Current issues in Islamic finance
Banking on Tax, Issue 8
The Board of Taxation (BOT) released a discussion paper on the review of the taxation treatment of Islamic finance, banking and insurance products on 13 October 2010. Following consultation meetings and consideration of submissions from various parties, the BOT has provided a report to the Assistant Treasurer. However, the Government is yet to respond to the BOT’s report or release the report to the public.
In an environment in which the loan-to-value ratios of banks are being squeezed and single customer limits are being scaled back, the higher risk-tolerance of Islamic finance investors and the ability to participate as a syndicate with Islamic lenders should be welcome relief for senior funders and developers/sponsors.
The construction industry in Australia, in particular, has seen the participation of Islamic investors in the form of:
- Equity investors through managed investment schemes
- Mezzanine financiers
- Senior lenders and syndicated arrangements.
Transactions to date have had to undergo significant structuring to mitigate any unintended consequences arising from tax and regulatory impacts.
The following tax issues should be considered in structuring Islamic funding arrangements for project and development finance:
- Are the amounts arising under Islamic finance instruments deductible and what is the impact of withholding taxes?
- Does structuring the arrangements to avoid adverse tax consequences diminish the funders’ sponsor support that it would otherwise enjoy through mortgage and security interests?
- What is the regulatory impact of large-scale funding arrangements?
Deductibility and withholding tax
Notwithstanding its treatment under Islamic financing principles, the returns under the arrangement can be structured to operate in the same way as “interest” under a conventional debt instrument. This raises a number of issues:
- It would be typical for Islamic investors to participate in the capacity of a mezzanine financier and share in the profits of the project. The terms of the instrument would, therefore, have to be carefully considered to ensure it is treated as debt for the purposes of Division 974 of the Income Tax Assessment Act 1997
- Whether a liability to interest withholding tax applies at the rate of 10% (subject to any applicable tax treaty) will depend on whether the returns derived by the Islamic investor fall within the expanded definition of interest, as either amounts in the nature of interest or amounts in substitution for interest
- Public placement of the debt through Sukuk issuance (Islamic bond-equivalents) may allow an exemption from withholding tax under section 128F of the Income Tax Assessment Act 1936; however, careful consideration needs to be undertaken to ensure that the noteholders’ interest under the Sukuk qualifies as a debenture.
Availability of sponsor support
An Islamic equity or mezzanine investor cannot be a party to the senior facility agreement. It is typical in these arrangements to have the project sponsor as the borrower under the senior facility agreement and the Islamic investor will instead be a step removed and contract with the senior lender through an inter-creditor agreement. This raises the very real issue of structural subordination for the Islamic investor (e.g. does the Islamic mezzanine financier have a second-ranking security interest in the project’s assets?).
A Sukuk is the Islamic finance equivalent of a bond issuance and they are widely used in debt capital markets to tap surplus liquidity in Asian markets and the oil rich nations of the Arabian peninsula. However, the unintended consequence of structuring a Sukuk to ensure parity of Australian tax treatment with conventional bonds means that regulatory impacts must be considered (e.g. what is the impact of APS 120 (Covered Bonds) given Sukuk holders may enjoy a preferential claim on the project’s assets?).