In light of the global economy in our modern world, there is a consensus that it is no longer possible for advisors in the finance, tax, wealth management and legal sectors to remain ignorant of the possible implications of another country’s laws. In the Middle Eastern region where VIRGINIA LA TORRE JEKER has a significant practice, many countries follow Shariah law. In the US itself, a wide variety of financial transactions occur on a daily basis which implicate Shariah law.
US multinational companies engage in such financial transactions both directly and indirectly through their foreign affiliates. Islamic finance departments are part and parcel of many US financial institutions. General Electric, Goldman Sachs and the World Bank have all issued Sukuk, and financial firms such as Fidelity are active participants in the Sukuk market. The average Muslim–American buys homes in the US with Shariah compliant mortgages or takes out Shariah compliant student debt to attend school.
Meanwhile, the US tax laws do not exist in a vacuum. Certain transactions are tax-favored, or help certain ‘American dreams’ become a reality — such as home ownership and obtaining higher education. For example, there are US tax benefits through deductions for interest paid on home mortgages or student loan debt. And, while Shariah compliant financial transactions continue to grow in number on a worldwide basis, there remains a general lack of government guidance on the tax treatment of such financial transactions. This is especially true in the US, where Shariah law is a hotly contested and somewhat toxic topic.
US taxation and Shariah
The tax treatment of a transaction meeting Islamic tenets presents a challenge because the US taxation system, like most others, is based on conventional models of financial transactions. In Shariah compliant transactions, while designed to give a similar economic outcome to the conventional type, various intermediate steps will be required to meet Islamic religious requirements. These intermediate steps may give rise to unintended tax consequences.
When US taxpayers are involved in a Shariah compliant financial structure, how should such transactions be analyzed and reported from a US tax perspective? For example, given the obvious tension between Riba and specific US tax rules that impute a fair market rate of interest when such a rate has not been provided by the parties, how should an interest-free loan be handled when Shariah law is implicated in the loan transaction? The answer is not so clear.
Documents or contracts cannot refer to interest, but perhaps the ‘rent’ that is referred to can be treated for US tax purposes as the equivalent of interest. If the transaction involves a party in a foreign country, are withholding taxes required to be made when paying ‘interest’ to the person overseas? Will treaty benefits apply to reduce or eliminate that withholding?
Another example involves a taxpayer’s ability to claim a mortgage interest deduction. Generally, interest is paid on a mortgage loan secured by the taxpayer’s residence. Murabahah or Ijarah financing, however, does not allow the individual to receive the title to the home for many years, opening the door for the Internal Revenue Service (IRS) to deny the mortgage interest deduction on grounds that the purported homebuyers do not actually own the residence (they are ‘renting’ it or buying it in ‘installments’).
US tax is also impacted by Shariah in other areas including Muslim marriages with multiple wives, forced inheritance, as well as numerous cross-border transactions. Consider for example, the US tax impact of being either the US creator or US beneficiary of an Islamic Waqf, or of the increasingly popular ‘foundation’ entity created under recently enacted laws in the UAE.
Despite the proliferation of cases, there is apparently no guidance from US tax authorities as to how such matters should be resolved. There are no court cases, no statutes or regulations, nor has the IRS ever addressed these issues.
Given the political climate in the US, there is a palpable reticence when touching on this topic. The area should not be viewed as a matter of religion, however. This will only serve to stymie any constructive discourse. Rather, the entire topic should be viewed as a call for action on the part of the US to guide tax professionals and taxpayers in remaining compliant when Shariah impacts their transactions.
It is an interesting time in the tax world regarding the intersection of Islamic financial transactions and US tax law. With the Muslim population growing in the US, the IRS will have to confront this issue head-on as various Shariah compliant alternatives will most likely be more frequently utilized. It will certainly be exciting to see the IRS’s official position and the possible attention in the US courts.
While at the current time guidance is lacking as to how such matters should be resolved, an analysis of various transactions involving Shariah and how they may be viewed from a US tax perspective is provided in my article, ‘When Sharia and US Tax Law Collide’ (Tax Notes International, Volume 87, No 8, 21st August 2017).
In the UK for example, Islamic financial products are regulated in the same manner as their conventional counterparts within the framework of the UK’s existing legislation and regulations. The approach by the UK has been secular; the UK did not enact laws specifically addressing Islamic finance. It has kept religion out of the tax law, which certainly would be the approach taken by the US given its adherence to the principle of the separation of church and state. The intent behind the UK approach is that Shariah compliant transactions are to be subject to the same tax treatment applicable to the corresponding conventional ones.
From a tax perspective, changes were made to the UK tax laws using the doctrine of economic substance to ensure that the tax treatment of Shariah compliant structures would be the same as conventional finance alternatives. The US tax system strongly adheres to the ‘substance over form’ principle and there is no reason why guidance cannot be crafted along these same lines to assist practitioners with proper tax reporting of Islamic-based transactions.
US tax professionals dealing with clients who have any connection to Shariah must pay careful attention to the potential impact of the Shariah rules on their client’s case. Similarly, non-US professionals in jurisdictions following Shariah law must consider the US tax implications when any ‘US person’ is involved.
As an aside, determining who qualifies as a US person for tax purposes is itself a very tricky matter. For a start, the analysis is vastly different for US income tax versus US gift and estate tax purposes, let alone there are a vast number of ‘accidental Americans’ in the world who are not yet aware of their US status. A tax plan can usually be devised to take the aspects of Shariah into account, but obviously this is not possible if the advisors remain unaware of the intersect between the tax and Shariah issues.
Awareness, knowledge, professional expertise and collaboration with scholars of Shariah law and US tax appear to be the only tools currently available to thread the very narrow eye of this US tax/Shariah law needle. With proper guidance from a US tax professional, all the pieces can be brought together reducing the likelihood of unpleasant surprises arising later.