Chapter 5
Canada
A Promising Emerging Market for Islamic Finance
Jeffrey Graham
Partner, Borden Ladner Gervais LLP
Canada is widely considered to have the most effective and safest banking system in the world, according to the World Economic Forum. The Global Financial Magazine reports that 6 of the world's top 10 safest banks are Canadian, and the World Bank ranks Canada in the top five countries for investor protection.
A strong domestic economy in Canada ensures a steady demand for financial services. Canada has a national banking system with more than 8,000 branches. It has a highly competitive domestic financial sector, resulting in high service standards at competitive costs to consumers. In addition, there is a strong commitment to innovation: Canada has a high number of automated banking machines per capita and benefits from high levels of utilization of electronic channels. Further, Canada has a very stable environment; failure in the Canadian financial sector is rare.
Within Canada, Toronto is Canada's financial services capital and one of North America's premier financial centers. Other Canadian cities with significant financial sectors are Montreal, Vancouver, and Calgary.
One of the most rapidly growing segments of the international financial services sector is Islamic finance. Recognizing this trend, and in competition with a number of other Western financial centers, including London, Toronto is leading Canadian efforts to explore the prospects of attracting additional Islamic financial activity.
With a prominent and growing Canadian Muslim community and a strong and innovative financial sector, Toronto could certainly emerge as a North American center for Islamic finance. Most recently, the government of Ontario announced plans to level the playing field to ensure that legislative or regulatory barriers for alternative finance (i.e., Islamic finance) are eliminated. Discussions are under way between Canadian federal and provincial authorities and the private sector to identify relevant provisions of law and policy and then identify and implement legislative or regulatory solutions.
Past Performance
Toronto is home to Canada's five largest domestic banks, all of the major foreign banks with a presence in Canada, the major bank-owned investment dealers, and more than 100 non–bank owned investment dealers.
Toronto is also the headquarters of Manulife and SunLife (two of the top 10 life insurers worldwide, based on market capitalization), a significant number of domestic and international property and casualty insurance companies, and the major corporate brokerage houses. Both Manulife and SunLife operate in Asian markets and have experience with Islamic insurance models.
In the world of fund management, the leading Canadian mutual fund companies, institutional fund managers, and many of the country's largest pension funds are headquartered in Toronto.
In addition, Toronto is the home base of the TMX Group, the third largest stock exchange in North America and the eighth largest in the world based on market capitalization. For example, more mining companies are listed on TSX and TSX Venture Exchange than on any other exchange in the world. Combined, TSX and TSX Venture Exchange have at least 1,200 mining companies with a combined market capitalization in excess of US$320 billion.
The Toronto region is also the home of a growing and increasingly influential Muslim community, with emerging financial service businesses serving a growing need for retail products and services that are compliant with the requirements of Islamic commercial law. In the past several years, a number of Canadian-based financial entities have emerged that have focused on a growing demand for Shari'ah-compliant residential mortgages. In addition, there appears to be a growing interest among the international community, both Islamic financial institutions and individuals (including Canadians living abroad), in investing in Canada in entities or structures that are compliant with the principles of Islamic commercial law.
There are several educational ventures that are helping to develop the Islamic finance knowledge base in Canada. For example, the Rotman School of Management within the University of Toronto is a globally ranked Canadian business school and continues to provide a leadership role in Islamic finance education. It introduced Canada's first master's of business administration (MBA) course in Islamic finance, which is now entering its third year. The students who have taken this course come from diverse ethnic and religious backgrounds. The course is very rigorous and requires students to construct Shari'ah-compliant financial structures and compare and contrast them to conventional structures. More recently, the DeGroote Business School at McMaster University in Hamilton, Ontario, has begun to offer an MBA level course in Islamic finance. In addition, a prominent Ontario college, Centennial College, is offering a program on Islamic finance and investment based on a similar program offered by the UK Securities and Investment Institute.
Prospects
Although Islamic finance is still in its infancy in Canada, the experience of Canada with Islamic mortgages is significant and constitutes an important step in the building of an Islamic finance industry in this country. Canada has a long history of pioneers; indeed, the country was built by many brave souls who struggled against almost impossible odds to build one of the most tolerant and open societies in the world as well as one of the most successful.
There is a growing community of Islamic finance pioneers who are embarking on a similar journey, and there is good reason to expect that many of these pioneers will also succeed. Although progress has been slow, there is reason to be optimistic that Canada, and Toronto in particular, will emerge as the North American center for Islamic finance.
