Malaysia: The Growth Of Islamic Finance In Asia - A Labuan Perspective

Last Updated: 19 April 2011
Article by Aderi Adnan

In recent years Islamic finance has emerged as one of the most rapidly expanding sectors of the global financial industry, with expectations that it will play an increasingly more important role in the years to come.

The size of the global Islamic banking industry is believed to have grown from about US$$820 billion at the end of 2008 to more than US$$1 trillion in 2010, while latest studies indicate that the steadily growing Islamic banking system could reach US$$1.5 trillion in 2012 and US$$3 trillion by 2015.

The global economy is gradually recovering, this coupled with an improvement in market conditions and investor sentiment, has meant that in the first nine months of 2010, total Sukuk (Islamic Bonds) issued globally increased further to US$27.9 billion, 62.3 per cent higher than the similar period in the previous year and surpassing 2009 full year issuance of US$24.7 billion.

Why is there a growing demand for Islamic Finance products world-wide?

The underlying concept fundamental to Islamic banking and finance is justice, which is accomplished through the sharing of risk.

Stakeholders are under an obligation to share profits and losses derived from financing transactions and to refrain from dealing at usurious interest rates, which are unacceptable in Islam. This principal of ethical finance is proving increasingly more attractive to non-Muslims.

The Islamic financial system also practices a strict prohibition of investments in risky instruments such as toxic assets and derivatives, which have adversely affected their conventional competitors.

Islamic products enable the issuer to reach cash-rich investors and ethical investors world wide. This is evidenced by the growth of Islamic finance in both Muslim and non-Muslim communities alike.

Buffered from the global financial crisis

Islamic finance is not immune to the global financial crisis but has proved to be less affected by the economic down turn due to its requirement for asset backing coupled with ethical financial principles.

The crisis exposed the loopholes and weaknesses within the conventional system, allowing Islamic products to become more popular because their principles have shielded them from the sub-prime crisis. Debt-selling (derivatives), the primary cause of the crisis, is not allowed in Islamic finance.

Increasing demand and popularity for Sharia compliant products and structures post the global financial crisis will form a strong demand base for Islamic financial instruments, especially for Sukuk.

Islamic financing has gained in popularity as various initiatives are taken by non-Muslim jurisdictions to develop legislative and regulatory frameworks which embrace Islamic finance into their financial system. This has resulted in significant efforts by a number of international business and financial centres to attract foreign investments from cash-rich Muslim investors and ample liquidity within the Islamic capital market.

Conventional players are starting to look into the 'ethical financing' philosophy, much of which a term from Islamic finance.

Islamic Finance as an alternative to 'conventional' finance?

Banks and financial institutions that comply with Islamic law (Sharia) showed impressive resilience during the financial crisis that hit the world economy at the end of 2008, knocking out a substantial number of conventional banks, particularly in the United States. This encouraged countries with Muslim minorities, such as Britain, Germany, the US and France, to increase the proportion of Islamic banks within their conventional banking industry.

Islamic banking is gaining ground with non-Muslims worldwide due to its strict and ethical lending principles. Sharia finance is a blend of Islamic economics and modern lending principles and its products are well received by non-Muslims, since the onset of the global credit crisis, which cast doubt on many Western risk management practices.

Labuan – A Hub for Islamic Finance

Malaysia is among the pioneering jurisdictions that have successfully developed and incorporated Islamic finance into its modern financial system. The Islamic finance infrastructure that Malaysia has, coupled with Labuan IBFC's regulatory strength and conducive business environment for Sharia-compliant business, paved the way for Labuan IBFC to expand its Islamic finance market.

The Legislation in Labuan IBFC provides a facilitative and flexible framework for industry players to be innovative and create new products for their clients. Continuous reviews have been undertaken to enhance the regulatory and business framework in order to meet market demands whilst ensuring market practices are at par with international standards.

Labuan IBFC collaborates with and compliments the Malaysia International Islamic Financial Centre (MIFC) to promote Islamic financial products and services to an international audience.

Labuan IBFC is offering the following attractions to Islamic entities established in the centre:

  • Competitive overhead and operation cost as compared to other international financial centers in Europe, GCC, South East and Far East Asia.
  • A competitive tax rate. Under the Labuan Business Activity Tax Act, non-trading companies pay no tax at all while trading companies can opt to pay tax each year at the rate of 3 per cent of the net audited profits or a flat rate of RM20,000. Alternatively, companies can opt to be taxed at the standard rate under the Malaysian Income Tax Act.
  • Malaysia has signed 73 comprehensive double taxation treaty agreements and 2 limited shipping agreements, making its Double Tax Treaty Network the most extensive in the region. Individuals or companies established in Labuan IBFC can enjoy access to the majority of them. Companies opting to be taxed under the Malaysian Income Tax Act instantly have the benefit of all of Malaysia's Double Taxation Agreements.
  • Comprehensive legal framework with better clarity for Islamic finance with international recognition.
  • Continuous innovation on Islamic capital market products supported by Bank Negara Malaysia, the Central Bank of Malaysia.
  • Ample talent pool of Islamic finance expertise.
  • Endowment fund allocated by the Central Bank of Malaysia to develop and promote Islamic finance.
  • Flexibility to collocate in any other parts of Malaysia.
  • The Malaysia government has amended its taxation framework to create a level playing field and unbiased market for Islamic finance transactions.

