leal and regulatory issues i b - tkbb consider some of the main issues that arise in connection with...
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WORLD BANK – BRSA –PBAT JOİNT WORKSOP11 WORLD BANK – BRSA – PBAT JOİNT WORKSHOP
MİCHAEL J.T. MCMİLLEN
WORLD BANK – BRSA – PBAT JOİNT WORKSHOP
ISTANBUL, TURKEY
MARCH 3, 2017
LEAL AND REGULATORY ISSUES İN ISLAMİC BANKİNG
Curtis, Mallet-Prevost, Colt & Mosle LLPAdvisor to The World Bank
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Objective and Perspectives
Objective: Consider some of the main issues that arise in connection with legal and regulatory reform efforts within the Islamic banking sector?
Perspectives:
World Bank advisory activities to capital markets boards, national treasuries and central banks in connection with the implementation of Islamic banking and Islamic capital markets legal and regulatory reforms in various countries.
International perspective, with some references to the issues as applicable in Turkey.
NOTE: Some of these matters have been addressed and resolved, at least in part, in Turkey.
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Reform Objectives
Compare each conventional interest-based banking structure with its equivalent Islamic banking structure.
Principles:
there should be a level playing field as between conventional interest-based banking structures and the equivalent Islamic banking structures for all regulatory, legal, financial and economic purposes.
Neither conventional banking nor Islamic banking should have an advantage or a disadvantage.
In the case of taxation, the Islamic banking framework should be tax neutral:
No increased burdens on taxpayers. No less revenue to the taxing authority.
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Main Issues
Taxation
Special purpose vehicles
Trusts and beneficial interests in property
Asset backed – asset based considerations and beneficial interests in property
Collateral security
Bankruptcy and insolvency
Shari’ah governance
Willingness of government divisions and entities to participate
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Regulatory and Supervisory Perspective
Developing and refining the Islamic finance (banking and capital markets) regime is dependent upon understanding:
The structures and arrangements used by an Islamic bank or window to source funds from the customers and the associated risks.
The role of the bank in the Islamic banking process and the associated risks.
The structures and arrangements used by an Islamic bank to put the customer’s funds to use, which means investing those funds and the associated risks.
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Regulatory and Supervisory Perspective
Islamic banks (including Islamic windows) use different structures than are used by conventional interest-based banks.
Most (not all) of the Islamic banking structures are designed to achieve the same ends as interest-based loans. That is:
Both provide financing amounts to customers.
Both provide a return or charge a rate to customers and banks.
The return or rate charged on conventional instruments is “interest”, the return or rate charged on Islamic instruments is “profit” – frequently the rates are the same.
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Islamic Banking Activities
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Two Structures: Murabaha and Ijara
Two examples:
Murabaha (cost-plus purchase and sale).
Ijara (lease, which is a sale of usufruct under the Shari’ah).
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Conventional Loan
Principal CustomerBank
Loan
No tax (income, VAT or stamp duty) on
principal repayment.
Income tax to Bank on interest payment.
Stamp duty on loan documents.
Interest
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Murabaha as a Loan Substitute
Purchase and sale of a commodity or other object at a mark-up: itis a sale and must meet all sale requirements
Mediation of a financier in the purchase of an object at the request of a party needing financing.
Financier purchases the object on the spot market and then sells it to the party needing financing on a deferred payment basis
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Basic Commodity Murabaha
Murabaha
Purchase AgreementSeller
Financier will execute the purchase agreement and purchase the commodity from Seller. Financier will resell the commodity to Financed Party at a mark-up pursuant to the Murabaha Agreement.
Financier
Financed Party
Title
Title Payment (+ mark-up)
Payment
Financed Party desires financing for the purchase of a commodity from Seller. Financed Party negotiates a Purchase Agreement with Seller.
Financed Party requests financing from Financier. Financier agrees to do a murabaha financing and executes a Murabaha Agreement with Financed Party.
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Basic Commodity Murabaha
Murabaha
Purchase AgreementSeller Financier
Financed Party
Title
Title Payment (+ mark-up)
Payment
Stamp duty on murabaha documents (equivalent to loan).
VAT on purchase.
Stamp duty purchase documents.
VAT on purchase.
Income tax on profit (interest equivalent)
and on principal equivalent.
