The Taxation Treatment of Islamic Finance in Canada

8/3/2019 The Taxation Treatment of Islamic Finance in Canada

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The taxationtreatment o

Islamic fnance

in CanadaDiscussion paper

kpmg.ca
http://www.kpmg.ca/http://www.kpmg.ca/


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In May 2010, the Islamic Finance Working Group o the Toronto Financial ServicesAlliance issued a report Making Toronto the North American Centre for Islamic Finance:Challenges and Opportunities . The report discussed at a high level the development o

Islamic Finance in Canada and also highlighted some o the Canadian tax challenges.This discussion paper provides a more comprehensive analysis o the direct andindirect tax implications rom a Canadian perspective. The report also highlightssome o the measures taken by other western jurisdictions to deal with the taximplications o Islamic Finance products.

From a Canadian perspective, we hope that this paper will help in the ongoingdiscussion o Islamic Finance in Canada and enable policy makers, regulatorsand practitioners to take steps to urther the development o Islamic Finance inCanada. Certainty in the taxation realm is a critical part o ensuring that Torontoand Canada can emerge as a North American centre or Islamic Finance.

We would like to express our sincere thanks to members o the IslamicFinance Working Group, and in particular, Je rey Graham o Borden LadnerGervais LLP, or their insight in the preparation o this report.

Steven C. Watts Carmela Pallotto John BainPartner, Audit Partner, Tax Partner, Tax

PREFACE

2012 KPMG LLP, a Canadian limited liability partnership and a member rm o the KPMG network o independent member rmsa liated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.


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I Introduction ..............................................................................1

II Shariah principles ....................................................................2

III Taxation o Islamic fnanceproducts in other jurisdictions ...............................................3

IV Income and commodity tax challengeso Islamic fnance products ....................................................5

V Conclusion ..............................................................................16

TABLE OF CONTENTS

2012 KPMG LLP, a Canadian limited l iability partnership and a member rm o the KPMG network o independen t member rmsa liated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.


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1 Standard & Poors, Islamic Finance Outlook 2009 , 12 May 2009, p.5.

Islamic nancial products and servicesare based on Shariah or Islamic law,which sets out guiding principles. Underthese principles, Shariah-compliant

nancial products can di er signi cantlyrom conventional nancial products.

For this reason, nancial institutionsand other parties that seek to o erthese products must address certainchallenges to achieve success in theCanadian marketplace. From a taxperspective, Islamic nancial productspose a challenge because:

Tax authorities and taxpayers lackknowledge o the speci c eatures oIslamic nancial products

The wide array of Islamic nancialproducts may require signi cantresources to approach tax authorities

Obtaining rulings from tax authoritiescan be a lengthy process because othe technical, interpretive, and policyissues that must be addressed.

Because these products must adhereto Shariah principles, understandingthe exact nature o the product and itscorresponding income and commoditytax treatment are essential. Thisknowledge can help address anypotential issues that would give anIslamic nance product an advantage or

disadvantage compared to a conventionalproduct.

At year-end 2009, assets o the top500 Islamic banks expanded 28.6%to $822 billion and it is estimated thatShariah-compliant assets currently totalabout $1 trillion worldwide 1. Accordingly,

Shariah-compliant nancial productso er tremendous opportunities andgrowth potential. Many jurisdictionshave implemented, or are in the processo implementing, taxation, nancialregulation and supervision systemsto deal with Islamic nance productsand transactions. To take advantage othe available opportunities and remaincompetitive in the nance sector, it isimperative that Canada address thetaxation o Islamic products and services.While there are currently some productsbeing o ered in Canada, i the taxissues can be remedied, more nancialinstitutions will o er Shariah-compliantproducts and more o them such thatconsumers will have more choice.

I. Introduction

1 | THE TAXATION TREATMENT OF ISLAMIC FINANCE IN CANADA

2012 KPMG LLP, a Canadian limited liability partnership and a member rm o the KPMG network o independen t member rmsa liated with KPMG International Cooperative (KPMG International), a Swiss entity. All rights reserved.


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Institutions that o er Islamic nancialservices must ollow Shariah principlesor Islamic law. Essentially, Islamic

nance must unction in accordancewith the rules o the Islamic aith, whichis generally premised on the ollowingprinciples:

Prohibition of interest : It isunacceptable, in and o itsel , ormoney to increase in value merely bybeing lent to another person.

Prohibition of uncertainty or speculation : Contract terms shouldnot be ambiguous or lack clarity as

this can o ten give rise to speculation.Transactions should not be undertaken

or purely speculative purposes.

Prohibition of investing in sectors that are prohibited : Investmentshould not be made in sectors thatare incompatible with the Muslim

aith, such as pork products, armsand ammunitions, alcohol, gaming orpornography.

Sharing of risk and return and asset backing : Risk and return must beshared and transactions must be tiedto an underlying or tangible asset

II. Shariah principles



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The United Kingdom, Australia, Ireland,South Korea, France, Singapore,Malaysia and Indonesia have modi edor are modi ying their taxation regimesto ensure Islamic nance productsand treated the same as conventionalproducts. These jurisdictions haveimplemented the ollowing changes:

United Kingdom : The United Kingdomintroduced tax legislation to ensurethat Islamic nance products aretreated in a tax-neutral manner

compared to conventional products.Certain de nitions were introduced,but no mention o Shariah or otherIslamic nance terms are made.Generally, the tax treatment is similarto the treatment o interest. Likewise,existing legislation that applies to debtinstruments also applies to alternative

nancing arrangements or Sukuk(see below). For the purposes o UKvalue-added tax (VAT), interpretiveguidance was published on severalShariah-compliant nancial products.

