Tax rebate for Shariah-compliant listed manufacturing companiesArchive
THE Finance Act 2016 has introduced a 2pc tax rebate for Shariah-compliant listed manufacturing companies. This article tries to look at the motivation for exclusive tax rebate on this category of manufacturing companies to the exclusion of other manufacturing firms.
The stock screening criteria used for ascertaining Shariah compliance of companies focuses on the nature of business. In addition to that, the screening process examines compliance to a set of financial indicators. These financial screens are used to discourage involvement in interest- based borrowings, investments and earning interest based or other non-Shariah compliant sources of income.
Islamic scholars have put a cap on how much interest-based debt can be used to finance total assets. If the ratio of interest- based debt to total assets is 37pc or more, then, Islamic scholars disallow investment in ordinary shares of such a company.
As a matter of fact, Islamic banks hardly use Mudarabah and Musharakah to finance private sector manufacturing clients. The predominantly used modes of financing are debt-based in nature — Murabaha, diminishing Musharakah and Ijarah. Thus, in terms of leverage, an Islamic debt-based mode of finance involves similar cash flows as compared to a conventional loan.
Suppose company A uses an Islamic debt-based mode of finance to purchase 40pc of its fixed assets and company B uses an interest based debt to finance 40pc of its fixed assets. Then, investment in shares of company B will be rendered non-compliant.
But, from the perspective of leverage, company B will have the same nature of financial liability and cash flow commitments. If Islamic banking finance is costlier, fixed installments to Islamic banks could be higher than conventional, all else being equal.
In the past, companies like Hubco, Kapco, Nishat Mills, Engro, Fauji Fertiliser Bin Qasim Limited and DGK Cement had been financed by Islamic banks and the commercial financing to these ‘un-Islamically leveraged companies’ had been a source of huge profits for Islamic banks.
But, conversely, these higher profits result in a higher cost of financing for the manufacturing companies and/or relatively lower profits for the depositors on investment deposits amidst higher Islamic banking spreads as compared to the conventional banking spreads.
Ironically, for small investors, investment in ordinary shares of such companies will not be allowed solely due to an ‘operational restriction’ since the cap on interest- based leverage was neither mentioned in Quran nor Hadith. In Pakistan, this cap on interest-based leverage had been 45pc for some period, 40pc afterwards and currently, it is 37pc. This cap is designed to to discourage ‘leverage’ and promote Islamic banking.
But, as we have seen, the Islamic debt- based modes of finance do not differ in their leverage characteristics. These financial services are provided less efficiently by Islamic banks than by conventional banks.
Islamic banking spreads have been consistently higher than conventional banking spreads. The difference has remained consistently above 1.5pc in the 2010-2014 period. Last year, the central bank governor had urged the Islamic banks to share their profits equitably with the depositors amidst huge profits earned by Islamic banks.
But, the recent exclusively favourable legislation for Islamic banking would engender further complacency through indirect tax subsidy. In addition to that, Islamic banks have an extremely lower finance to deposit ratio of below 40pc.
Not only this goes against the spirit of circulation of wealth cherished in Islamic economic framework, but it also undermines the very basic economic function of providing efficient financial intermediation between savers and entrepreneurs.
However, Islamic banking in Pakistan is now an established industry with 12pc market share achieved in just over a decade. Its branch network has crossed the 2,000 mark and its assets stood at Rs1.6tn ($1.52bn) on March 31.
The writer is a PhD scholar in economics at the National University of Malaysia.
Published in Dawn, Business & Finance weekly, July 18th, 2016