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MurabahaAgreement
Asset Purchase Agreement
Generic Vector Murabaha Transaction
Seller
Financier purchases the metal from Seller on the spot market for immediate payment. Financier then sells the metal on a deferred payment basis to Financed Party. Financed Party then sells the metal Purchaser on the spot market for immediate payment.
Purchaser
Financier
Financed Party
Title
Title
Spot Market Payment
Title
Spot Market Payment
DeferredPayments
Negotiation of Asset Purchase
Agreement
①②③ There are three VAT, stamp duty and income tax assessments for what is really a loan. In ② VAT is assessed before the payments are made.
①
②
③
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Lease (Ijara) Transactions
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Conventional Loan
Principal CustomerBank
Loan
No tax (income, VAT or stamp duty) on
principal repayment.
Income tax to Bank on interest payment.
Stamp duty on loan documents.
Interest
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Lease as Loan
Lease Arrangement CustomerFunding Company
Bank
Loan
Interest and Principalvia
Basic Rent PaymentsPurchase Price Payments
The economic substance of the transaction is a loan from the Bank to the Customer.
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Simple Lease Transactions
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Bank “Loans” Styled as Leases
The most frequently used structure for home purchase financings, project financings, asset financings and other sophisticated financings is a lease (ijara).
The bank (or a subsidiary of a bank or a trust or special purpose vehicle owned by an accommodation party) purchases the asset and leases it to the bank’s Customer. Conventional banks also use this structure to provide Shariah-compliant financing.
Ultimately, the Customer will own the asset.
VAT or the equivalent is legitimately levied on the asset sale – one time.
However, the structure incurs two VAT levies due to two sales instead of one (the original purchase and a subsequent sale by the bank, trust or SPV), with the second VAT transaction really being only part of the principal repayment of the loan.
Additionally, the repayment of the loan is characterized as “rent”. In reality, it is repayment of the principal and interest.
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Simple Generic Ijara: Documentation
Understanding to Purchase
Lease (Ijara)
Understanding to Sell
Managing Contractor Agreement
Asset Seller
CustomerBank
Asset Purchase Agreement
The rent on the Lease (Ijara) is really a loan repayment to the bank. Rent is comprised of a basic rent amount (i.e., the principal) and a profit amount (i.e., the interest component.
The Understandings are styled as “purchase” arrangements (a put option) and “sale” arrangements (a call option in the customer). They are not really purchases and sales. They are mechanisms to
effect repayment of outstanding principal amounts of the financing. The Customer will ultimately own the asset.
VAT on the asset sale. This is really a sale of the asset to the Customer
(with a loan financing styled as
a lease.
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Asset Purchase Agreement
Simple Generic Ijara: Cash Flows
Understanding to Purchase
Lease (Ijara)
Understanding to Sell
Asset Seller
CustomerBank
Price Asset
RentRent
Rent
Final Rent
Asset
This should not be taxable as a rental payment: it is repayment of principal
and interest on a loan equivalent.
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Bifurcated Structures:Generic Ijara
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Bifurcated Structure: Most Jurisdictions
Lease (Ijara)
Bank
CustomerFunding Company
Tenants or Off-takers
Tenant Leases or Off-take Agreements
Non-Compliant Compliant
Conventional Loan AgreementOther Loan Documents
The Funding Company is usually owned by a third party as an “accommodation”. The third party has no other participation in
the transaction is paid a small fee to own the entity.
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Bifurcated Structure
Understanding to Purchase
Lease (Ijara)
Understanding to Sell
Managing Contractor Agreement
Bank
CustomerFunding Company
Tenants or Off-takers
Tenant Leases or Off-take Agreements
Non-Compliant Compliant
Conventional Loan AgreementOther Loan Documents
Other essential ijara-related documents – necessary for Shari’ah reasons.
SPV (discuss). And start thinking about sukuk, which contain multiple lease arrangements.
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Special Purpose Vehicles
SPVs are widely used in Shari’ah-compliant financings.
Often to hold the asset and allow the asset to be leased.
To limit the credit exposures of the transaction.
For bankruptcy remoteness: and here the issues pertaining to collateral security regimes arise (not so many issues in Turkey).
Is enforceability clear and predictable?
Are Shari’ah principles incorporated?
