Feasibility of Islamic Finance in India

Is change in the Indian regulatory framework inevitable for the development of Islamic Finance? or can there be structures worked around existing laws?

– Qasim Saif I Manager (qasim@vinodkothari.com) 

Islamic Finance, also referred to as sharia compliant finance or interest-free financing, has always been a topic of discussion in the world of finance. Development of Islamic finance has been viewed as a tool for promotion of inclusive growth by way of financial inclusion as faith plays a major role in inclusive growth.

Islam is the second most followed religion globally, and hence, Islamic finance can stimulate the growth of business sector by proving much needed financing, while also release the untapped sources of capital as some investors may only be willing to invest in products that are permissible under their faith.

Importantly, the application of interest free banking can not be said to be limited to a particular faith. The nuances caused by unchecked interest rates, and the exploitation of the poor by debt trap of the high interest loans has its impact across geographies and religion. As the Islamic finance majorly focuses on asset backed financing and principles of sharing of risk and reward, the same can also be viewed as a solution to the centuries-old problem of exploitation of the poor by way of high interest loans.

In this write-up, after discussing the basics of Islamic finance, we get into the interplay of Islamic finance products with the regulatory framework in India. Towards the end, we discuss a model that can be worked out for the development of Islamic finance products in India.

The proof of concept for the Islamic finance can be traced to the development of the sector. Islamic finance has shown a positive growth rate over the globe [Refer chart below]. Though it shall be pertinent to note that the volumes of Islamic finance assets are concentrated in 3 countries^[1] which contribute 66%^[2] of the global volumes, further volumes of Islamic finance assets are minuscule against the total outstanding debt globally that is $296 trillion.^[3]

Principles of Islamic Finance

The principles of Islamic Finance are laid down in the sharia or Islamic law. However, as the faith has always been a subject of personal interpretation so has the principles of Islamic Finance. Worldwide, different scholars have been placing their own interpretations and understanding of the principles. This has particularly resulted in a degree of vagueness in the practical implementation of Islamic finance products.

The Accounting and Auditing Organization for Islamic Financial Institutions, a non-profit organisation set up in Bahrain, has prescribed standards for the sharia compliant products, along with accounting and auditing standards for such products. Though the standards have a wide acceptability, they are not accepted as a global benchmark.

The basic features of Islamic finance are as follows:

• Prohibition of Interest: The major bifurcating factor between Islamic Finance and traditional Finance is prohibition of interest (Riba) in sharia law.
• Profit And Loss Sharing: The partners will share their profit and loss according to the part they played in the business. There will be no guarantee on the rate of the returns hence, there is partnership relationship and not that of creditor and debtor.
• Shared Risk: As the relationship is that of partnership, the risk is necessarily shared between the parties.
• Prohibition on gambling and speculation: Ambiguous and uncertain transactions are prohibited; both parties should have proper control over the business. Derivatives and gambling are prohibited.
• Prohibition on unethical businesses: The industries that are harmful to society or have a threat to the social responsibilities are prohibited such as, alcohol, drugs, weapons, or any product not considered halal (permitted) in Islam such as pork.

On the broader view, participants in transactions are considered business partners who jointly bear the risks and profits. Islamic financial instruments and products are equity oriented and based on various forms of profit and loss sharing. Islamic financial institutions are expected to act as partners of their clients, both sides of financial intermediation are based on sharing risks and gains.

For instance, in case of islamic finance equivalent of deposits, even the transfer of funds from clients to the financial institutions (depositing) is based on revenue-sharing and usually calculated ex-post on a monthly basis and the financial institution shares the profit with the client (depositor) at the end of the month.

Similarly, the transfer of funds from the financial institution to the clients is based on profit-sharing (lending, financing), either at a mutually agreed-upon ratio as in the case of mudarabah or at a mutually agreed-upon fixed rate as in the case of murabaha. Such ratios and rates vary between institutions and may also vary between contracts within the same institution, contingent upon perceived business prospects and risks.

Islamic finance finances only real transactions with underlying assets; speculative investments such as margin trading and derivatives transactions are excluded. Lending or financing is backed by collateral; collateral-free lending would normally be considered as containing a speculative element or moral hazard. Hence, all kinds of financing other than asset backed financing are almost absent in case of Islamic Finance. This particularly rules out opportunities for working capital and supply chain financing. Similarly, to avoid speculation and moral hazard, normally only investors with several years of successful business experience are financed.

The same principle of partnership is applied to Islamic insurance. It is based on a collective sharing of risk by a group of individuals whose payments are akin to premiums invested by the Islamic financial institution in a mudarabah arrangement for the benefit of the group.

