Shariah-compliant Financial Products

by Muhammad Ashraf
Shariah compliant finance is an important part of life for the faithful. Currently, Shariah-
compliant financial products are available to both Muslims and non-Muslims around the
globe. Hence, all consumers should have the opportunity to take up these products
without facing undue regulatory barriers. Consequently, regulatory framework, including
taxation, of Shariah compliant products should apply equally regardless of the faith of
provider or consumer.
State bank of Pakistan is currently regulating the Islamic banking Mechanism through
various regulatory instruments of law which includes circulars, etc, hence, alignment of
other laws is required for a good framework for the correct interpretation of Shariah
compliant products which ought to be based on the principle of concordare leges legibus
est optims interpretandi modus – to make laws agree with laws is the best mode of
interpreting them. Moreover, the law should be so amended to include the nature of
contract instead of the types of contract because of the fact that contractus regit actum –
contract governs the act.
This article is an endeavor to suggest a principle based framework for Shariah compliant
financial products and will try to encompass various aspects of the nature of existing
Shariah compliant financial products. This includes effect of laws relating to property
including motor vehicle, transfer of property, registration of property, stamp duty, hence,
will not only be restricted to Income Tax Ordinance, 2001 and Sales Tax Act, 1990. The
suggestion in this article is based on the concept that leaving the issue unresolved would
amount to maihemium est inter criminia majora minimum, et inter minora maximum –
mayhem [chaos] is the least of great crimes and the greatest among small.
SHARIAH COMPLIANT FINANCIAL PRODUCTS
The most pronounced difference between Islamic financing and existing equivalent
products is the prohibition of interest. This is based on the principle that it is unacceptable
in and of itself for same commodity, including money, to increase in value merely by
being lent to another person. However, Shariah does not prohibit the making of a return
on capital if the provider is willing to share in the risks of a productive enterprise.
The principle deduced from the above discussion concludes the fact that Shariah prohibits
transactions that involve interest, gambling, speculation, unethical investment,
contractual terms of a transaction involving uncertainty, deception, ambiguity or lack of
clarity and give rise to speculation (Gharar). Hence, Islamic financial transactions are
structured using contracts or combination of contracts that satisfy the requirements of
Shariah. Some of the most common Shariah compliant financial products are discussed
below.
Murabaha – Basic price plus profit
A financial institution in Murabaha financing purchases the goods for the customer and
re-sells them to the customer on a deferred basis, adding an agreed profit margin. The
customer then pays the sale price for the goods either in installments or on lump sum
basis at the end of the period. There are three sub products of this product – Basic
Murabaha, Commodity Murabaha and Reverse Murabaha.
Basic Murabaha can be used to fund the purchase of a variety of assets including cars,
fridges, televisions and property (both residential and commercial). Title to the asset will
always pass from the Shariah Compliant financial product provider to the customer at the
beginning of the arrangement.
Commodity Murabaha is used in two most common situations. Firstly, a customer
requires a loan. The Shariah Compliant financial product provider purchases
commodities from a supplier including the title but not the delivery and then sells
immediately to the customer at cost plus profit. This allows the customer to defer
payment either over a set period or until a specified future date. The customer takes title
but not the delivery. The customer, using the Shariah Compliant financial product
provider as its agent, then immediately sells the commodities to a purchaser at a price,
equivalent to the cost to the Shariah Compliant financial product provider , to a
purchaser. The Shariah Compliant financial product provider who acts as an agent but do
not charge anything from the customer for acting as agent. All this is done on spot, that is,
it is done almost instantaneously to avoid the risk of either a rise or fall in the commodity
price. The proceeds equivalent to cost is credited in the customers account allows for
subsequent use. The profit on sale of the commodity by the Shariah Compliant financial
product provider to the customer is what the Shariah Compliant financial product
provider makes from the deal.
In second situation, a customer requires a loan. The Shariah Compliant financial product
provider , using an agent, purchases commodities from a supplier by just taking the title
but not the delivery and then sells immediately to the customer at cost plus profit. This
allows the customer to defer payment either over a set period or until a specified future
date. The customer takes title of the goods. All this is done on spot, that is, it is done
almost instantaneously to avoid the risk of either a rise or fall in the commodity price.
The profit on sale of the commodity by the Shariah Compliant financial product provider
to the customer is what the Shariah Compliant financial product provider makes from the
deal.
