 Islamic Finance: Integration into the Financial Mainstream Adapting Western Tax Systems to Accommodate Islamic Finance Mohammed Amin 28 May 2008

PricewaterhouseCoopers LLP 28 May 2008 Slide 2 Mohammed Amin Mohammed Amin is a tax partner at PricewaterhouseCoopers LLP and leads their Islamic Finance practice in the UK. He is: a Council member of the Chartered Institute of Taxation a member of the Policy & Technical Committee of the Association of Corporate Treasurers a member of the Business & Economics Committee of the Muslim Council of Britain a member of HM Treasury’s Islamic Finance Experts Group, set up to advise the Government on Islamic finance strategy Many of Amin’s previous articles and presentations on Islamic Finance can be found on his Islamic Finance blog at: pwc.blogs.com/islamicfinance Tel: Fax: Mob: Web: PricewaterhouseCoopers LLP

Agenda/Contents Why Western tax systems can be challenged by Islamic Finance The Swiss position How the UK tax system has been adapted for Islamic Finance

PricewaterhouseCoopers LLP Why Western tax systems can be challenged by Islamic Finance

PricewaterhouseCoopers LLP 28 May 2008 Slide 5 Assumed tax system Assume equipment expenditure amortisable over equipment life on straight line basis. When does amortisation start? - When machine purchased - After payment made What constitutes a finance cost

PricewaterhouseCoopers LLP 28 May 2008 Slide 6 Illustrative transaction Conventional purchase - Machine delivered, cost 1,000 - Pay immediately by borrowing bank loan - Two year bank 5% simple interest payable on repayment. - Five year machine life Islamic purchase -Machine delivered now - Payment due after two years - Machine price 1,100 - Five year machine life Identical cash flows

PricewaterhouseCoopers LLP 28 May 2008 Slide 7 Conventional purchase Goods obtained Cost 1,000 Finance cost 100 Bank Goods supplier Customer 1,000 Sale for immediate payment Cash loan 1,000 PricewaterhouseCoopers LLP Loan repayment 1,100 Pay 1,000

PricewaterhouseCoopers LLP 28 May 2008 Slide 8 Conventional purchase tax deductions Amortise from purchase, interest on accruals basis YearAmortisationInterestTotal Total1,0001,100

PricewaterhouseCoopers LLP 28 May 2008 Slide 9 Islamic purchase Goods obtained Cost1,100 Bank Goods supplier Customer 1,000 Sale for immediate payment Sale for 1,100. Payment deferred by two years PricewaterhouseCoopers LLP Payment 1,100. Implications of tax system type

PricewaterhouseCoopers LLP 28 May 2008 Slide 10 Legal evaluation of Islamic purchase There is no cost of finance The machine cost 1,100 Machine is paid for two years after delivery Implications of tax system type

PricewaterhouseCoopers LLP 28 May 2008 Slide 11 Islamic purchase tax deductions Following legal analysis Amortise from payment, no finance cost YearAmortisationInterestTotal Total1,100 Implications of tax system type

PricewaterhouseCoopers LLP 28 May 2008 Slide 12 Economic evaluation of Islamic finance purchase Machine value on delivery 1,000 Agreed price 1,100 Excess 100 price must be finance cost Payment due after two years 50 per year finance cost Implications of tax system type

PricewaterhouseCoopers LLP 28 May 2008 Slide 13 Islamic purchase tax deductions Following economic analysis YearAmortisationFinance costTotal Total1,0001,100 Implications of tax system type

PricewaterhouseCoopers LLP 28 May 2008 Slide 14 Tax systems classified Implications of tax system type Legal approachEconomic approach USANetherlands UK Specific tax law needed for Islamic finance Zero or limited need for specific tax law

PricewaterhouseCoopers LLP The Swiss position

PricewaterhouseCoopers LLP 28 May 2008 Slide 16 Tawarruq or Commodity Murabaha Party A (Bank) Commodity sellerCommodity buyer Party B 100 Sale for immediate payment Sale for deferred payment 110 Sale for immediate payment Sale100 Cost110

PricewaterhouseCoopers LLP 28 May 2008 Slide 17 Tawarruq – basic Swiss tax questions Can Party B deduct loss? – Yes if for business purposes. Party A’s income may be treated as trading or financial income. No automatic Permanent Establishment if Party A non-Swiss.

PricewaterhouseCoopers LLP 28 May 2008 Slide 18 Diminishing Musharaka Bank Eventual Owner 75% share, diminishing Asset 25% ownership share, increasing Sole occupier Payment to vendor for 25% Payment to vendor for 75% Payments to increase ownership Rent on bank’s 75% (diminishing) share

PricewaterhouseCoopers LLP 28 May 2008 Slide 19 Diminishing musharaka – Swiss tax questions Rent deductible if for business purposes. Rent taxable in Switzerland due to Swiss real estate, even if bank foreign. Real estate transfer taxes on each transfer.

PricewaterhouseCoopers LLP 28 May 2008 Slide 20 Sukuk (Diagram 3) $50,000 share capital XYZ Sukuk Ltd $500m Investors Charity Shareholders XYZ Trading Company Mudarabah Agreement Trust Sukuk Certificates Periodic Payments limited to 6% Purchased Assets used in XYZ Trading Company’s business $500m to buy assets Mudarib 1% Rab al-maal 99%

PricewaterhouseCoopers LLP 28 May 2008 Slide 21 Sukuk – Swiss tax questions Legal form for sukuk transaction needs review. No Swiss law of trusts. 35% withholding tax if over 10 investors. No automatic permanent establishment.

PricewaterhouseCoopers LLP The UK tax system’s approach to Islamic finance Religion neutral Deeming approach Override of specific obstacles

PricewaterhouseCoopers LLP 28 May 2008 Slide 23 Religion neutral No mention of Islamic finance Key concepts -Purchase and resale -Deposit -Profit share agency -Diminishing shared ownership -Alternative finance investment bond PricewaterhouseCoopers LLP The UK tax system’s approach to Islamic finance

PricewaterhouseCoopers LLP 28 May 2008 Slide 24 Deeming approach “Equate(s), in substance, to the return on an investment of money at interest” If within statutory definitions -Customer’s expense treated for tax purposes in the same way that interest is treated -Same for financial institution Tax definitions are precise PricewaterhouseCoopers LLP The UK tax system’s approach to Islamic finance

PricewaterhouseCoopers LLP 28 May 2008 Slide 25 Override of specific obstacles Anti-avoidance rules to stop equity finance being disguised as debt -ICTA 1988 s.209(2)(e)(iii) “securities under which... the consideration given… is … dependent on the results of the company’s business” -interest treated as “distribution” ( = not tax deductible) Specific override in “Islamic finance” legislation PricewaterhouseCoopers LLP The UK tax system’s approach to Islamic finance

PricewaterhouseCoopers LLP This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. © 2008 PricewaterhouseCoopers LLP. All rights reserved. 'PricewaterhouseCoopers' refers to PricewaterhouseCoopers LLP (a limited liability partnership in the United Kingdom) or, as the context requires, other member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.  The extent to which a tax system needs to be adapted for Islamic finance depends upon the extent to which it taxes the economic reality or the legal form of transactions.