Key Points: Australian fund managers wishing to test investor demand for Shariah-compliant products should consider Shariah windows when making investment decisions.
Australia is well placed to service the increasing regional and domestic demand for Shariah funds (also known as Islamic funds). However despite increasing demand, understanding of Shariah funds remains relatively low in the Australian financial services industry.
Shariah funds, products and finance are not confined to people of Islamic faith and provide an alternative to conventional investment and financing arrangements.
This article examines the key features of Shariah funds, and outlines the current opportunities and challenges for Australian financial institutions and fund managers looking to establish or provide services to these funds.
Key features of a Shariah fund
Shariah funds are investment funds that are established and managed according to the principles of Shariah (Islamic Law).
Shariah funds can be broadly compared to ethical or socially
responsible funds in that they rely on certain guiding principles
that dictate the form of their investment structure and that inform
their investment objectives and strategies. In the case of Shariah
funds, these guiding principles are the tenets of Shariah, which do
not allow investment in entities or products that involve:
- interest paying financial arrangements (eg. a prohibition on investment in non-Islamic banks and certain financial institutions);
- speculation, betting and preventable uncertainty (eg. a prohibition on the use of certain derivatives and insurance contracts); or
- banned activity (eg. a prohibition on investments associated with gaming, armaments, pork, alcohol, tobacco or pornography).
To ensure compliance with Shariah, a Shariah fund would most commonly engage a board of scholars known as a "Shariah Board" to advise the fund on the appropriate form of investment and governance structure as well as approve the fund's investment objectives and strategy.
Similar to the experience in the ethical investment funds industry, it is possible that different Shariah Boards may hold different opinions regarding the interpretation and practical application of Shariah. In addition, it is not uncommon for individual members of a Shariah Board to have different points of view on investment matters and this is an ongoing practical consideration for fund managers. As a result, there are both subtle and material differences in the structure and investment philosophy of different Shariah funds around the globe.
One particular aspect unique to Shariah funds and which is not seen in the ethical investment funds arena is the process of "purification". It will often be difficult for fund managers to ensure that a Shariah fund is entirely Shariah-compliant. Where a Shariah fund is unable to comply with a particular aspect of the Shariah Board's advice, or where income or profits of the fund are unavoidably obtained from sources that are not Shariah-compliant, Shariah funds can take advantage of "purification" whereby the tainted profits or income are given to an approved charity. It is usual practice for a Shariah fund's "purification ratio" (that is the ratio of untainted income to income requiring purification) to be assessed on a regular basis and for the fund to set "purification ratio" targets (usually around 20:1).
"Shariah windows": an intermediary step
In addition to establishing Shariah funds, Australian financial institutions are able to participate in Shariah finance through targeted investment in Shariah-compliant investments or projects known as "Shariah windows".
The ability of an institution to operate a Shariah window is conditional on the assets in the Shariah-compliant investment being segregated from an institution's non-compliant investments. An example of a "Shariah window" may be where a fund manager invests in Sukkuk, which are Shariah-compliant bonds backed by Shariah-compliant assets. Another example is where a fund makes a segmented investment in a major works project which uses Shariah-compliant financing. Importantly, the bonds confer a beneficial interest in the underlying assets and provide the holder with up and downside exposure to those assets.
Shariah windows also provide an opportunity for Australian institutions and fund managers, to become familiar with Shariah finance and to scope investor appetite for Shariah-compliant products.
Shariah investment options
As a way of better serving the investment needs of Australia's Muslim community, Australian institutions and fund managers may also wish to consider including Shariah funds, bonds and windows as investment options within their investment funds or on their investment platforms.
Opportunities in the global Shariah funds industry are increasing. Globally, there are now over 700 Shariah funds whose assets under management total around US$50 billion. Confidence and momentum in the industry is also increasing, particularly as Shariah funds have fared well during the global economic crisis.
In Australia, four factors in particular are fostering
- Australia's proximity to Malaysia, Indonesia, Singapore and other countries with significant Muslim populations;
- Australia's increasing domestic Muslim population;
- increasing global influence of Shariah finance and increasing global infrastructure and experience to service Shariah funds and products in both Muslim and non-Muslim countries ; and
- the commitment of the Australian Government and the financial services industry to positioning Australia as a leading financial services centre in the region, including a commitment to assist in the building of the local infrastructure and modifying the regulatory and tax regime to attract and service Shariah funds.
