Anticipated Tax Challenges In The Adoption of Islamic Finance in Uganda
Financing as per the Shariah is not loan or interest based, but it is instead asset based and provided through Sale based contracts (Murabaha, Salam and Istisna), Lease based contracts (Ijarah and its variations) and Sharing contracts (Mudarabah-profit share/loss borne by owner of capital, Musharakah-profit share/loss borne to extent of capital ownership, Muzara'a-revenue share). The above-mentioned contracts thus create the uniqueness in the taxation of Islamic financial products compared to conventional financing products.
I will simply highlight below some of the possible technical tax issues in regard to the commonest and most popular Islamic finance products that may need to be addressed by those planning to enact tax laws in Uganda either through specific tax legislation or by regulations and maybe practice notes.
- The Murabaha (purchase of an asset by the bank from a supplier at cost and sale to a customer at Cost plus Mark Up). Key tax issues to be addressed are;
- Whether for corporation tax purposes in the customer's tax computation the mark-up will be treated as a deduction similar to interest for amortization purposes or whether it will be treated as part of the full cost of the asset and granted as a wear and tear deduction as per the tax depreciation of assets in the Income Tax Act.
- Whether the income earned by the financial institution will be recognized immediately as profit and thus taxable or it will be recognized as and when it is earned since the Murabaha customer pays for the financed asset in instalments.
- For VAT purposes, the sale by the supplier of the asset to the financial institution will have to charge VAT to the bank. Will there be provisions for the bank to claim this VAT on this first sale? What happens to the sale by the financial institution to the customer? Will VAT be chargeable on the Selling price (Cost plus Mark-up) or will the Mark-up be VAT exempt? Which part of the transactions will be disregarded for VAT purposes? What happens when the customer is not a business and may thus not be VAT registered, does this mean that the Islamic finance transaction may be more expensive than the conventional banking product.
- Mudarabah Deposits (Profit Sharing Investment Deposits received by the Bank as the Mudarib- (investment manager) while the customer provides the deposit funds as the Rabb ul Mal- (owner of funds). Key tax issues to be addressed under this Islamic financial arrangement are as follows;
- Who is taxable in the commercial venture's profit (Mudarib Vs Rabb-ul-mal)?
- Whether the Mudarabah arrangement between the financial institution and the customer is classified as a partnership for tax purposes?
- If it is the financial institution paying out the profits from the commercial venture, is this amount tax deductible?
- If the Mudarabah depositors are overseas, does this create a PE (Permanent Establishment) for tax purposes. Is Withholding Tax (WHT) applicable on the payments to them? (This same tax issue can be applied to the Wakalah-Agency Islamic finance product where the financial institution manages funds received from investors and receives a commission as fund manager.)
- Sukuk investment bonds (used as a form of shariah compliant securities and are a representation of ownership in an underlying asset that is to be financed). Although, we are yet to see any changes in the USE listing laws and regulations to accommodate Sukuk issuance in Uganda, I will discuss the following tax specific issues to be addressed by the relevant enacting authorities;
- Whether Capital Gains Tax is due on the disposal of the asset by the owner to the Sukuk Special Purpose Vehicle (SPV).
- Whether Stamp duty is due on the transfer of ownership to the SPV
- Whether in the case of cross border payments from the SPV to the investors, WHT is due.
- Whether for VAT purposes the various sales between the SPV, the asset owner and the lease transactions are taxable transactions.
- For tax purposes, what is the nature of the payments by the SPV to investors.
- Diminishing Musharakah in house financing. Financial institution (bank) and the customer create joint ownership in a house by jointly purchasing a certain percentage, for example the bank purchases 70% of a house while the customer purchases 30% of the cost of the house. The bank rents out its share to the customer who pays a monthly rent. Both parties agree that overtime the customer will gradually purchase the bank's share of ownership in the house until the customer fully owns the house. The bank's rent of its share of ownership to the customer gradually decreases as the customer's ownership in the house increases. Below are some of the tax issues that may have to be addressed;
- Whether Stamp duty will be applicable on the first sale of the property from the seller to the bank (70%) and the customer (30%).
- Whether Stamp duty will be applicable on the second sale of the 70% by the bank to the customer.
There are many tax scenarios that may need to be addressed through regulations or practice notes in order to avoid such dilemmas. Another foreseeable dilemma is whether the enacted tax laws will only be applicable to financing arrangements where a financial institution is involved. What happens in the event that the transacting parties have no financial institution involved and the parties have an Islamic finance arrangement? How will the tax laws address this?
The laws also need to incorporate anti avoidance measures to prevent taxpayers from taking advantage of these Islamic finance-specific tax provisions while also enforcing arm’s length transactions where there are related parties involved. As a possible solution to all the above scenarios, we can borrow ideas from the UK (surprisingly its tax laws in regard to Islamic finance have progressed and advanced faster than the likes of Indonesia and Malaysia). The Kingdom of Saudi Arabia and the United Arab Emirates have also only recently introduced VAT and we may thus learn a thing or two from their Islamic Finance specific sections in their VAT laws and regulations.