21 May 2010 Financial Services Inquiry Victorian Competition and Efficiency Commission GPO Box 4379 Melbourne Victoria 3001 Dear Sir/Madam Inquiry into Regulatory Impediments in the Financial Services Sector Islamic Finance and Opportunities in the Wholesale Market 1. Introduction The Australian Financial Markets Association (AFMA) appreciates the opportunity to meet with the Commission on 10 May to discuss opportunities for Victoria to promote the development of a wholesale market for Islamic finance. As noted in our submission to the Inquiry into Regulatory Impediments in the Financial Services Sector, the inappropriate application of stamp duty to certain wholesale Islamic finance transactions represents an impediment to the growth of shariah compliant investment based on land, other assets that are dutiable property, shares or units in land rich entities and registered motor vehicles (which we collectively refer to as dutiable assets ). As requested at our meeting, this submission sets out the activities that may currently be prevented by the absence of broader exemptions from the application of stamp duty, and actions the Victorian Government can undertake to address the impediments. The recent difficulties experienced by businesses in raising funds in the capital markets as a result of the financial crisis illustrate the importance of having a range of financing options available. Islamic finance is an alternative form of financing that may be attractive to businesses that cannot use conventional fund raising methods either because the business is shariah compliant and cannot use conventional finance, or because appropriate conventional finance is not available (to the business, or to the market more generally). 2. Key Transaction Structures The inappropriate application of stamp duty to the transfer of dutiable assets that may underpin a shariah compliant transaction affects two types of Islamic finance structures that the industry has identified as presenting the most opportunities for Victoria within the near term, namely the Ijara and Australian Financial Markets Association ABN 69 793 968 987 Level 3, Plaza Building, 95 Pitt Street GPO Box 3655 Sydney NSW 2001 Tel: +612 9776 7955 Fax: +61 2 9776 4488 Email: info@afma.com.au Web: www.afma.com.au
Murabaha structures. These are the most common financing techniques used in the Islamic finance market, with Ijara and Murabaha based transactions accounting for over 70 percent of the global sukuk market in 2009 1. 2.1. Ijara As noted in our previous submission, an Ijara based transaction is a financing technique used to enable an entity to raise funds by utilising the value of assets that it holds. The graphical depiction below illustrates an example of a sukuk transaction based on an underlying Ijara contract, where there may be multiple investors. The same financing method may be used between a financial institution and borrower, in which case the assets would transfer directly between the financial institution and the entity raising the funds. An Ijara contract is akin to an entity raising debt funding from the capital market or a financial institution. Conventional bonds and borrowings from a financial institution can be secured by a mortgage or charge over the underlying asset. By contrast, the equivalent Islamic finance transaction involves a sale and leaseback of the underlying asset with two transfers of assets: first at the commencement of the transaction from the entity raising funds (the Owner) to the SPV (investor/s), then at the end of the term of the financing arrangement, the property is transferred from the SPV (investor/s) back to the Owner. The Duties Act 2000 would impose stamp duty on this Islamic finance transaction twice where it relates to a dutiable asset. The conventional secured loan equivalent would not give rise to any stamp duty liability. In addition, under the Land Tax Act 2005, the SPV, being the vehicle through which the Islamic finance arrangement is effected, will be subject to land tax as the owner of the property. If the property is non-residential property, the SPV may recover the land tax from the Owner/borrower under the lease arrangement and thus contractually attain a "level playing field" with the otherwise equivalent conventional finance transaction. However, this cannot be achieved if the property is the principal place of residence of the Owner/borrower. Graph 1 Source: Austrade, Islamic Finance, 2010 1 This percentage was sourced from internal research of a financial institution. Page 2 of 5
2.2. Murabaha The Murabaha form of financing is often used in Islamic financing transactions to fund asset purchases. The asset is purchased by the financier (the Bank), then sold at a mark-up to the entity requiring finance (Party A), at which point the entity may retain the asset for its own use or on-sell it to obtain cash finance. The Duties Act would impose stamp duty on this transaction twice, if the entity being financed retains the dutiable asset, or three times if the dutiable asset is on-sold. Again, the conventional secured loan equivalent would not give rise to any stamp duty liability. From a land tax perspective, the Murabaha arrangement can be structured to ensure that as at midnight on 31 December the Bank is not in possession of the land. However, it would be preferable for section 16 of the Land Tax Act 2005 to provide flexibility in relation to Murabaha arrangements. Graph 2 Source: Austrade, Islamic Finance, 2010 3. Opportunities for Victoria The Report of the Australian Financial Centre Forum notes Australia s reliance on foreign capital as a key feature of the economy 2. The role of the financial sector in channelling these offshore funds into Australia, either by borrowing the funds offshore and lending directly to business and individuals, or by arranging and underwriting debt issuance on the capital market, has supported investment in the economy. The opportunities presented by the excess of funds in the Gulf region, an increasing part of which is seeking shariah compliant investments, has been well documented 3. The value of worldwide Islamic financial assets was US$822 billion in 2009 and this is projected to reach US$1.6 trillion by 2012. Victoria provides an attractive venue for foreign investors looking for asset diversification. The resilience of the Australian economy (and Victoria s in particular), the good international reputation of the regulatory environment and low country and market risks are factors attractive to many investors. Funds obtained through Islamic financing increase the pool of funds available to Australian businesses and individuals, and have the potential to reduce the cost of these funds through increased competition. 2 Australian Financial Centre Forum, Australia as a Financial Centre, 2009. 3 See for example: Austrade, Islamic Finance, 2010. Page 3 of 5