For sukuk issuances.
One of the main issues, around the world, is how easy or difficult it is to form and SPV. Difficulty in formation is an impediment to Islamic finance.
SPV formation in the United States as an example.
A related issue is whether and how the SPV is taxed. Consider the “check the box” regulations.
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Conversion of Bifurcated Structure to Shariʿah-Compliant Structure
Understanding to Purchase
Lease (Ijara)
Understanding to Sell
Managing Contractor Agreement
Bank
CustomerFunding Company
Tenants or Off-takers
Tenant Leases or Off-take Agreements
Shariʿah-Compliant Financing Documents
Additional stamp duty and VAT.
Additional tax considerations depend upon the exact type of Shariʿah-compliant financing that is used.
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Funds Infusion
Lease (Ijara)
Financing AgreementOther Financing Documents
Debt
InvestmentCustomerFunding
Company
Bank
Seller
Purchase Price
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Lease (Ijara)
Lease (Ijara)
Financing AgreementOther Financing Documents
Tenants or Off-takers
The Funding Company, as the lessor, will lease the Project or asset to the Customer, as the lessee, pursuant to the Lease (Ijara). This is a Shariʿah-compliant lease. In the US, Basic Rent equals periodic debt service, precisely.
Debt Service
Rent
Rent or Payments
Loan PaymentsDividends
CustomerFunding Company
BankCustomer Retention
Tenant Leases orOff-take Agreements
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Lease (Ijāra)
Tenant Leases orOff-take Agreements
Lease (Ijara)
Financing AgreementOther Financing Documents
Bank
Tenants of Off-takers
The Funding Company, as the lessor, will lease the Project or asset to the Customer, as the lessee, pursuant to the Lease (Ijara). This is a Shariʿah-compliant lease. In the US, Rent equals periodic debt service, precisely.
Rent
Rent or Payments
Loan PaymentsDividends
CustomerFunding Company
Debt Service
Retention
Is this a taxable entity?Double taxation issue.
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Understanding to Purchase
Understanding to Purchase
Lease (Ijara)
Financing AgreementOther Financing Documents
Tenants or Off-takers
Tenant Leases orOff-take AgreementsUnderstanding to Purchase is, conceptually, a put option for the property.
It is a sale agreement for Shariah purposes, but a repayment of principal in economic and financial substance. The strike price equals all principal amounts due on the bank financing. Shariʿah rule on inability to collect future rents. Mechanism to accelerate. All mandatory prepayments –total and partial.
Strike PriceCustomerFunding
Company
Bank
Title
Debt Service
This is styled as a “purchase and sale” but is really only a repayment of the principal amount of the
financing. Additional income tax (on principal), VAT, transfer taxes and stamp duty
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Understanding to Sell
Understanding to Purchase
Lease (Ijara)
Financing AgreementOther Financing Documents
Understanding to Sell
Tenants or Off-takers
Tenant Leases orOff-take Agreements
Understanding to Sell is, conceptually, a call option for all or part of the project. It is a sale agreement. The strike price equals all amounts due on the conventional loan. All voluntary prepayments – total and partial.
Strike Price
CustomerFunding Company
Bank
Title
Debt Service
This is styled as a “purchase and sale” but is really only a repayment of the principal amount of the
financing. Additional income tax (on principal), VAT, transfer taxes and stamp duty
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Pay
Pay
Pay
Pay
Pay
Pay
Sukuk al-Ijara
Funding Company
Issuer
(Trust or SPV)
Rent
Project Company
Funding Company
Project Company
Funding Company
Project Company
Sukuk Holder
Sukuk Holder
Sukuk Holder
Rent
Rent
In most of the world, this is a trust. Always an SPV.
Bankruptcy issues, especially
for ratings.
All SPVs. One asset per company.
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True Sale
Asset Originator
Sukuk HolderIssuer
Asset Transfer
Creditors of Asset Originator
No True Sale
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True Sale
Asset Originator
Sukuk HolderIssuer
Asset Transfer
Creditors of Asset Originator
True Sale
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Beneficial Interests and Asset Based Sukuk
Sovereign asset transfers: impermissible.
Reasons for using collateral security interests:
Unable to immediately transfer. Transfer costs: VAT, transfer taxes, types
of assets., previous agreements. Consents to transfers.
