TAX AND ZAKAT TREATMENT ON ISLAMIC FINANCEPRODUCTS

Dr. Muhammad M SaidLecturer at Sekolah Tinggi Agama Islam Palangka

Raya, INDONESIA

The paper describes tax and zakat as the twodifferent duties levying on every Muslim. Taxlevied by the government on every citizenincluding Muslim as their citizen duties thathelp the government under which they increase thewellbeing of the citizens while zakat is paid bythe Muslim on the basis of their religious duty.Zakat is collected for socio-economic purpose,namely benevolence loan (qardul hasan). In thecontemporary Islamic economics, zakat is regardedas a tool for Islamic societies to avoidthemselves from the poverty and unemployment. tofree their economies completely from all tracesof interest; moreover, to replace the interestthey can impose the religious tax of zakat in astrict fashion, abandoning all kinds ofspeculation. On the one hand, the conventionaltools of analysis leave a great number ofunanswered questions; on the other hand, thefirst way being able to apply to anticipate theunanswered questions is collecting religious taxof zakat. In the contemporary Islamic economicand finance system, imposing zakat is an integralpart of the Islamic-finance transaction.

INTRODUCTIONIslam requires its adherents who have

wealth to spend a certain amount of zakat forthe public interest in accordance with theconditions set by God, becoming the fourthpillar of Islam obligated for every Muslim tobe paid in their yearly income1. Amount ofzakat is 2,5 percent of all that comes undernisab. Zakat is a levy of 2.5 per cent on netwealth and asset value in liquid form. In theeconomy perspective the Zakat variable inmonetary units be denoted by Z and is leviedon wealth and asset value we save in theIslamic bank by certain consensus ofshareholders. Thereby, Z is mobilized throughthe Islamic bank into Shari’a- compliantprojects in the economy to generate GrossDomestic Product (GDP) (Y) related to thoseprojects and sectors2

In addition, according to thelegislation, the state also demanded every

1M.M. Metwally. Economic consequences of ApplyingIslamic principles in Muslim societies. International Journalof Social Economics, Vol. 24 No. 7/8/9, 1997, pp. 941-957. 2Masudul Alam Choudhury, Sofyan Syafri Harahap.Interrelationship between Zakat, Islamic bank and theeconomy: A theoretical exploration. Managerial Finance,Vol. 34 No. 9, 2008, pp. 610-617.

citizen to give some of their wealth to thestate treasury in order to cost developmentand maintenance of the state, so-called tax.Zakat and tax are two different things we mustnot put them as the same. Zakat is very smallpart of yearly income while tax is a hugeshare of monthly income one earns3.

The recognition of taxation in Islamgenerally follows the traditions in Judeo-Christian teachings, albeit with somedifferences. The equivalent term of tithe inIslam is ushr, but they have different nature.Ushr is tenth of gross agricultural output,calculated from gross agricultural outcome,whether the land is irrigated naturally or byman.

Etymologically ushr has the same meaningas ma'asher (the tithe) in Hebrew. But in Islamthis tithe is only obtain when there is grossoutcome, to the extent that when the produceis destroyed by acts of God, its paymentlapses4.

Thus, ushr is a form of tax on income inthe sense that it is the value of goods(produce) that become the basis of taxableincome. Ra'ana argues further that the caliph3 Ibid. 4Brett Freudenberg" and Mahmood Nathie. The ConstitutionAnd Islam: Are Tax Reforms Possible To Facilitate Islamic Finance? (2010) 20 REVENUE LJ

(the head of state today) has the right tolevy on the people the amount needed if fundsare not available in the public treasury. Theushr was a fixed levy, but the jurist Abu Yusufin his treatise of fessing different views ontax, have not vitiated tax imposition both inits customary form and its present character.Their treatment of tax is explored todemonstrate how each religion's own tenetsacknowledge the role of tax in society5.