Reverse Murabaha is basically the reverse to the commodity Murabaha and is normally
used to affect a loan between financial institutions. Similarly, there are also two
situations, however, both the Shariah Compliant financial product provider s act as
agents. Firstly, Shariah Compliant financial product provider 1 requires a loan. Shariah
Compliant financial product provider 2 purchases commodities from a supplier but not
delivery. Shariah Compliant financial product provider 1 acting as agent, without any
charge, for Shariah Compliant financial product provider 2 takes the title to the
commodities and then sells the commodities immediately to Shariah Compliant financial
product provider 2 at a cost plus profit, allowing Shariah Compliant financial product
provider 2 to defer payment either over a set period or at a specified future date. In this
process, Shariah Compliant financial product provider 1 takes title to the commodities
but not delivery. Shariah Compliant financial product provider 2 then immediately sells
the commodities at a cost, equivalent to the cost, to an end-purchaser. All this is done on
spot, that is, it is done almost instantaneously to avoid the risk of either a rise or fall in
the commodity price. The proceeds equivalent to cost is credited in the Shariah
Compliant financial product provider 1’s account allows for subsequent use. The profit on
sale of the commodity by the Shariah Compliant financial product provider 2 to the
Shariah Compliant financial product provider 1 is what the Shariah Compliant financial
product provider 2 makes from the deal.
In second situation, Shariah Compliant financial product provider 1 requires a loan.
Shariah Compliant financial product provider 2 purchases commodities from a supplier
but not delivery and sells immediately to Shariah Compliant financial product provider 1
at a cost plus profit, allowing Shariah Compliant financial product provider 1 to defer
payment either over a set period or at a specified future date. In this process, Shariah
Compliant financial product provider 1 takes title to the commodities but not delivery.
Shariah Compliant financial product provider 1, with Shariah Compliant financial
product provider 2 now acting as its agent, immediately sells the commodities at cost to
an end-purchaser. All this is done on spot, that is, it is done almost instantaneously to
avoid the risk of either a rise or fall in the commodity price. The proceeds equivalent to
cost is credited in the Shariah Compliant financial product provider 1’s account allows
for subsequent use. The profit on sale of the commodity by the Shariah Compliant
financial product provider 2 to the Shariah Compliant financial product provider 1 is
what the Shariah Compliant financial product provider 2 makes from the deal.
Ijara – Operating Lease
This product is a renting product that can be used to lease a variety of assets including
cars, fridges, televisions and property (both residential and commercial). The Shariah
compliant product offering institution acquires title to the asset and gives on rent to the
customer. At no time does title to the asset pass to the customer nor is it expected to pass.
If the customer wishes to purchase the asset at a later date a separate agreement is drawn
up.
Ijara wa Iqtina – Finance Lease
This product is the same as the Ijara described above except that title to the asset is
expected to pass to the customer at some time, usually at the end of the contract period. It
can be used to purchase both goods and property.

Diminishing Musharaka – Shared Ownership

This product involves the use of two written contracts, being Ijara agreement and a
diminishing ownership agreement (Musharaka), where two or more parties share
ownership of an asset. For instance, a customer wisher to purchase a property and pays a
specific percentage as a deposit to the vendor of the property and then enters into a
diminishing ownership agreement with the Shariah compliant financial product provider
under which the Shariah compliant financial product provider pays the outstanding
amount, taking title to the property by way of a sub-lease between the vendor and the
Shariah Compliant financial product provider. The Shariah compliant financial product
provider’s customer now have, say 10%, beneficial interest or share in the property, with
the remainder being with the Shariah compliant financial product provider. The Shariah
compliant financial product provider allows the customer to defer payment of 90% over a
period of, say 25 years. It does not and cannot add any interest to the 90% and so under
this contract the customer pays back the exact amount paid out by the Shariah Compliant
financial product provider.
At the same time, customer enters into the diminishing ownership agreement he also
enters into a lease agreement, whereby the Shariah compliant financial product provider
agrees to lease its share of the house to the customer for a variable amount of rent. This
lease agreement runs concurrent with the diminishing ownership agreement. The
customer may also be expected to pay any outgoings related to the property as well as all
administrative and legal costs, arrangements fees and stamp duty.
Both the amounts repaid under the diminishing ownership agreement and the amount
paid under the lease agreement are amalgamated and used to calculate how much of the
Shariah compliant financial product provider’s share of the property has been purchased
per month by the customer. As the Shariah compliant financial product provider’s share
in the property decreases so does the amount paid under the lease agreement.
