The principles of Islamic finance


Islamic finance operates in accordance with the principles of Islamic law (or Shariah). The basic principle of Islamic finance is underlined by the prohibition of investment in interest-based ventures and businesses that provide goods and services considered contrary to its principles like tobacco, alcohol, gambling, vulgar entertainment and conventional finance.

Another fundamental principle of Islamic finance is highlighted in the sharing of profit and loss between parties in a business transaction. Common terms used in Islamic finance include profit sharing (Mudharabah), joint venture (Musharakah), leasing (Ijarah), safekeeping (Wadiah) and cost plus (Murabahah). Currently estimated to be worth around US$1 trillion globally with 300-plus Shariah compliant financial institutions operating in more than 75 countries today; this industry is growing at a remarkable pace of approximately 15%-20% on a yearly basis, thus representing a vast practice which has developed its presence on a global scale. Despite a widespread misconception, Islamic finance does not require specific laws and is not limited to the Muslim community. Except for several predictable prohibitions mentioned earlier, Islamic finance solutions are applicable everywhere and by anyone.

It is of standard practice that Islamic banks and banking institutions that offer Islamic banking products and services are required to establish a Shariah Supervisory Board to advise them and to ensure that the operations and activities of the bank comply with Shariah principles. An essential ingredient is a regulatory framework that can accommodate Islamic finance principles and a regulator that is prepared to work with Islamic institutions to overcome technical hurdles. There must also be a tax regime that enables Islamic financing structures and products to be treated in an equivalent manner to their conventional counterparts. 

The appeal for Islamic finance has become infectious to an extent where the largest Muslim populations in the world, most notably India has developed a profound interest for Shariah compliant products to cater for its community and business sector. In view of capitalizing on the opportunities that Islamic finance has to offer, the Indian government and corporates have taken the initiative to closely examine which Shariah compliant companies and sectors are able to further contribute to the development of Shariah market capitalization in India. This is solely due to the fact that India believes that by complying with the economic laws of Shariah, she can become an attractive destination for Islamic investments. The Islamic finance sector in the United Kingdom has also seen enormous growth both domestically and internationally. London is one of the top five financial centres in the world for Islamic finance.

Islamic finance has always been known and seen as a form of socially responsible investing whereby Shariah law requires that investments made have to be based on tangible assets and that lenders and borrowers in a business transaction share profits and losses. It is unfortunate however, that the rapid growth of Islamic finance has converted itself as a breeding ground for socially irresponsible investors who are ignorant about the social impact of investment. It is not unusual to come across conventional profit-driven investments these days that are dressed up to look like Islamic finance. The presence of Shariah-dress investments only serves as an invitation to unethical profit chasers who seek to threaten the health and reputation of the Islamic financial market. As such, it is vested within the powers of national financial watchdogs to ensure that Shariah-dressed investments are not part of an Islamic financial market that only decreases its immunity to the global financial crisis.

The issuance of sukuks, which conform to Islam’s prohibition of receiving or paying interest, has come under intense scrutiny in recent times over fears of a debt default in Dubai. Commonly referred to as Islamic bonds, companies that issue sukuks make payments to investors using profits from the underlying business instead of paying interest. The Dubai crisis has sparked speculation that Islamic finance is no different from conventional finance that led to the financial turmoil a couple of years ago.

However, many fail to understand that the main cause of the Dubai crisis is purely one of a credit issue where Dubai World and its subsidiary Nakheel have over borrowed and over expanded within the real estate and tourism sectors to an extent where near-term repayment obligations cannot be met. In short, the Dubai crisis demonstrates the fragility of the financial and economic system in Dubai, which is one based on excessive borrowing to finance excessively luxurious projects without giving much consideration to the economic feasibility of such projects. Notwithstanding, the assistance by Abu Dhabi in the form of USD10 billion has allayed all the fears.