A different variant of the ushr known asthe ushur also exists-one introduced by thesecond caliph Umar - that resembled a type ofsales tax. It was charged to traders whoentered the Islamic state to conduct trade. Athird form of taxation in Islam is what isknown as kharaj or land tax payable to the state- irrespective of who owns the land. Theimplications of these tax impositions is thatthe state's right to tax is legitimized-although this right is not to be assumed to beunfettered6. Chapra has argued that:

[While] Islam does allow the levying oftaxes to a reasonable extent to meet allnecessary and desirable stateexpenditures, it does not permit anunjust tax structure which penalizeshonesty and creates an un-Islamic

5 Ibid6 Ibid.

tendency of evading taxes. Chapra arguesthat an Islamic state has the right toraise resources through tax collection:This right is defended on the basis ofthe Prophetic saying that 'in your wealththere are also obligations beyond the zakat,and one of the fundamental principles ofIslamic jurisprudence is that 'a smallbenefit may be sacrificed to attain alarger benefit and a smaller sacrificemay be imposed in order to avoid a largersacrifice'. Most jurists have upheld theright of the state to tax ... If theresources of the state are notsufficient, the state should collectfunds from the people to serve the publicinterest because if the benefit accruesto the people it is their obligation tobear the cost7.

Raquibuz Zaman stated that it is anethical behavior for a Muslim to evadeindirect taxes which include excise taxes,customs duties and perhaps corporate incometaxes. Al- Awwal has reported that everytaxpayer has a right to arrange its affair ina manner to minimize the tax incident withinthe ambit of the provisions of tax laws. Ifthe arrangement is such that it is contrary

7 Ibid

to, the provisions of law, it amounts toevasion of tax, which is an offence. Under taxplanning, what is required to be done is thatthe taxpayer should avail the benefit of allthe deductions, exemptions properly tominimize the incidents of tax as provided inthe statute. Consultancy on tax planning is animportant business in many advancedcountries8.

ZAKAT VERSUS TAXThe preview above clearly shows us the

different nature between zakat and tax.Furthermore, it also inspires us todistinguish tax in the context of Abrahamicreligious traditions -- Judeo, Christian, andIslam. The following paragraph presents deeplydifferent characteristics of the subjectmatters.

There are some characteristics thatdifferentiate between zakat and tax which are:First, zakat is due of total amount to be paidonce within one Islamic year. Meanwhile, taxis levy counted on the basis of one yearfiscal established by the authority throughsome legal act in buying or selling thecommodity. 8Raquibuz Zaman, M. (1986). Monetary and Fiscal Policiesof an Islamic State. The American Journal of Islamic Social Sciences, vol. 3, No. 1, pp. 125 140.

Second, zakat’s purposes are to care aboutthe poor people of the society while the taxcollection of the country is applied for theprojects which directly or indirectly benefitpoor people.

Third, zakat cannot be seized for anyproject which cannot benefit poor people. Itstrictly comes into use by the government forthe poor as an obligation while taxes are notnecessary sources to better the poor’s welfaredirectly.

Fourth, there is a proper way andprocedure which are defined and strictlyfollowed for tax deduction while there is notstrict system for zakat deduction as such inmany Muslim countries and those who have it,however, they do not successfully utilize itbecause of the various sects and their ownmade philosophies. Shias do not pay zakat somany people fill up their own forms showingtheir identity as shias and even from banksthey save their money to be paid in zakat.

Fifth, taxes are used and eaten up by themen in power since there is no check andbalance for the security of the public moneywhereas zakat cannot be eaten up that easilysince zakat is that part of money which has tobe used for the betterment of the society atlarge. Sixth, zakat eradicates poverty whiletax increases all parts of the society, hence,people pay taxes happily but they avoid paying

zakat which is less than taxes and better inuse than the taxes.9

Obviously, these two obligations havedifferent nature and function and that theview equally sees and puts zakat equal to thetax is unwarranted. Even, there are someopinions proposing that the Muslim faiths arenot tax, tithe or charge interest.Consequently, some of them argue that theonward tax levy constitutes a violence of thefree exercise of religions so that taxcollection is odds in some Muslim religiousconvictions10.

Moreover, Peerzade proposed twoconditions in the tax system in order to beconsidered as an Islamic tax system. The firstis the necessity in which the perceivedapproach of Zakat should form the core of theresource mobilization effort. The second isthat, in addition to the current secular rulesand regulations regarding rates, exemptionlevels, administrations, etc, the approachshould also incorporate the Islamicprescriptions11.

9 Dokumen, 2012. 10 Brett Freudenberg" and Mahmood Nathie. The Constitution And Islam: Are Tax Reforms Possible To Facilitate Islamic Finance? (2010) 20 REVENUE LJ. 11 Peerzade, S. (2005). Towards Self-Enforcing Islamic Tax System: An Alternative to Current Approaches. J.KAU:Islamic Econ., Vol. 18, No. 1, pp. 3-12.