Asset Management
Islamic mutual funds have been created in Canada by taking advantage of the global and the Canadian regional Dow Jones Islamic Market Index (DJIMI).
The most successful Islamic mutual fund in Canada is the Global Iman Fund. The fund is offered by Global Growth Assets (www.globalgrowth.ca), a Toronto-based subsidiary of the Global family of companies.
The Global Imam Fund is an ethical global equity fund that is Shari'ah-compliant. It is for investors interested in including ethical or socially responsible holdings in their portfolios. It is also for investors looking for capital appreciation through investments that adhere to Islamic financial investment principles. The fund avoids certain kinds of businesses or sectors, such as alcohol, tobacco, pork-related products, financial services, weapons and defense, entertainment, and gambling. An investor in the fund would have a moderate risk tolerance and a medium- to long-term investment horizon.
To ensure that the fund meets Shari'ah requirements, the investments are carefully selected and scrutinized by DJIMI's Shari'ah supervisory board, which consists of five eminent scholars from around the world. The geographic diversity of the scholars ensures that diverse interpretations of Shari'ah are represented. The board currently consists of Sheikh Abdul Sattar Abu Ghuddah (Syria), Sheikh Nizam Yaquby (Bahrain), Sheikh Dr. Mohamed A. Elgari (Saudi Arabia), Sheikh Yusuf Talal DeLorenzo (United States), and Sheikh Dr. Mohammad Daud Bakar (Malaysia).
To achieve its fundamental investment objective, the Global Imam Fund invests directly in (1) equity securities of the public companies listed on DJIMI, known as the 100 titans; (2) instruments that mirror the performance of DJIMI or a selection of public companies listed on DJIMI; and (3) other investments that have been deemed Shari'ah-compliant by an applicable Shari'ah advisory committee. The components of DJIMI are selected by filtering the index universe through screens for business activities and financial ratios to remove stocks that are not suitable for Islamic investment purposes. The remaining holdings are evaluated according to several financial ratio filters, based on criteria set up by DJIMI's Shari'ah supervisory board to remove companies with unacceptable levels of debts or interest income.
The index is reviewed quarterly, annually, and on an ongoing basis. The majority of holdings are selected from this index, which means that the fund portfolio is compliant on an ongoing basis. The board makes declarations regarding the “purification” of DJIMI and determines which amounts of gains derived in the index are considered noncompliant and thus required to be donated to charity. The portfolio advisor and the fund manager subsequently determine which of these amounts are applicable to the fund. From time to time, the fund manager may also allocate and donate a percentage of the net income on investments from the fund's portfolio to charitable organizations of its choice.
The Global Imam Fund has an independent review committee that monitors and reviews any real or potential conflict of interests. The fund is rated in Canada by Morningstar as a three-star fund and is sold by several top financial institutions, including top investment advisors and other independent financial advisors.
Less public than the mutual fund structure noted above are a number of private investment funds in Canada that invest on a Shari'ah-compliant basis. Recently, there have been efforts to create an Islamic mortgage investment corporation (MIC). Under an MIC, income earned on its investments can be flowed to shareholders without the imposition of Canadian corporate tax. The stated purpose of the MIC by the government of Canada was “to enhance the marketability of mortgages issued on residential properties in Canada and improve the effectiveness of the contribution of the private sector to the financing of housing in Canada.”
In addition, there are portfolio managers based at the Canadian Imperial Bank of Commerce and other leading Canadian financial institutions who offer Shari'ah-compliant investment programs to their clients. Bank of Montreal owns an asset management firm, Pyrford International, that offers clients Shari'ah-based investment strategies from its London location. In Malaysia, Manulife Financial offers a number of a private retirement schemes consisting of the Manulife PRS Growth Fund, the Manulife PRS Moderate Fund, the Manulife PRS Conservative Fund, and corresponding Shari'ah-compliant funds.
Tax and Accounting
Obtaining further clarification on the income and indirect tax treatment of Islamic finance products will be important to the development of Islamic finance in Canada for a number of reasons. To this end, KPMG in Canada has been instrumental in helping the financial community understand the taxation issues that must be addressed for Islamic finance to enjoy the level of certainty that is available to conventional finance.
