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T O W A R D S A N I N F O R M E D M A R K E T DHURRY CASH AWQAF

Islamic Finance Bulletin April - June 2009 Issue #24 1 IBFIM

Dhurry Cash Awqaf – Opportunities for the General Ummah Jamil Ramly Islamic Banking and Finance Institute Malaysia Sdn Bhd Concept and Philosophy of Cash Waqf

he literal meaning of waqf (plural awqaf) is “detention”, “to prevent” or “to restraint”. From

the fiqh definition, waqf has 4 essential elements:

1. Waqif – the owner of the property to be waqf

2. Mauquf – the property to be waqf 3. Mauquf alaih – the recipient of the

income/revenue from mauquf 4. Sighah – the contract

The administrator is known as the Nazir al-waqf or Mutawalli. The subject matter to be waqf can generally be categorised as manqul (movable) or aqar (immovable).

Thus, waqf is a commendable and pious act to dedicate property1 of any kind, permanently dedicated by a Muslim for any activities or the management of investment portfolios recognised by Islam, for an enduring charitable or religious object that secures any benefit to human beings and its ain (material 1 Property includes any movable or immovable property and any interest in any movable or immovable property, any right, interest, title, claim, chose in action, whether present or future or which otherwise of value in accordance with Hukm Shara’ (Sec 2 – Wakah (State of Selangor) Enactment 1999 (No.7 of 1999)

elements) remains intact. In short, waqf is a permanent, irrevocable transfer of a portion of one’s property (movable or immovable assets) to Allah for His pleasure. The said property thus becomes Allah’s property forever. There are 2 types of waqf, namely Waqf Am2 and Waqf Khas3. Waqf Khas is further sub-divided into Waqf Ahli/dhurri4 and Waqf Specific5. Legitimacy of Waqf As quoted in the Quran: “The parable of those who spend their wealth in the way of Allah is that of a grain of corn; it grows seven ears, and each ear has a hundred grains. Allah gives manifold increase to whom He pleases; and Allah is ample, all-Knowing”6. 2 Waqf Am - any waqf that is created for a general charitable purpose, i.e. for general public according to Hukm Shara’. 3 Waqf Khas - a waqf that is created for a specified charitable purpose according to Hukm Shara’. 4 Waqf Ahli/dzurri - a waqf where the beneficiaries are family members. 5 Waqf Specific - a special waqf (Waqf Khas) where the beneficiary is named specifically, e.g. for an orphanage, a hospital, or a tahfiz school. 6 Al-Baqarah: 261

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The hadith of the Prophet (s.a.w.) quotes that: “When the son of Adam dies, his deeds comes to an end, except with enduring benefits (sadaqah jariyah), his knowledge which benefits others and his virtuous son; they pray for him”.7 It was stated at the time of the Prophet (s.a.w.), when Umar, the second Caliph, at the partition of Khaybar, acquired a piece of land named Thamgh, which he treasured. He came to the Prophet (s.a.w), seeking his advice on it. He said: “O Prophet! I have obtained a piece of land in Khaybar, which is the best of all properties I have ever owned. What is your opinion on putting it to use in the name of Allah?” The Prophet (s.a.w.) said: “If you wish, retain the real and devote its usufruct to pious purposes.”8 Umar accordingly dedicated the property, on condition that the land should neither be sold nor made the subject of a gift or inheritance. The income alone should be spent on the poor and relatives and on freeing the slaves and on the services rendered to travellers and on hospitality. The administrator shall have the power to take some of its income; the rest of it would be used for feeding others, not accumulating riches. The Unique Nature of Waqf Waqf is a commendable and pious act Waqf is a form of an enduring charity Waqf assets cannot be sold, given as a

gift or inherited There is a clear distinction between: one who holds it in trust

(administrator); and 7 Hadith reported in Sahih Muslim. 8 A hadith reported by Sahih al-Bukhari as narrated by Ibn Umar.

one who derives benefits from it (beneficiary).

Review of Waqf Institution The trustee is usually an institution. One of the most important waqf institutions is the mosque. The first waqf mosque was the Qubah mosque, built by the Prophet (s.a.w.) after migrating from Mecca to Medina. Later, in Medina, the Prophet (s.a.w.) had built a second mosque known as Masjid Nabawi. In the early days of Islam, mosques had acted as premier educational institutions. These included the Fustat Mosque, Qairawan Mosque and Azhar Mosque. In this classical waqf, the contributor is the donor that creates the trust, appoints the trustee(s) and designates the beneficiary. The donor may appoint any person or institution he trusts to serve as trustee. In the contemporary waqf, the institution is a regulated body or council appointed by the federal or state government to run the waqf properties/fund. Waqf may be in the form of grants. Between the fifth and twelfth centuries Hijrah, there had been about 70 waqf schools. Libraries have also been contributed as waqf assets. The first waqf library was the House of Knowledge, established by Abu el-Qasem Ja’afar bin Muhammad al-Faqih al-Shafei’. Waqf in the form of institutions such as hospitals used to give free medical treatment. There had been about 50 waqf hospitals in the Spanish city of Cordova. Waqf properties can also take the form of public infrastructure such as bridges, roads and public toilet. Waqf income has been allotted to the poor, the needy and wayfarers.