There are other perspectives towardpaying taxes by Muslims. The first Islamicperspective argues that collecting the tax byGovernments is completely prohibited in allcases. Muslims have been already given aperfect system, Zakat, to do so from Allah,the God, having been ruled in the Holy Quranand the Prophet Muhammad (Peace and blessingof Allah be upon him) has taught us how toimplement this system. So it is forbidden toimport non- Muslim, Western, tax system andreplaced by Islamic Zakat system.

The second Islamic perspective agreeswith the first group about the prohibition ofcollecting tax in Islamic countries generallyexcept that there are some conditions thegovernment has the right to impose tax throughand, in this case, it is not considered a sin.These conditions are: (a) there is alegitimacy public need of the money; (b)Inadequate Islamic-legitimacy resources; (c)Eliminate wasteful expenditure before imposingtax; (d) Consulting Islamic parliament beforeimplementing tax; (e) the tax imposed shouldbe amount as needed; (f) It should be imposedjustly and according to Islamic legitimacyresources, and; (g) the tax collected has tobe spent in the interests of the nation forwhich it was collected12. 12Khaled Slamen Yaslam Aljaaidi (Corresponsing author),Dr. Nor Aziah Abdul Manaf and Professor Stewart S.

The third Islamic perspective argues thatMuslims under an Islamic government have toobey the rules and laws of the government13.In line with this point view, some Islamicthinkers believe that the Muslim has to paytax. They justified their opinion by tworeasons: firstly, the tax is paid for servicesproviding and facilitating many transactionsrelated to taxpayer’s life and trade.Secondly, that Muslims should pay what isrequired because evasion of taxes may lead tothe evasion of Zakat14.

TAX TREATMENT ON ISLAMIC FINANCE On the basis of those distinctions

between tax and zakat, in now days modernIslamic financial practice, zakat and taxbecome two different obligations that must beexerted by the Islamic finance clients. Ofcourse, it is hard for them to pay the twosimilar obligations as such when they use theproducts of Islamic financial institution.They must pay not only zakat which isobligated by religion but also tax determinedby the Canadian government15.

Karlinsky. Tax Evasion as a Crime: A Survey ofPerception in Yemen. International Journal of Businessand Management Vol. 6, No. 9; September 2011 p, 190-20113Ibid. 14Ibid.

Some of the countries which are well-respond to Islamic financial institutions havereformed their taxation of laws. Indonesia,for instance, has arranged the law regardingzakat. In the Law (Undang-Undang) Number38/1999 on the Management of Zakat article 14section 3 mentioned that zakat is to be paidto BAZ or LAZ (Zakat Institution) which issubtracted from one’s profit or income that issubject of tax from the one who has a duty ontax according to the prevailed law. It isfollowed by the Law (Undang-Undang) Number 172000 article 9 section 1 stating that todetermine the amount tax income for domesticperson and permanent corporation having dutyon tax is allowed to be subtracted from zakaton income that is paid by the taxpayer16.

A closer look at tax reforms is a waythat may produce tangible benefits also doneby Australian government. The governmentreforms tax regulation in trans-nationalbanking co-operations, capital and investmentflows and tax revenues. Given its stringentand prudential banking regulations and itspre-eminent position in financial markets,

15Afif Noor. Hubungan Zakat dengan Pajak dalam UU. No.

38 Tahun 1999 dan UU. No. 17 Tahun 2000. Masters thesis,Post Graduate Program, Dipenogoro University, 2003. 16 ibid

Australia becomes a potential financial hub ofSouth East Asia.17

Tax reformation carried out by somecountries is their attempt to open the wayconfronting the growth of Islamic financialinstitutions in their countries. Principally,it is because of not only giving the rulerbenefits economically, (improving its brandover other countries -- particularlydemocratic global-economy country, one ofwhose principle is eradicating entry barriersfor other countries willing to conductbusiness activities in them), so that Islamicfinance is able to run well, compete withconventional finance institution safely andfairly but also escaping Muslim society fromdouble duties example tax and zakat.

