Islamic financing to be bolstered significantly in Australia by proposed tax changes

In brief - Financiers and borrowers should prepare for opportunities

The Federal government’s recently released budget 2016-17 has paved the way for reductions on tax barriers to asset-backed financing arrangements, creating new Islamic financing and sovereign wealth opportunities for financiers and borrowers.

Shari'a law allows for asset-backed financing arrangements

Islamic financing is subject to religious principles under Shari’a law, which forbids interest and gambling but allows for asset-backed financing arrangements. The most typically used Islamic financing contract is either a murabaha, where a borrower purchases a commodity on a deferred payment basis, or an ijara, which is effectively an instalment-based leasing arrangement.

There is a fundamental requirement that returns must be earned from profit derived transactions. In pursuit of this return, Islamic finance contracts are based on acquiring interests in underlying assets or revenues with a strong ethical and lower-risk focus.

The Islamic financing space is mature, competitive and yields numerous opportunities. According to the Top 500 Islamic Financing Institutions report published by The Banker in November 2015, estimated global Shari’a compliant assets were worth $1,273 billion in 2015.

Asset-backed financing to be taxed like conventional financing

The Australian taxation system presently does not accommodate non-interest bearing loans. Islamic investors can therefore expect to accrue multiple capital gains tax, land tax and stamp duty obligations as titles in assets often change hands - in some cases, multiple times.

Subject to the relevant bill being passed, this will change on 1 July 2018. The new laws will apply to transactions supported by assets, including deferred payment arrangements and hire purchase arrangements. As part of the Ten Year Enterprise Tax Plan, the Turnbull government has committed to taxing asset-backed financing arrangements as if they were "traditional" loan agreements.

This follows on from the Taxation Board’s 2011 Islamic financing report, "Review of the taxation treatment of Islamic finance". Whilst it is unclear how this will be legally implemented, the government’s refocus on Islamic funds and diversifying capital resources is evident.

Tax incentives may increase demand for Islamic funding and revitalise capital markets

These changes have the potential to significantly boost the Islamic funding sector and revitalise capital markets in Australia. Financiers and borrowers alike should prepare for these tax incentives which should create rising demand for Islamic funding, whilst increasing the profitability of any current contracts on foot.

We see this budget announcement as having broad implications for stimulating growth in long-term projects in the infrastructure, agriculture and mining sectors, as well as for providing an alternative funding source in the Australian property and development space.