Sukuk, Taxation, and its Necessary Legal Structures

For sukuk to be successful in countries outside of the main sukuk hot spots (Northern Africa, the GCC states, and Southeastern Asia,) it is important for these nations to create the necessary legal framework for these Islamic financial instruments to thrive. More countries are starting to integrate sukuk into their tax codes, especially as the success of sukuk and Islamic finance becomes more apparent. Not wanting to miss out on the investment opportunities that are available from the vast resources that are concentrated in Muslim regions, countries in the West have started to update their tax systems and financial regulations to accommodate Shariah compliant financial instruments.

One of the most important factors that is necessary for sukuk when it comes to tax regulations is to ensure that there is a parity between taxation on sukuk and conventional bonds. If the tax system favors one of these, this creates an unfair market where it is impossible for the financial instrument in disadvantage to thrive. Currently, most tax systems around the world are structured to handle conventional bonds, but lack some of the specific attributes necessary to work with sukuk and other Islamic financial instruments.

There are several reasons why the appropriate legal structures are necessary for the use of sukuk. These types of Islamic bonds usually involve multiple transfers due to the nature of how they are backed by real assets rather than working on the basis of interest. Legal structures that are not designed to handle this will tax every transfer, creating an unsustainable situation for those involved in the sukuk transaction. The main reason for this is that sukuk often require that ownership of the asset covered by the sukuk be transferred repeatedly from one party to another. Ownership of assets in many regions requires additional tax duties and often involves other legal transactions that incur additional costs. Without special provisions for sukuk, this characteristic of Islamic financial instruments puts them at a severe disadvantage if the right legal frameworks do not exist. A typical example is an Ijara sukuk structure. In these cases, the initial transfer of asset ownership can trigger capital gains, sales tax, holding tax, and stamp duty. Each time a transfer of ownership occurs, which will happen at least twice, these taxes would be required, unlike convetional bonds which would only be taxed according to their capital gains.

One hurdle when creating the necessary legal framework for sukuk in a country’s legislation is the differential treatment between profit and interest. Most of the time, interest payments are tax deductible. On the other hand, profit is taxable. Some types of transactions are affected by additional duties. For example, Murabahah sukuk must pay sales tax or Ijarah sukuk often suffers from additional stamp duty payments. Currently, the United Kingdom, Malaysia, Qatar, and Turkey are the four countries that have some of the best conditions when it comes to taxation systems and frameworks for Islamic financial instruments.

In 2010, the United Kingdom, France, Luxembourg, and Ireland issued tax neutrality laws that ensured that sukuk transactions would be tax neutral with conventional bonds. Laws issued generally use conventional bond taxation as a model for applying taxes to sukuk in order to facilitate the different transfer transactions involved in a typical sukuk agreement. Legislation involved in these cases usually considers sukuk certificates as securities, treating investment returns on sukuk in the same way interest would be treated on a security. Sukuk issuers are entitled to the appropiate deductions, comparable to how conventional bond interest payments are taxed. Necessary tax regulations enacted in these countries also included amendments to stamp acts and other applicable taxes to ensure that sukuk are considered an exemption from payment.

There have been failures by governments around the world to integrate sukuk into their finances. For example, South Korea failed to find an appropriate strategy for these financial instruments. The fact that these bills are not being approved in some countries should serve as a warning for the global Islamic banking system that sukuk are still not at the level of acceptance where they should be to become truly competitive on a global scale. The recent issuance of sukuk, classified as “alternative investment bonds”, by the United Kingdom in 2014 will certainly ensure that these Islamic financial instruments gain wider acceptance and are integrated into more countries’ financial legal frameworks in coming years.

Sukuk have also made advances in other countries around the world. France and Luxembourg have published tax regulations that specifically show how Islamic financial products are treated according to their tax codes. Singapore has also made amendments to its income tax regulations to clarify how Islamic banking is handled in detail. In the case of Singapore’s Finance Ministry, steps have been taken to detail the legal framework for other Islamic financing schemes such as Islamic partnership agreements, joint financing and projects, and interbank transactions in an Islamic banking system. Although North African countries have played an important role in sukuk since its inception (in fact, some of the first Islamic banks were founded in Egypt,) they have been relatively late in creating the legal framework for a true impact of sukuk on their markets. It was only in late 2013 and 2014 that comprehensive legal frameworks and tax regulations for these countries were put into place.

There is also the case of Malaysia, which is considered one of the most important, if not the most important sukuk market in the world. Curiously, the way taxes on sukuk are handled in Malaysia is somewhat different to what would be expected from other economies. The reason for this is that the Malaysian government has made sukuk a very important part of their economic development plan moving into the future. Malaysia’s intentions to become the global center for Islamic finance have certainly been successful in recent years. To attract more Islamic investment and sukuk into the country, Malaysia’s tax code provides substantial incentives which actually put sukuk at an advantage over conventional bonds. Rather than being tax neutral, sukuk in Malaysia are tax positive thanks to these incentives.