Moving forward - Cash for Waqf Imam Zufar, a Hanafi scholar, is of the opinion that cash9 can be waqf based on urf (customary practice). Sheikh Muhammad Syarbini Khatib is of the opinion that cash can be waqf if it serves as money10. According to the ruling, the manager can mobilise funds in the form of cash, to be used to acquire “property with mal”. Cash in this context is only the medium used to acquire the “asset with value”11. Cash waqf was first introduced in the Ottoman era in Egypt. Waqf fund had been given as seed capital to the third party to carry out their investment under murabahah trading or mudharabah investment. Upon maturity, the capital and the profit - after administrative charges – would be returned to the waqf administrator. These pools of profits derived from such activities had been distributed to the general public through cash payments for services rendered, or subsidised the payment for maintenance of the public properties. Socialisation of Cash Waqf Professor Mannan socialised cash waqf in Bangladesh, through Social Investment Bank Limited (“SIBL”). SIBL issues Cash Waqf Certificates to collect funds

9 Please refer to Hasyiah Rad al-Mukhtar (pgs 361-363) by Ibn ‘Abidin. 10 As a medium of exchange; measure for value; standard deferred payment and store of wealth and a liquid asset. 11 Ref: Shamsuddin Ibn Khudamah; Al-Mughni wa ya lihi al-Sharhul al-Kabir Vol 6 (pg 192). Syed Ahmad bin Omar al-Shatiri; Al-Yaqut al-Nafis fi Mazhab Ibnu Idris (pg 117).

from the public and corporates. The pooled cash is invested in SIBL’s investment portfolios, the proceeds derived from such investments are then distributed to the general public. SIBL imposes administrative charges from the proceeds, prior to distribution. Malaysia, through the Labuan IOFC, has launched the Cash Waqf Certificate to fund off-shore financing activities. National Awqaf Foundation of South Africa (Awqaf SA) also collects from the public who wish to endow cash for waqf; it uses the income generated from investments to fund a variety of community development projects and programmes which promote integrated community development and self-reliance. The waqf institution will manage the administration and investment portfolios, pool the cash waqf proceeds and distribute to the beneficiaries prescribed in the waqf deeds; the beneficiaries are the family members of the contributor/donor. This modus operandi is known as Cash Waqf Ahli or Dhurry Cash Waqf or Family Cash Waqf. Shariah approves the cash waqf ahli/dhurry, where the usufruct of the proceeds can be for 2 generations. Upon the expiry of the second generation, the said created cash waqf will be transformed into the waqf am or general waqf. The beauty of this is that ordinary people can create the waqf through annuity payments into the pool waqf account, and the family member can benefit from the investment proceeds of this account. Normally, existing Cash Waqf Ahli or Dhurry Cash Waqf creates opportunities for the wealthy and deprives the less fortunate from performing waqf. A new model opens up opportunities to the general ummah, and the less wealthy segment of society can do their part. This



proposal is for a number of persons donating their small resources in the form of cash into a pooled fund, making the pool big enough to be able to acquire a worthwhile asset to become a perpetual source of income that caters to the needs of the less fortunate members of Muslim society. Therefore, the cash must first come from the donors. Receipts, certificates and/or Cash Waqf statements have to be issued to the donors to make them feel comfortable that their donations are not wrongly used, and also to keep records of the donations. The original rule of waqf is that the waqif manages his own waqf or the authority in society manages the waqf; as there are many donors and their individual donations are small, a manager needs to be appointed to collect the donations, pool them into a fund, acquire assets from the fund, and manage them so as to get returns for distribution. The manager also asks permission from the donors to manage the asset. Dhurry Cash Awqaf Model Objective: To facilitate the establishment of a fund known as the Cash Waqf Fund (“CWF”), and to allow the institution or recognised body (as the mutawalli) to manage12 the CWF professionally. Operationalisation of the Dhurry Cash Awqaf Other Required Approval Upon approval by State Waqf authority. Perceived Value Waqf of Cash

12 It refers to the management of investment portfolios and the distribution of revenue/profit according to waqf deeds.

Contribution of cash for waqf. Essential elements of Cash Waqf: 1. Waqif - contributor/donor 2. Mauquf - subject matter -

money/Nuqud 3. Mauquf a’laih - beneficiaries are the

family member(s) of the contributor 4. Sighah (binding contract) Contributor/Donor/Waqif To give opportunity to those who do

not own property but still wish to contribute waqf in an alternative form.

Waqif has a platform to contribute the waqf to the professional trustee/foundation.

Individuals may be allowed to make monthly salary deductions or through standing instructions.

Incentive may be in the form of tax rebate/exemption for the individual donor.

Administrator To facilitate a mutually beneficial

arrangement between the donor (waqif), a foundation (Nazir al-waqf or mutawalli), and the beneficiaries.

The Nazir al-waqf or mutawalli that can benefit from the fee-based transaction (management fee for managing the waqf fund).

Management fee can be priced according to market practice, as it is up to the wisdom of management.

Beneficiaries Beneficiaries who are the family

members of the waqif can benefit from the said established institution, by receiving the allocated sum either in the form of a grant, cash or other acceptable means, as per the waqf deeds.



Cash Waqf Support Islamic Financial Market Cash Waqf pooled funds can create a

perpetual Islamic source of fund to support domestic financial markets and international Islamic financial markets, through the utilisation of Islamic financial tools.

Stages in Dhurry Cash Waqf Creation of Cash Waqf Fund Receive cash for waqf from contributors/donors (waqif). A foundation (Nazir al-waqf or Mutawalli) will issue a certificate (cash waqf certificates) and/or Cash Waqf statements that are updated semi-annually. The donor (waqif) will receive the said certificates and/or Cash Waqf statements as evidence of contribution. The collection of such contributions will be pooled. The pooled fund will be called the Cash Waqf Fund (or CWF). There may be 3 CWF pools: the Dhurry Cash Waqf, the Specific Cash Waqf and the Cash Waqf Am, classified according to its deed. Dhurry Cash Awqaf Refers to cash for waqf, with the condition that the proceeds from the revenue generated is meant for specific beneficiaries with a particular tenure, e.g. to be given to the identified beneficiaries for 2 generations. Upon the expiry of the said tenure, the cash will be distributed and pooled into the Cash Waqf Am. Cash Waqf Am Refers to cash for waqf without conditions. It is meant for general purposes, but within the boundaries of Shariah.