The Labuan Islamic Financial Services and Securities Act 2010

The Labuan Islamic Financial Services and Securities Act 2010 (LIFSSA ) has clarified, streamlined and consolidate all Islamic finance related issues in Labuan and sets new standards for the jurisdiction.

LIFSSA signifies a landmark achievement for Labuan IBFC as a major business and financial centre that caters to the specific requirements of Islamic finance industry, covering banking, takaful, retakaful, Sukuk issuance, trust and fund management.

The LIFSSA provides a greater degree of comfort for investors in Islamic financial activities as it is a dedicated piece of legislation that serves to ensure compliance with Islamic Sharia principles.

The legislation has introduced changes to Sharia governing system in Labuan by establishing the Sharia Supervisory Council (SSC) to replace the Sharia Advisory Council (SAC). Among the key function of the SSC is to ascertain the Islamic law in relation to any businesses regulated by the Labuan FSA in Labuan. All rulings made by the SSC can be used as reference by the court in arriving at a decision.

Doing business in Labuan

As previously outlined, Labuan's strong regulatory framework ensures that Islamic financial transactions can be completed effectively. The Labuan taxation framework creates a level playing field for conventional and Islamic financial transactions.

Financial centres with fiscal systems developed within a framework of conventional financing have found it necessary to introduce specific measures to enable the matching of profits with Islamic finance. A number of financial centres such as the United Kingdom have made a start on this process and others like Japan are considering doing so. Korea, on the other hand, recently rejected making any changes.

These issues arise because the making of interest is prohibited under Sharia law and in general this results in Islamic financial products being 'equity' based as opposed to the debt based approach of conventional financing.

Tax law always treats equity and debt differently and therefore Islamic finance transactions may be disadvantaged as follows:

  • An exposures to multiple transfer taxes on transfers of property and the creation of leases.
  • Profits might be subject to an upfront taxable capital gain.
  • The 'finance cost' of the issuer might be regarded as a distribution of profit and non-tax deductible.
  • The 'finance return' to the investor might be made from 'after-tax' income thus reducing the return on investment.

In an international context there may be additional issues. Since the 'finance return' is not interest, it may not enjoy the reduced rate of withholding tax for interest under tax treaties and with some Islamic finance transactions taking the form of a partnership, a cross border transaction may create a taxable presence in a foreign location.

Yet the simple and straight forward Labuan tax system has the following features that overcome all of the issues:

  • No tax on profits from passive investment;
  • No capital gains tax;
  • No withholding taxes; and
  • No transfer taxes.

Further, Labuan has no exchange control restrictions and a Labuan entity that is tax resident in Malaysia may access the majority of Malaysia's extensive tax treaty network. This would be beneficial because the tax treaty may prevent a taxable presence being created in the foreign treaty party's location and Malaysia's more recent treaties replace the 'Interest' article with a 'Finance Cost' article to ensure Islamic finance transactions benefit.

It follows therefore that conventional and Islamic finance transactions both enjoy 'tax neutrality' via Labuan, which when factored into the pricing of the products, allows for competitive pricing between the two.

The future for Islamic Finance in Asia

It is anticipated in 2011 that demand for Islamic finance products will continue to grow due not only to the recovery in global economic activities, but also due to more accommodative monetary policies, more sovereign issuers to tap the Sukuk as governments will continue to raise funds to support economic growth and fund fiscal deficits, and also due to the emerging market players as well as new non-Islamic issuers tapping the Sukuk market, with potential debuts from Thailand, Indonesia and Japan.

In ensuring Islamic finance grows further moving forward, globally accepted standards and terminology on Islamic finance are required. Innovation around risk sharing products needs to be escalated while ensuring ample liquidity is available at competitive price.

Moving on as one of the leading Islamic finance hub, Labuan IBFC will continue to develop across all four main sectors of Islamic finance, namely Islamic banking, takaful, Islamic funds and Islamic capital markets.

Labuan IBFC is committed to further enhance the breadth and depth of the Islamic finance sector in Labuan by creating greater linkages with the international financial system.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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