Islamic Finance in India

Islamic Finance in India is at a nascent stage, with only a handful of players in the systemic sector. The entire South Asia region had $73 Billion in Islamic Finance Asset by 2019^[4]. The majority were from Pakistan and Sri Lanka, leaving a miniscule volume in India.

The participation of Banks in Islamic finance, what we refer to as Islamic Banking, has always been stuck in the abeyance for the lack of clarity in the Indian legal structure. The Banking Regulation Act, 1949 favours the ‘banking with interest’ system, the operation of ‘banking without interest’ faces challenge in the form of several regulations, such as restriction on profit sharing business, restriction on owning immovable property other than banking assets, SLR requirements, etc.  However, it shall be pertinent to note that there is no specific legal bar on Islamic finance, though banks may be deferred from participating due to the Banking Regulations Act, nothing stops other financial institutions such as NBFCs from following the path.

The RBIs committee on Medium-term Path on Financial Inclusion^[5] proposed in its report,  for setting up a separate window for Islamic finance products rather than establishing a separate framework for Islamic banking. However, there were several media reports that RBI in response to a RTI application, stated that it is not pursuing the development Islamic banking further due to the “wider and equal opportunities available to all citizens.”

Hence, though the Islamic finance products may be offered by entities other than banks, the participation of banks shall remain in abeyance till RBI takes any other steps. This restricts the majority of the capital pool from this space.

Offering Islamic Finance products in current legal framework in India

On the question as to whether Indian laws are required to be amended to promote Islamic Banking, the answer would be a clear yes.  Participation of banks in Islamic finance can be expected only after regulatory measures in this regard are taken.

Almost all the publications around the Islamic finance space leave the discussion to conclude that Islamic finance can not be done unless the RBI amends the Banking Regulation Act, 1949. Though participation of banks can play a major role given the large pool of capital accessible to them, however, nothing restricts other entities from engaging in Islamic finance. [Discussed in detail further]

In our opinion, the majority of Islamic Finance instruments can be provided by non-banking entities under the current regulatory framework of India. The same is summarised in the Table below:

Name	Feature	Permissible legal structure in India
Profit Sharing Models
Musharakah	Equity participation, investment and management from all partners; profits are shared according to a pre-agreed ratio, losses according to equity contributions.	Permitted in all sort of entities, also there can be contracts providing for profit linked payments without dilution of control
Mudarabah	A profit-sharing partnership to which one contributes the capital and the other the entrepreneurship; or the financier provides the capital, the customer manages the project. Profit is shared according to a pre-agreed ratio	Partnership and JV structures can be incorporated
Qard Hasan	Charitable loans free of interest and profit-sharing margins, repayment by instalments. A modest service charge is permissible	Several trusts in India, are providing such loans for charitable purposes.
Wakalah	An authorization to the financier to conduct some business on the customer’s behalf	Agency Contract
Hawalah	An agreement by the financier to undertake some of the liabilities of the customer for which the financier receives a fee. When the liabilities mature the customer pays back the financier	Invoice/Bill discounting
Asset Backed Finance
Murabahah	A sales contract between a bank and its customers, mostly for trade financing. The bank purchases goods ordered by the customer; the customer pays the original price plus a profit margin agreed upon by the two parties. Repayment by installments within a specified period	Credit Sale Contract
Mu’ajjal	Purchase with deferred delivery: A sales contract where the price is paid in advance by the bank and the goods are delivered later by the customer to a designated party	Deferred sale Contract
Ajaar Ijarah Ijarah Mutahia Bittamlik	Lease and Hire Purchase: A contract under which the bank leases equipment to a customer for a rental fee; at the end of the lease period the customer will buy the equipment at an agreed price minus the rental fees already paid.	Leasing and Hire purchase
Sukuk	Sukuk represent aggregate and undivided shares of ownership in a tangible asset as it relates to a specific project or a specific investment activity. An investor in a sukuk, therefore, does not own a debt obligation owed by the bond issuer, but instead owns a piece of the asset that’s linked to the investment.	Ownership participation certificates (detailed discussion is given below)
Insurance products
Tadamun, Takaful	Islamic insurance with joint risk-sharing	Profit-share contract, however applicability of IRDA regulations might be an debatable issue on these contracts

Based on the discussion above, it shall be pertinent to note at this stage, most Islamic finance instruments are not in the nature of financing transactions, rather they are akin to operating business transactions, where parties mutually share risk and reward.

Financing the Islamic Financiers

As per the discussion above, the majority of the Islamic finance instruments can be offered without regulatory changes in India. However, the challenges may arise in funding these institutions, as not having a regulatory recognition would severely restrict the entities capabilities to raise finance from the public at large, further, as the very basis of the Islamic finance lies on the interest free banking, possibilities of interest-bearing finance from banks and other financial institutions can also be ruled out.