Therefore, Islamic finance institutionmore focus on imposing zakat from theirclients both domestic person and permanentcooperation. Islamic finance mobilizes theZakat as source by Islamic finance instrumentare widely known as Qard hasanah (interest-freegrants and loans), Mudarabah (shares based onprofit and loss sharing projects in which thepoor can participate as shareholders bymobilizing their portion of Zakat), TradeFinancing (in which zakat can be made to17 Brett Freudenberg" and Mahmood Nathie. TheConstitution And Islam: Are Tax Reforms Possible ToFacilitate Islamic Finance? (2010) 20 REVENUE LJ

revolve for the benefit of the Zakatrecipients). Islamic finance thus performs acentral role in resource mobilization in theways to which the economic objectives ofsocial welfare are simultaneously realized byactivating the development financing Shari’ah-compliant instrument.

Choudhury Mausudul Alam and SofyanHarahap note that in regarding the wideeconomy-resource mobilization withintersectoral linkages with Zakat, the verynature of specific project spending the Zakatfund linking up with similar expenses in theother sectors, reveals the microeconomicnature of the Zakat-accounting in the Zakat–Islamic bank– economy interrelationship18.

Thus, financial institutions and partiesthat seek to offer these products must addresscertain challenges to achieve success in theCanadian marketplace. From a tax perspective,Islamic financial products pose a challengefor several reasons. First, tax authoritiesand taxpayers have limited knowledge of thespecific features of Islamic finance products.Second, the wide array of Islamic financialproducts may require significant humanresources able to approach tax authorities.18Masudul Alam Choudhury, Sofyan Syafri Harahap.Interrelationship between Zakat, Islamic bank and theeconomy: A theoretical exploration. Managerial Finance,Vol. 34 No. 9, 2008, pp. 610-617.

Third, obtaining rules from tax authoritiescan be a long process not only on technicaland interpretive issues but also on policythat must be addressed. Because these productsmust adhere to Shariah principles, it is tounderstand the exact nature of the product andits corresponding income and the commodity taxtreatment. This knowledge can help addresspotential issues that would give an Islamicfinance product an advantage or disadvantagecompared with a conventional product.19

Accordingly, Shariah-compliant financialproducts offer tremendous opportunities andpotential growth. Many jurisdictions have beenimplemented, or are in the process ofimplementing taxation, financial regulationand supervision systems to deal with Islamicfinance products and transactions. To takeadvantage of the available opportunities andremain competitive in the finance sector, itis imperative that Canada address the taxationof Islamic products and services. While thereare currently some products being offered inCanada, if the tax issues can be remedied,more financial institutions will offerShariah-compliant products so many consumerswill have more choice.

19 Standard & Poor’s, Islamic Finance Outlook 2009, 12 May2009, p.5.

TAX AND ISLAMIC FINANCE STRUCTURES

In the following section, the writer willbriefly re-describe those structures in recentpractical context of Islamic finance inCanada. Nearly all the provinces in Canadahave their own independent in formulating taxregulation based on their condition andcontext and the provinces probably have theirown characteristics distinguishing oneanother. In some provinces such as NovaScotia, New Brunswick, Newfoundland andLabrador, they are subject to the HarmonizedSale Tax (HST) example 13% tax (of which 5%represents the federal and 8% provincialpart). Schedule IX to the Act and the previousPlace of Supply (GST/HST) Regulations set outthe place of supply rules to determine whethersupplies were made in those threeparticipating provinces or in the rest ofCanada20.

The tax regulation in Canada continuallychanges almost every period of time. BeforeJuly 1, 2010, taxable supplies made in Canadaare subject to 5% rate of the Goods andService Tax (GST). The changes occurredeffectively July 1, 2010 when the Governmentof federal decides to set up their own tax

20 Ibid.

rate. The detail changes of these provincestax rate are presented in the following:

Ontario introduced a 13% HST, of which 5%represents the federal part and 8% theprovincial part, The Government of BritishColumbia introduced a 12% HST, of which 5%represents the federal part and 7% theprovincial part. On August 26, 2011,Elections BC announced that BritishColumbians have voted in favor ofeliminating the HST in British Columbia. OnFebruary 17, 2012, the Department ofFinance published a news release,Department of Finance AnnouncesTransitional Rules for the Elimination ofthe Harmonized Sales Tax in BritishColumbia (2012-2017), announcing proposedtransitional rules for the provincialdecision to eliminate the HST in BritishColumbia (B.C.). The proposed transitionalrules specify how and when the B.C. part ofthe HST would cease to apply totransactions that straddle that date. Theimplementation date for the transition fromthe HST to the GST on taxable supplies madein B.C. would be April 1, 2013, subject tothe approval of the British ColumbiaLegislature.The Government of Nova Scotia increased theprovincial part of the HST from 8% to 10%.The HST rate in Nova Scotia is now 15%, of

which 5% represents the federal part and10% the provincial part. On April 2, 2012,the Government of Nova Scotia announcedthat the province’s surplus will besignificant enough in 2014 to lower the HSTby one percentage point, and anotherpercentage point in the following year,bringing the rate of the HST back to 13% in2015. On April 18, 2012, the Government of PrinceEdward Island announced they were enteringinto formal negotiations with the federalgovernment to implement an HST, effectiveApril 1, 2013. The combined HST rate willbe 14% with a provincial part of 9% and afederal part of 5%. Because different taxrates came into effect in July 1, 2010, andto modernize the rules, a number of changeswere required to be made to the place ofsupply rules, including the introduction ofsome new place- of- supply rules. For thisreason, the Place of Supply (GST/HST)Regulations were repealed and replaced byPart 1 of the New Harmonized Value-addedTax System Regulations, that set out thenew place of supply rules applicable tocertain supplies made on or after May 1,2010; after February 25, 2010 and beforeMay 1, 2010 unless any part of the

consideration for the supply became and dueor was paid before May 1, 201021.

Islamic finance as business institutionoperating in Canada listed as financialinstitution must subject to the tax regulationmade by the government where they operate. IFmust not asses by itself as it is clearlydefined in subsection 225.2 (1) cited in thefollowing statement:

It should be noted that generally,selected listed financial institutions(SLFIs), as defined in subsection225.2(1), are not required to self-assessthe provincial part of the HST underDivision IV.1, and are not entitled toclaim any rebates in respect of theprovincial part of the HST. Also, SLFIsare not generally required to self-assessthe provincial part of the HST underDivision IV. Instead, SLFIs generallyaccount for the provincial part of theHST through adjustments to their net taxcalculation under subsection 225.2(2),and related regulations, includingproposed regulations issued on January28, 201122.

21GST/HST Technical Information Bulletin B-103 June 2012, p. 9-10 22 Ibid.

IF applied some structures to serveCanadian customers who use its facilities andservices. Mainly, IF in Canada serves itscustomers using many different products andservices meeting tax treatment23. All theIslamic Finance Products have specific incomeand commodity tax challenges such as Mudaraba(an Islamic deposit account) and Murabaha (anIslamic credit arrangement).

MUDARABA In the previous chapter I have presented

the nature of Islamic products and services.In the following section, I will brieflydescribe again these structures in to thecurrent practical Islamic-finance-in-Canadacontext. The customers who wish to maintainregular or irregular saving pattern in Islamicfinance can use the product known as Mudaraba.Under Shariah principles, this type of accountis based on a profit or loss-sharing conceptbut in consequence, a risk that customers losetheir initial capital saved in Islamic financeprovider may occur24.

23 Free discussion on the challenges faced by Islamic finance in Canada that took place at the office of UM, Canada October 15, 2012. 24 M.M. Metwally. Economic consequences….

The financial institution (or Mudarib)collect its customers’ funds to invest inShariah-compliant assets (i.e., certaincommodities) and charges a fee (Mudarib fee)often explicitly the finance institutionsidentified along with other profit components.Each month, the Mudarib calculates the actualprofit, only then does mudharib credit theprofit into customers’ accounts on mudarabasaving on the basis of previously profit-sharing-ratios consensus, however, if mudarib get lose,the customer also lose their profitaccordance to profit ratio or even, they lose alltheir initial capital. A Mudaraba may becompared to an index-linked note or anothertype of note where the return is tied to thefuture value of some commodities, such ascertain gold, silver etc. In a way, a Mudarabais partnership. It is true the risk is shared,but the profit can be much larger than othertype notes and in the practice the risk can beminimize25.