The following summary draws upon the published work of KPMG done for the Toronto Financial Services Alliance. First, Shari'ah-compliant products generally do not fit within the definitions that currently govern conventional financial products in Canada, despite their similar economic features. Second, tax authorities and taxpayers lack detailed knowledge of the specific features of Islamic finance products. Third, the large number of Islamic finance products may create the need for significant resources to approach tax authorities. The process of obtaining rulings from tax authorities can be quite lengthy, considering the technical, interpretative, and policy issues to be addressed. From a Canadian tax perspective, a taxpayer should follow the legal nature of the transaction provided that tax legislation does not indicate otherwise or the transaction is a sham.
Following is a summary of the Canadian federal and provincial tax issues in the context of some of the most common forms of transactions subject to Islamic commercial law that will be addressed in the discussions between the government of Canada and the government of Ontario.
Mudaraba
The fees, profit, and loss from the mudaraba should be included in the provider's business income for income tax purposes. The customer's share of the profit should be treated as income and fully taxed. Issues may arise when the customer is not a resident of Canada. In this case, it will be necessary to examine the character of the payments from a Canadian legal perspective, and in some cases a nonresident withholding tax may be required.
The mudaraba manager's fee relates specifically to the Islamic finance provider's profit and is often explicitly identified along with other profit components. Issues arise because the fee may be viewed as analogous to a fund manager's fee and therefore subject to commodity tax in Canada—the harmonized sales tax (HST), in Ontario. Therefore, it is important to properly characterize, in any terms and conditions, the fee as a share of or a deduction from the overall profit and not a fee related to fund management.
Murabahah
Generally, for income tax purposes, a taxpayer should include in business income the difference between the cost of a good and the amount for which it has been sold to the customer in the year of sale. When the proceeds have not been fully received in the year of sale, the taxpayer may claim a reserve (except when the property is real property) for unpaid amounts for up to three years. Accordingly, it is possible that a financial institution may report financing income earlier under a murabahah structure compared to a conventional financing structure such as a loan.
However, when it is reasonable to consider a payment as part of an income nature (such as interest) and part of a capital nature, Canadian tax legislation provides that the part of the payment that can reasonably be regarded as being of an income nature should be included in taxable income in the year in which the amount was received or became due. Since the fair market value of the property is less than the amounts to be paid over the term of the murabahah, each payment under the murabahah may be considered to be part of a capital nature and part of an income nature. Accordingly, the profit margin may be recognized in the provider's taxable income over the term of the murabahah as each payment is made. If the provider takes this position, then there should not be a significant difference from an income tax perspective between a murabahah and a conventional loan.
For a customer, the total amount paid for a property should typically be the cost to the customer of the property. However, when only a portion of the amount paid can be considered to reasonably represent interest or another income item to the recipient, the customer may be able to claim a deduction for the income portion of the payment if it was incurred to earn business or property income.
Under a conventional credit arrangement, under which the title to property being sold is transferred on the date of the sale and the borrowed amount is payable in installments, the sale of the product would be subject to the HST in Ontario and the credit charge would be HST-exempt as a financial service. In the case of the murabahah, the institution purchases and resells the goods. Since there is a second transaction on an increased amount (i.e., the price of the goods plus the profit), a higher HST amount may be required. The HST would not arise if the profit amount could be viewed as a financing cost or as interest and thus as a financial service. Ensuring that the profit element (i.e., the amount equivalent to a financing charge) is HST-exempt will be crucial to the product's competitiveness, and achieving this treatment will require collaboration with the tax authorities.
Diminishing Musharaka with Ijara
If a transaction is considered to be a lease of the property combined with a series of dispositions by the financial institution, the institution should include the monthly rent in taxable income when the payments are received or on an accrual basis for income tax purposes. In addition, when the property is depreciable property, it will be categorized into various tax depreciation classes according to the type of property. The financial institution should be able to claim a deduction for tax depreciation based on the tax depreciation rate for the particular class. The amount of tax depreciation that can be claimed may be restricted when the leased property is considered to be “specified leasing property.”
The portion of each installment payment that represents the proceeds of the disposition of a portion of the property should be credited to the relevant class of property to the extent that the proceeds do not exceed the original cost of the assets. Under certain circumstances, a recapture of previously deducted tax depreciation may occur, or a terminal loss for the undepreciated portion of leased property may arise in the year.
For the customer, the total amount paid for goods should typically be the cost to the customer of the goods. Consequently, the portion of each installment that represents consideration for acquiring an additional ownership share should be added to the customer's cost of the property. The portion of each installment that represents rent may be deductible by the customer for tax purposes if it was incurred to earn business or property income.
