This site is solely dedicated to publish my writing, mostly on the topic of Islamic finance. Some of the articles were written as partial fulfillment for completing the Chartered Islamic Finance Professional (CIFP) certifications and for the Ph.D in Islamic Finance that I am currently undertake. Interested parties, including reporter/press or students, may reproduce or quote materials published provided that the credit has to be given to my blog (arzim.blogspot.com). Comments must be accompanied by names or pseudonyms. Anonymous postings and those containing profanities and obscenities will be rejected.

Friday, February 18, 2011

Quranic Verse on Debt 4:11

Allah (thus) directs you as regards your Children's (Inheritance): to the male, a portion equal to that of two females: if only daughters, two or more, their share is two thirds of the inheritance; if only one, her share is a half. For parents, a sixth share of the inheritance to each, if the deceased left children; if no children, and the parents are the (only) heirs, the mother has a third; if the deceased Left brothers (or sisters) the mother has a sixth. (The distribution in all cases after the payment of legacies and debts. You know not whether your parents or your children are nearest to you in benefit. These are settled portions ordained by Allah; and Allah is All-knowing, All-Wise.

Quranic Verse on Contract 5:10

O you who believe! Fulfill your obligations.

Quranic Verse on Contract 2:282

O you who believe! When you deal with each other, in transactions involving future obligations in a fixed period of time, reduce them to writing. Let a scribe write down faithfully as between the parties: let not the scribe refuse to write: as Allah Has taught him, so let him write. Let him who incurs the liability dictate, but let him fear his Lord Allah, and not diminish anything of what he owes. If the party liable is mentally deficient, or weak, or unable Himself to dictate, let his guardian dictate faithfully, and get two witnesses, out of your own men and if there are not two men, then a man and two women, such as you choose, for witnesses, so that if one of them errs, the other can remind her. The witnesses should not refuse when they are called on (for evidence). Disdain not to reduce to writing (your contract) for a future period, whether it be small or big: it is more just in the sight of Allah, more suitable as evidence, and more convenient to prevent doubts among yourselves, but if it be a transaction which you carry out on the spot among yourselves, there is no blame on you if you reduce it not to writing. But take witness whenever you make a commercial contract; and let neither scribe nor witness suffer harm. If you do (such harm), it would be wickedness in you. So fear Allah; For it is Good that teaches you. And Allah is well acquainted with all things. If you are on a journey, and cannot find a scribe, a pledge with possession (may serve the purpose). And if one of you deposits a thing on trust with another, let the trustee (faithfully) discharge his trust, and let him fear his Lord conceal not evidence; for whoever conceals it, his heart is tainted with sin. And Allah knows all that you do.

Quranic Verse on Charity 2:215

They ask you what they should spend (in charity). Say: Whatever you spend that is good is for parents and kindred and orphans and those in want and for wayfarers. And whatever you do that is good, Allah knows it well.

Quranic Verse on Charity 2:177

It is not righteousness that you turn your faces towards east or west (in prayers); but righteousness (is the quality of) the one who believes in Allah, the Last Day, the Angels, the Book, the Prophets and gives his wealth in spite of love for it to the kinsfolk, orphans, the needy, the wayfarer and to those who ask and to set slaves free and is steadfast in prayer and practices Zakah; and those who fulfill their covenants when they make it; and who are firm and patient, in extreme poverty and ailment and throughout all periods of panic. Such are the people of truth and they are the pious.

Sunday, February 13, 2011

Malaysia: The Tax Haven For Islamic Finance


By Arzim Naim CA(M). FCCA . CIFP

(This article has appeared in the Islamic Finance News magazine on 6 October 2010)

The international Islamic finance hub
The international tax landscape has been rapidly changed in the recent decade. The tax regime of a country has long been seen as an effective fiscal tool in managing domestic policy. It is also can be manipulated to encourage flows of capital into the country. From investors’ perspectives, tax is always deemed as a hidden cost in any funding structure. Any potential tax inefficiencies will result into undesirable tax liabilities which will then be translated into the financing structure. Therefore, investors will always look for tax advantages beside stable environment and sustainable business structures. Any tax incentives are very much welcomed by investors. The recent development in the international tax planning has seen the resurgence of tax haven to encourage inflows of foreign investments or capital. Even the Organization for Economic Cooperation and Development (OECD) play an active role in encouraging its members to provide some form of tax haven in every member’s country. On the Islamic finance context, whether the changes in the individual countries’ tax regime will have a significant effect to the cross-border international Islamic finance transactions, we have yet to see the results. An often overlooked bilateral tax treaty between countries may be a good starting point for motivated countries to try to integrate Islamic finance systems with their respective trading countries.

