Turkey: Islamic Financing: Notion And Key Instruments

1. What is Islamic Financing?

Islamic financing or Islamic banking as the main pillar of the Islamic financing has been traditionally defined as the system of banking or banking activity that is consistent with the principles of the Shari'ah (Islamic rulings). In its core, Islamic banking has the same purpose as conventional banking which is to make money by lending out capital, except that it operates in accordance with the rules of Shari'ah.

2. What are the Fundamentals of Islamic Financing?

Islamic financing is based on the principle of eliminating "Riba" or interest in all its forms. In other words, no capital may be loaned unless such capital is interest-free. From this point of view, Islamic financing is actually an antithesis of the conventional banking as it strongly rejects the most important underlying principle of it which is that money creates money or that money has a premium, known as interest. This derives from the principle that money does not have any value itself and it is a medium of exchange.

Unlike conventional financing, particularly conventional banking, there is no banker-customer or creditor-debtor relationship exist in Islamic financing. As stated above, since interest is forbidden in all its forms, the relationship between the parties is based on partnership formed to share the profits and losses of investment. Accordingly, Islamic finance requires that all banking business based on sale or lease must have an underlying asset. Therefore an Islamic bank acts more like trader instead of pure lender.

Since Islamic rulings prohibits certain products such as non-halal foods i.e. pork, non-slaughtered animals or animals which were not slaughtered according to Islamic principles, intoxicating drinks, entertainment and pornography, tobacco-related products and weapons, Islamic funds would not be invested involved in such businesses.

Another fundamental principle of Islamic financing is the prohibition of uncertainty(Gharar) since Islamic rulings require absolute certainty as to the price, time of delivery and the subject matter of the agreement.

3. What are the Major Instruments Used under Islamic Financing and Particularly in Turkey?

As stated above, Islamic financing is more of a trading activity than a financing activity. From this point forward, products of Islamic financing can be listed as Ijarah (leasing), Istisna' (deferred payment, deferred delivery), Mudarabah, Murabahah, Musharakah, Qard (benevolent loan), Salam (prepayment, deferred delivery), Sukuk Al Istithmar, Tawarruq, Wadi'ah (demand deposits) and Wakalah (agency). While some of these products are similar to those in conventional banking, commonly used and particular to Islamic financing products are:

  • Mudabarah: Under Mudarabah, financing institution agrees to supply the capital while the other party provides the expertise. Profit is shared between the parties based on pre-agreed ratio in light of Gharar principles. Unless due to customer's negligence, losses are solely borne by financing institution.  The liability of the customer is limited only to his time, effort and expertise.
  • Musharaka: Under Musharaka, while financing institution contributes capital, other party contributes capital and expertise. Like Mudabarah financing, earnings are shared based on pre-agreed percentage. Losses, on the other hand, are shared pro rata to capital contribution.
  • Murabaha: Under Murabaha, a three party arrangement is made where the customer places an order with the financial institution to purchase goods from a supplier. The financial institution, having purchased the goods from the supplier, then sells them to the customer at a price including mark up with a fixed credit period. The important point here is that the customer has full knowledge of the cost of acquiring the specified product from the supplier (Gharar) and the profit margin is negotiated between the customer and the financial institution. The total cost is usually paid in installments.
  • Sukuk: There are various types of sukuk structures relating to the nature of the underlying asset. However, in common terms, sukuk can be defined as a certificate representing a proportionate ownership interest in any right deriving from underlying tangible asset or revenue (such as ownership of an asset, management agreement, business, partnership, construction agreement). In this regard, purchaser of sukuk certificate replaces the issuer in pro-rated ownership of the assets. The issuer is obliged to pay the Sukuk holders irrespective of the performance of the asset.

SUKUK AL IJARA- LEASE CERTIFICATES UNDER TURKISH PRACTICE

Sukuk certificates are regulated under the Article 7/A of the Law No. 4749 on the Regulation of Public Financing and Debt Management and Communique published on Official Gazette No. 28670, dated 7 June 2013 on Leasing Certificates. Sukuk al ijara has gained significant importance with the enactment of said legislation and become an important, alternative financing tool. In accordance with said legislation, both public (Treasury Sukuk) and private sectors may issue sukuk certificates.

Sukuk certificates issued by the Treasury Undersecretariat Asset Lease Joint Stock Company (HMVKŞ) are sold within the framework of Article 7/A of the Law No. 4749 on the Law Regulating Public Finance and Debt Management, through the sales of public real estates to HMVKŞ. Sukuk certificates issued by other institutions are regulated by the Capital Markets Board's Lease Certificates Communiqué no. III-61.1 published in the Official Gazette no. 28670 dated June 7, 2013. This Communiqué allows companies to raise funds from the capital markets by issuing lease certificates.

Taxation of Sukuk (al ijara) Certificates

Corporate Tax: According to Article 5/1.e of the Corporate Tax Law No. 5520, earnings gained from transfer of assets and rights to asset leasing companies for the purpose of sukuk issuance and transferring back such assets and rights to the originator are exempted from corporate tax.

VAT: Both sale and transfer of the asset by the originator to asset leasing company and vice-versa and leasing of the asset by that asset leasing company to the originator as well as issuing lease certificates are exempted from VAT according to Article 17/4.g of the Value Added Tax Law No. 3065.

Stamp Tax: As per the Stamp Tax Law No. 193, any document related to the sale, transfer, lease, transfer back and pledge transactions therein between the originator and the asset leasing company regarding subject matter assets are exempted from stamp tax together with lease certificates to be issued in this regard.

Income Tax: Earnings gained from sukuk certificates issued onshore (regardless of maturity) will be subject to income tax in the rate of 0 % for corporations and 10% for real persons.

With regard to the income generated from the issuance of offshore Sukuk certificates, a varying rate of 0% to 10% will be applicable depending on such certificate's maturity. In this regard, earnings from sukuk certificates issued offshore with a maturity of (i) one year will be subject to 10% income tax, (ii) maturity of one to three years will be subject to 7 % income tax, (iii) maturity of three to five years will be subject to 3% income tax and (iv) with a maturity of five years will be subject to 0% income tax.

Conclusion

It is evident by the abovementioned tax conveniences regarding sukuk certificates that Turkish legal system laid the way open for Islamic financing. Recent trends in the global financial markets show that the Islamic finance is likely to grow and attract more customers over time. In this respect, Turkey may become an attractive market especially for Gulf investors; provided that legislative structure for Islamic financing becomes to be more encouraging and well explained to potential investors.

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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