Despite an impressive 12 months for Islamic finance, the view from the industry is that results could be even greater if hurdles concerning taxation, regulation, legal frameworks, market challenges and a lack of qualified scholars are tackled.

Islamic finance, from a very humble beginning in 1963, has become a global phenomenon. Today, the industry covers many dimensions – such as asset classes, product types, industry players, issuers and investors – and spans various markets and regulators as well as jurisdictions. Such expansion and growth is undoubtedly welcome. Yet while the pace of Islamic finance's development is clearly impressive, it could have accomplished even greater results if it was able to overcome some of the hurdles it faces. 

While some of these hurdles are regulatory, others exist because of the market and human capital. The future of Islamic finance, especially in some jurisdictions, largely depends on the ability to overcome these hurdles in the near future. Regulatory challenges are numerous. They could be related to a certain legal proposition, a tax treatment or even the enabling acts and statutes to allow the introduction of Islamic finance either for banking or insurance or fixed income.

Relatively speaking, a legal hurdle may be more challenging as it is invariably enshrined in a country or jurisdiction's legal system. In jurisdictions that do not recognise the equity principle of ‘beneficial ownership’, any transfer of asset for sukuk ijarah (lease-backed notes) purposes must result in a real transfer of an asset, which may not be desired by the originator of the sukuk. New legislation and an amendment to the transfer of ownership law have been effected in Bahrain and Indonesia, respectively. There is a debate in some civil law countries that the principle of 'usufruct' (the right to use and derive profit/benefit from property that belongs to another person or which is under common ownership, as long as the property is not damaged) being enshrined in the country's legal system is as good as ‘beneficial ownership’ in the English common law. If this can be established, then sukuk ijarah will be feasible in the near future in those countries.

Level playing field

Taxation has always been the utmost concern for new jurisdictions and new entrants to Islamic finance. The industry has never appealed for any special taxation treatment. It merely tries to create a level playing field for both traditional and Islamic finance to co-exist and be subjected to the same tax treatment. Many countries have been actively involved in the debate on 'the form versus the substance' in some products and services of Islamic finance. The advocates of the 'form' would always argue that Islamic finance will normally involve multiple transactions, and for this, each and every transaction must be taxed as per the existing laws.

To effect an Islamic house financing or sukuk ijarah, for example, the bank and the issuer must purchase certain assets before they can either sell to the customer under murabahah (deferred payment sale) or lease back to the originator under ijarah. Obviously, there will be two transactions before the real economic benefit of this transaction is transferred to the ultimate customer. A stamp duty or perhaps the property or land registration tax will be imposed twice in the above transactions. This will render Islamic finance more expensive, and thus not competitive.

To date, Islamic finance has been able to provide most of the products that traditional finance has been offering to the community, and in some cases the cost of the two products is very competitive – if not equal

Dr Mohammed Daud Bakar

The advocates of 'substance', on the other hand, will put forward a very logical and neutral argument which is, in essence, that the Islamic banks (or the special purpose vehicle in the case of sukuk) never intended to purchase these assets for themselves. They have to do this merely to comply with the sharia requirements and in the process, there is no transfer of economic benefit to them. 

As such, this leg of the transaction must be exempted from any tax since if it is merely being carried out to facilitate the second leg of the transaction. As there is no economic benefit to any party such as capital gains, the tax will not be relevant. 

Substance acceptance

Some countries, such as the UK, Singapore and more recently Turkey, have amended their tax laws to take into account the 'substance' of the transactions instead of the 'form' in murabahah and sukuk ijarah transactions, respectively. In 2007, Malaysia introduced not only a tax neutrality policy but also provided a raft of tax incentives to support the growth of certain Islamic finance products in the country.

Today, Malaysia leads the charge as the biggest Islamic financial market in Asia, which is due in no small part to the tax neutrality initiatives of the Malaysia International Islamic Financial Centre (MIFC). This has led to the removal of obstacles such as double taxation and duties through legislative changes which stipulate a single tax on an entire structured product rather than taxing individual tranches. Current tax incentives for Islamic finance products have been extended until 2015.