Recently, the tax neutrality has becoming buzz word in lieu of facilitating the Islamic financial transactions. The tax neutrality is a form of tax incentives whereby a relief is given to the tax charges that was supposed to be imposed onto the Islamic financial transactions. Tax neutrality is considered utmost important in Islamic finance environment because this will make Islamic financial products as attractive/cost-efficient as its conventional counterparts. While there are numerous types of Islamic financial instruments available, there are underlying principles shared by these instruments. Beside the prohibition of earning/charging of interest in the financial transactions, the integral part of Islamic finance is the requirement to have an al-bay or trade embedded in the financial transactions which will then be translated into the form of profits and losses sharing principles with implied acceptance of underlying risks by the parties involved. It is not uncommon in the Islamic finance environments to have buying and selling transactions for more than once as the steps in issuing the Islamic financial instruments such as Sukuk or any working capital financing by the Islamic banks. This selling and buying of assets will invoke tax for the transactions. For example, in the application of Musharakah Mutanaqisa (diminishing Musharakah) or Murabahah (cost-plus-financing), there shall be multiple stamp duty land tax to be imposed for every buying and selling transactions in the Malaysia jurisdictions. This will directly increase the costs to the participants in the Islamic financial transactions. By comparison, this will make Islamic finance less attractive as compared to the conventional counterparts. Indeed, to have a tax neutrality in the issuance of Islamic financial instruments is very much encouraged in order to solve the tax intricacies. To quote Yahia Abdul-Rahman, founder of LARIBA house of financing in Pasadena, California, where he claimed (in his book, The Art of Islamic Banking and Finance: Tools and Techniques for Community-Based Banking, 2010) that the tax imposed from the buying and selling of the underlying assets can be huge and without the application of the tax neutrality, Islamic financing will always be costly compared to conventional finance.

The growing interest in Islamic finance by the European countries can be seen from the introduction of tax-friendly law to accommodate the issuance of Islamic financial instruments in the country. The UK has long introduced the tax neutrality to facilitate the issuance of Sukuk and other Islamic banking products. The UK tax law has provide a relief on the stamp duty land tax for the acquisition of real estate under Musharakah Mutanaqisah (diminishing Musharakah) or Murabaha arrangements. The relief is also extended to partnerships and also companies. The step was followed by French and Luxembourg where both governments have overhauled its tax laws to facilitate the Islamic financial transactions such as Murabaha (cost-plus) financing that primarily used in the working capital financing plus Sukuk issuance. Ireland has follow suit under its Finance Bill 2010, which has came starting January 2010. Ireland, like other EU countries, is warming to the Islamic finance and indeed, becoming rivals to EU countries. The changes in their respective tax legislations may be seen as a signal to other countries of their intention to become the Islamic financial hub of European continents. Notwithstanding to that, other countries such as South African, Kenya, Nigeria, Indonesia and Hong Kong are amending their tax laws with a views of taxing the Islamic financial transactions on an equal footing as the conventional finance plus granting incentives in order to facilitate Islamic financial products in their respective jurisdictions.

Malaysia is seen to have an edge to be the Islamic financial hub in the South East Asia region. Malaysia has spearheaded itself having an establishment of Islamic Financial Services Board (IFSB) and Malaysia International Islamic Financial Centre (MIFC) besides leading in the Islamic banking arena for more than twenty years. Malaysia has also anticipated the problem of shortage of talents in this arena by way of establishing the International Centre for Education in Islamic Finance (INCEIF) to produce the necessary talents. In addition, the International Shariah Research Academy for Islamic Finance (ISRA), the research entity of Central Bank of Malaysia was established with a mandate to promote applied research in the area of Shariah and Islamic finance. The fact that Malaysia was one of the first countries in the region to introduce a framework and parallel regulatory system for Islamic finance has proved to the world its competencies by introducing various Islamic financial products for banking, capital market and insurance/takaful sectors respectively.