Despite reservations held by several parties that Islamic finance is just as susceptible to the global economic turmoil, many still maintain that there is vast potential and opportunities for financial institutions to tap in the field of Islamic banking and finance. With the adoption of stringent Shariah principles, Islamic finance offers a huge alternative economic opportunity to the conventional methods that investors have become accustomed to. Many countries globally from Europe, Middle East, Asia, Australia and even the United States have realized the importance of Islamic finance. Malaysia, being one of the pioneers of Islamic finance and location of the highest number of sukuks issued globally remains at the forefront which provides guidance to others in terms of regulatory and legal aspects.


LAWorld News

IRS proposes new regulations on carried interests and fee waivers as disguised compensation

The Internal Revenue Service of America recently proposed new guidelines that, under certain circumstances, would re-characterize carried and other service-related equity interests in partnerships (which for tax purposes includes limited liability companies) as disguised payments for services. 

If a partnership interest granted to a service provider is re-characterized as disguised compensation, then the service-related partnership interest disappears for tax purposes and the service provider is no longer treated as an equity owner (i.e., a partner or member) with respect to the service-related partnership interest. As a result, partnership allocations and distributions made on the service-related partnership interest to the service provider become ordinary compensation income (even if the partnership’s underlying income consists of capital gains), potentially subject to FICA and other employment-related tax provisions.

Taking an overall “facts and circumstances” approach, the proposed regulations view the presence or absence of “significant entrepreneurial risk” (which itself is also determined in light of the overall facts and circumstances) as the overriding indicator of whether a service-related partnership interest is a disguised compensation arrangement. If a service-related partnership interest carries “significant entrepreneurial risk,” the partnership interest will generally not be treated as a disguised compensation arrangement, unless the presence of other compensation-related factors indicates otherwise (e.g., transitory or short-term equity ownership, allocations and distributions tied to the types of services rendered or made over periods comparable to those over which non-partner service providers would typically receive payment, and a small continuing interest in overall partnership profits).

In contrast, a service-related partnership interest without “significant entrepreneurial risk” is deemed to be a disguised compensation arrangement, regardless of the degree to which other compensation-related factors may or may not be present. The presence of any one of the following five factors creates a presumption that no “significant entrepreneurial risk” exists: (1) a cap on allocations if the cap is reasonably expected to apply in most years, (2) an allocation for one or more years if the service provider’s income share is reasonably certain, (3) an allocation of gross income, (4) an allocation that is either (A) fixed in amount, (B) reasonably determinable, or (C) designed to assure that sufficient net profits are highly likely to be available for the service provider (such as a profit share for a specific transaction or accounting period that is not tied to the long-term success of the enterprise) or (5) a fee waiver that is either (A) non-binding or (B) is not disclosed timely to the partnership and its partners. By way of an example discussing the grant of a partnership interest to an investment manager in lieu of a management fee, the proposed regulations indicate that an irrevocable fee waiver made and disclosed to the investment fund’s limited partners at least 60 days prior to the start of the period for which the management fee would otherwise have been payable does not cause the partnership interest to lack “significant entrepreneurial risk.”

Although purportedly intended to address fee waivers in the investment fund context, the scope of the proposed regulations is not so limited and may affect tax planning for carried interests in partnerships engaged in real estate and other active businesses. As shown in the included examples, the proposed regulations conclude that “significant entrepreneurial risk” exists when a carried interest’s participation in partnership allocations and distributions is tied to and limited by the partnership’s overall lifetime profitability (combined with a corresponding “clawback” obligation). However, the proposed regulations fail to give any negative guidance on when a carried interest lacks “significant entrepreneurial risk.” So, when deciding to accept a carried or other partnership interest, service providers should consider carefully the extent to which any deviation from the terms of the example partnership interests increases the probability that the partnership interest will be found to lack “significant entrepreneurial” risk” (e.g., by omitting the lifetime profit limitation and/or any clawback obligation).

The proposed regulations are intended to apply only to partnership arrangements entered into or modified after the date on which the regulations are issued in final form. However, the IRS views the proposed regulations as a clarification of existing law, hinting that it may seek to apply the principles set forth in the proposed regulations to pre-existing partnership arrangements.

For more information, please contact Andrew Lustigman, Partner with Olshan Frome Wolosky LLP, a law firm based in New York: http://www.laworld.com/laworldmembers/view_company/83 

Email: alustigman@olshanlaw.com  

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