This guidance draws heavily onexisting legislation, interpretivepolicy, and jurisprudence. The UKtax authorities also provided rulingsand interpretations that taxpayerscan rely on to acilitate the timelycommencement o trade. To achievetax neutrality, changes were requiredto the stamp duty and land reserve tax.

III. Taxation o Islamicfnance products inother jurisdictions




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Ireland : Generally, Ireland treats thetax treatment o an Islamic nanceproduct the same as their conventionaleconomic equivalents. Irelandintroduced legislation to acilitateIslamic nancing arrangementssuch as credit transactions, deposit

transactions and investmenttransactions. For example, the taxlegislation clari es that the return ona Sukuk, or Islamic bond, certi cate isinterest on a security and that a Sukukissuer can deduct the interest paid ona coupon. Legislation has also beenproposed to exempt certain Islamic

nancial transactions rom VAT.

France : Essentially, France oundthat changes to tax legislation werenot necessary, and instead provided

guidelines to explain the tax treatmento Islamic nancing. For example, thesame tax rules were applied to Islamic

nancing arrangements that resembleddebt instruments.

Singapore : Singapore has taken stepsto align the treatment o Islamic nanceproducts to equivalent conventionalproducts.

Malaysia : A key global player in Islamicnance, Malaysia has enacted tax

legislation to ensure that Islamicnancial arrangements are taxed in

the same manner as conventionalarrangements. For tax purposes,the pro ts o Islamic nancialarrangements and the payment o

pro ts is generally treated as interest.Furthermore, Malaysia has introducedtax incentives to promote the growth oIslamic nance in the country.

Indonesia : Indonesia has introducedspeci c laws to recognize trust

structures which now allow or the useo Sukuk to raise nance. In addition,legislation was introduced to ensureIslamic nance products are not subjectto double taxation.

South Korea : As with Indonesia, SouthKorea is looking to remove tax barrierswhich prevent the use o Sukuk. It isthought that the tax treatment will besimilar to conventional bonds.

Australia : Australias Board o Taxationis reviewing the tax treatment o

Islamic nance products to makerecommendations to ensure that thetax treatment o Islamic products isat parity with conventional products,where possible. Should the Boarddetermine that amendments to taxlegislation are required, it will considerwhether existing tax legislation canbe adjusted rather than developingspeci c provisions that apply solely toIslamic nancial products.

As this overview demonstrates, many

countries have been proactive in theirconsideration o Islamic nance. Theseglobal experiences could serve as ause ul roadmap or Canada to addressthe income and commodity taxation oIslamic nance products.

THE TAXATION TREATMENT OF ISLAMIC FINANCE IN CANA



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When considering applying income andcommodity tax to Islamic nance productsand services, it is important to analyze allaspects o these products and their currenttax treatment. While this analysis shouldbe straight orward or products that arestructured similar to conventional products,there are challenges in structuring morecomplex Islamic nancial products andservices to be both Shariah-compliantand income and commodity tax neutral.Experience has shown that the incomeand commodity tax treatment o Shariah-compliant products can be at odds withthe tax treatment o conventional nancialservices.

The ollowing Islamic nance products allhave speci c income and commodity taxchallenges, as discussed below:

Mudaraba (an Islamic deposit account)

Murabaha (an Islamic creditarrangement)

Diminishing Musharaka with Ijara (anIslamic mortgage product)

Sukuk-al-Ijara (an Islamic bond)

Takaful (Islamic insurance).

MUDARABA The Mudaraba is a deposit account

or customers who wish to maintain aregular (or irregular) saving pattern. Inaccordance with Shariah principles, thistype o account is based on a pro t orloss-sharing concept, with a risk thatcustomers may lose their initial capital

saved with the Islamic nance provider.The nancial institution (or Mudarib)pools its customers unds with its own

unds to invest in Shariah-compliantassets (i.e., certain commodities) andcharges a ee (Mudarib ee), which iso ten explicitly identi ed along with otherpro t components. Each month, theMudarib calculates the actual pro t andcredits its customers accounts based onpreviously agreed pro t-sharing ratios. Asnoted, in the case o losses, customersmay lose some or all o their initial capital.

A Mudaraba may be compared to anindex-linked note or another type onote where the return is tied to the

uture value o a commodity, such ascertain metals. In a way, a Mudaraba is apartnership, as risk is shared, although inpractice the risk is minimal.