Islamic finance tax incentives: The Malaysian experience
1.   Profits, rebates and withholding tax matters
Malaysia has always been in the forefront in developing and expanding the infrastructure to support the development of Islamic finance. One of the ways is by providing incentives in this area. Because the main focus is to keep Islamic financing as attractive as the conventional financing. It is crucial to examine the tax implications to give Islamic finance as equal footing to compete with the long established conventional finance at the level playing field.

The Income Tax Act (1967) is considered the main legislation that governs the taxation matters in Malaysia beside Stamp Act (1949). Income Tax Act (ITA) prescribes the taxability of income and deductibility of expenses. The application of tax in Islamic finance environments can be categorized into two categories: (i) individual basis, and (ii) Corporate basis.

First, in the context of Islamic finance, the main concern is the treatment of profit associated with Islamic financial transactions since interest is not allowed under Shariah principles. ITA has made certain provisions on this matter on the Section 2(7) where:

“any reference in this Act to interest shall apply, mutatis mutandis, to gains and profits received and expenses incurred, in lieu of interest, in transactions conducted in accordance with the Shariah”.

This mean the treatments of profits will be similar to that of interest for tax purposes. Thus, all other rules relating to interest such as withholding tax on interest, interest exemption and interest restriction rules will also apply to profits.
Profits received will always be taxed as same as interest income. However, the profits are paid in the course of the business, then, the profits become tax deductible if the funding received associated to the profits paid is used to generate business income or to purchase assets to generate income. For example, given a scenario where depositors deposit some money in the Islamic banks. Two schemes which are normally used by Islamic banks in Malaysia are the Al-Wadiah yad Dhamanah (safekeeping with guarantee) or Al-Mudharabah (profit sharing) investment account. The former is a savings account of conventional banking alike whilst the latter is a fixed deposit account of conventional banking alike. For Al-Wadiah yad Dhamanah, the return to the depositors is in the form of hibah or gift, up to the bank’s discretion. On the other hand, the Al-Mudharabah investment account with varying investment periods would share the agreed varying proportion of profits (depending on the tenure of investments) with the rab al-mal or the investment account holder according to the profit distribution ratio.

On individual perspectives, the hibah earned from the placing of deposits on Al-Wadiah yad Dhamanah account is exempted from tax up to the equivalent of a deposit of RM100,000 as per para 2(b) of Income Tax (Exemption) (No.13) Order 1996. However, the hibah earned associated to deposits placed over the ceiling limit (RM100,000) is liable to 5% tax by virtue of Part VI of Sch I of the Act. The tax must be deducted at source as per 109C of the Act. Any profits earned from the placing of deposits in the Al-Mudharabah investment account is fully exempt as per para 2(b) of Income Tax (Exemption) (No.13) Order 1996 if it is for more a period of twelve months or more. The share of hibah or profits paid by the Islamic banks to the depositors for either Al-Wadiah yad Dhamanah account or Al-Mudharabah investment account will be an allowable expense in arriving at the bank’s adjusted income or loss.

Generally, for Malaysian tax residents, any interest or profits received from the financial institutions will be subjected to tax. However, special incentives are given to the Malaysian individuals, unit trust or close-end funds to be exempted from income tax if the profits received are derived from the Sukuk approved by Securities Commission (SC) or from the selected Islamic bonds issued by the Central Bank of Malaysia.

On the other hand, according to Paragraph 33, Schedule 6 of ITA, any payment of interest to the foreign investors/non-residents by the financial institutions, securities or bonds guaranteed by the government is generally exempted from withholding tax. This exemption has been extended to cover the profits payments from the Islamic financial institutions and Islamic securities to foreign investors/non-residents.

ITA has also provide deductions of rebate for any obligatory religious payment such as zakat (Islamic tax) or fitrah as per ITA Section 6A(3):

“A rebate shall be granted for a YA (Year of Assessment) for any zakat, fitrah or any other Islamic religious due payment of which is obligatory and which are paid in the basis year for that YA to, and evidenced by a receipt issued by, an appropriate religious authority established under any written law”.

