is similar to the tax treatment of a promissory note prior to the introduction of section 24J that may have been issued at a discount. Such difference between the price paid and the face value of a promissory note was not in terms of conventional law deemed to be interest. Specific provision thus had to be made for a scenario where a financial instrument is issued at a premium or discount so that the difference could be treated as interest in terms of tax laws.