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Malaysia tax breaks may shift Islamic bonds beyond murabaha

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The Malaysian sukuk market is already the world's largest, accounting for two-thirds of total global issuance of about US$100 billion so far this year - PHOTO: BLOOMBERG

[Kuala Lumpur] Malaysia is adjusting its tax structure to favour issues of some types of Islamic bond, in a move that could attract more foreign issuers and investors to its market and narrow differences with the Gulf, the other main centre of Islamic finance.

The Malaysian sukuk market is already the world's largest, accounting for two-thirds of total global issuance of about US$100 billion so far this year. But the market consists largely of local-currency deals which tend to rely on government-linked institutions as ready buyers.

By far the most common type of sukuk format used in Malaysia is murabaha, a cost-plus-profit arrangement where one party agrees to buy merchandise for another, which promises to buy it at an agreed mark-up. In the first half of 2014, 82 per cent of all corporate sukuk approved in Malaysia used murabaha, Securities Commission data shows.

But murabaha may be limiting the Malaysian market's development, because many international issuers and investors prefer to use other structures such as ijara and wakala. Some Islamic scholars in the Gulf have said murabaha lacks a clear link to the assets backing the structure, and is therefore not sufficiently based on real economic activity, a key principle in Islamic finance.

Also, many Gulf scholars don't view murabaha as a tradeable instrument, further limiting its appeal to investors from outside Malaysia.

So Prime Minister Najib Razak sought to reduce Malaysia's reliance on murabaha by announcing last week, in his annual budget speech, that the government would extend tax deductions for ijara and wakala sukuk structures from 2015 until 2018. Ijara and wakala accounted for only a combined 9 percent of corporate sukuk deals in the first half of this year.

At the same time, tax breaks for other structures including murabaha, bai bithaman ajil, istisna and musharaka would expire by the end of this year.

The effect of the tax changes may be to shift some issuance away from murabaha and encourage the use of ijara and wakala, making the Malaysian market more closely resemble the Gulf. "The extension of the tax incentives for sukuk based on the sharia principles of ijara and wakala is part of Malaysia's long-term strategy to internationalise the Islamic capital market," the Securities Commission said in a statement to Reuters. "These two sharia principles are widely adopted internationally and the extension of tax incentives would further promote cross-border transactions." Arshad Mohamed Ismail, head of corporate and investment banking at Maybank Islamic, said the new tax structure would make ijara and wakala deals more efficient to execute. "Authorities would certainly like to see greater diversity in the types of sukuk structures executed in the local market," he said.

Ijara, a sale and lease-back contract, is the most common structure used by governments issuing sukuk; Britain, South Africa and Luxembourg all employed that format when making their debut issues this year.

Wakala, an arrangement in which one party acts as agent for another, has emerged as the most common structure for big conventional banks entering the sukuk market as issuers. Goldman Sachs used wakala in its US$500 million sukuk issue last month; Bank of Tokyo Mitsubishi and Societe Generale chose it when laying plans this year to issue sukuk in Malaysia. "We foresee more variants of sukuk wakala to emerge," said T C Kok, chief executive of Malaysia's AmInvestment Bank.

Any shift away from murabaha in Malaysia is not expected to be overwhelming. The tax deductions are for expenses incurred by issuers on their sukuk; these sums of money are not necessarily decisive, bankers say, and issuers also consider other factors when choosing structures.

Murabaha remains the easiest and fastest structure to design, a key consideration for issuers, Kok noted. "We feel that it will not discourage issuers from murabaha altogether. The ease of execution and time to market for murabaha may continue to appeal to issuers, given the volatile interest rate environment." Although ijara is very popular with investors, it is still one of the hardest structures to sell to issuers, said Badlisyah Abdul Ghani, chief executive of CIMB Islamic. "Not every issuer can do ijara or wakala. Different issuers with diverse requirements will opt for different structures to tap the sukuk market. So we will not see a movement away from murabaha," he said.

While murabaha can use commodities provided by an arranging bank, without the issuer having to own those assets, ijara and wakala require the issuer to own specific assets to back its structure, such as real estate.

This may be a challenge for firms planning to raise money for new projects, as their assets may not be immediately available or of sufficient value, Kok said.

Nevertheless, authorities appear determined to diversify the sukuk market. There is concern that Malaysian issuers have come to rely too heavily on a few local investors to buy their sukuk, such as the countries' two huge pension funds, the Employees Provident Fund (EPF) and Retirement Fund Incorporated (KWAP). "The government wants more foreign investors to come into the Malaysian capital market to reduce the over-reliance on the likes of EPF, KWAP etc.," said another Malaysia-based banker. This looks unlikely to happen as long as Malaysian issues are overwhelmingly murabaha. REUTERS