The Muslims regard zakat and fitrah as part of religious obligations. The normal calculation of zakat is 2.5% and the zakat is based on their wealth and income. The ITA allows payment of zakat and fitrah by the resident to be set off against the tax payable in the form of rebate. However, any excess of rebate over tax payable cannot be carried forward. Starting from YA 2005, companies that pay corporation zakat are allowed to deduct against their total aggregate income with limit up to 2.5% of their aggregate income.

However, the rebate from zakat and fitrah shall only be granted to resident individual and companies but not available for Islamic financial institutions such as Islamic banks or takaful companies.

Tax neutrality
This section can be taken specifically for the subject of the Islamic private debt securities and the Sukuk issuance. As mentioned above, Islamic financing products are normally requiring more steps such as buying and selling or leases of the underlying assets. Thus, the tax implication will be more intricacies without the exemptions from the Act. The reality of Islamic financing requires the assets transfer for more than once. Thus, the ITA Section 2(8) allows the underlying sale of assets or leases to be ignored for tax purposes so long as the transferring of assets is to meet the Shariah requirements. The following is the provision contain in the Section 2(8) of ITA:

“Subject to subsection (7), any reference in this Act to the disposal of an asset or a lease shall exclude any disposal of an asset or lease by or to a person pursuant to a scheme of financing approved by the Central Bank, the Securities Comission or the Labuan offshore Financial Services Authority, as a scheme which is in accordance with the principles of Shariah where such disposal is strictly required for the purpose of complying with those principles but which will not be required in any other schemes of financing”

This provision helps to keep the cost of Islamic financing to be at the same level to the cost of conventional financing. In addition, any additional stamp duty in lieu to the transfer of the underlying transactions is also exempted as long it is for the purpose of Shariah requirements. Not only have that, the above provision also overridden the Schedule 3 of ITA. Under normal circumstances as per Schedule 3 of ITA, the transferor of the asset will always be liable to the balancing adjustments (either balancing allowance or balancing charge, based on the difference between the sales proceeds and the tax written down value of the asset) for every disposal. However, Section 2(8) overridden the requirement and the transferor will not be subjected to the balancing adjustments. Such that the transaction remains tax neutral.

In addition to the specific provision in the ITA for the Shariah finance instruments, changes have also been made to the Stamp Act, 1949 with the same spirit so that the Islamic financing transactions are not adversely taxed as compared with its conventional counterparts. According to the Stamp Duty (Exemption) (No.2) Order 2000, PU(A) 16/2000, that any issue or transfer of private debt securities issued under Shariah Law are exempted from stamp duty. This provision is cemented by the Stamp Duty (Exemption) (No.2) Order 2004, PU(A) 19/2004, whereby all instruments executed between customer and financier with regards to Asset Sale Agreement and Asset Lease Agreement is exempted from stamp duty if it is made under the principle of Shariah for the purpose of renewing any Islamic revolving financing facility.  According to the Stamp Duty (Exemption) (No.3) Order 2004, PU(A) 20/2004, any instruments made by financier relating to the purchase of property and to lease it back will be exempted from stamp duty as long it is made in accordance with the principles of Shariah or if it is under a principal sale and purchase agreement by which the financier will assume the contractual obligations of a customer.

Islamic Accounting — Exclusivity, Harmonization or Convergence?

Islamic Accounting — Exclusivity, Harmonization or Convergence?

By Arzim Naim CA(M). FCCA . CIFP

(This article has appeared in the Islamic Finance News magazine on 25 August 2010)

When the notion of Islamic economics was introduced, the argument against its very existence was expected. Along the way, not only did people eventually appreciate its main distinctions, it flourished and Islamic finance principles and products were spread to the world. These phenomena have led to the existence of Islamic accounting principles to be used as it is more suitable in conveying the true nature of Islamic financial instruments. The never ending debate on the need to use Islamic accounting by the Islamic financial institutions (IFIs) over the use of conventional accounting has pushed Islamic accounting to a new level.