Cash Waqf Specific Refers to an individual or a corporation that wishes to give cash or assets to specific beneficiaries, e.g. money contributed by the party, where the proceeds from the revenue will be distributed to specific beneficiaries, such as for research and development, a foundation or an institute. Investment Avenues Cash Waqf funds may be invested in diversified portfolios of Shariah-compliant investment avenues. Investment portfolios are diversified to spread the risks. The proceeds from the investment portfolios are for distribution to the specific beneficiaries. In case of losses due to normal and prudent practices, the investment portfolio’s account may absorb the loss. Appointment of Professional Management Company Shariah has laid down the responsibilities of the mutawalli. The salient terms of the mutawalli include, but are not limited to, the following: The mutawalli should be capable of

managing the waqf fund, to be a productive source of capital.

Administrating and monitoring the collection of the CWF, such as opening the Cash Waqf Account for the individual waqif and identifying the beneficiaries as per the Dhurry Cash Awqaf deeds.

Administrating, managing and monitoring the pool of cash waqf funds through the investment portfolio’s management policy and schemes that are Shariah-compliant.

Administrating, managing and monitoring the investment returns in terms of profits or dividends derived from such investments.

Administrating, managing and monitoring the distribution of the said



returns to the beneficiaries accordingly.

The mutawalli may appoint or outsource to third parties to manage part of the funds as part of the investment strategies.

The mutawalli, as the manager, is entitled to the management fee for the services rendered in managing the fund.

Pool of Profit/Revenue Generated from the Investment Proceeds from the investment avenues in the form of rental, profits, commissions, fee-based transactions and dividends shall be pooled prior to distribution to the beneficiaries. Distribution of revenue Revenue will be distributed according to the waqf deeds. Distributed to the general

beneficiaries/reinvested into the pool CWF.

Distributed to specific beneficiaries (as per the Dhurry Cash Awqaf and Specific Cash Waqf deed).

The Dhurry Cash Waqf is for specific named beneficiaries. The beneficiaries only receive the proceeds up to a particular tenure. Upon expiry of the tenure, the entire proceeds will go to the general cash waqf pool. The mutawalli only gets a management fee for the services rendered in managing the fund. The management company is not entitled to distributions on the generated revenue.

Conclusion We are proposing a new waqf model that is capable of enhancing waqf activities in contemporary Muslim society. This is the organised voluntary waqf, by creating a waqf pool fund via issuing waqf certificates and/or cash waqf statements, which are evidence of waqf contributions by potential waqifs. The pooled fund is invested according to Shariah principles, to generate income/revenue. The income/revenue from the said diversified portfolios is then pooled for distribution, according to the identified beneficiaries as per the waqf deeds. In this respect, the role of such a waqf administration would be to develop and manage the established Cash Waqf for income/revenue generation. Cash Waqf is a facility provided by the mutawalli, as a platform for the potential individuals as waqifs, to contribute waqf favouring the identified beneficiaries according to the waqf deeds.



Jamil Ramly has been in the banking and finance industry for more than 25 years, including 2 decades in Islamic finance. His strength lies in his vast knowledge of Islamic finance, as well as its development and enhancement. Jamil is also a competent trainer in Islamic finance. Particularly keen on the development of new Islamic banking and financial products, he has been involved in various research and development programmes in this sphere. Jamil is currently a Senior Manager in IBFIM’s Certification Programme. Before this, he had been the organisation’s Head of Structured Programme, developing the Certified Islamic Financial Planner (or IFP) programme, which confers a licence to practice financial planning; and IBFIM’s progressive programmes on professional accreditation in Islamic Banking Practice Qualification (or IBPQ) and Takaful Practice Qualification (or TPQ). Prior to that, he had been attached to the CEO’s Office under special project development and the delivery of cash waqf for LOFSA IOFC. He had also been part of the secretariat for the IIFM Sub-Committee as well as the SC Legal and Shariah Sub-Committees. Jamil graduated with an MBA in Islamic Banking and Finance from the International Islamic University Malaysia, where he is currently pursuing a PhD in Islamic Banking.

ISLAMIC BANKING AND FINANCE INSTITUTE MALAYSIA SDN BHD Islamic Banking and Finance Institute Malaysia Sdn Bhd (IBFIM) is an institute dedicated to producing well-trained, high-calibre individuals and management teams with the required expertise in the Islamic finance industry. Based on the industry’s demands and customers’ needs, we provide complete assistance to our clients through a wide spectrum of inter-related services: training and education, advisory and consultancy, and research and development in Islamic finance. Our close relationship with the industry gives us the opportunity to share knowledge and resources. We also enjoy a strong network with local and international authorities and financial institutions. Having assisted numerous governments, financial institutions, and other organisations in this arena, we are driven to serve the need for further enhancement and development of the industry in years to come.