Income Tax IssuesMudarib calculate its fee, profit and

loss form mudaraba into the financial-institution business income. It is notcertainty whether or not the customer cantreat the profit on account of capital. To

25 TFSA. Islamic Housing Finance. Document, 2012.

examine the legal nature of the relationshipbetween the financial institution and thecustomer will be important. The Canadian taxauthorities’ view is that, generally,transactions in the instrument relatingcommodity should be treated as ordinary incomefor tax purposes26.

However, in certain circumstances, ataxpayer can decide to treat all their gainsand losses on transactions in commodities ascapital gains and losses. Accordingly, if thecustomer is viewed from a legal perspectiveunderlying commodities transactions and thecustomer is able to treat the profit onaccount of capital, only one and a half of thegain is subject to tax. This would be apreferential tax treatment rather than anequivalent traditional financial product,where all interest is generally subject totax. When customers have decided to treatcommodity transactions on capital account andrealized a loss, they should account theirloss of capital whether Mudaraba get morebeneficial than the traditional financialproduct.

Capital loss of the taxpayers isdeductible to a certain extent if they have26 GST/HST Technical Information Bulletin B-103 June2012, p. 9-10

lost their capital in the year, the threepreceding years, or following years. Incontrast, if the customers have not decided totreat the gains and losses on the Mudaraba andother commodity transactions on capitalaccount, losses on a Mudaraba will be fullydeductible. In addition it is possible thatthe Islamic finance product receives apreferential tax treatment.

There may be additional issues where acustomer is not a resident of Canada, so thatto examine the legal nature of therelationship between the customer and theprovider and the character of the paymentsfrom a Canadian legal perspective isnecessary. When the relationship is viewed asa partnership, the non-resident maypotentially be considered to carrying businessin Canada therefore required to file Canadianincome tax returns, unless the non-residentdecide to treat all gains and losses oncommodity transactions on capital account. Incontrast, a non-resident investing in a notelinked to the return on a basket ofcommodities would generally not be consideredto be carrying on business in Canada solely byvirtue of making such an investment27.

To ensure conducting a Mudaraba and atraditional deposit or linked note product

27 Ibid

well, in their own nature, changes to theIncome Tax Act (Canada)28 are required. Thesechanges should deem that, in transactionsunder Shariah principles, gains or profitsreceived in lieu of interest are consideredinterest. In addition, changes are required toensure that associations established to enableShariah-compliant investment are considered aspartnership or relationship agency forCanadian income tax purposes.

Commodity Tax IssuesThe application of GST/HST to charge the

operation relating to Mudaraba should exemptfrom tax, according to existing legislationand interpretive policy that applies to bankaccounts. However, issues could arise as theMudarib fee may be viewed as comparable to afund manager’s fee and therefore subject toGST/HST, that is, the fee would be excludedfrom the definition of “financial service” insubsection 123(1) of the Excise Tax Act329 and,therefore, not exempt.

28 RSC 1985, c. 1 (5th Supp.), as amended (hereinreferred to as the “ITA”). Unless otherwise stated,income tax statutory references in this article are tothe ITA Act and regulations thereunder.29 RSC 1985, c. E-15 as amended (herein referred to asthe “ETA”). Unless otherwise indicated, all commoditytax statutory references are to the Excise Tax Act.

In contrast, in practice -- one of thefigures -- it is simply deducted indetermining the profit element to be shared bythe financial institution and the customers asprevious consensus; accordingly, the Mudaribfee may be specifically identified. Thus, thefee is not consideration for a supply forGST/HST purposes and GST/HST does not apply.

Commodity Tax Changes RequiredIt is unlikely that changes to the

GST/HST legislation are required. However, CRAguidance would need to be updated and amendedto ensure a clear understanding of the properGST/HST treatment. To anticipate therecommendation by the Department of Finance ofsuch a regulatory change and to allow affectedparties gaining benefit from theadministrative simplification that taxauthority would provide, the CRA has begunadministering the new place of supply rule,where suppliers choose to apply the rule.

Therefore, as an exception to the generalplace of supply rule for sales of goods, wherea supplier makes a supply by way of sale of aspecified motor vehicle, the supply would beadministratively considered by the CRA to bemade in a particular province if: (a) thevehicle is registered (other than on atemporary basis) by or on behalf of the

recipient under the laws of the particularprovince relating to the registration of motorvehicles within seven days after the day onwhich the vehicle is delivered or madeavailable to the recipient in a participatingprovince (other than the particular province),and (b) the supplier maintains evidencesatisfactory to the Minister of NationalRevenue of that registration30.