The question now is whether Islamic accounting should (i) live in its own exclusivity, or (ii) harmonize or (iii) to converge with conventional accounting. These three options have been highlighted by Mohammad Faiz Azmi, chairman of the Malaysian Accounting Standards Board (MASB).

Exclusivity means that Islamic accounting is to live side by side with its conventional counterpart. Thus, any Islamic financial instruments will only be recorded by way of Islamic accounting. The harmonization concept is when the financial reporting standards (FRSs) are fine tuned — for example, certain exemptions are allowed/disallowed or Shariah related disclosures are allowed for any Islamic financial instruments. The last option is convergence, or simply put, applying FRSs in every aspect, even to Islamic financial instruments.

This article attempts to fill the gap in the literature and encourage emancipator perspectives to the notion of Islamic accounting. In order to do so, we need to go back to the basic building blocks of both Islamic and conventional accounting. Are they really miles apart?

What is Islamic accounting?

Accounting is just a recording function, just a tool. An academic definition for accounting is the “identification, recording, classification, interpreting and communication of economics events to permit users to make informed judgment” (American Accounting Association, 1966). It is a total value free definition without attaching any religious dogma to it. However, the main difference lies in two major categories (i) its objectivity and to whom the information shall be communicated, and (ii) the identification, valuation and measurement of information.

1. Objective of accounting

It is widely accepted that the primary objective of financial reporting and accounting is to provide useful information to assist users in making economic decisions. It is the objective of the accounting to provide a fair information flow between the principal and agent. One of the arguments on the basic differences between Islamic accounting and conventional accounting falls within the ambit of the objective of accounting itself. Conventional accounting leans towards the term ‘decision usefulness’ whereas Islamic accounting leans towards the context of ‘accountability’. The ‘decision usefulness’ is where the information disseminated will only useful to certain parties (for example, bankers, creditors, staffs and such). On the other hand, ‘accountability based’ framework within the Islamic context is a consequence of responsibility. In Islam, man has a covenant with God. Accordingly, this covenant requires the man to discharge his accountability in accordance with the responsibilities laid down by the Shariah (Islamic law).

Whether those arguments are real or not will depend on the perceptions of the public. Some would say that conventional accounting has always catered for all users of financial statements. The person preparing financial statements will always be held accountable for the accuracy of the financial statements. The fact that modern accounting requires more transparency in the accounts has proven that the ‘decision usefulness’ framework no longer prevails in its framework. In addition, the core content of modern corporate governance will always focus on the fair information flow to all parties particularly through financial statements.

The ‘accountability based’ framework has now become universal practise. However, I must say that the only distinction of the ‘accountability based’ framework espoused by Islamic accounting is that the rule of accountability must be purely divined since financial reporting and accounting carries religious obligations. In this sense, Islamic accounting must not incur any form of reporting that gives way to interest based elements. For example, under the new requirements of the FRSs, any form of loan given by a  parent company to its subsidiaries must be discounted back using an  appropriate rate of returns/interest rate used by the company’s panel actuary after the timing for the repayment of the loans have been forecasted. The fact that this requirement includes the Qard al-Hassan (benevolent loan) by the company to another party to be discounted back using an appropriate interest rate, definitely contravenes the Islamic precepts itself. 

2. Identification, valuation and measurement

Conventional accounting in its current structure follows what is known as generally accepted accounting principle or the fundamental accounting concepts. This takes into account among others accrual and matching, substance over form, going concern, prudence or conservatism, consistency, monetary measurement, materiality and others.

(i)      Going concern and accruals

These two concepts are considered part of the bedrock of accounting. The going concern is particularly important with regard to measurement. As a result, the conventional accounting standards requires that financial statements be prepared on going concern and requires that the directors assess whether there are significant doubts about the entity’s ability to continue as a going concern. The accruals concept lies at the heart of the definitions of assets, liabilities, gains, losses and changes to shareholders funds. Accruals basis of accounting requires the non-cash effects of transactions to be reflected in the financial statements for the period in which they occur. This concept is closely related to the ‘realization’ concept whereby the firms can only allow profits that are ‘realized’ by the balance sheet date to be included in the income statements.