For more information, please contact:

Islamic Banking and Finance Institute Malaysia Sdn Bhd (340040-M) Level 3, Dataran Kewangan Darul Takaful Jalan Sultan Sulaiman 50000 Kuala Lumpur, Malaysia Tel: +603-2031 1010 Fax: +603-2031 9191 E-mail: [email protected] Website: www.ibfim.com.my

T O W A R D S A N I N F O R M E D M A R K E T ISLAMIC FINANCING - TAX CONSIDERATION

Islamic Finance Bulletin April - June 2009 Issue #24 8 PricewaterhouseCoopers Taxation Services

Going For Conventional or Islamic Financing? – A Tax Consideration Azura Othman Islamic Financial Services Practice PricewaterhouseCoopers Taxation Services Introduction

s the economic gloom reaches our shores, companies have started bracing themselves for

turbulent times ahead. Nobody has been spared from the crunch of rising costs, salary cuts and cancelled order books. However, life has to go on and businesses have to face the challenging environment by re-strategising their activities and cost maintenance. During challenging times like this, cost will be an item that comes under the microscope. As revenue starts dwindling, managing costs will be the focus vis-à-vis keeping businesses afloat. When undertaking a financing activity for projects, many considerations need to be taken into account, i.e. mode of financing, tenure, rate of financing, legal and regulatory requirements, and incidental costs, to name but a few. The economics of the project must be sufficiently robust to keep the project profitable in the face of adverse conditions. Under the current economic environment, the rule of thumb is to go for financing facilities with the least cost and minimum access time to liquidity. While companies vigorously embark on various cost-cutting measures, the 25% of profits channeled towards tax payments is often forgotten.

Tax is a hidden cost in any financing structure. There is a need to ensure that in assessing and adopting the financing facilities of a company, its tax efficiency is factored in to avoid any additional leakage. As the economic crisis gets deeper, however, such costs can be the deciding factor. This is more so when undertaking cross-border financing. The tax jurisdiction of the other contracting party needs to be considered as countries typically apply withholding taxes on dividends, interest payments, management fees and royalties paid to foreign entities. There are also tax treaties between countries that may shelter contracting parties from unfavourable tax treatments. Where tax treaties provide favourable withholding tax treatment to the recipients in certain jurisdictions, projects will have the incentive to raise funds in that jurisdiction. Ultimately, the aim is to design a financing structure that complements the efficiency of operating the company. Inefficient structures would only add to the cost of financing.

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Choice of Islamic and Conventional Financing Malaysia is blessed with a sound financial system that has stood its ground, thanks to good regulatory and supervisory oversight. To a certain extent, it has cushioned the effects of the sub-prime credit crisis when, elsewhere in the world, other notable financial institutions have taken a tumble, only to be saved by rescue packages. Malaysia has a dual financial system, whereby the Islamic and conventional financial systems operate in parallel. Since the introduction of Islamic finance in the 1980s, Malaysia has paved its way towards becoming an international Islamic financial centre. Along with it have come incentives and facilitative policies to spearhead the growth of Islamic finance in Malaysia, towards its goal of becoming an international financial hub. A host of tax incentives have been given to the players and investors in Islamic finance in Malaysia, covering the areas of Islamic banking and takaful, capital markets and human capital. Therefore, Malaysia offers market participants a choice of either conventional or Islamic finance. When it comes to modes of financing, originators also have the choice of going for conventional or Islamic financing. Many projects that have traditionally been funded through more established sources of financing now have the option of Islamic financing. The existence of a highly liquid pool of Islamic funds, and with increasingly more demanding investors, more Shariah-compliant financing structures have helped to make Islamic financing a viable mode of financing that is comparable to its conventional counterpart.

Tax Neutrality in Islamic Finance Transactions

The law governing the taxation of commercial transactions in Malaysia, i.e. the Income Tax Act, 1967, (“the Act”), had been enacted long before Islamic finance became popular. As there is no specific tax framework for Islamic finance, Islamic commercial transactions are subject to the same laws and regulations that govern conventional transactions. Islamic financing is essentially a sale transaction. Because of the underlying assets in Islamic finance transactions, there will be tax issues due to additional steps that need to be taken to facilitate a Shariah-compliant transaction. In recognition of this, tax neutrality has been provided in Malaysia. The elements of tax neutrality in Malaysia include the following: Profits in Islamic transactions are

treated the same way as interest in a conventional transaction, which essentially means: - Profits associated with Islamic

finance will be taxable, just like interest income under conventional financing.

- Profits will be deductible if the funding has been used to generate business income or to purchase assets to generate income.

- All other tax rules relating to

“interest”, such as withholding tax on interest and interest exemption, will apply equally to profits.



Disposal of assets to facilitate an Islamic transaction is ignored for tax purposes.

Stamp-duty exemption is given on the purchase of a property by a financier, for the purpose of resale under the principles of Shariah.

A Musharakah transaction is treated as a financing arrangement, and there is no requirement to file a partnership tax return.

With the tax-neutrality provisions, Islamic and conventional transactions are placed on a level playing field. The next question, then, is whether one is better than the other in the context of taxation. The general rule of taxation is that income within the Act’s scope of taxation is taxable on the recipient, and any expense expended wholly and exclusively to derive that income is given tax deduction when arriving at the income chargeable to tax. The tax authorities make a distinction between costs incurred in the production of income and costs incurred for the production of income. The latter is seen as costs incurred to put taxpayers in a position to derive income and, as such, is not treated as deductible for tax purposes; cost of financing is generally seen as such. While interest expenses on financing are given tax deduction if incurred to derive the income of the taxpayers, expenses related to obtaining such financing are not. Examples of such expenses are legal fees and stamp duties on loan documents, consultancy and syndication fees, and rating fees for securities issuance. Such expenses can form a major portion of the cost of financing; if tax deduction is not available, the financing is not cost efficient.

