Sharia law is already here — the IRS must respond

Sharia law is already here — the IRS must respond
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On October 21, 100 lawyers and finance professionals will gather in Washington, D.C., to explore ways to expand Sharia-inspired finance in the United States.

Don’t panic!

Despite the public furor – and occasional fear – that arises whenever Sharia law is discussed in public, the reality is that an estimated $4 billion of financial transactions that follow Sharia principles are conducted annually in the United States. And hundreds of billions of dollars of such transactions are conducted globally each year, including transactions involving U.S. companies and their subsidiaries. General Electric and Goldman Sachs issued sukuk bonds. Do you want a mortgage that is Sharia-compliant? Dial toll-free 1-87-786-IJARA

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Yet, public objections to Sharia law paralyze discourse about the intersection of Islamic finance and U.S. rules for tax and accounting. The result is extreme uncertainty, which likely costs the U.S. government critical tax revenue and leaves both taxpayers and regulators confused. Uncertainty also limits the role of U.S. financial institutions in the growing field of Sharia-compliant finance. 

Most Americans cannot explain Sharia law. But many know they don’t like it. Concerns arise primarily because of perceptions and misperceptions of what Sharia law says about women and the structure of families. But in the field of finance, the principles of Sharia that have emerged over eight centuries are not controversial.

Four principles take center stage: No payments of interest or unacceptably high profits; risks should be shared and not shifted entirely to another party; no excessive uncertainty or speculation; and no investments in unethical goods or activities, such as alcohol or gambling. 

A challenge arises when businesses want to borrow money or finance sales and still stay true to Sharia principles. Not many lenders provide funds interest-free. So the Islamic finance industry developed techniques to provide financing while staying sufficiently true to Sharia principles.

Transactions typically involve extra parties and extra steps, compared to conventional financing. In a typical ijarah financing, the buyer and seller interpose a financial institution into the transaction. The seller sells equipment or a building to the bank, which then leases the item to the purchaser. The purchaser pays “rent” with an option to purchase the item later for a nominal fee. 

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How should the transaction be characterized for U.S. tax purposes? The rent is economically equivalent to interest, or to interest plus principal. But the payment is denominated as rent. Federal tax law limits the deductibility of interest but generally does not limit deductions for rent. Will the buyer treat the payment as rent or as interest? Does the form or the substance of the transaction control the consequences?

There is no IRS guidance. And in the absence of guidance, taxpayers may whipsaw the government, reporting based on the substance of the transaction when that is beneficial, and reporting based on the form when that gives a better result. Like the taxation of cryptocurrencies and digital services, the absence of clear rules invites taxpayers to choose whichever approach serves them best.

Many countries, both large (the United Kingdom) and small (Morocco), provide guidance on Sharia-compliant transactions. The lack of guidance here is not a minor irritant; it is a major gap. In the U.K., the leading dispute on Islamic finance transactions took 10 years to resolve before guidance was issued. The United States should avoid that same path. 

A decade ago, a taxpayer sought an IRS ruling on the tax treatment of a mortgage program that followed Sharia principles. The IRS refused to rule. The Office of the Comptroller of the Currency approved Sharia-compliant mortgage programs in 1997 and 1999, but the IRS lags behind. 

Despite the toxic view many Americans hold toward Sharia law, the principles of Sharia are followed in financial transactions every day. U.S. multinational companies engage in these matters, both directly and through foreign affiliates. Banks have Islamic finance departments. And ordinary Americans buy homes with mortgages that are Sharia-compliant. 

The United States and the IRS will be better served by acknowledging these transactions and providing guidance on how to treat them under our law, rather than pretending Sharia-compliant finance lies wholly outside our shores.  

Peter Barnes is an of counsel tax attorney at the law firm Caplin & Drysdale. He serves as a senior fellow at the Duke Center for International Development and was a deputy international tax counsel at the U.S. Treasury before being a senior international tax counsel at General Electric.