MURABAHAThe Murabaha is a Shariah-compliant

substitute for conventional creditarrangements under which the title to propertybeing sold is transferred on the date of thesale and the borrowed amount is payable byinstalments. A Murabaha may be compared to atraditional mortgage product or other loanproduct used to finance acquisition of anasset such as a car.

The “white-goods” Murabaha (as opposedto the Commodity Murabaha or Tuwarruq) is anIslamic financing facility to help customersbuy consumer goods (e.g., cars, homefurnishings). This product works as follows:(a) the purchaser selects a good for purchase;30Draft GST/HST Technical Information Bulletin B-103,Harmonized Sales Tax – Place of supply rules fordetermining whether a supply is made in a province.June 2012, 9.

(b) the purchaser and the Islamic financeinstitution agree on a profit margin and theinstitution purchases the good from thevendor; (c) the purchaser takes possession ofthe good as an agent of the institution; (d)the institution sells the good to the customerbased on cost plus the agreed profit margin,which is payable over an agreed period oftime, and; (e) the title to the good passes tothe customer at the time the sale occurs.

Income Tax IssuesFrom the financial institution’s

perspective, the Murabaha’s tax issues relateto the timing of recognizing the profit wherethe term is more than a year or straddles afinancial institution’s taxation year-end. Forexample, if the Murabaha is used as anequivalent to a five-year loan to financeacquisition of business assets, there isuncertainty regarding when a financialinstitution would be required to include intaxable income the gain on sale of the asset —at the time of sale of the business assets,over three years, or over the payment period.In a conventional loan scenario, theeconomically equivalent “interest” would berecognized over the term of the loan (i.e.,five years). OK, furthermore, stated that:

Generally, a taxpayer should include inbusiness income the difference between

the cost of a good and the amount it wassold to the customer for in the year ofsale. Where the proceeds were not fullyreceived in the year of sale, thetaxpayer may claim a reserve (exceptwhere the property is real property) forunpaid amounts for up to three years.Accordingly, from the perspective of thefinancial institution, the profit fromselling the assets to the customer at amark-up should be included in income overthree years at most31.

However, if it is reasonable to considerthat a payment is partially of an incomenature (such as interest) and partially of acapital nature, Canadian tax legislationprovides that the part of the payment that canreasonably be regarded as being of an incomenature should be included in taxable income inthe year in which the amount was received orbecame due. As the fair market value of thegoods in the example above is less than theamounts that are paid over the term of theMurabaha, each payment under the Murabaha mayarguably be considered to be partially of acapital nature and partially of an incomenature.

31Free discussion on October 15, 2012 in Toronto, Canada.

Accordingly, it may be possible torecognize the profit margin in the financialinstitution’s taxable income over the term ofthe Murabaha as each payment is made. If thefinancial institution takes this position,there should not be a significant differencebetween a Murabaha and a conventional loan,from an income tax perspective. Where thefinancial institution is not resident inCanada, it may be deemed to be carrying onbusiness in Canada by virtue of offeringsomething for sale in Canada.

Consequently, the nonresident financialinstitution may be subject to Canadian incometax on the gain unless a tax treaty betweenCanada and the foreign financial institution’scountry of residence provides relief. Incontrast, a foreign financial institution thatsolely provides a conventional loan to aCanadian resident and does not have any otherCanadian activities or presence would notlikely have to pay Canadian non-residentwithholding tax on the gross amount of neitherinterest received nor Canadian income tax onthe net income earned from the loan to theCanadian resident32.

Typically, for the customer, the totalamount paid for a good should be the cost tothe customer of the good. There is uncertainty

32 Document, Draft GST/HST…

regarding whether a customer that has used aMurabaha to finance an asset used to earnbusiness or property income can deduct the“profit” component paid to the financialinstitution. Where only a portion of theamount paid can reasonably be considered torepresent interest or another income item tothe recipient, the customer may be able toclaim a deduction for the income portion ofthe payment based on the same provision in thetax legislation described above. If thisposition is taken, the profit component shouldnot form part of the cost of the asset.

