New Islamic financing tax laws to attract more foreign investors to South Africa

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16 August 2010 | Category: Tax

South African Islamic investors and financiers are likely to be recognised by way of a new insertion in the Income Tax Act. One of the benefits is that it should attract further foreign investors to the country’s financial markets.

Islamic finance is derived from the Sharia’h and it essentially involves profit and risk sharing and forbids the paying or receiving of interest or investment in certain industries.

The proposed new section of the Act brings three types of Islamic financing transactions into the tax net – the investment account agreement called Mudarabah, the financing transaction known as Murabaha and joint ownership financing which is termed Diminishing Musharaka, all removing interest from the equation.

“Interest is considered economically harmful by Sharia’h law as the extension of credit increases money supply, which stimulates demand for goods and services but does not always result in real, tangible economic activity,” says Tasneem Gangat, a tax consultant at Grant Thornton Johannesburg. “It believes interest-bearing transactions result in economic ills including issues such as high inflation and unemployment.”

The proposed new section 24 JA takes into account three types of Islamic financing and will be aligned to Sharia’h law. For investment account agreements, or Mudarabah, tax will be payable on any profits derived by the client as these will be deemed as interest, thus making them taxable at the hand of the client.

Any Murahaba financing transactions between a client and the financier will see “marked up” amounts within the agreement as the taxable amount payable in favour of the bank for tax purposes. For joint ownership financing – known as Diminishing Musharaka – the client purchases the bank’s “portion” of ownership in the asset over time and the amount paid monthly to the bank includes both the premium payable and taxable amount owed to the bank.

South Africa joins Australia, Hong Kong, the United Kingdom and a growing number of other non- Muslim countries developing their Islamic finance sector by changing regulations to attract investors who can only put their money in Sharia’h compliant assets. The changes will be effective from a date to be announced by the Minister of Finance.

Sharia’h law states that the emphasis on economic activity must ensure that money changes hands (from provider to user), accompanied by an increase in trade, manufacture, service provision and, as a result, employment.

The basis of Islamic finance is equity through profit and loss sharing schemes and rental income, usually mutually developed through agreements between the bank and client. The Islamic financier will assume the risk of the purpose of the funds he is investing and share in pre-agreed ratios in profit or loss which result from the transactions.

“The principles of investment management such as sector diversification, low risk versus high risk, income versus capital growth etc, will still apply to an Islamic investor, but the manner in which these objectives are achieved, as well as the investments utilised, will differ from conventional finance,” says Gangat.

Islamic financing is available to the general public and not exclusively made to people of the Muslim faith. Even though Islamic finance is still a young concept, it is a way forward as entrepreneurs realise the scope of the potential market for Islamic products.

“Judging by this success of ethnical funds worldwide, the need to bolster GDP in SA and the intense focus on business ethics, Islamic finance is likely to become a permanent feature of SA economic landscape,” concludes Gangat.

Further information on Islamic finance transactions
Mudarabah

• An investment account where anticipated profits are divided proportionately in terms of an agreement that is concluded between the bank and the client, essentially a partnership. The client bears the risk in relation to the funds deposited and shares in the profits made by the underlying assets of the deposit.
• This form of relationship is also the most common mechanism that banks and collective investment schemes use to access retail investors.
• From a tax perspective any profits so derived by the client shall be deemed to be interest and taxable in the hand of the client.

Murabaha

• A financing transaction where the bank will purchase an asset (say machinery) from a third party and thereafter sell the asset to the client at a pre-agreed price. The mark up by the bank is determined with reference to the time value of money. The client will settle the “purchase consideration” to the bank by way of regular instalments that will not vary over the lifetime of the arrangement. The bank retains the right to re-possess the asset if the client defaults on payment.
• For example an individual identifies a printing machine from an equipment dealer and approaches the Bank for financing. The Bank agrees to purchase the equipment for R 9000 in its own name and to on-sell the equipment to individual at R 17 000 (including a profit margin), the amount of which is payable by individual in one lump sum at the end of a 24 month period.
• The individual is deemed to have directly acquired the printing machine directly from the dealer at a cost of R 9 000 and the Bank is deemed not to have acquired or disposed of the printing machine. The marked up amount of R 8 000 constitutes a “premium payable” by the client and constitutes a taxable amount in favour of the bank for tax purposes.

Diminishing Musharaka

• A form of financing whereby the bank and client will acquire joint ownership of an asset on the basis that the client will purchase the bank’s “interest” in the asset over a period until such time as the client becomes the sole owner of the asset, similar to a financial lease.
• For example a client identifies a residential property worth R 1 million and approaches the Bank for financing. The Bank agrees to purchase property jointly with the individual from the seller on condition that individual pays 20% (R 200 000) of the purchase price and the Bank pays 80% (R800 000); the individual will purchase 10% of the Bank’s proportionate interest in the property each year over a period of 8 years for R 100 000 per year, and the individual pays an annual rental of R 96 000 for the right of occupation in the Bank’s proportionate interest in the residential property.
• For income tax purposes, the individual is also deemed to have acquired the property directly from the seller at a cost of R 1 million. The R 800 000 constitutes the issue price of the instrument. The Bank is deemed not to have acquired or disposed of the property. The annual rental of R 96 000 constitutes the premium payable by the client and a taxable amount in favour of the Bank.

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