The infrastructure deficit - Is Islamic finance part of the solution?
By Rhys Jewell (Partner)
Australia’s “infrastructure deficit” is significant. Some estimate that, over the next decade, the difference between our infrastructure needs and available government resources could blow out to as much as $770 billion. There is no one solution to solve the infrastructure funding gap. Rather, the puzzle is comprised of many different pieces and requires a variety of new or innovative solutions. It is now time to investigate Australia’s appetite for Islamic finance as potentially forming part of the solution.
Islamic finance in the Australian context
In 2009 and 2010, there was considerable momentum for Australia to seize the initiative on Islamic finance. The Government had identified Islamic finance as an opportunity to tap into new funding sources.
The treatment of Islamic finance for Australian taxation purposes was also the subject of a comprehensive review by the Board of Taxation. Disappointingly, the Board’s report, and the government’s proposed response, has yet to be released publicly, and no further guidance was provided in the recent 2012/13 Federal Budget.
Inaction is frustrating many in the nascent Islamic finance sector here, and there is a concern that Australia might miss the boat. With many countries vying to attract the “halal dollar”, there are signs that potential foreign participants are losing patience with Australia and looking elsewhere. Japan and Hong Kong, in particular, are fast-tracking tax and regulatory amendments as they seek to become Islamic finance hubs in Asia along with Kuala Lumpur.
Australia needs to act soon. This can start by simply highlighting the potential of Islamic funding. Introducing alternative sources of wholesale funds such as Islamic sukuk could potentially expand Australia’s debt capital market and offer more financing options for infrastructure projects. It could also increase the competitive pressure among traditional providers of debt finance thereby pushing down the cost of finance. For consortia in highly competitive bidding processes, and governments that ultimately pay for the infrastructure, this can only be a positive outcome.
The next step is to identify Islamic finance products that are suitable for large scale infrastructure projects and to provide mechanisms to overcome any hurdles that impede their use.
Islamic finance products suitable for infrastructure projects
Common Islamic finance structures include musharaka (joint venture), mudaraba (limited partnership), murabaha (cost plus financing) and ijara (operating lease).
Two of the common Islamic finance products that could be used for Australian infrastructure projects are istisna-ijara and sukuk.
An istisna is a type of procurement contract whereby a financier purchases the relevant asset, to be constructed by the customer, by making part payments to the customer during construction (similar to drawdowns along a construction S-curve). Once the asset is built and handed over to the financier, the customer then leases the asset back from the financier (an ijara) at a rental rate that reflects a conventional repayment and interest profile. An alternative is to have “parallel istisnas” involving a second istisna whereby the customer buys the asset from the financier on deferred payment terms (the repayment profile).
While sukuk has generally been a corporate financing technique, established Islamic finance markets are increasingly structuring project sukuk. Sukuk involves sharia-compliant financial certificates, which are broadly comparable to asset-based bonds. One way in which they can be structured is by way of a special purpose securitisation vehicle which acquires an asset from an originator (ie. the borrower) which it then leases (by way of ijara) back to the originator for a rental which is broadly similar to the repayment of principal and interest. The securitisation vehicle issues the certificates to investors to which the periodic rental income is distributed. At the conclusion of the arrangement, the originator will repurchase the asset and the investors will receive the sale proceeds (ie. face value of their certificates).
Istisna-ijara and sukuk share some of the same hallmarks as securitised lease or licence structures which have been successfully utilised on many recent infrastructure projects in Australia.
Hurdles facing Islamic finance in Australia
While istisna-ijara and sukuk arrangements may, prima facie, be suitable structures for infrastructure projects, there are regulatory and tax hurdles (amongst others) to overcome.
Regulatory issues include the lack of specific prudential and accounting standards and the possibility that certain Islamic products, due to their structures and numerous investors, will fall within the definition of a managed investment scheme or other regulated entity under the Corporations Act.
Despite recommendations to the Federal Government to remove any regulatory barriers necessary, there has been no obvious developments thus far. Some States have given in principle support to identify potential impediments, or declared that there are no (non-taxation) regulatory barriers, although it is clear that they are waiting for the Federal Government to take the lead.
Prospective Islamic finance institutions and investors will be reluctant to enter the market until they can be reassured the local regulatory regime supports the sector.
The underlying taxation principle should be for economically equivalent transactions or financial instruments, either conventional or Islamic products, to be taxed in the same way (ie. substance over form). This much has been acknowledged by government and formed the basis of the Board of Taxation’s review. Although Islamic finance does not involve the derivation of interest, the approach in other jurisdictions to encourage and facilitate this form of finance is to apply the same tax rules that apply to interest derived in more conventional financing arrangements.
Amending Australia’s complex income tax laws that apply to financial arrangements will not be simple. However, by adopting uniform concepts and product neutral drafting that is principles-based, those amendments should be achievable.
Even with such reforms, the various stamp duty regimes remain a big impediment. As Islamic finance products must be based on tangible assets, often real estate, dealings in such assets may result in multiple stamp duty imposts. Murabaha, for example, involves the financier acquiring an asset and agreeing to on-sell that same asset to the borrower, albeit on deferred payment terms.
In New South Wales, the potential for double duty has been recognised as a significant issue facing Islamic finance stakeholders and the New South Wales Government has been urged to consider amending the Duties Act 1997 (NSW) on property transfers under Islamic mortgages once the Federal response to the Board of Taxation report has been released. In Victoria, the Duties Act 2000 (Vic) was amended to prevent double duty on some murabaha transactions involving a natural person as the borrower.
However, a more uniform approach across the States and Territories is necessary to apply to Islamic finance in an infrastructure context and will require inter-governmental co-operation. This path will be difficult to negotiate and may test the Federal Government’s resolve to facilitate a level playing field for Islamic finance.
Most infrastructure projects in Australia are procured by State and Territory governments, each of which can have different approaches to the risks associated with such projects. However, the public private partnership model is designed to promote innovation by the private sector with a view to providing a more optimal solution.
Our experience is that government is capable and willing to respond to innovative financing solutions offered by the private sector.
For solutions involving Islamic finance, an open dialogue with government will be particularly important as there are conceptual differences between it and more conventional financing approaches which need to be appreciated, particularly in the context of infrastructure funding.
Islamic finance products are capable of broad acceptance by government once they become more visible in the market and it is seen that, despite the different conceptual approach, they do not materially differ in economic characteristics or risk profile to conventional solutions.
There are hurdles to overcome before Islamic finance is readily accessible in an infrastructure context. As a first step on this journey, the Federal Government needs to signal to the finance industry whether it retains the appetite to facilitate Islamic finance playing a more significant role in solving the infrastructure funding gap. One way to flag its position would be to respond to the Board of Taxation report delivered June 2011.
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