A discussion on the use and taxation of Islamic financial instruments in Kenya to enable the Nairobi International Financial Centre Authority understand the principles that define the nature of Islamic financial transactions.

1. Islamic Financial
Instruments:
TheirLegalPrinciplesandTaxation
Lyla Latif
TaxTalks Series hosted by the Committee on Fiscal
Studies, University of Nairobi, 13 June 2018

2. Historical
Background
 Started in Egypt in 1963, on a low key
 Took the form of a savings bank based on profit-sharing
 Neither charged nor paid interest, invested mostly by engaging
in trade and industry, directly or in partnership with others, and
shared the profits with their depositors.
 In the 70s, realization / emerging need to establish Islamic financial
institutions
 Local Islamic banks formed in Dubai, Pakistan and Malaysia.
 In the 80s’ and 90s’ Islamic banks quickly evolved to provide short
term credit facilities by using the Murahaba structure.
 2000s saw:
 Increased demand for Islamic products; Islamic finance
available for longer tenor project finance
 Sukuk became popular and accepted as an investment by
conventional banks

3. An
Introduction
to Islamic
Finance
 Islamic finance is finance under Islamic legal
principles derived from:
 Primary sources: the Holy Scripture and Legal
Tradition
 Secondary sources: Analytical deductions and
reasoning (Qiyas), consensus of Islamic scholars
(Ijma) and legal reasoning (Ijtihad)
 It is a different form of financing that is asset based
as opposed to currency. Financing is structured on;
 exchange or ownership of assets
 contractual certainty
 legitimacy of trade

4. Principles of
Islamic
Finance
 These are well settled and established and include:
1. Prohibition or taking or receiving interest at
exorbitant rates (Riba). This does not preclude a
rate of return on investment.
2. A prohibition of pure debt security.
3. Risk in any transaction must be shared between
at least 2 parties so that the provider of capital
and the entrepreneur share the business risk in
return for a share in profit.
4. Prohibition of speculative behaviour (Gharar) is
not allowed. This means that gambling,
traditional derivatives and extreme uncertainty or
risk is prohibited (Maysir) and thus contractual
obligations and disclosure of information are a
sacred duty.

5. Principles of
Islamic
Finance
 These principles also include restrictions on:
1. Investments that violate the rules of Islamic law,
advised against by Shar'iah boards and are
generally non ethical meaning that investment in
businesses related to alcohol, pork related
products, conventional financial services,
entertainment (casinos, cinema, pornography,
music), tobacco, weapons and defence.
2. Investment in companies:
a. whose total debt divided by trailing 12 months
average market capital is greater than 33%
b. whose account receivables divided by total assets
are greater than 33% (sometimes 45%)
c. whose sum of cash and interest bearing activities
divided by trailing 12 months average market
capital is greater than 33%

6. Difference
between
conventional
and Islamic
finance
Conventional
Financing
 Deposits are loans to
the bank as debt
 Assets are invested in
fixed income securities
and loans
 Bank has fixed
obligations on deposits
but uncertainty on
assets returns
 Bank is exposed to
assets and liabilities
mismatch risk
Islamic
Financing
 Depositors are
investors rather than
lenders
 Risk sharing through
profit and loss sharing
 Assets and liabilities
are matched
 Ethical and socially
responsible assets

7. Types of
Islamic
Financing
Instruments
 Islamic financial instruments: Banking
 Islamic financial instruments: Capital Markets

8. IF
Instruments:
Banking
a. Murabahah: sale on profit (money is not lent to
the customer)
b. Musharakah: joint venture partnership (2 or
more parties contribute capital to a business and
participate with the related profits and losses)
i. Consecutive
ii. Diminishing
c. Mudarabah: profit sharing (investor with capital
develops a partnership with an entrepreneur with
an agreement to share the profits. Entrepreneur
does not bring in capital, brings in management)
d. Ijara: leasing (right to use the object for a
specified period of time)
e. Bay al Salam: forward contracts (buyer pays the
seller the full negotiated price of a specific
product which the seller promises to deliver at a
specified future date – payment is made at the
deal date)

9. IF
Instruments:
Capital
Markets
 Sukuk (certificates – asset based long term
partnership)
 Where the investor shares the asset