This leaves owned funds as the only option for the financiers. Financial experts will readily agree that 100% equity funded entities in the financial sector is a rare sight. Inability to leverage would severely hamper the growth prospects of the Islamic financiers.

Further, equity investors would be facing significant liquidity issues in their investments given the miniscule penetration of Islamic finance in India and because it can not be easily bought back by the Company. Leaving dividend as the only manner by which investors can earn a return. Also, the larger pool of investors in such entities are expected to be from the countries where Islamic finance is in a rather developed stage, and RBI’s keenness to allow such investment in the financial sector can not be predicted at this stage.

Hence, the major challenge that arises today for Islamic finance would be to fund the financial entities, under the current applicable regulations.

Islamic finance by Non-banking Non-Financial Companies.

As discussed above, the Islamic finance instruments are in essence not financing transactions, rather business transactions, where risk and reward related to business and/or assets are shared by the parties in accordance with agreement between the two.

For example, in the case of Mubarah, the transaction is a credit sale with deferred payment, whereby the parties agree to buy-sell assets for a particular price, which has an embed margin for the asset provider. The transaction is a sale transaction and not a financing. Similarly, Ijara (leasing) if structured as an operating lease, would be akin to renting of assets rather than financing.

Here it shall be noted that Section 45-I (f) of the Reserve Bank of India Act, defines – ‘‘non-banking financial company’’ as follows:

‘‘non-banking financial company’’ means–

(i) a financial institution which is a company;

(ii) a non-banking institution which is a company, and which has as its principal business the receiving of deposits, under any scheme or arrangement or in any other manner, or lending in any manner;

(iii) such other non-banking institution or class of such institutions, as the Bank may, with the previous approval of the Central Government and by notification in the Official Gazette, specify;”

Further, as per the RBI press release 1998-99/1269 dated 8th April, 1999^[6], any company which carries on the activities specified in section 45-I (c), in a manner that satisfies the principality test, based on the last audited balance sheet of the company, will be deemed to have been carrying on the business NBFC. In order to pass the principality test, the following two conditions must be met:

a. At least 50% of the total assets are financial assets; and

b. At least 50% of the gross income comes from such financial assets.

An entity providing Islamic finance options, shall not be considered to be engaged in the business of non-banking finance^[7], as the transactions entered by them would not be financing in the first place. Offering products such as deferred credit sale and operating lease does not require much legal discussion, currently, several non-banking non-financial entities enter into such arrangement.

However, funding such entities remains a challenge, as owned funds without a proper leverage can not be said to be a viable solution for a business that earns by blocking liquid cash into long term arrangements. Funding the entire business by owned funds would significantly hamper the scalability of such entities.

We see a probable solution in sukuks, that is to say, participation certificates backed by Islamic finance instruments. A simple balance sheet of such an entity would have Islamic finance instruments such murabaha and ijara on its asset side whereas sukuk on its liability side.

Understanding intricacies of sukuk

Mubaraha and Ijara being just an alternative nomenclature for credit sale and leasing does not require much discussion. However, issuance of sukuk in Indian regulatory context would require in depth deliberation.

In brief, sukuks are nothing more than pass through certificates, (PTCs) which channelise actual cash flows to the investors. However, this is a Islamic finance instrument, hence would not carry fixed flows; rather actual cashflows from the underlying asset would be passed through to the investor. This of course does not mean that the cashflows would be entirely uncertain, as the underlying assets would have a defined cashflow structure, hence until and unless there is a default or disruption, the investor would receive the cashflows as defined in the agreement.

Probable structures

To ease the discussion of regulatory and taxation aspects we would propose two different structures for the issuance of sukuk:

• Option 1: Amortising Structure

The sukuk would have amortising cashflows, that is to say, the investor would be paid both profits and principal, as and when received. This would be a pure pass through structure, and the issuer would be required to issue new securities as when it wishes to enter into further transactions.

From a financial perspective, the structure is not much appreciable for both investor and issuer, as the issuer would be stripped for liquidity whereas investors capital would be paid back, reducing investors return over time.

The structure has payouts of principal and does not result in recycling or reinvestment of funds.

• Option 2: Bullet Repayment

In this structure, the investor would receive regular profit payments, whereas, principal would be paid at maturity of the instrument. This would be similar to interest-yielding PTCs.

The issuers cash flow would be an amortising cashflow, whereas the payout of the capital would be in bullet, this shall provide issuer with an opportunity to reinvest the funds for further originations.

