A key announcement by the Federal Government in its Budget last week is a pledge to “enhance access to asset backed financing” by removing key barriers to the use of asset backed financing arrangements imposed by Australia’s current tax laws.  While the announcement was made without much fanfare, it may prove to be one of the most significant tax changes in the Budget.  Potentially, the announcement may open the door to Islamic financing in Australia, allowing Australian borrowers to access a new financial market to fund projects, particularly in the infrastructure and agricultural space.

Infrastructure funding

The Board of Taxation’s report on Islamic financing was released on Budget night.  The report notes that “access to diverse sources of offshore capital is important in the context of Australia being a net capital importer. The Board recognises that Islamic finance may provide a further finance option to help meet this demand, particularly for infrastructure projects in Australia”.   

Norton Rose Fulbright has acted on Shariah-compliant financing structures throughout the world to fund large infrastructure projects (including PPPs) and privatisations including airports, hydro-power stations, toll roads and ports etc.  Different Islamic financing structures are available to suit the risk and return profiles of different infrastructure types (including to address construction risk), however, the differential tax treatment when compared with other financing structures has been a significant impediment to the development of the market in Australia.  For example, many Islamic financing transactions are not treated as a loan for tax purposes, but are instead subject to tax under the CGT or trading stock rules and can be subject to GST or stamp duty.  As a result, Australia’s ability to access this source of funding has been limited.  Transactions involving Islamic financing in Australia have to date required complex structuring and involved a combination of Islamic financing and conventional financing to create innovative hybrid structures.

More information about the Board of Taxation’s review

Back in April 2010, the Federal Government announced that the Board of Taxation would undertake a comprehensive review of Australia’s tax laws to ensure they do not inhibit the expansion of Islamic finance, banking and insurance products in Australia. Norton Rose Fulbright was amongst a small number of firms which contributed submissions to the Board proposing taxation reform at both the State and Federal level. The measures we suggested were to follow the United Kingdom approach.  The changes would place transactions structured in a Shariah-compliant manner on a similar footing to conventional financing so far as the tax consequences are concerned.

While the Board’s initial Discussion Paper discussed a wider range of possible Islamic financing structures, its final report focuses on facilitating the following:

Murabaha: This is where an asset is sold for a deferred payment or series of payments which include a profit element. This type of transaction may be used, for example, in place of a mortgage loan to enable a residential house purchase.

Tawarruq: This is also known as a commodity Murabaha where a party buys an asset (typically a tradeable commodity such as platinum) on deferred payment terms, then immediately sells that asset in order to obtain use of the cash.

Ijara muntahia bittamleek: This is essentially a finance lease arrangement where the lessor makes a promise to transfer ownership of the asset at the end of the lease. There are differences from the typical Western finance lease, in particular that the rental for the whole term must be determined at the outset, and liabilities associated with ownership of the asset must be borne by the lessor.

Sukuk: This denotes a certificate representing a beneficial interest in assets, and is similar in function to a tradeable bond or note. A Sukuk sits above a Shariah-compliant underlying structure. The example in the Board’s report envisages a leased asset as the underlying transaction and the most likely structure in an Australian context, although various underlying structures may be used.

The Board made the following recommendations:

Recommendation 1: Amend the income tax law to ensure that, in respect of deferred payment arrangements whose main purpose is to raise debt finance, the finance gain or loss is treated the same as interest on a conventional borrowing. This and Recommendation 8 below primarily facilitate deferred asset purchase transactions such as the Murabaha and the Tawarruq.

Recommendation 2: Expand Division 240 of the ITAA 1997 (provisions relating to the characterisation of certain leases as a notional sale and loan) so that it applies to hire purchase arrangements relating to all assets (not just goods) and ensure that this same division applies to credit arrangements that have the same economic characteristics as a hire purchase arrangement. This primarily facilitates an Ijara muntahia bittamleek transaction.

Recommendation 3: Develop guidance on whether the return on a deferred payment arrangement or an asset based lease security (ie, the Murabaha, Tawarruq and Sukuk products) should come within the expanded definition of “interest” for interest withholding tax (IWT) purposes. IWT is payable on Australian source interest derived by a non-resident unless an exemption applies. There is uncertainty under the current tax regime whether the return on certain Islamic finance products would fall within the current definition.

Recommendation 4: Amend the income tax law to ensure IWT exemptions are made available for publically offered Islamic finance products with equivalent economic characteristics to debentures or those interests that are currently eligible for the IWT exemptions. This, together with recommendation 3 above, would facilitate foreign investment into both Tawarruq and Sukuk products and enable access to capital markets.

Recommendation 5: Develop guidance on whether certain Islamic finance products would come within the definition of “offshore banking activity” under the current law entitling such arrangements to concessional tax treatment for finance transactions that are economically equivalent to offshore banking activities. Such guidance should be helpful in the context of all the Islamic finance products considered by the Board’s report.

Recommendation 6: Develop guidance on whether investment by a managed investment trust (MIT) in a Sukuk would constitute “eligible investment business activity” in order for the MIT to maintain its eligibility for trust taxation treatment under Division 6 of the ITAA 1936.

Recommendation 7: The current taxation framework for partnerships and joint ventures should not be amended. This reflects the view of the Board that the 4 structures described above should be the focus of the Government’s reforms.

Recommendation 8: Develop guidance on the characterisation of the ‘profit’ element of Islamic financing arrangements and its treatment for GST purposes. In particular, it is recommended that the guidance clarify whether the ‘profit’ component is to be considered as: (i) a debt, credit or right to credit or (ii) a charge or mortgage over real property (in the case of property transactions).

Recommendation 9: The current reduced input tax credits (RITC) regime for financial supplies should be maintained and not extended to other input taxed supplies such as input taxed residential premises.

Despite these changes, the Government’s reference to Islamic finance being used in infrastructure projects highlights stamp duty as a key issue which the Federal Government has limited power to address.  Currently, only Victoria has introduced a limited exemption to prevent double duty on property purchases by individuals. Stamp duty costs represent a significant impediment for Islamic financing structures and, without relief being implemented by the States and Territories, Islamic finance involving real property in Australia is likely to be restricted.

Timing and implementation

The measures are intended to apply from 1 July 2018.  We  expect that the Government will consult with industry to ensure that the new rules provide enough flexibility to attract different sources of financing.  We hope that State and Territory Governments will also support these developments with necessary stamp duty reforms.

Please contact your local Norton Rose Fulbright contact for more information or if you would like to contribute to the discussion.


Chair, Europe, Middle East and Asia

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