Meanwhile, Malaysia’s tax incentives on sukuk have made it the biggest worldwide issuer, accounting for more than 60% of the global sukuk market.

Malaysia’s recognition of the fact that funding sharia instruments conventionally is often not commercially viable has seen it develop what is largely regarded as the world’s most dynamic and comprehensive Islamic financial system. 

To further promote innovation in Islamic securities products, the 2011 budget the Malaysian government has proposed that expenses for the issuance of Islamic securities adopting the principles of murabahah be given tax deductions, while takaful contributions for export credit will be given double tax deductions.

In reducing the cost of Islamic financing in this way, Malaysia has helped Islamic institutions to compete on a level playing field with conventional counterparts. Several countries in Asia are now following suit. 

Sharia principles

Another key regulatory hurdle is the enabling act or statutes. While a few jurisdictions have legalised Islamic finance via relevant acts and statutes, most of the jurisdictions have done this via guidelines only. It is proposed that a more robust act to govern Islamic finance is needed to move forward. It does not really matter whether this system is known as Islamic finance or otherwise (such as a participation bank – for example, in Turkey) as long as the financial and legal behaviour of these institutions conform to the minimum sharia requirements. The same applies to takaful – an Islamic insurance concept that is grounded in Islamic muamalat (Islamic law of commerce), observing the rules and regulations of Islamic law. 

In addition to regulatory hurdles, the industry is also faced with many market challenges. In several jurisdictions, there is no sharia-compliant inter-bank money market. Therefore, Islamic banks operating within these jurisdictions have to subscribe to a few products that do not abide with sharia principles in terms of their liquidity management. This is a substantial hurdle and an immediate solution must be found to enable Islamic banks to manage their liquidity according to sharia principles.

The issue is equally problematic for new entrants in foreign countries that do not have any sharia-compliant liquidity papers. The newly established Islamic finance entities may need to deposit their monies in short-term investment papers that are not sharia-compliant.

In the past, there have been some attempts to venture into new markets but the fact that there are no such instruments in the host country has served as a deterrent to institutions. It is important for the local market to have strong, liquid and short-term sharia-compliant papers to support the introduction of new Islamic financial institutions in that market.

Revising skill sets

Last but not least is the challenge pertaining to human capital. Professionals who are highly qualified in Islamic finance are still in relatively short supply, despite the annual steady growth of Islamic finance. 

As a result, what has happened is that the same group of qualified industry professionals keep rotating from one institution to another. The under-supply of sufficient professionals is a problem that persists from year to year. The industry needs to come together to collectively discuss how to close this supply-demand gap in the near future.

Practitioners, both senior and junior, will need a more flexible method of learning to equip themselves with the skill sets required for the Islamic finance industry. Most of the academic and professional programmes available are tailored towards a general set of skills but fail to deliver specific skill sets such as legal documentation, financial engineering, sharia audit, risk management, treasury and liquidity management. A revision of these respective syllabi and curricula is crucial to ensure that future industry professionals are equipped with the relevant skills and knowledge base. Of course, the future development and sophistication of the industry is dependent on such revisions and therefore addressing this matter is somewhat urgent. 

In addition to the hurdles mentioned above, there is also the issue of a strategic decision by a stakeholder in any particular aspect. For example, in some countries, a dual banking system has been accepted and promoted where Islamic finance can co-exist in parallel with traditional finance. This has proven to be a very successful story in the countries that opted for this approach as it is more cost-effective and competitive. One wonders whether the time has come to appraise whether a more strategic policy should be adopted in the near future to create another success story for Islamic finance. 

To date, Islamic finance has been able to provide most of the products that traditional finance has been offering to the community, and in some cases the cost of the two products is very competitive – if not equal.

In some countries, Islamic financial products are appealing to both Muslims and non-Muslims alike. Thus, it is only reasonable to expect that Islamic finance, at least in some jurisdictions where Muslims have majority representation, could be promoted as the main and premier banking and financing infrastructure, with traditional financing as a supplementary scheme.

Dr Mohammed Daud Bakar is founder and managing director of Amanie Islamic Finance Consultancy and Education, based in Kuala Lumpur, Dubai, Luxembourg and Cairo.

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