Musharakah

This mode of corporate financing, like PTC, has come into being without any legal framework and as such no statutory definition can be offered except that it is one of the forms of “redeemable capital” defined by the Companies Ordinance, 1984. Generally speaking, the arrangements that have been concluded until now between banks and the borrowing entities bring to the fore an important feature that under this mode of financing, working capital needs of business entities, which are short term are intended to be catered. In the light of this, the musharakah arrangement may be said to encompass agreement on the concept of profit-loss sharing in which the parties agree to contribute capital and managerial effort or a combination of both on an agreed basis. Here again, the contractual arrangement may envisage profit-sharing in any agreed proportion but the losses, if any, have to be borne alone by the party contributing the capital and in the case of both investing in the venture, it shall be in proportion to the respective investment of the parties.

It would not be out of place to mention that as a consequence of having launched PLS account scheme vigorously, commercial banks seem to find themselves laden with disposable funds, which they should endeavour to put in interest- free pursuits. In this context, it is imperative to realise that there is a close link between the operation of PLS account scheme and the investment by banks under musharakah.

The salient features of the musharakah agreement may be summed up as under:

1. The profit-sharing arrangement is contemplated on the basis of future projections of profits which in turn is based on past averages duly adjusted according to the future plans and projections and overall state of the economy, the duty and tax structure to which the business is subject to and the industry in which the firm operates. How far such projections and, in turn, share of profits or losses are realistically determined has more to do with the integrity of the entities, the general state of accounting, the degree of credibility and a realistic assessment of other surrounding factors.
2. A provision usually contained in various musharakah agreements is that a certain weightage is assigned to the total amount invested by the bank while the equity of business entity is based on actual levels. This feature which enables banks to claim higher percentage of profits compared with the actual investment seems to be questionable because if at all any weightage appears desirable it is in respect of the undertaking’s own investment because besides capital, it is contributing business management and expertise.
3. The funds being basically provided for working capital needs of the business are in the form of a chequing account somewhat akin to cash credit or overdraft account in which operation could be carried out by depositing funds and withdrawing the same.
4. The investment of die bank is construed to be the totals of daily products of the account participating in profit arrangement. Correspondingly, the investment of business entity for the limited purpose of profit- sharing arrangement under musharakah agreement is also to be determined on the basis of the totals of the daily products of paid-up share capital, revenue reserves and undistributed profits. Funds within die use of business entity obtained from any other source which is not liable to any interest shall also be part of the company’s investment. Likewise, in order to determine “net equity” of the company, accumulated losses shall be deducted.
5. While in theory, it is envisaged that the directors of the company and management shall have absolute independence in managing and conducting the affairs of the company, in practice, however, it seems that certain major decisions such as disposition of profits, change in the existing line of business, etc. may be subject to bank’s consent. In any event, however, it seems imperative that banks shall employ some mechanics for monitoring the affairs of the company.

Although it is conceded that in the initial phase of the existence, additional safeguards to secure the interest of the investing bank may have been a practical necessity, two fundamental features of musharakah agreement, which closely resemble the dominant features of an interest-bearing arrangement must be mentioned. All musharakah agreements contain a provision which declares the legal relationship between the parties to the contract as that of debtor and creditor. While this may seem to be in consonance with the existing statutory requirement of the Banking Companies Ordinance, 1962, which has expanded the definition of "debtors” and "creditors” to include parties to a profit-sharing arrangement as well, this provision cuts at the very root of the arrangement. Consequently, while no partner in any partnership would seek to obtain physically any security, the kind of partnership envisaged under the musharakah agreement requires that the same type of security shall be made available by the business entity as were hitherto furnished in respect of the usual interest-bearing bank borrowings.

On the positive side of the whole arrangement is the fact that due cognisance is being given to acknowledge superiority and managerial excellence, the reward for which is termed as “good management bonus” in such agreements. The mechanics of this aspect is to set aside first a certain proportion of profit for management bonus and the balance is to be pro rata in agreed proportions based on projected profits before taxation.

Major Impediments During Transition

The foregoing survey of the principal features of the profit- sharing arrangements envisaged under PTC and musharakah would make it quite clear that every effort has been made to ensure that the existing banking system is not subjected to perilous upheavals and to prevent existing commitments, both national and international, from being disturbed. One can also discern keenness on the part of banks and financial institutions participating in the so-called profit-sharing arrangements to ensure that they do get a return on their investment at least equal to what they were earlier entitled to as interest.