IV. Income and commodity tax challenges oIslamic fnance products



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Income Tax Issues The Mudarib ees, pro t and loss romthe Mudaraba should be included in the

nancial institutions business income.There may be uncertainty aboutwhether the customer can treat thepro t on account o capital. It will benecessary to examine the legal natureo the relationship between the nancialinstitution and the customer. TheCanadian tax authorities view is that,generally, transactions in commodityrelated instruments should be treatedas ordinary income or tax purposes.However, in certain circumstances,

a taxpayer can elect to treat all theirgains and losses on transactions incommodities as capital gains andlosses. Accordingly, i the customeris viewed rom a legal perspective asengaging in the underlying commoditiestransactions and the customer is ableto treat the pro t on account o capital,only one hal o the gain is subject totax. This would be a pre erential taxtreatment compared to an equivalenttraditional nancial product, where the

ull amount o the interest is generally

subject to tax.Where a customer has elected to treatcommodity transactions on capitalaccount and realizes a loss, the lossshould be on account o capital underboth the Mudaraba and the traditional

nancial product. Capital losses canonly be deducted to the extent thetaxpayer has a capital gain in the year,the three preceding years, or utureyears. In contrast, i the customer hasnot elected to treat the gains and losses

on the Mudaraba and other commoditytransactions on capital account, losseson a Mudaraba will be ully deductible.Again there is the possibility or theIslamic nance product to receive apre erential tax treatment.

There may be additional issues where acustomer is not a resident o Canada. Inthis case, it is necessary to examine the

legal nature o the relationship betweenthe customer and the provider andthe character o the payments rom aCanadian legal perspective. Where therelationship is viewed as a partnership,the non-resident may potentially beconsidered to be carrying on businessin Canada and there ore required to leCanadian income tax returns, unless thenon-resident can elect to treat all gainsand losses on commodity transactionson capital account. In contrast, a non-resident investing in a note linked to

the return on a basket o commoditieswould generally not be considered to becarrying on business in Canada solely byvirtue o making such an investment.

Income Tax Changes Required

To ensure a level playing eld betweena Mudaraba and a traditional depositor linked note product, changes to theIncome Tax Act (Canada) 2 are required.These changes should deem that, intransactions conducted in accordancewith Shariahs principles, gains or pro tsreceived in lieu o interest are consideredinterest. In addition, changes are requiredto ensure that associations establishedto enable Shariah-compliant investmentare not considered partnerships oragency relationships or Canadianincome tax purposes.

Commodity Tax Issues The application o GST/HST to ees orcharges related to the operation o aMudaraba should be GST/HST exempt,

in accordance with existing legislationand interpretive policy that applies tobank accounts. However, issues couldarise as the Mudarib ee may be viewedas comparable to a und managers eeand, there ore, subject to GST/HST;

2 RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as the ITA). Unless otherwise stated, income tastatutory re erences in this article are to the ITA Act and regulations thereunder.




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that is, the ee would be excluded romthe de nition o nancial service insubsection 123(1) o the Excise Tax Act 3 and, there ore, not exempt.

Even though the Mudarib ee may bespeci cally identi ed, in practice it issimply one o the gures deducted indetermining the pro t element to beshared by the nancial institution andthe customers. Thus, the ee is notconsideration or a supply or GST/HSTpurposes and GST/HST does not apply.No PST issues should arise either.There ore, it is important to properlycharacterize the Mudarib ee in any termsand conditions as a share o or deduction

rom the overall pro t and not a eerelated to und management.

Commodity Tax Changes Required

It is unlikely that changes to theGST/HST legislation are required.However, CRA guidance would needto be updated and amended to ensurea clear understanding o the properGST/HST treatment (e.g., the GST/HSTMemoranda Series).

MURABAHAThe white-goods Murabaha (asopposed to the Commodity Murabaha orTuwarruq) is an Islamic nancing acilityto help customers buy consumer goods(e.g., cars, home urnishings). Thisproduct works as ollows:

The purchaser selects a good forpurchase

The purchaser and the Islamic nanceinstitution agree on a pro t marginand the institution purchases the good

rom the vendor

The purchaser takes possession of thegood as an agent o the institution

3 RSC 1985, c. E-15 as amended (herein re erred to as the ETA). Unless otherwise indicated, all commodity taxstatutory re erences are to the Excise Tax Act.

Supplier of goods

Sale and delivery of goods

SALE PRICE plus interest

Conventional Loan

Bank

Customer

Supplier of goods

Delivery of goods

SALE PRICE plus prot

Murabaha

Islamic FinanceProvider

Customer

TITLE

TITLE

SALE PRICE

Whether characterized as prot or interest, the

effect could be the same if properly structured

Consumer LoanMurabaha

The institution sells the good to thecustomer based on cost plus theagreed pro t margin, which is payableover an agreed period o t ime

The title to the good passes to thecustomer at the time the sale occurs.

The Murabaha is a Shariah-compliantsubstitute or conventional creditarrangements under which the title toproperty being sold is trans erred on

the date o the sale and the borrowedamount is payable by instalments.A Murabaha may be compared to atraditional mortgage product or otherloan product used to nance acquisitiono an asset such as a car.

Income Tax Issues From the nancial institutionsperspective, the Murabahas tax issues

relate to the timing o recognizing thepro t where the term is more than ayear or straddles a nancial institutionstaxation year-end. For example, i theMurabaha is used as an equivalent to a

ve-year loan to nance acquisition obusiness assets, there is uncertainty




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regarding when a nancial institutionwould be required to include in taxableincome the gain on sale o the assetatthe time o sale o the business assets,over three years, or over the paymentperiod. In a conventional loan scenario,the economically equivalent interestwould be recognized over the term o theloan (i.e., ve years).

