Recently, I was asked by Islamic Finance News, a leading provider of news in the Islamic financial world, to write an article addressing a largely unexplored topic. What is it? Why is it essentially uncharted and not discussed? The topic involves the unique impact on financial and other transactions when US tax and Shariah laws meet one another head on.
Why is there so little written on this? I think the answer is simple. Problems and discord result when “tax meets religion”. For many in the US, the entire topic of Shariah is highly toxic. The US Internal Revenue Service (IRS) prefers to remain silent. In the meantime, professionals and taxpayers struggle when faced with the US tax treatment of a transaction impacted by Shariah.
My article, Clash of the Titans: Can we Harmonize US Tax and Shariah Laws? while raising some general points and guidelines, is meant to serve as a wake-up call to various professionals dealing with clients who have any connection to Shariah. This extends not only to US tax, legal or wealth management professionals who must pay careful attention to the potential impact of the Shariah rules on their client’s case, but also to non-US professionals in jurisdictions following Shariah law. They must be on the alert and must consider the US tax implications when any “US person” is involved in their particular transaction.
With proper planning and structuring, a solution can usually be implemented to take the aspects of Shariah into account while addressing the US tax issues in an efficient way. Obviously, however, planning and structuring is not possible if the advisors remain unaware of the intersect between the US tax and Shariah issues.
I emphasize here that as far as I am aware, to date we have no guidance from the IRS, the courts or Congress when Shariah impacts a given transaction. Guidance is needed. As my article points out, although many may not be aware of it, transactions that involve Shariah arise on a daily basis for American individuals and companies. Viewing the issues as a “religious” matter will only serve to limit any constructive professional discussion. Instead, 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 transaction.
The full article is reproduced below. It was first published in Islamic Finance news Volume 17 Issue 29 dated the 22nd July 2020:
Clash of the Titans: Can we Harmonize US Tax and Shariah Laws?
By Virginia La Torre Jeker, J.D.
In light of the global economy in our modern world, there’s 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 East region where I have 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 a 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 a 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 do not allow the individual to receive 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 home buyers 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.
No guidance
Despite the proliferation of cases, there is apparently no guidance from the US tax authorities as to how such the 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 America, there is a palpable reticence to in any way touch 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 transaction.
It is an interesting time in the tax world regarding the intersection of Islamic financial transactions and U.S. 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’ 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, August 21, 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 that is 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.
Wake-up call
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. As a starter, 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.
Virginia La Torre Jeker, J.D. is the owner of VLJ US Tax Advisory FZE. She can be contacted at vljeker@us-taxes.org.
Posted August 6, 2020
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