The Financial Services and the Treasury Bureau presented feedback last year on the consultation on proposed amendments to the Inland Revenue Ordinance and the Stamp Duty Ordinance to ease development of an Islamic bond, or sukuk, market in Hong Kong.
As part of the Hong Kong government's long-standing policy initiative to develop Islamic finance in the city, the bureau sent out a consultation paper with detailed proposals for the amendment of relevant tax-related legislation. The essence of the proposal is that a level playing field needs to be created to enable Islamic finance products to be structured in Hong Kong.
The way things stand now, if property located in Hong Kong is used as the underlying asset in a sukuk then there would be a significant additional tax burden compared with a conventional product yielding similar economic returns, such as a bond.
In brief, Islamic law prohibits various activities, including the payment and receipt of interest. This means that while loans and bonds can be issued, no interest or coupon payments can be made or received. Several different structures have been developed over the centuries, many of which have roots in the medieval commercial markets that were pervasive in the Persian Gulf during Koranic times.
One group of these structures is often referred to as a sukuk (Arabic for "notes"). The notes issued under a sukuk represent an undivided beneficial interest in an underlying asset or business of the issuer. This asset or business is structured to generate a financial return that is often set at a pre-defined rate for the period of the note. This way, a sukuk can be structured to give an economic return similar to that provided by conventional fixed-income securities.
It should be noted that the Hong Kong financial services sector has been involved in many Islamic finance transactions but those transactions involve property and businesses outside of Hong Kong.
At present, if a company compliant with Islamic sharia law in Hong Kong wanted to finance a property or business located in the city, it would need to find a more structured solution involving assets located in a tax-neutral jurisdiction.
One good example of such structure would be a commodity-based murabaha facility in which commodities are bought by the financing institution(s) in a bonded warehouse and sold to the Hong Kong-based customer for a cost-plus profit price (the profit can be fixed at the time of the sale on a Libor-plus-margin basis). The customer will then sell the commodities to a third party to generate a cash balance that it can use to fund its Hong Kong activities. While this type of structure delivers the economic returns of a loan, it is constructed in a way so as to reflect profit from permissible trading activities.
The Islamic finance industry relies heavily on this sort of financial engineering but there is a strong push within the industry towards more direct financing of assets or businesses.
Other non-Muslim countries such as Britain, Singapore and Japan have already adapted legislation to enable a more level playing field and help its financial services sector sell products in the attractive and rapidly expanding market.
As with the Hong Kong proposals, these countries have not granted any special tax incentives to develop the market. Instead, they have ensured that financial products with similar economic risks and returns are given similar tax treatment.
Although this development is welcomed by Hong Kong's financial services industry, I do not think this means we can expect to see a deluge of transactions once the law actually changes.
Sharia-compliant transactions will be a niche product offering and a Hong Kong-based sukuk in particular, will give Hong Kong issuers access to a potential market worth about US$85 billion. Total assets in the Islamic finance industry are estimated at US$1.3 trillion.
The bureau's key conclusions were that respondents welcomed the proposals and supported the religion-neutral approach in the drafting of the bill. This means that there will be no use of Arabic or sharia terminology as opposed to referring to the various types of Islamic instruments - such as sukuk - that get used in the industry. This is the same approach that was taken in Britain and is the right way to go about the changes since it ensures a fully inclusive market and removes politically sensitive issues.
Although it has taken Hong Kong a long time to get here, the Financial Services and the Treasury Bureau should be congratulated for preparing a well thought out and detailed paper. This should ensure the government does not encounter long delays in drafting the bill.
Those interested in the development of Hong Kong's Islamic finance industry will be looking forward to the bill being presented and passed this year.
Regardless of how many actual transactions come to market in the years ahead, it will place Hong Kong in the minds of Islamic financial institutions and investors in Europe and the Gulf. This will raise Hong Kong's profile in the fast-growing market.
(South China Morning Post / 16 Jan 2013)
Alfalah Consulting - Kuala Lumpur: www.alfalahconsulting.com
Islamic Investment Malaysia: www.islamic-invest-malaysia.com