Generally, a taxpayer should include inbusiness income the di erence betweenthe cost o a good and the amount itwas sold to the customer or in the yearo sale. Where the proceeds were not

ully received in the year o sale, thetaxpayer may claim a reserve (exceptwhere the property is real property) orunpaid amounts or up to three years.Accordingly, rom the perspective o the

nancial institution, the pro t rom sellingthe assets to the customer at a mark upshould be included in income over threeyears at most.

However, i it is reasonable to considerthat a payment is partially o an incomenature (such as interest) and partially oa capital nature, Canadian tax legislationprovides that the part o the paymentthat can reasonably be regarded as beingo an income nature should be includedin taxable income in the year in which theamount was received or became due.As the air market value o the goodsin the example above is less than theamounts that are paid over the term othe Murabaha, each payment under theMurabaha may arguably be considered tobe partially o a capital nature and partiallyo an income nature. Accordingly, it maybe possible to recognize the pro t marginin the nancial institutions taxableincome over the term o the Murabahaas each payment is made. I the nancialinstitution takes this position, thereshould not be a signi cant di erence

between a Murabaha and a conventionalloan, rom an income tax perspective.

Where the nancial institution is notresident in Canada, it may be deemedto be carrying on business in Canada byvirtue o o ering something or sale inCanada. Consequently, the non-resident

nancial institution may be subjectto Canadian income tax on the gainunless a tax treaty between Canadaand the oreign nancial institutionscountry o residence provides relie . Incontrast, a oreign nancial institutionthat solely provides a conventional loanto a Canadian resident and does nothave any other Canadian activities orpresence would not likely have to payCanadian non-resident withholdingtax on the gross amount o interestreceived nor Canadian income tax onthe net income earned rom the loan tothe Canadian resident.

Typically, or the customer, the totalamount paid or a good should bethe cost to the customer o thegood. There is uncertainty regardingwhether a customer that has used aMurabaha to nance an asset usedto earn business or property incomecan deduct the pro t componentpaid to the nancial institution. Whereonly a portion o the amount paid canreasonably be considered to representinterest or another income item to therecipient, the customer may be ableto claim a deduction or the incomeportion o the payment based on thesame provision in the tax legislationdescribed above. I this position istaken, the pro t component shouldnot orm part o the cost o the asset.However, i the customer is not able totake this position, the customer will beat a disadvantage by using a Murabaharather than a conventional loan.




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Income Tax Changes Required To eliminate uncertainty over the timingo recognizing income, pro ts received inlieu o interest in transactions conductedin accordance with Shariah principlesshould be deemed to be interest. Thiswould also permit customers that haveused a Murabaha to nance an assetused or business purposes to claim adeduction, provided that all the regulartests or interest deductibility are met.

Commodity Tax Issues Under the conventional arrangement, thesale o a good is subject to GST/HST and,as a nancial service, the credit chargeis GST/HST-exempt under subsection123(1) o the ETA.

In the case o the Murabaha, theinstitution purchases and resells thegood through an arrangement that istypically structured to generate a returnin line with conventional nancing rates.As there is a second transaction on anincreased amount (i.e., the price o the

good plus the pro t), a higher GST/HSTis exigible. GST/HST would not arise ithe pro t amount could be viewed as a

nancing cost or interest and, thus, as anancial service. However, the current

de nition o nancial service in theETA does not appear to support thisinterpretation.

As a result, consumers ace highercosts under a Murabaha than a undera conventional nancial instrument,increasing the risk that Murabaha

products would be unattractive in themarketplace. Ensuring the pro t element(i.e., the amount equivalent to a nancingcharge) is GST/HST-exempt is crucial tothe products competitiveness 4.

PST issues will also arise under aMurabaha. Under a conventional

4 See additional comments under GST compliance below.5 Issues regarding consumer protection (e.g., warranties) under the provincial statutes governing sales o goods

would also need to be managed.

Conventional Loan Murabaha

Price o good: $100 Price o good: $100

Finance cost: $10 Pro t: $10GST: $5.00 ($100 5%) GST: $5.50 ($110 5%)

PST: $7.00 ($100 7%) PST: $7.70 ($110 7%)

structure, PST applies on the sale o thegood rom the retailer to the customerabsent any relieving mechanism, such asan exempting certi cate or permit. Undera Murabaha structure, a higher amounto PST would apply to the institutionssale to the customer because the tax ispayable on the value that includes thepro t element. Steps could be taken toexempt the sale rom the vendor to theinstitution rom PST, or example, byusing exemption certi cates or permits(depending on the jurisdiction).

As the table below shows (the exampleassumes that only GST at a rate o5% applies), the Murabaha structurewould result in higher GST/HST and PSTcosts to the purchaser and additionalcompliance obligations and costs or theMurabaha provider 5.

Table 1


To ensure that the pro t amount is treatedlike a nance cost or interest or GST/HSTpurposes, and there ore exempt, it isnecessary to review the de nitions o nancial instrument and nancialservice in subsection 123(1) o the ETA.

DIMINISHINGMUSHARAKA WITH IJARAThe Diminishing Musharaka with Ijara isa orm o Islamic mortgage product. Thismortgage could be structured as a joint




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purchase by the lending institution andthe customer as ollows:

The ownership is split in the ratio ofunding contributed by the respective

parties (i.e., the ratio o deposit paid bythe customer compared to the balancepaid by the Islamic nancial institution)

The institution rents its part of theproperty to the customer or a monthlyconsideration that covers the cost othe nancing and the repayment o aninstallment o the capital sum lent

When all of the installments are paid,the lending institution trans ers itslegal ownership share to the customerat a nominal price.

