It is clear that there is an “infrastructure deficit” in Australia. Some estimate that the deficit – between our infrastructure needs and available government resources - could range between $450 billion to $770 billion in the next decade.1
The task facing the public and private sectors in funding Australia’s infrastructure needs is immense. That task is made more difficult considering the economic headwinds coming out of Europe which have led to the exit of some foreign banks from the Australian market, exacerbating the infrastructure funding gap.
In its Issues Paper released in July 2011, Infrastructure Australia considered a variety of measures to enhance the pool of finance available for large scale infrastructure projects. For example, that paper focused the spotlight on the need to engage with the superannuation industry.
However, it is also clear that there is no one solution to solve the infrastructure funding gap. Rather, the puzzle is comprised of many different pieces and requires a variety of new or innovative solutions.
In this context, we think it is now time to investigate Australia’s appetite for Islamic finance as potentially forming part of the solution to the funding of Australian infrastructure projects.
Islamic finance in the Australian context
In 2009 and 2010, there was considerable momentum for Australia to seize the initiative on Islamic finance.2 At the time, Chris Bowen (the former Minister for Financial Services, Superannuation and Corporate Law), Senator Nick Sherry (the former Assistant Treasurer) and Simon Crean (the former Minister for Trade) identified Islamic finance as something that would add to the depth and sophistication of financial markets and provide an opportunity to tap into new funding sources.3
The treatment of Islamic finance for Australian taxation purposes was also the subject of a comprehensive review by the Board of Taxation which released an initial discussion paper in October 2010. After consultation with interested stakeholders and the receipt of submissions, the Board of Taxation reported its findings to government in June 2011. Disappointingly, the report, and the government’s proposed response, has yet to be released publicly, and no further guidance was provided in the recent 2012/13 Federal Budget.
Such inaction is frustrating many in the nascent Islamic finance sector in Australia who sense a “chicken and egg” syndrome setting in. While government commitment to facilitating the right settings for Islamic finance and promoting Australia’s interest in the sector will go a long way to moving activity forward, it seems that a certain level of organic growth may be required before government is encouraged to do more.
This all leads to a concern that Australia might miss the boat. With many countries vying to attract the “halal dollar”, there is much anecdotal evidence to suggest that potential foreign participants are losing patience and looking elsewhere. Japan and Hong Kong, in particular, are moving faster with their tax and regulatory amendments as they seek to become Islamic finance hubs in Asia along with Kuala Lumpur.
Australia therefore needs to act soon. This can start with highlighting what the expansion of the debt capital market through the introduction of alternative sources of wholesale funds such as Islamic sukuk might do. Not only could it potentially assist with securing finance for infrastructure projects, but it may also increase the competitive pressure with and between the more traditional providers of debt finance resulting in a downward impact on the cost of finance. For consortia in highly competitive bidding processes, and the governments that ultimately pay for the infrastructure, this could only be a positive outcome.
The next step is to identify those Islamic finance products that lend themselves to large scale infrastructure projects and to provide mechanisms to overcome any hurdles that impede their use.
Products that lend themselves to infrastructure projects
At the heart of Islamic finance is the need for any product to be compliant with sharia law, based on a determination made by a specialist Islamic scholar. One of the principles of sharia law is that investors are not permitted to earn interest (known as riba), although an investor or financier may, for example, generate a yield from profit sharing techniques or sale and leasebacks. Common Islamic finance structures include musharaka (joint venture), mudaraba (limited partnership), murabaha (cost plus financing) and ijara (operating lease).
In the Australian infrastructure context, there are various Islamic financing techniques that could be utilised. Two of these products are istisna-ijara and sukuk.
- An istisna is a type of procurement contract whereby a financier purchases the relevant asset, to be constructed by the customer, by making part payments to the customer during construction (similar to drawdowns along a construction S-curve). Once the asset is built and handed over to the financier, the customer then leases the asset back from the financier (an ijara) at a rental rate that reflects a conventional repayment and interest profile.
An alternative is to have “parallel istisnas”. Besides the istisna whereby the financier procures construction of the asset (the drawdown mechanism), there is a second istisna whereby the customer buys the asset from the financier on deferred payment terms (the repayment profile).
- While sukuk has generally been a corporate financing technique, there is a growing tendency in established Islamic finance markets to structure project sukuk. Sukuk involves sharia-compliant financial certificates, which are broadly comparable to asset-based bonds. One way in which they can be structured is by way of a special purpose securitisation vehicle which acquires an asset from an originator (ie the borrower) which it then leases (by way of ijara) back to the originator for a rental which broadly reflects repayment of principal and interest under a more conventional financing arrangement. The securitisation vehicle issues the certificates to investors to which the periodic rental income is distributed. At the conclusion of the arrangement, the originator will repurchase the asset and the investors will receive the sale proceeds (ie face value of their certificates).
It is interesting to note that istisna-ijara and sukuk share some of the same hallmarks as securitised lease or licence structures which have been successfully utilised on many recent infrastructure projects in Australia.
What are the main hurdles facing Islamic finance in Australia?