Direct Financing Through Issuance of Sukuk Take, for example, financing through the issuance of sukuk or Islamic securities. To encourage the growth of Islamic finance and to promote Malaysia as an international Islamic financial centre (or MIFC), various tax incentives covering issuers, investors and corporate advisors have been introduced to promote the issuance of Islamic securities out of Malaysia, especially in foreign currencies to attract international players to the country. Issuers The incidental costs incurred in issuing a sukuk can be quite substantial, such as legal and consultancy fees, trustee fees, rating and surveillance fees. Such expenses are not given tax deductions because they are incurred as a means for the issuer to commence its project. However, if the financing is raised in accordance with the principles of Shariah, specific deductions have been given through the following Gazette Orders: Income Tax (Deduction for

Expenditure on Issuance of Islamic Securities) Rules 2007 provide tax deduction of an amount equal to the expenditure incurred on the issuance of Islamic securities, approved by the Securities Commission (established under the Securities Commission Act 1993) pursuant to the principle of Mudharabah, Musharakah, Ijarah and Istisna’; or any other principle in accordance with the Shariah principle approved by the Minister until year of assessment 2010.



Income Tax (Deduction on the Cost of Issuance of the Islamic Securities) Rules 2007 provide tax deduction of an amount equivalent to the cost of issuance of the Islamic securities incurred by the special-purpose company.

Stamp-duty exemption under the

Stamp Act is given on issuance of securities approved by the Securities Commission.

Stamp-duty exemption on

instruments executed pertaining to Islamic securities issued in all types of currencies, as approved by the Securities Commission under the MIFC guidelines until 31 December 2016.

The incentives given would make issuing Islamic securities relatively cheaper than conventional securities. Special-Purpose Vehicle A special-purpose vehicle (“SPV”) established to facilitate an Islamic financing transaction would normally serve as a “flow-through” vehicle. However, the SPV is still regarded as a separate entity which has to comply with all the administrative requirements of Malaysian tax legislation. To facilitate the structuring of Islamic securities, Section 60I of the Act exempts SPVs established solely for the purpose of facilitating Islamic financing transactions from income tax; they are not required to comply with the administrative requirements under the Act, such as filing of tax returns, tax estimates and instalment payments. The income and expenses of the SPV are instead accounted for by the company that establishes it.

This incentive enables SPVs created purely for Islamic financing to be tax neutral, which will ease the administrative requirements of Islamic financing transactions. Investors In addition to the above, investors of Islamic securities are also given the following tax exemptions: Any persons, whether individuals or

companies, residents or non-residents of Malaysia, are given tax exemption on interest paid or credited in respect of Islamic securities, other than convertible loan stocks - approved by the Securities Commission – that are issued in currency other than ringgit.

Non-resident companies are given the

same tax exemption even for Islamic securities or debentures, other than convertible loan stocks - approved by the Securities Commission – that are issued in ringgit.

These incentives would attract local and foreign investors into the Malaysian capital markets and ensure that Islamic securities remain competitive. Corporate Advisors With effect from year of assessment 2009, more tax incentives to make the Malaysian capital markets more vibrant have been introduced through the following Gazette Orders: Income Tax (Exemption) (No. 10)

Order 2008 provides tax exemption on income derived from the regulated activity of dealing in securities and advising on corporate finance relating to the arranging, underwriting and



distributing of non-ringgit sukuk that originates from Malaysia and are issued or guaranteed by the Government of Malaysia or approved by the Securities Commission until year of assessment 20111.

Income Tax (Exemption) (No. 9) Order 2008 provides tax exemption on income derived from the regulated activity of dealing in non-ringgit sukuk that originates from Malaysia and are issued or guaranteed by the Government of Malaysia or approved by the Securities Commission until year of assessment 20112.

Whenever Islamic securities are distributed internationally, the provision of tax neutrality and tax incentives would resolve many tax issues and increase the attractiveness of the securities to investors. The incentives above are intended to develop and strengthen Malaysia’s position in the global sukuk market, as a result of competition from other financial centres. They are seen to encourage advisors to promote the issuance of Islamic securities, especially non-ringgit sukuk, more aggressively. The tax exemption on the income received from dealing of such securities would further enhance the issuance of non-ringgit securities. 1 This is applicable to a holder of a Capital

Markets Services License who is a registered person carrying on regulated activity of advising on corporate finance under Schedule 3 of the Capital Markets and Services Act 2007 which is solely incidental to the carrying on of its business or the practice of his profession.

2 This is applicable to a holder of a Capital

Markets Services License who is a registered person carrying on such dealing through his proprietary account.

Others To complement the growth of Islamic finance, tax incentives are also given to companies that set up Islamic stockbroking companies that will carry out the trading of Islamic securities. Income Tax (Deduction on Expenditure for Establishment of an Islamic Stock Broking Business) Rules 2007 provide tax deduction on expenditure incurred for the establishment of an Islamic stockbroking business, which otherwise would not be eligible for tax deduction. The expenditure that qualifies for tax deduction in this case applies to consultancy and legal fees, cost of feasibility studies, cost of market research, and cost of obtaining licence and business approvals for the purpose of establishing an Islamic stockbroking business. Through the granting of this incentive, the Islamic stockbroking company can be a one-stop centre for investors dealing in Islamic securities, which can increase the access and range of Islamic investments through the availability of screened Islamic securities. Investors trading through an Islamic stockbroking company can rest assured that all stocks traded are Shariah-compliant. The presence of global Islamic finance experts, such as Shariah scholars, in advising on Islamic finance transactions will help develop the Islamic financial instruments that are marketable internationally, and encourage product innovation as well as the convergence of Shariah opinions.

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Currently, stamp-duty exemption under the Stamp Act is given to instruments executed pursuant to a scheme of financing approved by the Central Bank or the Securities Commission as a scheme that is in accordance with the principles of Shariah. In addition, the following tax exemption is given: Stamp Duty (Remission) (No.2)

Order 2007 provides for an additional 20% stamp-duty exemption on the principal or primary instruments used in Islamic financing products approved by the Shariah Advisory Council of the Central Bank or the Securities Commission up to 31 December 2009.

