The author explores the differences in accounting approaches between the International Financial Reporting Standards (IFRS) and the accounting standards of the AAOIFI, and the relevant tax implications.
Conventional loan transaction
As a starting point, it is worthwhile considering the accounting treatment of the following transaction:
- On the 1st of January, 2012, company A borrows $100 from conventional bank B for three years.
- Interest of $5 per year is payable annually in arrears.
- When the loan is repaid on the 31st of December 2014, company A must repay $110 to redeem the loan, as well as paying the interest of $5 for 2014.
- The loan is secured on company A?s building, which was bought by company A many years ago for $20, and is now worth $150.
Ignoring any difference in the number of days from 2012, it being a leap year, this is equivalent to borrowing money at approximately 8.0766% as demonstrated by the loan table:
| Economics of conventional loan | ||||
| ? | B/F | Interest | Repayment | C/F |
| 2012 | 100.00 | 8.08 | -5.00 | 103.08 |
| 2013 | 103.08 | 8.33 | -5.00 | 106.41 |
| 2014 | 106.41 | 8.59 | -5.00 | 110.00 |
The borrower will report interest expense of $8.08, $8.33 and $8.59 during the three-year period, with the lender reporting the same amounts as interest income. These differ from the $5 cash interest payments, since the $10 loan repayment premium must be spread over the three year life of the loan.
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Sale and leaseback transaction
Meanwhile company C also happens to own a building worth $150 which it bought many years ago. Company C enters into the following transaction with Islamic bank D:
- On the 1st of January 2012, company C sells its building to Islamic bank D for $100.
- Islamic bank D leases the building to company C at a rent of $5 per year payable annually in arrears.
- Islamic bank D enters into a sale undertaking, whereby it agrees that if on the 31st of December, 2014, company C offers to purchase the building for a price of $110, then Islamic bank D will agree to sell.
- Company C enters into a purchase undertaking, whereby it agrees that if on the 31st of December, 2014, Islamic bank D offers to sell the building to company C for a price of $110, then company C will agree to buy.
- If the above purchases and sales do not take place on the 31st of December, 2014, then Islamic bank D is free to do as it wishes with its building.
This sale and leaseback transaction has many similarities with the conventional loan transaction, as well as some differences.
Similarities
- If the transaction proceeds go as planned, at the start and end of the transaction, companies A and C own their building.
- If the transaction proceeds go as planned, companies A and C have identical cash inflows on the 1st of January, 2012, and identical cash out?ows on the 31st of December, 2012, 2013, and 2014.
- If the transaction proceeds go as planned, companies A and C have the use of $100 for three years, paying $25 (3x$5 + $10 at the end) for this money.
Differences
- If company A defaults, conventional bank B would be entitled to sell the building. Under the law of most jurisdictions, if the price received on the sale is $150, conventional bank B would retain $110 plus any unpaid interest; and the balance of the $150 would be given back to Company A.
- If company C fails to exercise its right to purchase, and also fails to ful?ll its obligation to buy, then Islamic bank D should in most jurisdictions be entitled to sue for speci?c performance of company C?s obligation to buy. However if Islamic bank D chooses not to sue, once the sale and purchase undertakings exercisable on the 31st of December, 2014, have lapsed, then Islamic bank D will own the building free and clear. If it is able to sell it for $150, and Islamic bank D will be entitled to retain the entire $150.
- As the owner of the building during the three-year leasing period, Islamic bank D will have greater obligations regarding the building than would conventional bank B. However, little signi?cance attaches to this in practice, since it is standard for peripheral legal documents to pass this ownership risk back to the tenant company C, so in practice Islamic bank D expects to have obligations no different to those of conventional bank B.
Accounting for the sale and leaseback under IFRS
IFRS is about reporting the economic substance of the transactions. From an economic perspective, Islamic bank D has provided $100 to company C, in exchange for company C?s obligation to pay it $5 on the 31st of December, 2012, and 2013, and to pay it $115 on the 31st of December, 2014.
Accordingly, Islamic bank D would account as follows:
| Islamic bank D extracted accounting figures | |||
| ? | 2012 | 2013 | 2014 |
| Income statement | |||
| Financial income from leasing | 8.08 | 8.33 | 8.59 |
| Balance sheet | |||
| Investment in ?nance lease (Zero in 2014 as lease finishes) | 103.08 | 106.41 | 0 |
The accounting for company C would be the mirror image of Islamic bank D?s accounting.
| Company C extracted accounting figures | |||
| ? | 2012 | 2013 | 2014 |
| Income statement | |||
| Expense of obtaining finance | 8.08 | 8.33 | 8.59 |
| Balance sheet | |||
| Building (original cost) | 20.00 | 20.00 | 20.00 |
| Finance lease obligation (Zero in 2014 as lease finishes) | 103.08 | 106.41 | 0 |
Company C continues to show the building on its balance sheet at all times. The IFRS view is that company C continues to have full economic participation in increases or reductions in the value of the building, since it has the right and obligation to buy the building back on the 31st of December, 2014, at the fixed price of $110. All that company C has done, in economic terms, is to use the building to obtain $100 of finance.