Key challenges to establishing a viable Shariah funds industry
in Australia include:
- There is a shortage in Australia of potential Shariah Board members and of specialised skills to set up, manage and provide services to Shariah funds. These challenges are common to many jurisdictions wishing to develop a Shariah funds industry, and persist even in jurisdictions where the Shariah funds market is more developed. In Australia, these challenges are in part being remedied in the medium term through new courses in Islamic Finance  and through skilled migration. In the meantime, relying on institutions and Shariah Board members in overseas jurisdictions is one way of overcoming these challenges in the short term.
- Australia's tax system may produce some unintended results or inefficiencies for Shariah funds . There is also some uncertainty as to the characterisation for Australian tax purposes of certain types of income, margin or return derived by a Shariah fund from Shariah-compliant investments, which could lead to higher taxation for certain non-resident investors in a Shariah fund, as compared with those same investors investing in a non-Shariah fund .
- Given that Shariah funds are a relatively new concept in the overall Australian investment landscape, the level of investor appetite domestically remains untested. Launching and promoting Shariah funds in the region is also relatively untested.
The Australian Government and the Australian financial services industry have indicated a willingness to ensure Australian institutions are increasingly well positioned to take advantage of emerging opportunities in Shariah finance, particularly in respect of Shariah funds.
For example, IFSA, the Australian financial services industry body, has recently set up a Shariah Finance working group with the aim of promoting awareness of Shariah finance and assisting industry in developing and marketing Shariah funds within and outside Australia.
Industry has also been working with Treasury to identify potential reforms to Australia's legal and tax framework. The Australian Financial Centre Forum (a joint industry-government initiative aimed at positioning Australia as a leading financial services centre in the region) conducted a roundtable on Shariah finance and tax issues in March 2009, and this is expected to be an ongoing focus of discussion in the Forum.
Another significant development has been the launch of Australia's first Shariah fund which occurred in mid 2009. The fund has engaged overseas institutions, including an overseas bank and Shariah Board, and is offering investment in a range of major international currencies. The fund is targeting mostly Muslim investors in the Middle East and Southeast Asia.
The Australian Government and the Australian financial services industry are increasingly focusing on the opportunities that Shariah finance, funds and products, can provide to investors and the industry. This focus is part of the ongoing partnership between industry and the Australian Government to position Australia to become a leading financial services centre in the region.
In this context, it is likely that the legal and tax framework in Australia will need to further facilitate the setting up and servicing of Shariah funds in Australia and to encourage foreign investors to invest in those funds or in Australian Shariah windows.
This process will be guided by investor demand for Shariah funds and by experiences in overseas jurisdictions, particularly of those in the region and in existing financial services centres such as Ireland. In the meantime, Australian fund managers wishing to test investor demand for Shariah-compliant products should consider Shariah windows when making investment decisions.
 For example, the Irish Financial Services
Regulatory Authority has now established a dedicated regulatory
team for the authorisation of Shariah funds in Ireland.
 For example, La Trobe University has recently begun offering a Master of Islamic Banking and Finance.
 This issue has been recently addressed in countries such as France and the United Kingdom who have recently introduced tax neutrality laws specifically for Shariah financial products. The Australian Taxation Office released a Consultation Paper in August 2009, "Islamic Financing - Australian income tax implications for AFMA members and their clients", prepared for the purpose of initiating dialogue with the Australian Financial Markets Association to identify corporate tax issues relating to Islamic financing that require tax resolutions critical to the development of Islamic finance in Australia.
 For instance, if a return or profit from a Shariah-compliant investment is not characterised as "interest" for Australian tax purposes, the relevant amount could be taxed as Australian sourced income. This means the amount could potentially be taxed at a higher effective tax rate compared to the taxation of a return on an analogous conventional investment product that is characterised as "interest" and taxed at the Australian interest withholding tax rate of (generally) 10 percent. Alternatively, if a return or profit from a Shariah-compliant investment is characterised as "interest" for Australian tax purposes, the relevant amount could be subject to Australian interest withholding tax, without the benefit of any exemption that might otherwise be available if the investment was a conventional investment product.
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.