Abdullo Kurbanov and Zuhursho Rahmatulloev of Alif describe how fintech is transforming the development of Islamic finance, and they also look at some relevant issues on how to tax financial transactions that have been structured to comply with Sharia principles.

Global Islamic finance exerts considerable influence in the international banking sector. Forecasts from 2020 estimate that the total value of global Islamic finance assets will reach $3.69 trillion by 2024, with the sector posting 10.6% growth in 2020. While this may already seem an impressive figure, the reality is that Islamic finance is still finding its footing.

When we talk about Islamic finance, we are referring to all transactions and activities that adhere to Sharia principles. Conforming to these principles includes the prohibition of investments that profit from debt, such as products linked to interest payments. There are also sectors that cannot be invested in, such as alcohol, tobacco, gambling and “adult entertainment.” Finally, Islamic finance encourages asset-backed financing.

The application of Sharia principles to the banking sector, capital markets, and non-bank financial institutions is relatively new when compared to the advances of conventional finance. This is partly due to fragmented regulation and the inconsistent application of Sharia principles in different banking jurisdictions. Over 93% of international Islamic finance is concentrated in nine core markets, including major shares in Saudi Arabia, the United Arab Emirates and Malaysia.

However, if we look to other international markets where Islamic finance commands a small niche, there is a limited public awareness and a general lack of confidence surrounding the application of Sharia-compliant products. Training and awareness have important roles to play here, particularly for countries outside of the Gulf Cooperation Council.

The full potential of Islamic finance will be realized through technological innovation. Over the past five years, financial technology, or fintech, has disrupted retail banking and consumer finance in advanced Western economies. Led by high-growth startups, fintech has used existing software to empower the consumer and investor. Part of this success has come from the launch of applications providing effective user experiences.

A new wave of fintech is now on the rise, using technology to address issues and challenges relevant to niche audiences that make up the global financial landscape. As a result, Islamic finance is essentially being digitalized, ensuring consumers and investors in need of Sharia-compliant services are not only aware of existing solutions but able to take full advantage of them.

The Rise of Islamic Fintech

Islamic fintech has become the fastest-growing segment of financial technology among the Organization of Islamic Cooperation (OIC) countries. According to one report, Islamic fintech in OIC countries accounted for $49 billion in transaction volumes in 2020. To put this into perspective, we can see that the full potential of Islamic fintech is far from being realized—this figure accounted for only 0.7% of global fintech transactions in the same year.

The Global Islamic Fintech Report projects the volume of transactions within the Islamic fintech sector of OIC countries to grow at a compound annual growth rate of 21%, or $128 billion per year.

Again, when compared to the mainstream fintech market, we see why markets are becoming excited about the future growth potential—conventional fintechs are anticipating 15% compound annual growth over the same period. In a fast-paced, high-growth sector, Islamic fintech is very much leading the charge.

The application of fintech not only ensures access to Sharia-compliant products and services: We are also seeing companies use technology to address issues relevant to Islamic populations, which naturally require adherence to Sharia principles. If we look to Central Asia where Alif Bank is based, one of the core financial challenges faced concerns cross-border remittance payments. The traditional process of facilitating such transactions is long, expensive, and complicated.

Technology has a natural role to play here, and through the creative deployment of Islamic fintech services, remittance payments in Central Asia can be streamlined through fintech applications.

Understanding the Tax Issues Relating to Islamic Finance

As awareness of Islamic finance rises, questions will naturally arise on how to tax financial transactions that have been structured to comply with Sharia. While the majority of transactions are domestic, the ongoing development of the sector will naturally lead to more cross-border transactions between and within Islamic and non-Islamic jurisdictions.

As noted by the Institute of Chartered Accountants in England and Wales, there is no global approach to taxation regulations surrounding Islamic finance. Yet with the ongoing rise of the digital economy, a global approach is warranted.

This is an issue that affects not only Islamic finance but also the global banking sector. Recent proposals by the G-7 to implement a global corporation tax are gaining momentum, as talk about more cross-border regulation. This is a developing space, and any attempt to implement future global frameworks should also take into account issues concerning Islamic finance.

Another important aspect is the double taxation of the Islamic financing structure murabaha in countries where Sharia instruments are not treated equally to their traditional counterparts. Traditionally, interest payments are generally not subject to value-added tax (VAT). However, a murabaha transaction, which is essentially a purchase of an asset and resale with a mark-up, could be subject to VAT and other taxes.

To overcome this issue, regulation needs to be in place that addresses this specific point. Murabaha financing is one of the most common Islamic banking instruments, typically constituting more than 90% of the total assets of Islamic banks. Put simply, failing to address the double taxation issue can seriously hinder the progress of Islamic banking in that jurisdiction.

Technology is Part of Islamic Finance’s Evolution

Taking into account the tax issues surrounding Islamic finance, technology has a natural role to play in supporting its rise. The fact is that technological innovations are empowering more people to take better control of their finances.

The first wave of fintech companies demonstrated how the application of existing software solutions could drastically enhance all aspects of the finance sector, from personal finance to retail investors. Over time, these innovations have been refined to cater to the specific needs of different communities and groups.

Islamic finance is no exception—the rise of fintech will promote market awareness beyond Islamic jurisdictions, encouraging people of the Islamic faith to use technology to their advantage. As the sector continues to grow, this will generate questions around taxation and regulation. It is an evolving space that will require developing expertise and knowledge in the future.