Furthermore, the Australian equities market provides attractive opportunities for shariah compliant investors to diversify their investments into a range of sectors (including mining and resources) that fall outside the portfolio domain of many other jurisdictions seeking to promote Islamic finance 4. Whilst many of these opportunities will not raise stamp duty issues, we believe a holistic strategy to attract shariah investments will place Victoria in a better position in competing for investments. As well, it is well recognised that the increased availability of finance results in increased economic prosperity generally 5, and that this is typically accompanied by an increase in asset transactions (such as sales of dutiable assets). Although exempting financing transactions may itself forgo potential duty, the increased availability of finance can result in an increase in acquisition transactions that remain chargeable with stamp duty. 4. Our Proposal Victoria was the first State to recognise the inappropriate tax outcomes that may result for Islamic financing when it introduced relevant exemptions in 2004. Sections 57A to 57F of the Duties Act have addressed these issues for residential financing transactions, to the extent that the exemptions are restricted to transactions involving land between natural persons and financial institutions (as defined in the Duties Act). (We note that the transaction described in section 57B could include a Murabaha transaction and that the transaction described in section 57C could include an Ijara transaction, provided that the transaction involved land, a natural person and a financial institution.) However, these exemptions are not applicable to wholesale transactions because of this prescriptive nature of the provisions. We submit that the Victorian Government should take a principles-based approach in codifying the various exemptions. While ensuring that any exemption will cover at least the two structures described in this submission, we urge that an appropriate exemption should: Recognise that it is appropriate to exempt transactions with a particular substance (in providing finance) rather than of only a particular form; Extend to include wholesale, rather than only retail, transactions; and Apply to all forms of dutiable assets, rather than merely land. The existing financing exemption in section 89 of the Duties Act better illustrates the drafting approach that we propose. That exemption applies to financing transactions generally, without specifying a particular form of transaction and without limitation to either retail or wholesale transactions in particular. (However, we do recommend that the time limitation of 5 years in section 89(2) is extended; it is common for financing transactions to have a term exceeding 5 years.) 4 Such as Ireland, Luxemburg and Hong Kong. 5 See for example, R Levine Finance and Growth: Theory and Evidence in Handbook of Economic Growth, ed P Aghion and S Durlauf, Elsevier Science, The Netherlands, 2005. Page 4 of 5
We propose that similar, broadly drafted exemptions should be included in: Chapter 2 of the Duties Act, extending to all categories of dutiable property, not merely land; and Chapter 9 of the Duties Act, in relation to registered motor vehicles. To retain integrity measures, rather than the exemptions being limited to a term of 5 years, it may be possible to include a periodic review mechanism so that the SRO can disqualify avoidance transactions. (In any event, there are the general anti-avoidance provisions in Part 6 of Chapter 2 and Division 6 of Part 2 of Chapter 3 of the Duties Act to maintain revenue integrity.) In relation to land tax issues, a distinction is required in respect of land used as principal place of residence (or otherwise subject to particular exemptions) and land which would be subject to land tax if it were to remain owned by the borrower. Subject to land tax aggregation rules, the latter can be dealt with contractually between the Islamic financier and the borrower. However, the former requires an extension to the current exemption in sections 53 and 54 of the Land Tax Act 2005. A level playing field is required for Diminishing Musharaka (reducing partnership-share based mortgage) and Ijara wa iqtina (lease based mortgage) products that are equivalent to conventional asset financing products. It is particularly important that the flexibility is provided in the definition of "owner" for land tax purposes to cater for these arrangements. 5. Concluding Comments AFMA appreciates the opportunity provided by the Commission to further comment on the opportunities presented by Islamic finance. The Victorian Government has played a proactive role in recognising the opportunities and enabling growth of the market. Whilst the Commonwealth Government has now announced its commitment to provide a level playing field for the provision of Islamic financing alongside conventional financing, we believe opportunities remain for the Victorian Government to leverage off the work it has already done by implementing a more comprehensive tax solution for Islamic transactions. The industry would be happy to engage in more detailed discussion on technical revisions of the law required to enable substantial activity in the wholesale market, including (if appropriate) drafting the terms for our proposed exemptions to the Duties Act. Yours sincerely Duncan Fairweather Executive Director Page 5 of 5