Income Tax Issues Where the transaction is considered tobe a lease o the property combined witha series o dispositions by the nancialinstitution and the payments are received

on an accrual basis, the institution shouldinclude the monthly rent in taxableincome. In addition, depreciable propertywill be categorized into a tax depreciationclass according to the type o property. The

nancial institution should be able to claima deduction or tax depreciation based onthe tax depreciation rate or the particularclass. The amount o tax depreciation thatcan be claimed may be restricted wherethe leased property is considered to bespeci ed leasing property.

The portion o each instalment paymentthat represents proceeds o disposition oa portion o the property should be creditedto the relevant class o property to theextent that the proceeds do not exceed theoriginal cost o the assets. Under certaincircumstances a recapture o previouslydeducted tax depreciation may occur.

There may be a di erence in the timingo the recognition o income comparedto a conventional term nancingarrangement. In particular the recognitiono income will be delayed until the cashreceived exceeds the undepreciatedcost o the asset, assuming there areno other assets in that particular class.This de erral would be advantageous to a

nancial institution.

Where a nancial institution is notresident in Canada and the Musharakais viewed as a partnership, the nancialinstitution could be viewed as carrying onbusiness in Canada and, hence, requiredto le a Canadian tax return.

The non-resident may also be subject towithholding tax. Rent payments to non-residents are subject to 25% Canadianwithholding tax on the gross amount,unless a tax treaty reduces the rate.Where the rent is or real or immoveableproperty in Canada, the non-residentmay instead chose to le a Canadian tax

Third PartyPurchase Price

Customer

Islamic FinanceProvider

Sale

LeaseRent

Purchases with contribution from customer bank owns legal title in trust for itself and the

customer as tenants in common

Diminishing Musharaka

Capital payments increasecustomers benecial ownership

and reduce the banks share.

THE TAXATION TREATMENT OF ISLAMIC FINANCE IN CANAD



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return and pay Canadian tax on the netincome rom the property. In either case,the non-resident nancial institutionlikely requires the customer to cover theCanadian tax costs.

Under a conventional term loan, interestshould not be subject to Canadianwithholding tax when paid to arms-length non-residents, provided thatthe interest is not participating debtinterest. Here, the customer would onlypay the stated interest rate. Accordingly,a customer obtaining nancing viaa Musharaka product would be at adisadvantage to a customer obtaining

nancing rom a traditional loan product.

Income Tax Changes Required

Again, changes to the tax legislationthat deems a portion o the payments tobe interest would resolve the inequitybetween a conventional nance productand a Shariah-compliant one.

Commodity Tax Issues The Diminishing Musharaka with Ijaraillustrates how Islamic nance createsGST/HST issues. Conventional residentialmortgages essentially involve two steps:

Step 1The purchaser receivesunding rom the nance provider.

Step 2The purchaser buys theproperty rom the vendor.

The purchase is either GST/HST-exempt(e.g., used residential housing) or GST/ HST-taxable (e.g. , a newly constructedresidential complex). Any interest paid tothe nancial institution is GST-exempt.

As noted above, a Shariah-compliantmortgage structure involves our steps:

Step 1The Islamic nance providerpurchases the property rom the vendor.

Step 2The Islamic nance providerenters into a long-term lease or theproperty with the purchaser

Step 3The purchasers equityinterest increases over time.

Step 4The purchaser ultimatelypurchases the remaining legal interestin the property.

GST/HST-exemptions could apply to anIslamic residential mortgage, providedthe residential complex was consideredused. For example, the supplies byway o sale under Steps 1, 3 and 4 wouldbe GST/HST-exempt, under section 2o Part 1 o Schedule V to the ETA. Thelong-term lease between the nancialinstitution and the purchaser could alsobe GST/HST-exempt, under section 6 oPart 1 o Schedule V.

However, where the property is newlyconstructed, many issues must beconsidered. Under a conventionalmortgage, the purchaser pays GST/HSTto the builder and likely assigns anyresulting GST/HST new housing rebateto the builder. Any interest payableto the lender under the mortgage isGST/HST-exempt as a nancial service.

Under the Diminishing Musharaka with

Ijara, Step 1 would constitute a GST/HST-taxable supply. As the institution wouldenter into a long-term lease with thecustomer in Step 2, the institution couldbe considered a builder and requiredto sel -supply under subsection 191(1) othe ETA.

Consequently, the lender would berequired to account or GST/HST onthe air market value o the propertyand claim an input tax credit or theGST/HST paid under Step 1. As theinstitution would be leasing theproperty to the purchaser, the institutionwould be eligible or a new housingrebate as a landlord under subsection256.2(3) o the ETA. The rents would beGST/HST-exempt under section 6 o Part1 o Schedule V. The supplies made inSteps 3 and 4 should be exempt undersection 4 o Part I o Schedule V.

As outlined above, many moreGST/HST issues must be consideredunder a Diminishing Musharaka




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Sukuk

Tradingin Sukuk

Rent

Rent

Pay agentfees

IssueSukukCerticate

Sale andleaseback

Obligor

SPV

Investors Beneficial

owners of theasset

with Ijara. The increased complianceobligations and costs risk making thisproduct uncompetitive compared to aconventional mortgage product.