Therefore, Islamic financing transactions will incur 20% less stamp duty compared to conventional financing instruments. The stamp-duty remission is applicable to Islamic financing obtained from Islamic financial institutions, and is not relevant to Islamic securities issued out of Malaysia that do not incur any stamp duty, as highlighted above. Even though there are no major incentives here as given to financing through issuing Islamic securities, Islamic financing through financial institutions still has an edge.

Verdict With the various tax incentives given to a wide spectrum of the Islamic financial system to spearhead the growth of Islamic finance, financing through the Islamic route has a clear advantage in terms of tax cost savings. However, some of the incentives given are for a finite period; unless there are further extensions on the incentives, the line of advantage may be blurred between Islamic and conventional financing. Therefore, the participants in Islamic finance have to really subscribe to the values inscribed in Islamic finance, which are based on the tenets of real underlying economic activity and promoting social equality and justice, in order to sustain its continued viability and edge over its conventional counterpart.



PricewaterhouseCoopers Malaysia As one of the leading and largest professional services organisation, PricewaterhouseCoopers Malaysia has over 100 directors and over 300 managers, out of a staff strength of about 1,800 people. With offices in 9 locations - Kuala Lumpur, Pulau Pinang, Ipoh, Kuantan, Melaka, Johor Bahru, Kota Kinabalu, Kuching and Labuan, we work to deliver value to our clients. We provide industry-focused assurance, tax and advisory services for public and private clients. Integrating their skills and diverse knowledge, our professionals connect their thinking, experience and solutions to build public trust and enhance value for clients and their stakeholders. Our professional resources, experience, tradition of independence and integrity, commitment to the highest ethical standards, together with our worldwide service capabilities, give our clients the confidence to work with PricewaterhouseCoopers.

We have played an integral part in the growth and progress of Malaysia since 1900. Today, PricewaterhouseCoopers continue to work with many large multinationals, public sector entities and Malaysian companies, providing solutions to their complex business issues. PricewaterhouseCoopers refers to the individual members of the PricewaterhouseCoopers organisation in Malaysia each of which is a separate legal entity or, as the context requires, other member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.

T O W A R D S A N I N F O R M E D M A R K E T FINANCIAL DERIVATIVES FROM ISLAMIC PERSPECTIVE

Islamic Finance Bulletin April - June 2009 Issue #24 16 ISRA

Financial Derivatives from Islamic Perspective Edib Smolo International Shari’ah Academy for Islamic Finance Introduction

nvestors and players in the financial market are exposed to various types of risk. Some of them are manageable while others are not. Financial

derivatives, according to Sami al-Suwailem, are financial instruments used for trading risk. In his view, the purpose of derivatives is to distribute risk among the market players; if this distribution is done correctly, then every market player will be better off, leading to productivity and efficiency. The key fact here is that financial risk occurs naturally in a world without derivatives, and derivatives could be used to reduce, or hedge, that risk. Financial derivatives can be used for many purposes. In reality, however, they are mostly used for just one of 3 basic functions: hedging, arbitrage or speculation. Hedgers use derivatives to manage uncertainty, and speculators use derivatives to bet on it. Hedgers use derivatives to reduce financial risk, or the prospect that the price of things might “move against them.” On the other hand, arbitrageurs and speculators use hedging to take advantage of price differences in the market and to make a profit from simple speculation on the market moves, respectively. Is Hedging Desirable in Islam? Derivatives are excellent tools of risk management known as hedging.

Generally speaking, hedging involves recognising and measuring the financial risk of an existing position, then taking on some new position with opposite exposure characteristics such that the gains and losses of the positions cancel each other out. Simply, hedging can be seen as insurance policy against unexpected movements in the market. In banking, finance, and treasury operations, the objective of true hedging is the reduction of risk that has been assumed through trading and investment. Therefore, the purpose of hedging is to protect the value of a current or anticipated cash market or off-balance-sheet position from adverse changes in interest rates. There is no doubt that Islam calls for wealth protection; as such, any exposure of wealth to unnecessary risk is not desirable. With this in mind, it is worth mentioning 2 legal maxims that may be related to hedging: a. “Harm must be eliminated” (Ad-

dararu yuzal) b. “Hardship begets facility” (Al-

mashaqqatu tujlab at-taysir) Therefore, hedging plays an important role in preserving social well-being. By hedging, the wealth of people (be they investors, traders or simple individuals) is protected from financial calamities and losses. There are other benefits of hedging, e.g. they enable businesses to

I



plan better, leading to less price fluctuations that will then reduce costs, thus bringing further benefits to society. Even arbitrage brings benefits to society through the process of price realignment. According to Obiyathullah, arbitrage enhances the discovery process. He goes further by saying that arbitrage helps reduce the distortionary effects of government regulation/intervention. Quite contrary to hedging and arbitrage, speculation hurts more than it helps. Due to the increased volume of trading, however, transaction costs will decrease and there will be more liquidity. Hedging vs Speculation Due to pure management and lack of proper due diligence by banks and financial institutions, the conventional financial system has fallen into the abyss of a new great depression, accelerated by the sub-prime mortgage crisis, collateralised debt obligations (“CDOs”), and credit-default swaps (“CDSs”). The Islamic finance industry is not immune to the current financial crisis. Luckily, Islamic derivatives have not developed very much in recent years; this conservatism has saved this sector from the disastrous effects of the current credit crunch. On one side, Islam seeks the protection of wealth; on the other, it prohibits speculation (maysir) and interest (riba). These 2 (maysir and riba), fuelled by greed and self-interest, had been the main catalysts of the current global crisis. A simple way to distinguish investors from speculators is that the former risk their own capital with the hope of making profits from volatility in market prices. By hedging, they seek to offset some potential losses. On the other hand, speculators typically use the capital of

