Business, Taxation

Amendment in tax laws: Finance Bill may provide level playing field to Islamic banking

Finance Bill (2017-18) is expected to amend tax laws to provide a level playing field to Islamic banking aiming at providing tax neutrality to Islamic financial services. Sources told Business Recorder here on Monday that the budget makers were seriously reviewing proposals to bring tax neutrality between Islamic banking vis-a-vis conventional banking. If the proposal has been finalised, it would amend relevant tax laws through Finance Bill (2017-18), they added.

In its budget proposals for 2017-18, State Bank of Pakistan (SBP) has observed that the tax proposals for Islamic banking have been devised to provide a level playing field aiming at providing tax neutrality to Islamic financial services. This policy initiative will help make Islamic financial products more competitive against conventional banking products.

Though Rule 3 of the 7th Schedule of Income Tax Ordinance 2001 allows tax neutral treatment to Islamic banking institutions, the explicit tax neutrality is not provided to customers availing Islamic financial services. This has resulted in high profile cases between income tax department and large tax payers. The unfavourable tax treatment on account of availing Islamic financial facilities can potentially have far-reaching negative consequences, thus appropriate amendment is essential. Accordingly, in order to provide tax neutrality treatment to customers of Islamic financial institutions availing Islamic financial services under different modes of Islamic financings, a new sub-section (6) is proposed to be incorporated in Section 32 of Income Tax Ordinance, 2001, the SBP recommended.

Presently, the income tax law allows deduction of customers of the Islamic banks in respect of amount paid by them to a banking company under scheme of Musharakah. However, complete tax neutrality is not available in respect of other Islamic modes of financings. In order to provide tax neutrality to customers of Islamic banks in respect of different modes of Islamic financings, it is proposed that following sub- clause (1A) be introduced in Section 32 of the Income Tax Ordinance, 2001.

Any special treatment of Shariah compliant financing availed by a person from a bank or financial institution approved by the SBP or the Securities and Exchange Commission of Pakistan (SECP), as the case may, shall not be provided any reduction or addition to income and tax liability for the said Shariah compliant financings.

The rationale of the proposal is that it will provide complete tax neutrality to customers of Islamic banks in respect of Islamic mode of financings, other than Musharakah, which are presently not specifically covered in clause (h) of section 28(1).

The SRO No 445(1)/2004, dated June 12, 2004, only excludes Murabaha transactions from the definition of “supply” for the purpose of sales tax but not the transactions based on other Islamic modes of financing arrangements such as Musawama, Istisna, Salam, etc. Exclusion from the ambit of sales tax should specifically be provided in sales tax law for trade/ sales related Islamic modes of financings specifically approved by the SBP or the SECP. This lack of specific exemption in law, to exclude goods/commodities from the definition of supply purchased by Islamic financial institutions (IFIs) for extending financing to their customers under trade based Islamic modes is hindering use of other sales related modes like Salam, Istisna etc. Therefore an appropriate amendment in SRO No 445(1)/2 004 is proposed.

The objective of Rule 3 of seventh Schedule was to provide tax neutral treatment to IBIs; however, it is difficult to meet the condition of sub-rule (2) of Rule 3, keeping in view the diversified nature of Islamic banking transactions and equating each transaction to a conventional equivalence and then getting it certified by the auditor which is time consuming and costly for Islamic banking institutions. Moreover, it does not give space for differentiated transactions as each transaction from income tax purpose has to be equated with a conventional transaction. It is thus proposed that the audited financial statements of Islamic banks as well as those of Islamic banking branches/windows operations of conventional banks provided separately in the audited financial statements of conventional banks submitted to the SBP should be taken as basis of calculation for income tax with additions and deductions as provided in the Seventh Schedule to the Income Tax Ordinance, 2001, which is applicable to the entire banking industry in Pakistan.

The SBP further recommended that the FBR may clarify that gross receipts on account of any Islamic financing arrangement entered into by a banking company, authorised by the SBP to conduct Islamic banking business, shall not be considered as ‘turnover’ for the purposes of computing minimum tax under section 113 of the ordinance. Furthermore, all Islamic financing transactions shall be treated at par with the financing transactions conducted by conventional financial institutions for the purpose of computation of tax liability under this ordinance. Therefore, only the gross income reported in profit and loss statement of Islamic banking institutions shall be considered as turnover for the purpose of levying minimum turnover tax as is applicable in the case of conventional banks.

Gross receipts of Murabaha financing transactions have been considered as ‘turnover’, on account of sale of goods, for the purpose of computing minimum tax under section 113 of the Income Tax Ordinance, 2001. Whereas, Murabaha is a financing transaction and Islamic banking institutions are allowed by the SBP to extend financing through Murabaha and other Shariah compliant modes of financing. Therefore, only gross income reported in profit and loss statement of Islamic banking institutions should be considered as turnover for the purpose of calculating minimum turnover tax liability as the same rule is applicable in case of conventional banking.