From a GST/HST perspective, severalrule changes are needed. In particular,the rules in the a orementionedsections must be reviewed, includingthe de nition o builder ound insubsection 123(1) o the ETA, thesel -supply rules ound in section 191 and

the GST/HST new housing rebate rules.

Additional Concern

The land trans er tax (LTT) may alsoapply to the Diminishing Musharaka withIjara. In Ontario, absent any provincialgovernment relie , the transaction inStep 1 would be subject to LTT. Thetransactions under Step 3 and Step 4would also attract LTT, although thelegal title trans erred in Step 4 probablywould have only nominal value. UnderStep 3, LTT would apply again andtiming and valuation complications couldarise due to the tiering o LTT rates,depending on value o the real propertyinterest trans erred. It is critical thatthe provincial tax authority view Step 3as a back-to-back transaction andeither amend the legislation accordinglyor apply relie administratively on thisbasis 6. It is our understanding thatthat this issue has been raised withthe Ontario Ministry of Finance and iscurrently under review.

SUKUK-AL-IJARAConventional bonds are xed incomesecurities that promise the holder aspeci ed set o payments. In e ect,a bond investor lends money to thebond issuer in return or the issuerspromise to pay interest and repay

6 There is a Murabaha model or a residential mortgage that involves the ownership o the property being trans erredtwice in succession. It is understood that the Ontario government has previously granted Land Transfer Tax relief.

the principal on maturity. An Islamicbond, or Sukuk, is asset backed andthe certi cates represent an undividedshare in the underlying asset. In contrast,a conventional bond is a debt securityproviding a right to income rom theissuing entity. Conventional bonds andthe Sukuk di er in the way they arestructured and marketed. In the Islamicversion o a bond, the issue is basedon the exchange o a Shariah-compliantasset that allows investors to earnpro ts. Consider the ollowing Shariah-

compliant structure, a Sukuk al-Ijara: An obligor enters into a sale-leaseback

arrangement using a Special PurposeVehicle (SPV) or commercial real estate

Certi cates in the SPV are issued toinvestors who acquire a bene cialinterest in the underlying asset sold bythe obligor to the SPV

Investors buy Sukuk certi cates in theSPV, obtaining bene cial ownership inthe asset that the SPV buys rom the

obligor.




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The investors may choose to trade theSukuk on a secondary market.

A acilitator o the transaction may bepaid ees or arranging the structure.

Income Tax Issues

From an income tax perspective, thetaxation o this Sukuk-al-Ijara may besimilar to a sale-leaseback transaction,

rom the perspective o the SPV and theobligor. As such, there are no uniqueincome tax issues to resolve. I thetransactions are determined in law tobe a sale ollowed by a lease, the obligorshould realize a gain or loss on the sale othe asset to the SPV and may be able toclaim a deduction or the lease paymentsi they were made to earn income rom abusiness or property.

I , on the other hand, the transactions areconsidered to be a loan arrangement inlaw, then a sale o property is considerednot to have occurred, and the SPV andobligor are considered to be lender andborrower, respectively. In this case, the

payments are treated as a combination oprincipal and interest or tax purposes. TheCanadian tax authorities have indicatedthat the parties intent to enter into aloan arrangement is evident where thesales price o the property is substantiallydi erent rom its air market value.

Typically, an SPV is structured as afow through vehicle so that the SPVdoes not pay any income tax. Wherethe transactions are considered a saleand leaseback in law, the investors

are considered to receive either trustincome or rental income, dependingupon whether the SPV is a trust or apartnership. In both cases, the income

rom the SPV is ully taxed in the handso the investors.

Issues may arise where the investors arenon-residents. Under a conventional bondinstrument, interest should not be subject

to Canadian withholding tax when paidto arms-length non-residents, providedthat the interest is not participating debtinterest. However, depending upon thelegal character o the transactions and othe SPV, an investor holding a bene cialinterest in the underlying asset may beconsidered to be receiving rent on thatasset. Payments o rent to non-residentsare subject to 25% Canadian withholdingtax on the gross amount, unless a taxtreaty reduces the rate. Where the rent isin respect o real or immoveable property

in Canada, the non-resident may insteadchose to le a Canadian tax return andpay Canadian tax on the net income romthe property.

Alternatively, the investor may beconsidered to be receiving trust income.Trust income paid or credited to non-residents is also subject to 25% Canadianwithholding tax, subject to treatyreductions. Accordingly, non-residentinvestors in a Sukuk-al-Ijara productcould be at a disadvantage compared to

investors in a conventional bond.Income Tax Changes Required

A level playing eld should be restoredby changing the tax legislation to treatinterest equivalents paid by the SPV tonon-resident investors as interest.

Commodity Tax Issues Under a conventional bond arrangement,GST/HST issues are relativelystraight orward. Interest paid by anissuer to an investor is an exempt

nancial service or GST/HST purposes.Any services provided by arrangers oracilitators o the transaction must also

be analyzed to determine i any relatedees are taxable (e.g., advisory ees) or

exempt (i.e., ees or arranging services) 7.