What is a first ranking security interest?
Asset Originator
Sukuk HolderIssuer
Asset Transfer
Security Interest
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Shari’ah Governance
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Shari’ah Governance
First thought: Shari’ah Boards.
What Shariah boards? At level of each bank (market diversity)? At government level (Malaysia)? At a market participant association (some standardization, and then how much)? Combinations.
Qualifications of scholars? Fitness issues.
Authority and role within the organization and as a matter of law.
Liability of Shari’ah board members.
Conflicts of interest.
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Shari’ah Governance
Many other elements of Shari’ah governance that are often ignored (at least at inception).
Malaysia is a good example of a model of a well-developed Shari’ah governance system.
Shari’ah risk management and control function.
Shari’ah review function.
Shari’ah audit function: internal and external.
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The Will to Participate
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Political and Market Participant Will
A critical factor in implementing truly competitive Islamic banking and Islamic capital markets initiatives is the will and desire of the government and of the market participants.
An example: municipalities, which often have the assets and the capabilities.
An example: banks, which see the capital markets as competitors.
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Islamic Banking Models
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Islamic Banking Models
Theoretical models for the structure of Islamic financial intermediation and banking:
wakala (agency) model
two-tier mudaraba (service-capital partnership) model.
The type of model is not necessarily determinative of how the arrangement should be taxed: it is important to understand what use the bank makes of the customer’s funds in each model.
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Service-Capital (Mudaraba) Models
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Mudarib
One party provides services: the mudarib (the Islamic bank)
In Islamic banking contexts, the service provided by the bank is investing the customer’s “deposit”.
Rabb ul-maal
One or more parties provide capital: the rabb ul-maal (the Islamic bank’s customers or “depositors”.
Under the Shariʿah, this is not a “deposit” as bank regulators conceive of deposits. Most regulators treat it as a deposit, however.
How the bank invests the funds is critical for substantive characterization.
A type of profit sharing partnership between work (services) and capital.
What is a Mudaraba?
Work Capital
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Mudaraba – a type of partnership in which one partner contributes services and one partner (or group) of investors contributes cash
The service provider is the mudarib; in Islamic banking, this is the bank.
The cash investors are the rabb ul-maal; in Islamic banking, this is the bank’s customer.
Most bank regulators treat the customer’s contribution to the partnership as a “deposit” that must be insured.
The Shariʿah treats the customer’s contribution as a partnership contribution (much as a limited partner makes a contribution in a limited partnership arrangement).
What the Islamic bank does with the money – the type of investment – is the determinative factor, as a substantive matter.
Some investments are equivalent to “deposits” with deposit returns (e.g., vector murabaha investments); others are true profit sharing arrangements.
Mudaraba Elements: Definition
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Conventional Banking
Deposit
Customer
(Deposit)
Bank
(Services)
Interest
Deposit
No tax (income, VAT or stamp duty) on return of deposit.
Income tax, but no VAT or stamp duty
on interest payment.
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Mudaraba Generally
Mudaraba Agreement
Capital
Rabb ul-Maal
(Capital)
Mudarib
(Services)
Mudaraba
Business Activities
Revenue
Profit
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Banking Mudaraba
Mudaraba Agreement
Capital Customer
(“Deposits”)
Bank
(Services)
Banking Mudaraba
Business Activities
Revenue
Profit
Usually stamp duty.
Often stamp duty.’
Capital
Income tax.
Income tax.
Maybe tax.
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Banking Mudaraba
Mudaraba Agreement
Capital
Customer
(“Deposits”)
Bank
(Services)
Banking Mudaraba
Business Activities
Revenue
Profit
This “Revenue” stream can be either (a) true profit-and-loss sharing or (b) a vector murabaha to generate the equivalent of an interest rate return.
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Mudaraba
Two-Tier Banking Mudaraba
Mudaraba
Profit
Investment Profit
Business Activities
Profits
Investments
Capital
Mudaraba Agreement
Bank(Services)
Rabb ul-Maal(Capital)
Customer
(“Deposits”)
Mudarib(Services)
Five possible taxes (four certain taxes) at Tier 1 – not shown. The second tier adds at least two more taxes.
Often stamp duty.’Income tax.
Capital