others – often borrowed or trusted money – and assume the risk that investors seek to avoid. Like investors, speculators do not want to lose their capital; in the search for increasingly more profits, however, they expose themselves to greater risks. In fact, both investors and speculators do everything possible to minimise risk and maximise returns, trying to enter the market at the right time and the right price. Because they are using their own money, investors are more cautious. Derivatives and the Current Global Crisis As mentioned earlier, the current global turmoil had been fuelled by the sub-prime mortgage crisis, collateralised debt obligations (“CDOs”), and CDSs. To understand how derivatives, such as those mentioned above, are related to the global financial crisis, we will look at the most commonly used derivative instrument, known as a credit-default swap or CDS. A CDS is one of the most popularly used credit derivatives; it allows the trading of counterparty risk from one to another without changing the ownership of an underlying instrument. Investopedia defines a CDS as “a swap designed to transfer the credit exposure of fixed-income products between parties.” Ilya I Gikhman defines it as “an over-the-counter (or OTC) bilateral financial instrument used to hedge the default risk of a risky debt instrument or a basket of risky debt instruments.” The debate is still on as to whether CDSs had been responsible for the present credit chaos. However, no one denies that they played a major role, although they may not be the primary reason for the debacle. Initially these financial instruments had been responsible for the sub-prime lending fiasco, which led to the



economic crisis in the United States and eventually turned into a global crisis. How Does a Credit-Default Swap Work? The answer to this question is quite straightforward. For example, Customer A buys corporate bonds from Company X. Customer A believes that Company X will make money and be able to pay him back with interest. Nevertheless, there is still some risk that the company will default and the bonds will be worthless. If Customer A invests a huge amount of the money in this company, he may not be Up to this point, this swap arrangement is no different from fire insurance on someone’s house (i.e. you pay a premium and if your house burns down, then you collect your money from the insurer). However, there is a difference. Unlike fire insurance, Customer A does not have to actually own the asset to insure it. What does this mean? It means that, as in the case of the example above, if Customer A thinks Company X is

willing to take the risk of losing everything; so he may decide to buy insurance, just in case Company X goes bankrupt (refer to Figure 1). He approaches Bank Z and asks if it is willing to sell him insurance against Company X’s bond. If the Bank Z thinks it is worth the risk, it may insure it at, say, a 2% premium. Now, if the Customer A bought RM1 million worth of bonds, then he has to pay RM20,000/year to Bank Z for insurance against the bonds. However, if Company X goes bankrupt, then he can still collect his RM1 million from Bank Z (Figure 1).

going down, he can buy insurance against the latter’s bonds from Bank Z, even if he does not actually own the bonds. This is pure speculation, and Bank Z is no longer insuring against real assets - it is offering pieces of paper (derivatives) that could cost it many times over the bonds’ value (Figure 2).

Figure 1: Pure Hedging

1. Investor/Customer A buys the corporate bonds for RM1 million. 2. Company X pays back principal amount plus interest to the Investor/Customer A. 3. Investor/Customer A buys insurance policy from Bank Z at 2% of the principal amount, i.e.

RM20,000. 4. In case Company X defaults, the Investor/Customer A will receive the full amount from Bank Z.

1

2

3

4Company X

Investor / Customer A

Insurance Company /

Bank Z



Now, the question may be raised: Why is it a problem? Is not Bank Z supposed to have a reserve to pay people if they start making claims? Well, here lies part of the problem. Since the CDS market is completely unregulated and Bank Z is not required to have a certain percentage of reserves before offering insurance, the payments, once they are due, may not be made. Things get more complicated or worse because Bank Z not only sells the insurance but is also out buying insurance from other banks to mitigate its own risks. This is the real problem in the financial market. In other words, if Customer A bought insurance against Company X, he is counting on Bank Z to pay up in the event of a default (i.e. he is transferring his risk from Company X to Bank Z). However, since Bank Z also bought some insurance from Bank Y, then Bank Z is counting on Bank Y to pay up in case of default. Now, this means that if Company X defaults on its payments, Customer A will receive his insured amount only if Bank Y pays that

amount to Bank Z, which would only then pay it to Customer A. Unfortunately, the buying and selling of this insurance goes on and on until every bank (investor, hedge fund, pension fund or any other financial institution) is somehow interdependent on every other bank in the CDS market. It means that almost all players in the CDS market are caught in the CDS web; if Bank Z (or Bank Y or any other bank) defaults on its insurance, then Customer A will not get his money. However, this is not the end of the mess since Customer A was probably selling insurance as well. Since he was counting on Bank Z’s money, he will not be able to pay off his insurance either. So, this problem amplifies until a vast number of the banks in the CDS market are completely wiped out. We also should not forget that there is no underlying asset that is worth anything because Customer A did not have to own the bonds to obtain insurance against them; they were simply pieces of paper being bought and sold.

Figure 2: Pure Speculation

1. Since there is no requirement to own the asset, the Investor/Customer A buys an insurance policy

from Bank Z, believing that Company X will go bankrupt. 2. In case Company X in fact goes bankrupt, Investor will receive the insured amount from Bank Z.

Investor / Customer A

Insurance Company /

Bank Z

1

2

Company X



The scenario given may be best depicted by the following 2 figures (Figure 3 and Figure 4).