At the end of 25 years and if all the conditions contained within the two contracts have
been met, the Shariah compliant financial product provider will pass title to the property
to customer under the diminishing ownership agreement, normally for an additional
payment. Moreover, some Shariah compliant financial product provider also require the
customer to sign a third agreement under which the customer provides some form of
security against payment of the amounts due under the other tow contracts, other Shariah
compliant financial product providers may also require more than three agreements to be
signed.
Wakala – Agency
This is an investment product, which functions in the same way as Mudaraba. The
difference between the two is that with a Mudaraba all the profit is divided between the
parties. Whilst with a Wakala the investor receives only the agreed ratio against
investment. Anything made above that ratio is kept by the Shariah compliant financial
product provider and not given to the investor.
For instance, an investor agrees to invest a sum with the Shariah compliant financial
product provider for an agreed return of say 10%. The Shariah compliant financial
product provider pools the investor’s funds with the funds of other investors along with
its own capital and invests in Shariah compliant financial asset. At the end of a given
period the Shariah compliant financial product provider return the invested sum to the
investor along with the agreed 10%. Any additional revenue that the Shariah compliant
financial product provider makes on the money is kept by the Shariah compliant financial
product provider. If the Shariah compliant financial product provider does not make the
agreed percentage return then the investor gets what has been made whilst the Shariah
Compliant financial product provider gets nothing.

Islamic Current Accounts

These operate in the same way as the conventional current account except that there is no
overdraft facility and no interest added by the Shariah compliant financial product
provider to the account for funds in credit.
TITLE RELATED LAWS, STAMP DUTY AND CVT
Motor vehicle registration act, Transfer of Property Act, Capital Value Tax and Stamp
Duty Act, needs to encompass the nature of Shariah compliant financial products for a
smoother flow of transactions or contracts. The most common problem of Shariah
compliant financial products is the involvement of series of transaction which is
chargeable to CVT and Stamp duty and is not necessary under conventional mortgage
structures. Similarly, another regulatory burden specifically related to immovable
property and motor vehicle is the transfer of title in the name of Shariah Compliant
financial product provider and then to the customer.
To achieve this end, Legislation needs to be amended in a manner to encompass the
intrinsic features of the underlying contract based on principles deduced from Shariah.
Specifically, Government must relieve the transactions entered for the purpose of Shariah
Compliant property and motor vehicle related financial products from CVT and stamp
duty. Similarly, Transfer of property act, 1844 and Motor Vehicle Registration Act needs
to be amended in such a manner to avoid the hassle of series of transfer and the modus
operandi may include stamping in the case of hire purchase and under lien or mortgage.

SALES TAX ACT, 1990 [STA, 1990]

The sales tax treatment of Shariah compliant financial products is somewhat uncertain
and produces anomalous results. These anomalies can put the providers of Shariah
compliant financial products at a commercial disadvantage. Consequently, the customers
also suffer a disadvantage if Shariah Compliant financial product providers have to
charge proportionately more for Shariah compliant financial products. One must consider
the impact of sale to a general consumer and a trader as in the case of conventional banks
whereby the consumer finance is for end consumer and loans for traders.
Moreover, reverse Murabaha is the only instrument available for the Islamic banks to
meet the deficiency of short fall in cash reserve, hence, should not be brought into the
ambit of sales tax act, 1990.
Murabaha
In Basic and Commodity Murabaha, the title to the asset passes from the Shariah
Compliant financial product provider to the customer, hence, the sale should be treated as
a credit sale. There are two supplies being made by the Shariah Compliant financial
product provider – one of the goods and one of the facilities to defer payment. It is
suggested that the consideration for supply of the goods should follow the similar
treatment of hire purchase by conventional Shariah Compliant financial product provider
s, hence, should neither loose its basic treatment under STA, 1990 nor suffer any further
tax when the title passes from the Shariah Compliant financial product provider to the
customer. On the other hand, the profit element should also be exempted from tax and
treated as consideration for the defer payment by Shariah Compliant financial product
provider s. This treatment would not put the Islamic Shariah Compliant financial product
provider s at disadvantageous position over the conventional interest based Shariah
Compliant financial product provider s.
Ijara, Ijara wa Iqtina and Diminishing Musharaka
Consideration for supplies made under this arrangement needs to be treated in the same
way to Hire purchase or conditional sale, except property. As stated earlier, there are two
supplies being made by the Shariah Compliant financial product provider – one of the
goods and one of the facility to defer payment. It is again suggested that the consideration
for supply of the goods should follow the similar treatment of hire purchase by
conventional Shariah Compliant financial product provider s, hence, should neither loose
its basic treatment under STA, 1990 nor suffer any further tax when the title passes from
the Shariah Compliant financial product provider to the customer in case of Ijara wa
Iqtina.