In the case of newly constructed residential housing, under a conventional mortgage, the purchaser would pay the HST to the builder and likely assign any resulting HST new-housing rebate to the builder when the conditions for that rebate are satisfied. Any interest payable to the lender under the mortgage would be HST-exempt as a financial service.
Under a diminishing musharaka with ijara, the purchase of the newly constructed residential housing property would constitute an HST-taxable supply. Since the institution would be contracting a long-term lease with the customer, the institution would be considered a builder and required to self-supply. Consequently, the financial institution would be required to account for the HST on the fair market value of the property and claim an input tax credit for the HST paid. Since the institution would be leasing the property to the purchaser, the institution would be eligible for a new-housing rebate as a landlord. The rent payments would be HST-exempt.
Also of note is the potential application of the land transfer tax (LTT) to a diminishing musharaka with ijara transaction. In Ontario, without any provincial government relief, the acquisition of the subject property would be subject to the LTT. The subsequent transfer of title to the purchaser would also require the LTT, although the legal title transferred would have only nominal value.
Ijara Sukuk
From an income tax perspective, the taxation of the ijara sukuk product may be similar to the taxation of the sale-leaseback transaction of a special purpose vehicle (SPV) and the obligor. (SPV is also referred to as a “bankruptcy-remote entity” whose operations are limited to the acquisition and financing of specific assets. The SPV is usually a subsidiary company with an asset/liability structure and legal status that makes its obligations secure even if the parent company goes bankrupt.) As such, there are no unique tax issues to resolve. If the transactions are determined by law to be a sale followed by a lease, the obligor should realize a gain or a loss on the sale of the asset to the SPV and may be able to claim a deduction for the lease payments if they were made in order to earn income from a business or property.
If on the other hand, the transactions are considered to be a loan arrangement by law, then a sale of property is considered not to have occurred and the SPV and the obligor are considered to be lender and borrower, respectively. In this case, the payments are treated as a combination of principal and interest for tax purposes. The Canadian tax authorities have indicated that the intent of the parties to make a loan arrangement is evident when the sale price of the property is substantially different from its fair market value.
The SPV will typically be structured as a flow-through vehicle, so that the SPV will not pay any income tax. When a transaction is considered a sale and leaseback by law, the investors will be considered to receive either trust income or rental income, depending on whether the SPV is a trust or a partnership. In both cases, the income from the SPV will be fully taxed.
Potential issues may arise when the investors are nonresidents. Under a conventional bond instrument, interest should not be subject to Canadian withholding tax when paid to arm's length nonresidents (i.e., a party acting independently), provided that the interest is not “participating debt interest.” However, depending on the legal character of the transactions and of the SPV, an investor holding a beneficial interest in the underlying asset may be considered to be receiving rent on that asset. Payments of rent to nonresidents are subject to Canadian withholding tax at a rate of 25 percent on the gross amount unless a tax treaty reduces the rate.
The HST issues for a conventional bond arrangement are fairly straightforward. Interest paid by the issuer to the investor is exempt from the HST. Services provided by the arrangers or facilitators of the transaction would also have to be analyzed to determine whether any related fees would be taxable (e.g., as advisory fees) or exempt (e.g., as fees for arranging services) for HST purposes.
In the equivalent Shari'ah-compliant transaction, the HST could have a significant effect. Goods and services tax (GST) implications would arise on the sale-leaseback between the obligor and the SPV depending on the nature of the assets. If one assumes the property is commercial real estate the SPV would sell a beneficial ownership in the underlying asset, which would not be an exempt financial service. As the property is commercial real estate, the GST would apply to the sale of the beneficial interest to the investors. Any rents paid to the investors would be subject to the HST. Any subsequent trading would also have HST implications. Finally, any fees paid to the arrangers or facilitators of the transactions would be subject to the HST because no exempting provision applies. The HST could have a significant effect at each stage of the transaction.
When the SPV or the investors are nonresidents, particular care should be taken to determine which party accounts for the HST on the real property transactions (i.e., the initial sale and the sale of the interest to the investors).
Retail and Microfinance
Canada has a long history of mortgage lending that is consistent with the requirements of Islamic commercial law. Islamic residential mortgage lending in Canada began in the early 1980s and continues today. Prospects for further growth in Islamic mortgages in Canada seem encouraging, since the Muslim population is projected to grow from approximately 2 percent of the Canadian population today, or 1 million Muslims, to 6 percent of the Canadian population in 2031, or 6 million Muslims.