In the equivalent Shariah-complianttransaction, GST/HST could have asigni cant impact. GST/HST implications

7 CRA Policy Statement P-239, Meaning of the term arranging for as provided in the de nition of nancial service.




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could arise on the sale-leasebackbetween the obligor and the SPV,depending on the nature o the assets.In this example, as the property iscommercial real estate, GST/HSTwould apply. However, rather thanselling shares, the SPV sells a bene cialownership in the underlying asset, whichwould not be an exempt nancial service.As the property is commercial realestate, GST/HST would apply to the saleo the bene cial interest to the investors.

Any rents paid to the investorswould be subject to GST/HST. Anysubsequent trading would also haveGST/HST implications. Finally, any

ees paid to arrangers or acilitators othe transactions would be subject toGST/HST as no exempting provisionapplies.

GST/HST would have a signi cant impactat each stage o the transaction. Wherethe SPV or investors are non-residents,particular care should be taken whendetermining which party accounts or theGST/HST on the real property transactions,under subsection 221(2) o the ETA (i.e.,the initial sale and the sale o the interest toinvestors) 8. Routine issues, such as triple-net leases and property improvements,would also have to be managed. Ultimately,the transaction creates considerably moreGST/HST compliance obligations and costs

or the obligor, the SPV and the investors,and potentially cash fow issues.

As this example involves commercial realestate, signi cant LTT could also arise.

As with the Diminishing Musharakawith Ijara, there is a risk o multipleLTT applications, which could causesigni cant additional costs.

In short, even though a Sukuk isdesigned to give the same return asa conventional bond, the impact oGST/HST and LTT could make thesestructures unviable.

Commodity Tax Changes Required Revisions to a number of GST/HSTprovisions in the ETA are required or aSukuk to achieve a similar tax treatmentto a conventional bond. One approachwould be to have the provision o aSukuk be considered a nancial service,and thus GST/HST exempt, under thesupporting de nitions in subsection123(1) o the ETA. This may requirea new, stand alone de nition or anamendment to an existing one (e.g., nancial instrument).

TAKAFULTaka ul, or Islamic insurance, is basedon concepts o social solidarity,cooperation and mutual indemni cationo the losses o policyholders. Taka ulproducts must respect the guidingprinciples o Shariah law. EssentiallyTaka ul involves the payments ocontributions that are wholly or partlydonations to orm an insurance port olio.These contributions may be split intotwo components: one to cover riskand one or investment purposes. Theobjective o the investments is not tomake pro ts, but rather to mitigatelosses. The pooled donations are thenused to pay any claims when the insuredrisk occurs. A surplus that remainsa ter the payment o indemnities andexpenses is distributed among theparticipants. Conversely, the participantsmay be required to make additionalcontributions i there are losses inexcess o the contributions made todate and investment return.

Broadly speaking, a Taka ul arrangementis similar to a mutual insurancearrangement. The di erence is thatTaka ul members are typically notshareholders/unit-holders in theTaka ul company, which operates thearrangement or the Taka ul members.

8 I the property is situated in Canada and the SPV or investors are non-residents, signi cant withholding taxissues could arise or income tax purposes.




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The operator company is paid a ee orthe services rendered (i.e., Wakala) and/ or is entitled to a share in the returnreceived on the unds investments(i.e., Mudaraba). Taka ul includes general(e.g., property), amily (e.g., li e) andre-taka ul.

Income Tax Issues There do not appear to be any incometax issues applicable to such mutual risksharing arrangements. The existing tax

regime that applies to mutual insurancecompanies should apply to Taka ul.However, consideration should be givento the potential di erent tax treatmento compensation paid to the Taka uloperator company (i.e, Wakala vs. pro tshare). In addition, it is necessary toconsider the possible tax issues relatingto the Islamic nancing alternatives inwhich the contributions are invested.

Commodity Tax Issues

Generally, the ETAs exempting provisions

related to insurance premiums shouldapply to Taka ul. However, speci cde nitions must be satis ed or theGST/HST exemptions or insurance toapply; in particular, the de nitions oinsurer and insurance policy insubsection 123(1) o the ETA. There ore,the GST/HST treatment o Taka ul willlargely be driven by other regulatoryprovisions (e.g., does a Taka ul providermeet the de nition o insurer).

There are other issues related to aTaka ul structure. For instance, theremay be di erent commodity tax issuessuch as determining the GST/HSTstatus o a ee charged by an operatingcompany using a Wakala model withrespect to the operating companiescompensation, or a Mudaraba modelwhereby the operating company sharespro ts rom investment activities(please see the previous comments onMudaraba or this matter).

MISCELLANEOUSGST/HST COMPLIANCEISSUESA key question or any Islamic

nance product supplier is whether itquali es as a nancial institution, asde ned in section 149 o the ETA. Thisdetermination will govern the applicationo the ETA to the institution and itscompliance obligations. Subsection

149(1) o the ETA lists the types opersons that would be considered a nancial institution, including a bank,credit union, a person whose principalbusiness is the lending o money and aninsurer. The provision also sets out a deminimis test, which provides that personsgenerating revenues rom nancialservices over certain thresholds areconsidered to be a nancial institution.

