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.