On the other hand, the profit element should also be exempted from tax and treated as
consideration for the defer payment by Shariah Compliant financial product provider s.
This treatment would not put the Islamic Shariah Compliant financial product provider s
at disadvantageous position over the conventional interest based Shariah Compliant
financial product providers.
However, where the Shariah compliant financial product provider is unlikely to be the
absolute legal and beneficial owner of the asset but just takes the title by way of security,
the assignment of the title should operate by way of mortgage. Any payment made by the
customer will be the repayments of the price and where the amount repaid is greater than
the value of the asset advanced then this should be considered as part of the facility to
defer payment and be exempt from GST.
INCOME TAX ORDINANCE, 2001
It is high time that a framework needs to be incorporated in Income Tax Ordinance, 2001
whereby Shariah compliant products are taxed in a way that is neither more nor less
advantageous than equivalent Shariah Compliant financial product provider ing products.
The intended effect must be to allow providers to offer Shariah compliant products
without facing commercial disadvantage, and to enable customers to take up these
products without encountering uncertainty or disadvantage over tax treatment.
Murabaha
The most common problem of Shariah compliant financial products is the involvement of
series of transaction which falls within the ambit of minimum tax, capital gain and fair
market value related provision which is not the case under conventional financial
products.
Section 113 needs to be amended to exclude the sale transaction of a Shariah compliant
financial product from the definition of turnover. Moreover, section 153 also needs to be
suitably amended to exclude deduction of tax from the installments by the customer
instead of exemption certificate approach.
In furtherance, section 37, 68, 75, 77 and 78 needs to be amended in such a manner that
transaction, involving capital gain, entered into by a Shariah compliant financial product
provider should not be taxed under any provision of Income Tax Ordinance, 2001 in the
hands of Shariah Compliant financial product provider.
Ijara, Ijara wa Iqtina and Diminishing Musharaka
Section 18 needs to be suitably amended to incorporate the concept of Ijara and Ijara wa
Iqtina. In the absence of a suitable amendment, the Ijara wa Iqtina relating to a house will
fall under section 15 and would put the Shariah compliant product provider at a
disadvantage over the conventional Shariah Compliant financial product provider.
The core basis of such amendment is based on the fact that it involves payment of rent
and principal with rent. Under the conventional banking, the amount is debited from the
account and the need to deduct tax does not arise. However, the modus operandi for the
Shariah Compliant financial product provider remains same but the nature of contract
involves rent and principle.
Wakala – Agency
It is suggested that such an income needs to be considered in line with section 151 in the
hands of the customer.
Donation out of Penalty
A heavy non-performing portfolio and default on part of clients is a serious problem
confronted by the Shariah compliant financial product provider. This problem could be
threat to success of Shariah compliant financial product service provider. If clients do not
honor their commitment in respect of timely payment in respect of a Shariah compliant
financial product, it could cause irreparable loss to the system.
In Islam, it is permissible to penalize a financially debtor but delays payment of debt
without any genuine reason. Last Prophet (PBUH) said, “A rich debtor who delays
payment of debt commits zulm”. Hence, the jurists allow the punishment (Taazir) to such
borrower in the form of fine. In the opinion of some Maliki jurists, a delaying borrower
would be obliged to pay for charitable activities.
In view of the severity of the problem, all Shariah bodies including Shariah bench of the
Supreme Court of Pakistan have approved the provision of penalty clause in the
contractual agreements that keeps a balance between the requirement in view of severity
of the problem and that of the Shariah conditions/principles to keep the fine difference
between interest and profit on Shariah compliant financial product intact.
However, the penalty proceeds would be used for charity because penalty on default in
repayment cannot become an automatic source of income for the creditor. Hence, it is
imperative that a new sub-section needs to be introduced in section 20, whereby all such
penalties are donated and amounts are reflected in the tax returns of such not for profit
making organizations having NTN.
ECONOMIC ASPECTS
Nowadays, government should seek to address an existing inequality in the tax treatment
of Shariah compliant financial product and to promote fairness by contributing to the
Government’s financial exclusion and asset saving objectives.