While istisna-ijara and sukuk arrangements may, prima facie, be suitable structures for infrastructure projects, there are some hurdles to overcome, particularly from a regulatory and tax perspective.
Prospective Islamic finance participants need comfort that the local regulatory regime supports the sector. This is not yet the case in Australia and a number of regulatory issues will need to be resolved. Such issues include the lack of specific prudential and accounting standards and the possibility that certain Islamic products, due to their structures and numerous investors, will fall within the definition of a managed investment scheme or other regulated entity under the Corporations Act. 4
At State level, the New South Wales Government has undertaken a review of its regulatory system and concluded that there are no NSW specific (non-taxation) regulatory barriers to Islamic finance.5 Separately, the Victorian Government recently confirmed its “in principle” support to identify potential impediments to Islamic finance as a source of funding for infrastructure projects, and committed to considering action at a State level in conjunction with the Federal Government’s response to the Board of Taxation report.6
However, despite recommendations to the Federal Government to remove any regulatory barriers necessary,7until this is done many Islamic finance institutions and investors will be reluctant to enter the market, and the States may also be slow to commit to necessary reforms.
The underlying taxation principle should be for economically equivalent transactions or financial instruments, either conventional or Islamic products, to be taxed in the same way (ie substance over form). This much has been acknowledged by government and formed the basis of the Board of Taxation’s review.8 Although Islamic finance does not involve the derivation of interest, the approach in other jurisdictions to encourage and facilitate this form of finance is to apply the same tax rules that apply to interest derived in more conventional financing arrangements.
That is not to say the task of amending Australia’s complex income tax laws that apply to financial arrangements9 will be simple. However, by adopting uniform concepts and product neutral drafting that is principles-based, those amendments should be achievable. This is certainly the approach adopted in the United Kingdom (UK) between 2003 and 2007.
However, even with such reforms, a big impediment remains in relation to stamp duty. As Islamic finance products must be based on tangible assets, often real estate, dealings, directly or indirectly, in such assets may result in multiple stamp duty imposts depending on the relevant jurisdiction. Murabaha, for example, involves the financier acquiring an asset and agreeing to on-sell that same asset to the borrower, albeit on deferred payment terms. In New South Wales, it has been recognised that the potential for double duty is a significant issue facing Islamic finance stakeholders10 and that the New South Wales Government should consider amending the Duties Act 1997 (NSW) on property transfers under Islamic mortgages once the Federal response to the Board of Taxation report has been released.11 In Victoria, the Duties Act 2000 (Vic) was amended to prevent double duty on some murabaha transactions involving a natural person as the borrower.12 However, a broader and more uniform approach across the States and Territories is necessary to apply to Islamic finance in an infrastructure context and will require inter-governmental co-operation. This path will be difficult to negotiate and may test the Federal Government’s resolve to facilitate a level playing field for Islamic finance.
Responsiveness of government
Most infrastructure projects in Australia are procured by State and Territory governments, each of which can have different approaches to the risks associated with such projects. However, the public private partnership model is designed to promote innovation by the private sector with a view to providing a more optimal solution.
Competitive bidding processes will continue to drive innovation in the financing of such projects and it is important for the public sector to take the time to understand and ultimately get comfortable with the financing solutions offered by the private sector. For solutions involving Islamic finance, this is particularly relevant as there are conceptual differences between it and more conventional finance which need to be appreciated, particularly in the context of infrastructure funding.
However, our experience in advising governments across Australia on infrastructure projects suggests that government is capable and willing to respond to such innovation, particularly given current budgetary constraints throughout Australia. For example, when securitised lease or licence structures first appeared in the market, these structures required significant dialogue between private sector proponents and the public sector. Subsequently, they have now become commonly accepted in infrastructure projects. In our view, other innovative financing solutions, such as Islamic finance products, are just as capable of broad acceptance by government once they become more visible in the market and it is seen that, despite the different conceptual approach, they do not materially differ in economic characteristics or risk profile to conventional solutions. Notwithstanding the form of the investment structure, it is expected that the role and involvement Islamic financiers in a project will be similar to that of a conventional debt financier.
The complex issues facing debt markets and funding of infrastructure projects in Australia require multi-pronged solutions. One potential element may well be Islamic finance, which has previously been strongly endorsed by government. In fact, given that Islamic finance is underpinned by the requirement for tangible assets and the benefits to the economy and communities generated by infrastructure development, Islamic finance may be perfectly suited to funding such projects.
However, there are a number of hurdles before it will be readily accessible, particularly the existing regulatory and tax regimes at a Federal and State level. Moreover, it is necessary for the public sector to understand and accept Islamic finance as part of the solution to the private sector funding large scale infrastructure projects. The experience in the UK, and the ability of industry to engage with governments to explain innovative financing solutions such as securitised leases, suggests that these hurdles are not insurmountable.
As a first step on this journey, we suggest that the Federal Government needs to signal to the finance industry whether it retains the appetite to facilitate Islamic finance playing a more significant role in solving the infrastructure funding gap. One way to flag its position would be to respond to the Board of Taxation report delivered June 2011.