It would be critical or an Islamicnancial services provider to determine

its treatment under other regulatorystatutes. For example, i the providerwas authorized under section 2 o theBank Act , it would be considered tobe a bank or ETA purposes and thusquali y as a nancial institution undersubsection 149(1) o the ETA. Likewise,i person is licensed or authorized tocarry on an insurance business, theinsurer requirement would be satis ed.Alternatively, unless the ETA is interpretedliberally, Islamic nance providersactivities may not indicate that their

principal business is lending money,since their transactions typically generatepro ts or rents in lieu o interest. Finally,the de minimis tests would not likelybe satis ed as the tests are based onrevenue generated rom the provision o

nancial services, such as interest romloans or credit cards.

Again, a liberal interpretation o whatconstitutes a nancial service would berequired. Potential bene ts could arise

or Islamic nance providers that are notconsidered to be nancial institutions.Under the ETA, nancial institutions aresubject to certain provisions principally

ocused on restricting input tax credits(ITC) (e.g., sections 185 and 200 o theETA). These sections would not applyto the bene t o the Islamic nanceprovider. The proposed rules undersection 217.1 o the ETA or nancialinstitutions that import services romoutside o Canada would not apply. The

election under section 156 o the ETAwould be available to help relieve cashfow. Finally, the providers complianceobligations would be lessened as itwould not be required to le the AnnualInformation Return (GST 111). However,i the provider is captured within thede nition o nancial institution, itwould ensure that the Islamic nanceproducts and services provider does notbene t rom a competitive advantage!

Other compliance issues may arise. Forexample, a nancial institution having bothGST-exempt and taxable activities mustuse a GST/HST allocation methodology todetermine the extent to which GST/HSTpaid on inputs can be recovered. Howwould the additional transactionsnecessary to achieve a Shariah-compliant

acility be treated or ITC allocationmethodology purposes? Regarding loan

acilities, how would the buying and sellingo taxable goods a ect a method? Theasset transactions that underpin Islamic

nance could potentially distort the results

o the GST/HST allocation methodology,and would need to be care ully considered.Finally, ees are o ten charged orarranging or loans, and the GST/HSTstatus o the nancing element as exemptinterest or taxable pro t is critical ordetermining the status o these charges.


Section 141.02 o the ETA should bereviewed to ensure the appropriateapplication to Shariah-compliant products.




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Income tax Many Islamic nancial products involvethe sharing o pro t (e.g., a Mudaraba,a Sukuk). It may be unclear whethernon-resident withholding tax applies tosuch sharing o pro t. It may also beuncertain whether expenses incurredin lieu o interest are deductible.

Accordingly, consideration should begiven to amending the ITA so that anyre erences to interest apply to gainsor pro ts received, alternative nancereturn and expenses incurred in lieuo interest in transactions conducted inaccordance with Shariah principles.

Islamic nance transactions o ten requirean interest in an underlying asset and, thus,may involve the trans er o an asset. Tothe extent a portion o the gain realized bythe nance provider upon the trans er othe asset (e.g., in a Murabaha transaction,where a nance provider purchases anasset or the customer and then sells it tothe customer, almost immediately, or apro t) can be treated as remuneration orthe de erral o payment and is comparableto interest on a conventional nancialproduct, changes to the ITA to spread thetaxation o the gain over the payment termshould be considered.

Consideration should also be givento amending the de nition o a

disposition to exclude disposal o anasset pursuant to a nancing transactionrequired solely or the purpose ocomplying with Shariah principles (i.e.,to exclude a disposition strictly required

or the sole purpose o complying withShariah but that would not be required inany other nancing transaction).

Islamic nance transactions that areviewed as partnerships o ten pose taxissues. Changes are required to ensurethat associations established to enableShariah-compliant investment are notconsidered partnerships or canadianincome tax purposes.

Commodity tax The above analysis demonstrates theneed or a thorough review o the ederalGST/HST legislation and interpretivepolicy related to nancial services, PSTlegislation o provinces that operate aretails sales tax, and other legislation,such as land trans er tax.

De nitions in several sections o theETA must be reviewed to accommodateIslamic nancial products. In particular,the de nitions o nancial instrument, nancial service and insurer insubsection 123(1) o the ETA mustbe reviewed and amended wherenecessary, as well as the de nition o

nancial institution in section 149 othe ETA. Arguably, i these de nitionscan be appropriately amended to includeShariah-compliant products, this wouldaddress many o the commodity taxissues or GST/HST purposes.

General remarks Islamic nancial products and services isa ascinating area with a real potential orgrowth, but a number o critical issuesmust be addressed, including the taxtreatment o Shariah-compliant nancialproducts and services. As this paper hasdemonstrated, an understanding o Islamic

nance products and the resulting taxtreatment can ensure that any potentialissues that would place an Islamic nanceat a competitive disadvantage or advantagecompared to a conventional nance productcan be addressed on a timely basis.

Experience shows that a collaborativeapproach between industry andthe tax authorities is necessary toensure an equitable tax treatmentand the competitiveness o Islamic

nance services and products. Otherjurisdictions where the tax authoritieshave taken, or are in the process otaking, steps to ensure equitabletreatment o these services and productso er use ul precedents or Canada.

V. CONCLUSION



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Contact us

Steven C. WattsPartner, AuditKPMG LLPT: + 416-777-8532E: [email protected]

Carmela PallottoPartner, TaxKPMG LLP

T: + 416-777-3618E: [email protected]

John BainPartner, TaxKPMG LLPT: + 416-777-3894E: [email protected]

kpmg.ca

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The Taxation Treatment of Islamic Finance in Canada

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