The earliest organized form of Islamic residential mortgage lending in Canada appears to have been initiated by housing cooperatives regulated by Canadian provincial governments—first in the Toronto area by Ansar Cooperative Housing Corporation and later by other cooperatives elsewhere in Canada. Under the cooperative model, a member of the cooperative who is seeking an Islamic mortgage will provide a down payment, with the balance being funded by the cooperative. Throughout the term of the mortgage, the members purchase shares in the cooperative equal to the cost of the property.
In the case of Ansar, to qualify for an Islamic mortgage, members must have shares that equal 20 percent of the first CDN$100,000 of the purchase price of the property, 25 percent of the difference between the first CDN$100,000 and the cost of the property up to CDN$200,000, 30 percent of the difference between CDN$200,000 and the actual cost of the property up to CDN$300,000, and 100 percent of the difference over CDN$300,000. The cooperative's maximum contribution is CDN$225,000.
In Canada, cooperatives have developed a diminishing musharaka structure in which title to the property is acquired by the cooperative and the purchaser pays a monthly occupancy charge (i.e., rent) and purchases additional shares in the cooperative. In the case of Ansar, as further shares in the cooperative are acquired by the purchaser, the monthly occupancy share is proportionately reduced. Once the purchaser has acquired shares that equal the purchase price of the property (plus a preferred share), the title is transferred from the cooperative to the purchaser. To the extent that there has been a change in the value of the property since the time of the acquisition, the profit or loss is shared by the cooperative and the purchaser.
In addition to housing cooperatives, private companies have provided Islamic mortgages, from either company funds or third-party financing. In one well-publicized instance, for a number of years (now concluded) the financing was provided by a provincial central credit union (a body that provides various services to individual credit unions in the province) to the lender (UM Financial) under a mudaraba structure and re-lent to purchasers on a musharaka basis.
The purchaser and the lender would make a musharaka arrangement in which the purchaser would contribute a down payment and the lender would contribute the balance of the purchase price of the property. The purchaser would agree to repay the lender the amount borrowed plus a profit amount. Until the amount was advanced and the profit amount was repaid, the lender held security over the property in the form of a non–interest bearing mortgage covering the principal and the profit amount, with a right to assign the mortgage to any third party. The relationship between the central credit union and the lender included an arrangement in which the credit union provided the lender with a line of credit in exchange for a charge for the amount advanced, and it also took as security the assignment to the mortgages from the lender.
In Canada, credit unions are full-service financial institutions owned by their members and have a long history of community-based service, so they are a natural partner for those interested in promoting Islamic finance. Recently, Assiniboine Credit Union (ACU), based in Winnipeg, Manitoba, in western Canada, has started providing Islamic mortgages.
A few years ago, leaders from the local Muslim community approached ACU and asked if it would consider developing products for the community, because there was a lack of acceptable financial services. After extensive research and consultation, ACU agreed to develop a mortgage product that would make it possible for members of the Muslim community to become homeowners. ACU worked closely with the community and an Islamic advisory board to create a financing arrangement that would be acceptable to Muslims. In May 2010, it launched an Islamic mortgage product based on musharaka.
The mortgage is available for purchasing an existing property, including a condominium, as a primary residence. The property must be within the province of Manitoba. Buildings under construction, revenue property, and property on leased land are not eligible. The borrower's initial contribution must be a minimum of 20 percent of the purchase price or the appraised value of the home, and ACU contributes the balance. These amounts establish the percentage ownership that the borrower and ACU have in the property at the beginning of the contract. The property is registered in the name of the borrower, who is responsible for all obligations regarding the property. ACU retains a percentage ownership, secured by the mortgage, until the borrower has purchased all of ACU's original contribution.
The borrower agrees to purchase ACU's ownership share in the property over a specified period, up to 25 years. When the borrower makes the last payment at the end of the promise to buy, the borrower will own 100 percent of the home. While carrying out the promise to buy, the borrower has an exclusive right to occupy the home. In exchange for the right of possession and ACU's initial contribution, the borrower agrees to pay ACU a profit. The profit is comparable to the best rate that ACU would charge for a conventional, closed, fixed-rate mortgage.