The SBP said that acknowledging the fact that commodity Murabaha transactions are inter-bank investment/placement transactions, a level playing field should be provided to Islamic banking institutions vis-a-vis conventional banks in terms of tax liability on inter-bank transactions. Therefore, withholding and turnover taxes should not be applied on such commodity Murabaha transactions. For this purpose, a clarification may be issued by the FBR that purchases made by a banking company, authorised by the SBP to conduct Islamic banking business, for the purpose of inter-bank market placements or investments under commodity Murabaha should not be considered for applicability of withholding tax and minimum turnover tax.

Conventional banks conduct inter-bank transactions through money-lending or repurchase offer (Repo) mechanism to lend short-term money to the banks against securities and earn mark-up/interest thereon. Such transactions do not involve any sale-purchase of commodities and any cost involved is treated as an admissible expense. On the other hand, return on money-lending or Repo transactions (IBIs) are strictly prohibited in Islamic banking. As an alternative, IBIs are using commodity Murabaha mode of Islamic finance for inter-bank short-term investments /placements with other financial institutions. Under commodity Murabaha, transactions are traditionally carried out by involving market commodities as a medium to earn profit under Shariah principles. Such transaction involves purchase of commodities by an IBI for onward sale to the other bank on deferred payment basis which is in need of funds. The second bank sells the goods in the market on spot basis to generate liquidity. Though it is a Shariah compliant inter-bank market instrument for IBIs as an alternate to conventional money market instrument, however, in some cases FBR authorities have treated first leg of the transaction of IBIs, involving purchase of commodities from market, as a sale transaction simpliciter for applying withholding tax provisions under section 153 of Income Tax Ordinance. Such interpretation of withholding tax makes the Islamic inter-bank commodity Murabaha transactions unviable for IBIs, depriving them of legitimate liquidity management instrument which is vital for smooth functioning of Islamic banking industry, the SBP added.

It may be clarified by the FBR that the restriction on claiming depreciation under Rule 1(a) on the assets given on finance lease does not apply on Ijarah financing. Accordingly, the Islamic banking institutions may be allowed depreciation on Ijarah assets under section 22, in terms of Rule 1(a) of Seventh Schedule and tax should only be charged on net income (gross rentals minus depreciation) derived from Ijarah financing, which is also applicable in case of conventional lease financing.

Islamic financial institutions provide Ijarah financing facilities to their customers by renting out assets to them which is akin to leasing transactions. In terms of guideline laid down in Islamic Financial Accounting Standard (IFAS) – 2, gross rentals are recorded as income in accounts of IBIs against which depreciation is charged. As a result, net income from Ijarah is recognised by IBIs in their books of account. However, assets given on Ijarah have been considered by FBR authorities as ‘finance lease’ on certain grounds, and depreciation has been disallowed to IBIs under Rule 1(a) of the Seventh Schedule. Resultantly, tax has been levied on gross rentals of Ijarah financing, which results in levy of income tax on principal amount invested by IBIs for purchase of Ijarah assets.

It may be clarified by FBR that the financing availed by the customers of Islamic financial institution(s) licensed by SBP or SECP, as the case may be, under any Islamic mode of financing shall be treated at par with the financing obtained from conventional financial institutions for the purpose of computation of income tax liability under this Ordinance. Accordingly, benefit of depreciation would be allowed to customers of IBIs despite having joint ownership of property pursuant to an arrangement of Musharakah financing or diminishing Musharakah financing for the purpose of calculating tax liability of the customers of Islamic banking institutions.

Depreciation on assets financed through Musharakah or Diminishing Musharakah is being disallowed to Islamic banking customer on the ground that asset is jointly owned by the borrower and the Islamic financial institution. Whereas, a borrower of a conventional bank can avail benefit of depreciation on the fixed assets provided as security/collateral to financial institutions (Fl) under long/short term financing arrangement. Nevertheless, this tax benefit of depreciation should also be allowed if a customer avails financing from an IFI under Islamic mode of financing where applicable. Although the asset is jointly owned by the customer and IFI under a joint ownership agreement, yet an IFI cannot avail benefit of depreciation on its part of share due to restriction on them under seventh Schedule of Income Tax Ordinance, 2001. If the customer is also not allowed to claim benefit of depreciation on such assets, depreciation on assets financed by IBIs will not be allowed to either party. Resultantly, the customers of IBIs will be in a disadvantageous position vis-a-vis conventional banking customer. Considering the above tax issues, financing through Islamic modes of financing becomes unviable for customers, which eventually may jeopardise the overall efforts of the government for promoting Islamic banking, the SBP said.

A new sub-rule be added to Rule (3) of the Seventh Schedule specifically mentioning Musharakah, Modaraba, Murabaha, Musawama, Ijarah, Istisna and Salam and any other Shariah compliant transaction as a financing transaction and not trading activity ie sale/purchase transactions.

The introduction of new clause in Seventh Schedule explaining/ mentioning the transactions under Islamic mode of financing will remove ambiguity so as not to treat such transaction as a trading activity ie sale/purchase transaction which can attract withholding tax. The Islamic Financial Accounting Standard-II Ijarah issued by the SECP also confirms that such transactions are financing transactions, the SBP added.