This healthy competition would seek, would commit in working together with financial
services provider to achieve a reduction in the number of people who lack access to a
Shariah Compliant financial product provider account of any kind. Many people,
particularly those living on low incomes, cannot access mainstream financial products
such as Shariah Compliant financial product provider accounts and loans.
Currently, the Government is also seeking, through measures, to provide targeted support
and incentives for saving. Evidence suggests that on average people have less access to
an uptake of financial services. Part of the reason for this may be the lack of provision of
Shariah compliant financial product.
Applying the tax law as it currently stands would leave in place a real inequality since the
tax treatment would not always reflect the economic purpose of the transaction.
Customers could suffer if providers have to charge proportionately more for their
products than conventional Shariah Compliant financial product provider s, although
some may be better off overall if in some circumstances they would pay less tax on the
equivalent products from a conventional Shariah Compliant financial product provider .
There are close links between provides of Shariah compliant financial product and the
investment market, for instance, Islamic funds investment in stock market and
benchmarking of profit through KIBOR etc. Benchmarking of KIBOR as minimum profit
rate is criticized from Pakistan Nationals around the globe, however, some writers have
advocated in favor of this at various forums, however, might is not always right.
Government, in close consultation with Securities and Exchange Commission of
Pakistan, should consider allowing NBFC’s to offer Shariah compliant financial product
within their sphere of activities in line with Islamic Banking offered by conventional
banks. However, the modus operandi should be much more transparent by allowing them
to open separate branches with fresh induction of either capital or issuance of TFC’s
correlated with the weighted average rate of return on products offered by such NBFC’s
on prospective products. This will improve the environment of healthier competition and
serve as a deterrent of creation of cartel in Banking sector who are currently using the
KIBOR as basic profit margin without keeping an eye over the fact that the consumer is
ready to take any rate profit instead of a minimum guaranteed profit which is suspicious
in the light of Shariah.
Moves towards removing possibly disadvantageous tax treatment for Shariah compliant
financial product will extend product flexibility and consumer choice. They may also
have the effect of encouraging investment in Shariah compliant financial product’s
advertising themselves.
CONCLUSION
Doing nothing would not address the potential unfairness and uncertainty outlined above
and would not encourage the provisions of Shariah compliant financial product by the
regulated market. There is a risk that if no action is taken, such products might develop in
an unregulated market.
Issuance of explanatory circular and notifications / SRO’s could address the problem in
short term by alleviating the clearest anomalies whilst permanent solutions need to be
developed in legislation. This allows more time to develop long-term solutions in what is
still a fast developing area. However, this would provide only a temporary solution and
could not address areas where current tax treatment might have conferred an advantage
for one party on Shariah compliance financial product. It would not offer a structural
solution capable of giving a clear framework for the future development of new products.
Ministry of Finance and Law ought to move after a detailed internal analysis and
consultation, the preferred way forward is to recommend a legislative solution which may
include what is suggested in this article. However, the precise form of the legislation
requires careful consideration to fit with existing legal framework for tax law for Banking
and NBFC’s apart from Pakistan’s responsibilities under its network of taxation treaties.
After this due consultation it will emerge that it would not be possible to address all tax
issues affecting the development of Shariah Compliant financial product with a single
piece of legislation. Therefore, it may be imperative to establish a forum to evaluate
progress achieved by this sector and concerned ministries must work towards solutions
on outstanding issues of law identified above before the issuance of finance bill, 2007.
The pace of market development suggests that a large number of financial institutions
will be interested in developing a range of Shariah Compliant Financial products once
greater clarity is brought to the question of tax treatment, and will benefit from enhanced
flexibility in development and marketing.
Initially, most of the Shariah compliant currently in development be geared towards retail
customers. However, Shariah compliant financial business products are already being
developed and Banks have shown interest in expanding into this area. Over time a
significant proportion of the customer base for providers of Shariah Compliant financial
products is likely to be small businesses who wish to comply as far as possible with the
provisions of Shariah law. At present, they may face difficulties in reconciling this
obligation with securing necessary financial access.

In the light of this discussion, it can effectively be concluded that in recent years there
have been a number of prominent developments in the world including Pakistan’s Islamic
finance market, and there is now considerable interest in developing and marketing a
wide range of products. Shariah compliant current accounts, savings accounts and house
purchase facilities are now available apart from other products. The regulatory
framework discussed above needs fresh blood in the light of development discussed
above.
The author, Muhammad Ashraf is an International Tax Advisor, the opinion expressed in
this article is personal and the firm, with whom the writer is attached, may or may not
agree with it.