However, if the customer is not able totake this position, the customer will be at adisadvantage by using a Murabaha rather than aconventional loan33. To avoid the disadvantage,OK pointed out that:

To eliminate uncertainty over the timingof recognizing income, profits receivedin lieu of interest in transactionsconducted in accordance with Shariahprinciples should be deemed to beinterest. This would also permitcustomers that have used a Murabaha tofinance an asset used for businesspurposes to claim a deduction, providedthat all the regular tests for interestdeductibility are met34.

33 Document TFSA, 2012. 34 OR free discuss….October 15, 2012.

Commodity Tax IssuesUnder the conventional arrangement, the

sale of a good is subject to GST/HST and, as afinancial services, the credit charge isGST/HST-exempt under subsection 123(1) of theETA35. In the case of the Murabaha, theinstitution purchases and resells the goodthrough an arrangement that is typicallystructured to generate a return in line withconventional financing rates. As there is asecond transaction on an increased amount(i.e., the price of the good plus the profit),a higher GST/HST is eligible. GST/HST wouldnot arise if the profit amount could be viewedas a financing cost or interest and, thus, asa financial service. However, the currentdefinition of “financial service” in the ETAdoes not appear to support thisinterpretation36.

As a result, consumers face higher costsunder a Murabaha than a under a conventionalfinancial instrument, increasing the risk thatMurabaha products would be unattractive in themarketplace. Ensuring the profit element(i.e., the amount equivalent to a financingcharge) is GST/HST-exempt is crucial to theproduct’s competitiveness.37

35 GST/HST, document, 201236 Ibid37 Ibid

PST issues will also arise under aMurabaha. Under a conventional structure, PSTapplies on the sale of the good from theretailer to the customer absent any relievingmechanism, such as an exempting certificate orpermit. Under a Murabaha structure, a higheramount of PST would apply to the institution’ssale to the customer because the tax ispayable on the value that includes the profitelement. Steps could be taken to exempt thesale from the vendor to the institution fromPST, for example, by using exemptioncertificates or permits (depending on thejurisdiction)38.

To ensure that the profit amount istreated like a finance cost or interest forGST/HST purposes, and therefore exempt, it isnecessary to review the definitions of“financial instrument” and “financial service”in subsection 123 (1) of the ETA.

CONCLUSION

Many Islamic financial products involvethe sharing of “profit” (e.g., a Mudaraba andmurabaha). It may be unclear whether non-resident withholding tax applies to suchsharing of “profit”. It may also be uncertainwhether expenses incurred in lieu of interest38 TFSA, document, 2012

are deductible. Accordingly, considerationshould be given to amending the ITA so thatany references to “interest” apply to gains orprofits received, “alternative finance return”and expenses incurred in lieu of interest intransactions conducted in accordance withShariah principles.

Islamic finance transactions oftenrequire an interest in an underlying assetand, thus, may involve the transfer of anasset. To the extent a portion of the gainrealized by the finance provider upon thetransfer of the asset (e.g., in a Murabahatransaction, where a finance providerpurchases an asset for the customer and thensells it to the customer, almost immediately,for a profit) can be treated as remunerationfor the deferral of payment and is comparableto interest on a conventional financialproduct, changes to the ITA to spread thetaxation of the gain over the payment termshould be considered.

Consideration should also be given toamending the definition of a “disposition” toexclude disposal of an asset pursuant to afinancing transaction required solely for thepurpose of complying with Shariah principles(i.e., to exclude a disposition strictlyrequired for the sole purpose of complyingwith Shariah but that would not be required inany other financing transaction).

Islamic finance transactions that areviewed as partnerships often pose tax issues.Changes are required to ensure thatassociations established to enable Shariah-compliant investment are not consideredpartnerships for Canadian income tax purposes.

The above analysis demonstrates the needfor a thorough review of the federal GST/HSTlegislation and interpretive policy related tofinancial services, PST legislation ofprovinces that operate a retails sales tax,and other legislation, such as land transfertax. Definitions in several sections of theETA must be reviewed to accommodate Islamicfinancial products. In particular, thedefinitions of “financial instrument”,“financial service” and “insurer” insubsection 123(1) of the ETA must be reviewedand amended where necessary, as well as thedefinition of “financial institution” insection 149 of the ETA. Arguably, if thesedefinitions can be appropriately amended toinclude Shariah-compliant products, this wouldaddress many of the commodity tax issues forGST/HST purposes.