Legal and taxation aspects

Though the actual implementation of the structure would require in depth discussion on several fronts, given that there are no clear regulatory prescriptions in this respect; neither has this structure been put to practical implementation yet. (atleast to our limited knowledge)

Securitisation Regulations

Here it shall be noted that issuance of PTCs is regulated by Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021. However, these directions are applicable on financial entities such as banks and NBFCs. As the entity contemplated above would be a non-banking non-financial entity the said directions would not be applicable.

Collective Investment Scheme regulations

The legislative basis for collective investment scheme regulations is sec. 11AA (2) of the SEBI Act. The said section provides:

“Any scheme or arrangement made or offered by any company under which,

• the contributions, or payments made by the investors, by whatever name called, are pooled and utilized solely for the purposes of the scheme or arrangement;
• the contributions or payments are made to such scheme or arrangement by the investors with a view to receive profits, income, produce or property, whether movable or immovable from such scheme or arrangement;
• the property, contribution or investment forming part of scheme or arrangement, whether identifiable or not, is managed on behalf of the investors;
• the investors do not have day to day control over the management and operation of the scheme or arrangement.”

Now, what exactly is a CIS can be a long discussion. We have previously, in our article: Law relating to collective investment schemes on shared ownership of real assets, made an argument that “As long as the intent is to enjoy the usufructs of a real property, there is evidently a pooling of resources, but the pooling is not to generate financial returns, but real returns. If the intent is not to create a functional equivalent of an investment fund, normally lure of a financial rate of return, the transaction should not be construed as a collective investment scheme.”^[8]

Hence, it can be concluded that, CIS are pool of funds for common investment by group of investor managed by a third party manager whereas, sukuk signifies shared ownership of the underlying asset, and same should not be considered as CIS.^[9]

Hence, specifically, if the sukuk are structured as option 1, it can be contended that investors are merely joint owners of the asset, and the sukuk are certificates reflecting ownership of the underlying asset and not a joint investment fund.

Deposit under Companies Act, 2013

In respect to sukuk, it can be argued that, sukuk are in essence debentures, and having a security over the receivables of the Company would be considered as secured debentures hence escape the definition of deposit under Companies Act, 2013.

However, it shall be noted that structure would be required to be carefully crafted to ensure compliance with applicable regulations.

Taxation of Sukuk

The Indian Income Tax Act, 1961, defines AOP (Association of Persons) as an integration of persons for a mutual benefit or a common purpose. In the given case, the investors, if they become joint owners of a cashflow and may form an AOP, for the purpose of Income tax.

Whether such a structure would become an AOP would require understanding of what constitutes an AOP.

The reference can be made to the decision of Supreme court of India, in the case of Commissioner Of Income- Tax, … vs Smt. Indira Balkrishna^[10] where the apex court held that:

“there is no finding that the three widows have combined in a joint enterprise to produce income. The only finding is that they have not exercised their right to separate enjoyment, and except for receiving the dividends and interest jointly, it has been found that they have done no act which has helped to produce income in respect of the shares and deposits. On these findings it cannot be held that the three widows had the status of an association of persons within the meaning of s. 3 of the Indian Income Tax Act.”

Hence, contention can be made that where the parties have not acted in consonance as a joint enterprise rather have taken a back seat to enjoy the benefits from the asset, the same shall not constitute an AOP.

The same can also be held that the investors act as a joint owner of a property, and do not act as an enterprise hence, would not be taxed as AOP. Hence, even from taxation perspective option 1 may be a better structure as the same shall not result in formation of

Conclusion

The Islamic finance is a rapidly growing arm of the financial world, however in India it is still in the very nascent stage. The major reason for the unimpressive growth of Islamic finance can be attributed to the banks not being able to participate in the market. However, there can be structures that could be put in place to provide at least a start to interest free finance.

However, how the financial regulators view these transactions would be crucial, in further development of the industry.

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^[1] Iran, Saudi Arabia and Malaysia

^[2] https://icd-ps.org/uploads/files/ICD-Refinitiv%20IFDI%20Report%2020201607502893_2100.pdf

^[3] https://www.iif.com/Research/Capital-Flows-and-Debt/Global-Debt-Monitor

^[4] https://icd-ps.org/uploads/files/ICD-Refinitiv%20IFDI%20Report%2020201607502893_2100.pdf

^[5] https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/FFIRA27F4530706A41A0BC394D01CB4892CC.PDF

^[6] https://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/6059.pdf

^[7] Reference can be drawn from Section 45-I (c) of RBI Act, which defines “business of a financial institution”

^[8] Refer to our article: https://vinodkothari.com/2021/01/law-relating-to-collective-investment-schemes-on-shared-ownership-of-real-assets/

^[9] Currently, several companies in India offer shared ownership investment options into real estate sector as well as leasing of various assets

^[10] 1960 AIR 1172, 1960 SCR (3) 513 [Link: https://indiankanoon.org/doc/720212/]