No additional premium is charged. The borrower carries out the promise to buy through a series of renewable payment arrangements, each for a specified term ranging from one to five years. In each term, the borrower makes regular payments to purchase a portion of ACU's original contribution and pays the profit fixed for that period. Payments can be made to ACU weekly, biweekly, semimonthly, or monthly.
ACU is the first mainstream financial institution in Canada to offer an Islamic mortgage directly to members, allowing them to have a direct relationship with the financial institution.
In addition to the previously mentioned organizations working in the Canadian financial landscape, another important development has been the establishment and activities of the Islamic Finance Advisory Board. This is an independent nonprofit organization that provides professional and authoritative Shari'ah-compliant advisory, awareness, and audit functions to the financial services industry in Canada, including financial institutions in Ontario, Manitoba, and Alberta. The board is also very active in providing seminars and conducting courses in Islamic finance at various educational institutions, including the University of Toronto and York University.
These recent announcements and developments reflect the growing interest in the Canadian market for financial products and services that are compliant with Islamic commercial law, as well as in expanding the relationship between Canada and the Islamic world.
Takaful
In 2008 the Cooperators Group launched home and auto takaful products in association with Ansar Co-operative Housing Corporation and Qurtuba Housing Co-op. The Cooperators Group is the first Canadian insurance provider to create products to serve the growing Canadian Muslim population.
Outside Canada, two of the country's largest insurance groups are engaged in takaful-related ventures or efforts. SunLife Malaysia has the exclusive right to distribute takaful and life insurance products through CIMB Bank's network of 312 branches and 8 million customers across Malaysia. In addition, Manulife Financial is seeking a takaful license in Malaysia to penetrate the Bumiputera market (a newly emerging customer segment).
Sukuk and the Debt Capital Market
To date there has been no sovereign sukuk in Canada. The government of Canada and the government of the provinces have well-established conventional debt management programs. There is no evidence that either level of government is interested in exploring sukuk activity at this time.
To date, based on public information, sovereign wealth funds have not invested in an Islamic-compliant manner in Canada.
Prospects in Canada for a domestic sukuk market do not appear to be imminent. The pool of domestic institutional and corporate investors is unlikely to develop an appetite for financings organized as sukuk in the foreseeable future. However, it is more likely that certain senior Canadian issuers with interests in countries where a sukuk market currently exists may see the merits of exploring international sukuk markets. Several Canadian senior corporate issuers have been approached, and efforts continue to attract one or more Canadian private issuers to the global sukuk market.
Regulatory Issues
As one would expect, given Canada's growing interest in Islamic finance, Canadian financial service regulators have studied the implications of authorizing financial institutions compliant with Islamic commercial law to carry on business in Canada.
A joint task force that included representatives of the Financial Institutions Steering Committee (FISC)—the Bank of Canada, the Office of the Superintendent of Financial Institutions (OSFI), the Canada Deposit Insurance Corporation (CDIC), and the Department of Finance—have considered the extent to which current federal banking and other financial service rules would have to be adapted to accommodate Islamic banks, other institutions that seek to comply with Islamic commercial law, and non-Islamic institutions that seek to offer Islamic windows.
In addition, the Canada Mortgage and Housing Corporation released a study several years ago on the implications of the growth and development of a market for Shari'ah-compliant mortgages. The report confirmed that Islamic mortgages are permitted under Canadian law.
Most recently, in a process referred to as the Open for Business review, the government of Ontario made a commitment to level the playing field for alternative finance (i.e., Islamic finance). The government agreed to review tax and nontax requirements and make changes to eliminate any bias in favor of conventional finance. This is an important development and sets the stage for an Islamic financial sector in Canada.
Key Regulatory Challenges
Although the FISC report identified earlier has not been released to the public, one can expect that the regulators are considering the application of the current rules for federally chartered conventional banks to banks that are either entirely or partly in business lines that are Shari'ah-compliant. This would include the application of the Bank Act and the CDIC Act to banking institutions that are Shari'ah-compliant; it would also include commodity and income tax issues related to the activities of those entities.
Reforms in 2001 put in place a framework to encourage competition in the Canadian domestic financial market, and since that time, several new financial institutions have been authorized to conduct business. There is no reason to believe that banking institutions that are Shari'ah-compliant could not also obtain the necessary authority to conduct business in Canada, subject to satisfying the requirements of Canadian law.
The Bank Act
In determining whether to grant an applicant a charter to become a chartered bank, the Ministry of Finance is required to take into account all matters that it considers relevant to the application, including the following:
- The nature and sufficiency of the financial resources of the applicant as a source of continuing financial support for the bank.