10. Certification
of firms to
conduct
Sukuk
related
activities in
the NIFC

11. IF in Kenya
 According to the Islamic Financial Services Board’s
Islamic Financial Services Industry Stability Report
2016, the global Islamic financial services industry
reached an overall total value of USD1.88 trillion in
2015, with expectations of market size growth to
USD3.4 trillion by end of 2018, an 81 per cent growth.
 Kenya’s Islamic finance market has witnessed
substantial growth over the last few years with several
Islamic financial sector institutions in operation
including;
 3 fully fledged Islamic banks,
 5 Islamic windows,
 2 credit unions/Saccos,
 1Takaful company,
 1 Retakaful window and
 1 Capital Market UnitTrust Fund, as of June 2017.

12. Recent
Developments
 The launch of Islamic Finance Project Management
Office (PMO) by the National Treasury, which is
expected to further boost the nascent industry.
 The PMO is led by Islamic Finance Advisory &
Assurance Services (IFAAS), an international
consultancy firm specialized in Islamic finance, in
collaboration with Simmons & Simmons – whose
ultimate goal is to boost uptake of Islamic finance
products.
 The National Treasury also appointed members of
the Islamic Finance Consultative Committee (IFCC)
whose main objective shall be to provide support
and feedback on the proposed Islamic Finance
policies and regulatory changes to facilitate
operations in this complementary form of finance.

13. Taxation of Islamic
Financial
Instruments in
Kenya

14. Murabaha
‫المرابحة‬
1. Party B may not be entitled to a tax
deduction.
2. Not expected to obtain a tax relief for its
10 cost. Under sec 16.1 ITA the loss is
wholly and exclusively incurred by Party B
in the production of income
3. 10 is a gain for the bank and taxed
according to section 3.1 ITA

15. Musharakah
‫المشاركة‬
1. No tax relief for the rent.
2. Stamp duty.
3. Bank taxed on rent under sec 6.1 ITA as a
gain
4. Equity purchases
5. Mortgage relief for owner occupier under s.
15.3.b ITA not allowed

16. Sukuk
‫صكوك‬
1. Trust is taxed on its share of the income of the
partnership.This reduces the cash available to pay
the sukuk holders.
2. Stamp duty.

17. Taxation of
Islamic
Financial
Instruments –
introducedvide
section11ofThe
FinanceAct,2017
 Amendment of the IncomeTaxAct to:
 provide for equivalent tax treatment of Shar'iah-
compliant products with conventional financial
products,
 provide a definition of Islamic finance arrangement
and Islamic finance return so as to remove double
taxation
 Treat Islamic finance return as interest, whether
received or paid on a financial arrangement

18. Taxation of
Islamic
Financial
Instruments –
introducedvide
sections37-42ofThe
FinanceAct,2017
 Exemption from payment of Stamp Duty on:
 transfer of title relating to Sukuk bonds
arrangement to support Asset-Backed Securities
transactions,
 re-transfer of title/interest from financial institution
to owner
 No exemption if:
 transfer is made during or after the sukuk
transaction to any party other than the original
owner
 transfer is not effected for genuine commercial
reasons
 arrangement forms part of arrangements whose
main purpose is the evasion of a tax liability under
any tax law

19. Amendments
giving effect
to the
taxation of
Islamic
financial
instruments –
introducedvide
sections47and7of
TheFinanceAct,
2017
 Amendment to the Public Finance Management
Act to allow for Government investment in Sukuk.
 Amendment to the Value Added Tax Act that treats
Islamic finance return as interest, whether received
or paid on a financial arrangement and exempts
VAT on Shar’iah compliant finance products, that is
interest paid or received from Islamic finance return
and sukuk.

20. Amendments
giving effect
to the
taxation of
Islamic
financial
instruments –
introducedvide
sections51and52
and7ofThe
FinanceAct,2017
 Amendment to the Cooperative Societies Act, 1997
and Sacco Societies Act, 2008 to permit these
entities to deal as Islamic finance deposit taking
businesses so their gains can be taxed under sec
19A.4 ITA (Islamic finance return taxed similar to
gains/profits from interest)
 Amendment to section 2 of the Capital Markets Act
to facilitate Shar'iah-complaint capital market
products