In the present state of tiling’s, lack of mental orientation and preparation on the part of banks and financial institutions to bear and sustain loss is perceptible. The basic motivation for over-cautious safeguards against losses or miserably low rate of return is indicative of a principal aspect of our national life to which in varying degrees most of us are prone. My reference is to the widespread inclination to conceal real profits or in certain eases, the tendency to persistently declare a loss position. Let us hope that measures taken in various agreements to ward off consequences of such tendencies only prove to be transitory until adequate experience is gained. But the question is: when we have once again set out to chart for ourselves a course towards a system free from riba, does it not befit us to ensure that the deficiencies are removed not by superficial but by positive and objective measures which are imperative to make the system free from even an iota of interest? Should it be dubbed as a puritanical attitude?

We are aware of the underlying cause and although we may not have a sound and workable solution to get over such problems straight away, but there is an urgent need to take a fresh look at our taxation system which is predominantly revenue-oriented and is in total disregard of all other material considerations which are necessary to the success of an interest-free system.

While no patriotic citizen would commend tax evasion, is it not time to see what are the fundamental causes for the present state of affairs? The present rate of corporate taxes and the manner of tax administration only seeks to deter the honest, efficient and industrious while placing a premium on dishonesty. Sometimes, it is claimed that the rate of taxes in Pakistan is lower than many other countries. While this could be a separate debate, I would say that one of the imperatives for a successful operation of interest-free economic system makes it incumbent for a bold, honest, pragmatic and aggressive attitude towards tax reformation. It is futile to think that the society would be totally honest overnight after introduction of the Islamic economic system.

A quote from an article on limit of taxation by Parkinson, who in lighter vein states:

“It may not seem easy to fix on certain level of taxation as representing the maximum. So far it would seem that there are successive points at which evil results successively appear. With peacetime taxation amounting to over 10 percent of the national income, capital will begin to migrate. If its flight is prevented, whether by circumstances or by legislation, taxes could rise to 20 percent but against a stiffening opposition which takes the form of tax avoidance and evasion carried to the utmost lengths of determination and skill. Above 20 percent, each tax increase will produce proportionately less. Above 25 percent, there is serious inflation reducing the value of revenue collected. Above 30 percent, the decline in national influence, observable long before to the expert, becomes obvious to the world at large. At 35 percent, there is a visible decline in freedom and stability. At 36 percent, there is disaster, complete and final, although not always immediate. Taxation beyond that point, feasible and perhaps necessary in time of war, is lethal in time of peace. Of the taxation precipice, 36 percent (for most countries) represents the brink.”

The above would remind us that we too have reached in our corporate taxation what the Indian luminary, Mr Palkiwala, observed in the context of Indian situation that the corporate taxes have reached kelvin zero beyond which, just as in physics nothing can be colder than “kelvin zero”, so also in the matter of taxation, having reached extreme, nothing can go beyond. Let us pause to ponder: is our situation any different than that?

Whereas there would inevitably be some degree of tax evasion whatever be the rate of tax, it can hardly be disputed that a reasonable rate of tax shall certainly mitigate the incidence. We have experimented with quite a few matters in our national life, and may not always be with profitable results, it is essential that the lax structure be conceived on a pattern which should motivate our entrepreneurs to not only greater productivity and profits but also to a greater willingness to declare and share higher profits. Now that the interest-free system exposes banks and financial institutions to high stakes it is more pressing to undertake revamping and restructuring of the whole tax system. Time and again, we have resorted to extraordinary measures of general immunity for declaration of undisclosed income at a concessional rate of tax. But did such patchwork bring about desired results beyond generating a few thousand millions in the state exchequer? A suggestion is being mooted in certain quarters for establishing a nominal rate of profit margin or determining a norm as return on capital to enable various agencies including banks, financial institutions making investments on profit-sharing basis to judge the reasonableness of the declared rate of profit. But, besides being difficult to implement due to practical and technical complexities it would fail to achieve the desired results unless we infuse sanity in our taxation system.

Ebrahim Sidat

Source: Elimination of Riba, Khurshid Ahmad, Khalid Rahman and Zahed A. Valie. Repulished with permission.