The Benefits of Islamic Finance Instruments for Russian Businesses
Senior manager of international taxation group
Pepelyaev, Goltsblat and Partners
Islamic finance is gaining more business interest worldwide as well as in Russia. Why has this way of doing business gained so much popularity over the recent years?
The reason is that a significant number of Islamic investors have recognized that there is an opportunity of doing business in accordance with their religious standards and have encouraged the financial institutions that handle their funds to offer Shariah-compliant solutions. As Shariah is not a written law, but rather a flexible guidance based on a number of principles, creating such solutions was not that difficult.
What benefits can Islamic finance bring to Russian businesses? One of the most obvious benefits is to attract investment into Russia. There are a few Islamic finance instruments that are particularly useful for this purpose. These are financing of trading operations (murabaha), partnership (musharaka) and leasing (ijara). The latter could be done in the form of securitized leasing (sukuk-al-ijara).
Despite a widespread misconception, Islamic finance does not require specific laws and is not limited to the Muslim community. Except for several predictable prohibitions (trade in arms, alcohol, pornography, gambling etc), Islamic finance solutions could basically be used anywhere by anyone.
In fact, many conventional transactions may qualify as Shariah-compliant. Such examples include lease contracts, equity contributions into a joint venture and deferred payment sales.
Let us now take a closer look at the types of contracts briefly discussed above from the perspective of the existing Russian tax and legal environment.
In a murabaha contract a financial intermediary buys particular goods at spot price and sells them to a customer at a higher price on credit. There is nothing in Russian law preventing such transactions. The only limitation is the prohibition of trading activities for banks, which itself is subject to many limitations, e.g. permission to trade in securities and precious metals. In addition, the law No. 281 of Dec. 25, 2009, lifts the limitation further and permits banks to enter into forward or option contracts wherein the object of the contract is the delivery of goods, although that is on the condition that such contracts would not involve the physical delivery of such goods.
It appears that this amendment extends the involvement of banks in trade contracts and may support interpretations allowing Russian banks to be involved in murabaha transactions.
From the tax perspective, the difference from conventional loans is that in order to buy an item worth 100,000 rubles (VAT inclusive), a customer would take a loan of 100,000. Provided that interest rate is 10% annually, he would pay 10,000 rubles interest which is VAT free. In murabaha transactions the markup to the original price representing premium for deferred payment would be subject to VAT, i.e. the total price for the customer would be 111,800 rubles in a murabaha transaction compared to 110,000 rubles in the case of a conventional loan.
Therefore, somewhat disadvantageous treatment of murabaha is limited to specific cases of sale of goods on credit to retail consumer and might be remedied by clarification from the Ministry of Finance. This relative disadvantage is not based on the fact that the murabaha is Islamic finance transaction, but on the fact that sale on credit is treated differently from sale with the use of loan facility.
Ijara or lease contract would not involve any particular difficulties in structuring in both domestic and cross-border scenarios. In the case of lease payments to a nonresident without a permanent establishment in Russia, payment may be subject to withholding tax at the rate of 20%. However, under many Russian tax treaties, including the tax treaty with the Netherlands, such income would be exempt from tax in Russia.
In the case of a combination of sukuk and ijara, i.e. in classical sukuk structure, establishing a special purpose vehicle in the Netherlands or Luxembourg, which would lease out assets in Russia, possibly operating via a Russian branch, would help to create an efficient and transparent structure in full compliance with the Russian legislation.
These are just few examples of opportunities of successful implementation of classical Islamic finance instruments in Russia. Such instruments could be used for retail sector, project financing and other things relevant to the Russian market. Despite widespread negative perception, many Islamic finance instruments can be successfully implemented in Russia under the current tax and legal laws and regulations.