Basically, the going concern concept embedded in conventional accounting is not in conflict with the requirements of Islamic accounting. The directors should assess the firms’ ability to continue as a going concern. Consequently, financial statements must also be prepared on the basis of going concern unless otherwise, alternative valuations of assets and liabilities are used. The principle of accruals concept does not in conflict to the requirements of Shariah. It is permissible under the purview of Shariah. This is evidenced from the treatments of Murabahah transactions conducted by Islamic banks. The accrual basis method recognises profit based on a proportionate allocation of profits whether cash is received or otherwise. IFIs had once used the cash accounting method. This was due to the religious dogma that the income/profit will be recognized as and when money is received, and vice versa. The AAOIFI and MASB have rejected the applications of the cash basis accounting on the grounds that the accruals concept appears to be more conclusive in reporting.

(ii) Consistency and prudence (conservatism)

These two concepts are considered desirable qualities of financial statements. Consistency implies that a company should rarely change the way in which financial information is prepared and presented. The consistency requirement is not in conflict with the Islamic accounting requirement. However, the comparability is regarded to be a more fundamental objective than consistency. In particular, IFIs should not use consistency to justify an accounting policy that is no longer the most appropriate to its particular circumstances.

The prudence concept was closely linked to that of ‘realization’. The concept of prudence implies that IFIs should take a very pessimistic outlook in estimating income, expenses, assets and liabilities and promotes the need to be cautious in overstating assets or profits especially in the face of inevitable uncertainties in the business world with a reasonable dose in the preparation of financial statements. Apparently AAOIFI is silent on the prudence principle in financial reporting. If IFIs understate the potential income or assets value, the financial report would be ‘unfair’ to the stakeholders and the users of financial statements. AAOIFI leaves it to the best discretion of the preparers of financial statements.

(iii) Assets and the ‘substance over form’ principle

A major difference between conventional accounting and Islamic accounting lies in the definition of assets. In a conventional sense, any tangible or intangible is regarded as an asset when there is any future economic benefit embodied in it regardless of whether there is legal control by the reporting firm. From Islamic perspectives, to qualify as an asset, the reporting firm should have acquired the right to hold, use or dispose of the asset. Thus, Islamic accounting does not particularly endorse the concept of ‘substance over form’. In view of the primacy of contract in transactions in Islam, the emerging reality must be constructed or appear to be as the form. This view is espoused by AAOIFI. This stand is backed by many Shariah scholars on the need to recognize ‘substance’ together with the ‘form’ in financial transactions. Thus, there shall be no such recognition for the quasi-subsidiary for that matter.

Some may argue ‘form over substance’ is closer to Shariah because this principle is putting the intention as the utmost requirement no matter what legal structure or the ‘form’ the financial transaction wants to pose. It is the ‘substance’ that is matter. Most of the Sunni schools such as Maliki uphold that the ‘intention’ will be the determination in deriving to the rules due to certain acts.

(iv) Historical cost and market valuation

Historical cost concept only provides input to the ‘satisfying’ notion. Some decision makers do not seek to optimize but ‘satisfy’. It is easy and very cost favorable to the reporting firm. The Para 135, Statement of Financial Accounting No 2 of AAOIFI is taken as proof pertaining to the endorsement of historical cost technique. On the other hand, the new FRS advocates the use of the ‘mark-to-market’ valuation. It is expensive and undesirable. However, the ‘mark-to-market’ valuation is really Islamic in a way that it will lead to the fair value of Zakat computation which is so central to the Islamic faith, thus, should be given a prominent place in accounting.


From the analysis we can safely say that in basic principles, FRS is closer to the Islamic precepts. To answer the question of whether Islamic accounting is to be in exclusivity or to harmonize or to converge, will depend on the perceptions of the standards setters.

In my opinion, it is not an option to let the Islamic accounting remain in exclusivity. Such treatment will lead to undesirable arbitrage. On the other hand, to converge with FRS will be a better option except that the ‘discounted’ valuation technique for some Islamic financial instruments for example the benevolent loan is undesirable. Thus, the only option left is to harmonize both accounting schools. This means, the FRS has to be finetuned to accommodate Shariah principles. The new FRS could probably be issued for use only in IFIs. This has to be resolved as soon as possible in order to eliminate any hindrance that limits the progress Islamic finance developments.