Taxation of Islamic products

Man-Brothers-Islamic-Financial-InstitutionThe emergence of Islamic finance is done ​in regions of the world where tax rates are very low. Therefore, transposition of Islamic financial products in conventional systems is proved to be complicated because of a taxation perceived as inequitable for these products. Indeed, considering the peculiarity of Islamic financing, the lender or the bank, may be taxed in terms of taxes on income. In addition, payments made ​​by the borrower are likely to be subject to value added tax (VAT). Thus, to avoid penalizing the Islamic financial system, several countries, even Western, have had to adapt their tax system to allow Islamic banking services and products to exist.

In the UK, for example, the law state that all interests payment made by the banks to the depositors were deductible from gross income before calculating tax, while payment of interests related to profits made by a bank were considered as payment of dividends, their amounts thus were not deductible from the gross income, and they were treated as distribution of after-tax profits. This made the charges taxable in Islamic banks far greater than conventional banks, and would impact the viability of this economic model in the country. There was also a problem with double effect of stamp duty on goods financed by Islamic structures. Indeed, whenever the property is purchased, the buyer is bound to pay the stamp duty to a government: the Islamic bank which buys the property before selling it over the customer had a double stamp duty payable. To rectify this injustice and ensure that the products complaint with Sharia are taxed in a fair manner with conventional banking products, the British government had set up  new rules since 2002 which enabled to change the functioning of stamp duty in order to exclude double taxation in stamp duty under the terms of mortgage financing. A new law “UK Finance Act 2005“ also defined Islamic products as “alternative financial arrangements” and has devoted a specific treatment.

Thus, the mechanisms of profit-and-loss that are economically equivalent to traditional banking products and does not give rise to interest or speculative returns have become taxable in the same way as conventional transactions of interest. The law was also amended to allow Islamic deposit accounts to be taxed on the same basis as conventional deposits and payment of profits made on Islamic deposits are now treated equivalently to interests payment. These changes have enabled to make London the first capital management market of Islamic origin.

Several other countries have subsequently revised their tax model and adapted their legal environments to allow their financial centers to be able to benefit from Islamic Finance. Thus Morocco has, for example, allowed in 2007 the offer of products compliant with Sharia (Ijara, Musharaka and Murabaha). Bank Al-Maghrib then reduced VAT rate from 20 to 10% applicable to these products, designated alternative banking products. Similarly, France is trying to catch up with Britain with adoption of new tax instructions to encourage the development of Islamic finance. Thus four new tax instructions were created in 2010 to encourage the development of Islamic finance in France on Sukuk, Istisna, Ijara and Murabaha transactions.