- The soundness and feasibility of the plans of the applicant for the future conduct and development of the business of the bank.
- The business record and experience of the applicant.
- The character and integrity of the applicant—or, if the applicant is a corporate body, its reputation for being operated in a manner that is consistent with the standards of good character and integrity.
- Whether the bank will be operated responsibly by people with the competence and experience suitable for involvement in the operation of a financial institution.
- The effect of integration of the businesses and operations of the applicant with those of the bank on the conduct of those businesses and operations.
- The opinion of the superintendent on the extent to which the proposed corporate structure of the applicant and its affiliates may affect the supervision and regulation of the bank regarding (a) the nature and extent of the proposed financial services activities to be carried out by the bank and its affiliates, and (b) the nature and degree of supervision and regulation applying to the proposed financial services activities to be carried out by the affiliates of the bank.
- The best interests of the financial system in Canada.
These criteria are relevant whether or not the business being proposed is a conventional banking business or one that is compliant, in whole or in part, with the requirements of Islamic law.
All applicants must satisfy three fundamental elements of the application process: a strong business plan, experienced management, and adequate capitalization. All applicants are subjected to a very high level of scrutiny.
Canadian regulators will focus on the extent to which the business plans of an applicant can comply with the existing Canadian regulatory requirements. The regulators may take issue with the extent to which a Shari'ah supervisory board might purport to exercise some of the responsibilities that are traditionally vested in a board of directors.
The regulators may also be concerned with the role of an Islamic bank in acquiring and holding real estate as part of murabahah-based residential lending activities.
For applicants who have capital sourced largely or exclusively from abroad, the regulators may be concerned with issues related to ownership or control. The regulators may also be concerned with whether some of the activities of an Islamic bank can be construed as dealing in goods, wares, and merchandise.
The Bank Act includes limitations on the ability of a bank to be a general partner in a limited partnership or a partner in a general partnership. The superintendent's authority is required, and it may be an issue for a bank acting in accordance with the requirements of Islamic commercial law.
The rules concerning the disclosure of borrowing costs may have to be adjusted to reflect the non–interest bearing nature of lending provided by a Canadian bank acting in accordance with the requirements of Islamic commercial law. There is a regulation-making authority to exempt loans that are in a class prescribed in the regulations, and this could perhaps be relied upon to address the needs of a Canadian bank chartered to undertake the activities consistent with Islamic commercial law.
Finally, portfolio limits imposed on Canadian banks may be an issue. Specifically, a Canadian bank cannot hold real estate or equities beyond limits that are prescribed by the regulations.
The CDIC Act
Generally, the CDIC is required to insure deposits held by a financial institution, including a bank. An order approving the commencement and conducting of business must be issued by the superintendent. The order may prohibit the institution from accepting deposits in Canada or authorize the institution to accept deposits in Canada on a limited basis.
An issue of concern may be the extent to which banking institutions that are Shari'ah-compliant will be CDIC-compliant.
Other Regulatory Issues
There are other issues on which Canadian regulatory authorities, both federal and provincial, will want some input from the applicant or other interested parties. Some of these issues have been identified in the United Kingdom, and the summary following relies on the UK analysis of them. These include the following:
- Contract and documentation risk. In contracts for Islamic transactions, the enforceability of terms and conditions depends on the governing law. In the case of a dispute, it is unlikely that a Canadian court will give a verdict based on Shari'ah. The most proximate precedent here is the case of Shamil Bank of Bahrain EC v. Beximco Pharmaceuticals Ltd et al. in 2004, in which the UK Court of Appeals ruled that it was not possible for the case to be considered based on the principles of Shari'ah. There were two main reasons. First, there is no provision for the choice or application of a nonnational system of law, such as Shari'ah. Second, the application of Shari'ah principles was a matter of debate even in Muslim countries. To mitigate this risk, contracts have to be written very carefully to minimize potential disputes and state the governing law.
- The risk management framework. Shari'ah scholars of a wholly Islamic firm require all transactions within the firm to be in compliance with Shari'ah, including risk management. Many of the commonly used tools (e.g., certain types of derivatives that are used for hedging against currency, interest rates, and other risks) are not acceptable to almost all Shari'ah scholars.
- Liquidity management. This has also been a challenge because of the lack or limited availability of Shari'ah-compliant instruments.