Its accounts should look no different than the accounts of company A, and under IFRS they do not differ apart from some footnote disclosures so that investors are fully aware of the sale and leaseback transaction.
Accounting for the sale and leaseback under AAOIFI
The introduction to AAOIFI?s 1993 Statement of Financial Accounting No. 1: Objectives of Financial Accounting for Islamic Banks and Financial Institutions says:
?Financial accounting in Islam should be focused on the fair reporting of the entity?s financial position and results of its operations, in a manner that would reveal what is halal (permissible) and haram (forbidden).?
To achieve this, it appears appropriate under AAOIFI to account for the transaction that is actually taking place, which is a sale of the building and its eventual repurchase. Islamic bank D will show the building it purchases on its balance sheet, and report the rental income and the gain from selling the building in the periods when they arise.
This leads to the following accounting for Islamic bank D:
| Islamic bank D accounting figures under AAOIFI | |||
| ? | 2012 | 2013 | 2014 |
| Income statement | ? | ? | ? |
| Rental income from building | 5.00 | 5.00 | 5.00 |
| Gain on sale of building | ? | ? | 10.00 |
| Balance sheet | ? | ? | ? |
| Building (cost) (Zero in 2014 as building sold back) | 100.00 | 100.00 | 0.00 |
The accounting for company C under AAOIFI follows the same principles. In 2012 company C sells for $100 a building which it bought for $20, and reports that gain of $80 as well as reporting the rental expense of $5 each year. The $110 payment in 2014 is simply accounted for as the purchase of a building. This leads to the following accounting for company C:
| Company C figures under AAOIFI | |||
| ? | 2012 | 2013 | 2014 |
| Income statement | |||
| Rental expense | 5.00 | 5.00 | 5.00 |
| Gain on sale of building | 80.00 | ? | ? |
| (Cost US$20, sale price US$100) | ? | ? | ? |
| Balance sheet | |||
| Building (cost) | ? | ? | 110.00 |
It is not meaningful to ask which is right. The IFRS and AAOIFI accounting have different objectives and perspectives. IFRS analyzes the transaction entirely on the basis of its economic substance and sees it as a financing transaction. Fundamentally, this derives from the requirement to repurchase the building at a fixed price irrespective of the market value.
The main purpose of AAOIFI accounting is to satisfy the religious needs of the users of the accounts. Accordingly AAOIFI does not allow economic substance to determine the presentation of the accounts but instead gives significant weight to the legal form of contracts, and Shari?ah requirements are overriding.
Tax implications
The tax laws vary from country to country. However in generic terms two tax questions need to be considered.
Is the real estate transfer tax chargeable on the sale and the repurchase of the building?
In 2012, company C sells the building to Islamic bank D for $100, and in 2014 Islamic bank D sells it back for $110. Many countries have a tax chargeable on the transfer of real estate which should apply to these sales.
The UK introduced a special relief from its real estate transfer tax called Stamp Duty Land Tax (SDLT) several years ago. Accordingly the above sales by company C and Islamic bank D should not suffer any SDLT. A number of other countries have introduced a similar relief from their real estate transfer tax to facilitate Islamic finance.
Does company C?s sale give rise to a taxable gain?
Even though the economics of the transaction do not differ materially from the conventional loan, company C begins in 2012 by selling for $100 a building it bought for $20. At first sight, this gain would appear to be taxable.
In the UK, under current law, this sale would give rise to a taxable capital gain. The UK has already brought in a relief which applies if a sale and leaseback takes place with a special purpose vehicle that issues investment bonds (the tax law equivalent of Sukuk), but this relief does not apply if the sale and leaseback transaction takes place with a bank.
Given the precedent of relief for Sukuk transactions, it is probable that in the near future the UK will bring in a similar relief for transactions with banks.
In other countries, such as the US and the Netherlands, tax is primarily based on the economic substance of transactions. In such countries, the sale for $100 and repurchase for $110 are likely to be seen as primarily a financing transaction. The consequence would be that the sale and repurchase would be disregarded for tax purposes, so that company C would retain its historical tax basis in the building of $20.
About the Author
Mohammed Amin is an Islamic finance consultant and was previously the UK head of Islamic finance at PwC.
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Source: http://businessislamica.com/2012/08/13/accounting-and-tax-implications-of-sale-and-leaseback-2/
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