- Capital requirements. The UK experience in capital adequacy may be instructive in Canada. Under the accord known as Basel 1, murabahah-based home finance products were considered to have the same risk, 50 percent, as conventional mortgages. Ijara-based products, however, were risk weighted at 100 percent, making them slightly more expensive for providers than conventional mortgages. Under the European Union Capital Requirements Directive, the risk weights of all three products are the same in the UK, 35 percent, under the standardized approach. The Basel 2 capital risk framework has now been implemented in Canada. Basel 2 is a revision of the existing Basel accord that aims to make the framework more risk-sensitive and representative of modern banks' risk management practices. If, in practice, certain risks affect Islamic institutions more or less than conventional firms, then OSFI would expect these to be identified and quantified under Basel 2.
- The role of Shari'ah scholars. Although some Islamic principles are based on clear and explicit rulings, others are derived from Shari'ah scholars' interpretations and understanding of the law, known as fiqh, as set out in the Qur'an. These interpretations can and do differ among Shari'ah scholars. Certain contractual terms deemed to be acceptable under Shari'ah by the scholars of one school of fiqh may not be acceptable to scholars from another school.
On a global level, the approval of Islamic firms' products and services may also depend on the jurisdiction in which they are to be offered. This can add another layer of complication for regulators.
Shari'ah compliance is required throughout a product's life cycle. For Islamic finance providers, gaining approval on the Shari'ah compliance of a product before its launch is vital. Equally important for firms is recognizing that Shari'ah compliance is a continuous process, which means their products and services are adequately monitored. Unlike conventional finance, this has implications for an Islamic firm's prudential requirements as well as conduct of business. Products that breach Shari'ah compliance rules can adversely affect a firm's solvency by converting an asset into a liability on the balance sheet.
There are unique issues facing the sovereign issuers of sukuk in Canada, including analysis and the proposal of relevant changes to legislation governing borrowing and guarantees by governments and the sale and lease of public land. In Ontario, this would include consideration of the Financial Administration Act and the Public Lands Act and the applications of consumer and real estate law to private transactions that are Shari'ah-compliant.
Conclusion
Significant news from Canada may be expected in the near future regarding Islamic finance. In early December 2013, a high-level Canadian delegation attended, for the first time, the World Islamic Banking Conference (WIBC) in Bahrain. The delegation presented a panel promoting Canada as a destination for bankers interested in Islamic finance. Following the WIBC, the delegation went to Dubai to sign a memorandum of understanding (MOU) with the Dubai International Financial Centre. The MOU covers a number of areas of potential joint action, including Islamic finance.
In addition, plans are under way to bring the best practices in Islamic finance from across the globe to Canada, either through the work of a global Islamic finance advisory panel or one or more conferences at which international leaders in the field of Islamic finance are invited to speak. These initiatives should be very helpful to the Canadian governments that wish to level the playing field so conventional and Islamic transactions are treated in an equivalent manner under Canadian laws.
Finally, in the coming years, Canada will be looking to build strategic linkages with all regions of the world where Islamic finance has become a vital and growing reality. The long-standing ties between Canada and the United Arab Emirates may be helpful in forging a more profound relationship between Toronto, as it seeks to emerge as the North American center for Islamic finance, and Dubai, as it seeks to position itself as the global center for the Islamic economy. At the same time, Canada has growing trade and investment relationships with Malaysia and Indonesia, and one can expect these strong and growing relationships to tap into the incredible expertise that has been developed in the field of Islamic finance in this part of the world.
About the Author
Jeffrey Graham is a business law partner at the Canadian law firm Borden Ladner Gervais LLP (BLG). He is based in the firm's Toronto office but spends a great amount of time in the United Arab Emirates in his role as the co-chairman of his firm's Middle East practice and chairman of its Islamic finance practice. Before joining BLG, he was the senior lawyer in the government of the province of Ontario responsible for the regulation of financial services, and earlier in his career he practiced corporate law in Washington, D.C., at the international firm Hogan Lovells.
Jeff was the founding president of Life Sciences of Ontario, a president of the Association of Canadian Pension Management, and a founding director of the Toronto Financial Services Alliance (TFSA), a public-private partnership between all levels of government in Canada and Canada's major banking, insurance, and investment funds. In addition, he is the co-chairman of the TFSA working group on Islamic finance.
Jeff is a member of the bars of Ontario and the District of Columbia. He holds graduate degrees in law from Cambridge University and Columbia University. In addition, he is a graduate of McGill University.