Figure 3: Real CDS Market

Where: B – buys insurance

S – sells insurance

B B

B B S S

S S

Company X Investor / Customer A

Insurance Company /

Bank Z

1

2

3

4

B B S S

Insurance A

Insurance C

Bank X

Bank Y

Insurance B

Bank W



Figure 4: Real CDS Market (web)

Where: B – buys insurance

S – sells insurance

B B

B B S S

S S

B S

Insurance B

Company X Investor / Customer A

Insurance Company /

Bank Z

1

2

3

4

Insurance A Bank Y

Bank W

BS

Bank X

Insurance C

T O W A R D S A N I N F O R M E D M A R K E T FINANCIAL DERIVATIVES FROM ISLAMIC CONTRACTS


The Problems Faced by the Derivatives Market The derivatives market is far from perfect. Derivatives have been described as evil, acts of Satan, time bombs and weapons of mass destruction. For example, Warren Buffett describes derivatives as both "financial weapons of mass destruction" and “time bombs”. In his Berkshire Hathaway letters to shareholders, he said, "Unless derivatives contracts are collateralised or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems madmen).” From the above, the problems may be deduced and listed down as follows: 1. No Regulation – It is obvious that the

CDS contracts are carried over-the-counter and there are no rules and regulations governing them. The transactions are simply done over the phone or through e-mail. Due to their huge presence in the market and their influence on the stability of not only the American financial system but also the global one, the CDS market has to be regulated and monitored. If there had been regulation in place, then someone would have known that these types of transaction were a crisis waiting to happen; they could have intervened and taken the necessary actions to stop future transactions from taking place.

2. No Reserve Requirement – So far, the players in the CDS market have not had to have any reserves with regard to the insured amounts. This implies that in the event of default, the protected seller has no money at hand to cover the losses. The problem goes on through the domino effect, causing financial chaos all over the place. Had these types of derivatives been regulated, then the governing body would have made sure that the protected seller had sufficient reserves at hand to cover the losses. If the reserve requirement ever dipped below the required amount, the regulatory body would have stepped in to rectify the process.

3. No Underlying Asset – As an investor, I do not have to posses the asset in order to purchase insurance. CDSs resemble an insurance policy, as they can be used by debt owners to hedge or insure against a default on a debt. However, because there is no requirement to actually own any asset or suffer a loss, CDSs can also be used, and are used, for speculative purposes.

4. No Transparency – Since this market is unregulated, no one knows how much CDS is out there, or who is who in that market (i.e. who is the seller and who is the buyer of the protection). According to International Swaps and Derivatives Association, the notional amount outstanding of CDS decreased by 12% in the first six months of 2008 to USD54.6 trillion from USD62.2 trillion. This means that there are still some USD50 trillion of CDS out there, somewhere, in the market.



Conclusion From the discussion above, it is clear that true hedging aims at neutralising or minimising the risks involved in financial activities. As such, it falls under the umbrella of the objectives of Shari’ah and is desirable. However, Islamic finance should learn the lessons from the current global crisis and establish a system of rules and regulations that will serve the maslaha (public good) in general. This system should be subject to regulation and overview by a special body, with authority to interfere when necessary. Underlying assets should be attached to the trading activities, and these trades should be limited to the original buyers and sellers to avoid the speculative appetite of market gamblers. The sellers of hedge instruments should be specialised institutions that are subject to the required reserves. Furthermore, the activities of derivatives market players should be transparent, and the data should be available for tracking. Although these steps may hamper the derivatives market and reduce its volume, they will protect players in from future volatilities, as well as provide a more stable and more sustainable system that is less vulnerable to the greed and thirst of market speculators and gamblers.



The author, Edib Smolo, is an associate researcher in the Islamic Banking Unit, International Shari’ah Research Academy (ISRA) for Islamic Finance. He obtained his undergraduate double-degree in Economics and Islamic Revealed Knowledge with Honors as well as Master in Economics from International Islamic University Malaysia (IIUM), Malaysia. Prior to joining ISRA, Edib worked for an insurance company in Bosnia and Herzegovina and at the same time he was Assistant Professor at Faculty of Economics, Sarajevo School of Science. He participates in conferences and seminars related to economics, business and finance. He published several papers on Islamic microcrediting, economics, and finance. His interests are in Islamic banking and finance, microcrediting, and Islamic capital market products, among others.

INTERNATIONAL SHARI’AH RESEARCH ACADEMY FOR ISLAMIC FINANCE The establishment of the International Shari’ah Research Academy for Islamic Finance or more commonly known by its acronym, ISRA, is to promote applied research in the area of Shari’ah and Islamic finance. It will also act as a repository of knowledge for Shari’ah views or fatwas and undertake studies on contemporary issues in Islamic financial industry. ISRA will contribute towards strengthening human capital development in the areas of Shari’ah and provide platform for greater engagement amongst practitioners, scholars, regulators, academicians via research and dialogues, both in the domestic and international environment. Through pioneering research and rigorous intellectual dialogue, ISRA aims to promote innovation and dynamism into new boundaries of Islamic finance. It is envisioned that with greater research and dialogues, mutual respect and recognition would emerge within Islamic financial industry global community. As a part of the International Centre for Education in Islamic Finance (INCEIF), ISRA is able to leverage on the existing infrastructure and facilities as well as to tap on the knowledge, expertise and resources of the academic faculty and post graduate students in INCEIF. To provide input and assistance in the strategic direction of ISRA’s research works, the Council of Scholars, a group comprising of eminent local and international Shari’ah scholars, has been set-up.


International Shari’ah Research Academy for Islamic Finance 2nd Floor, Annexe Block Menara Tun Razak Jalan Raja Laut 59350 Kuala Lumpur Malaysia Tel: +603 2781 4000 Fax: +603 2692 4094 Website: www.isra.my

T O W A R D S A N I N F O R M E D M A R K E T RISKS IN ISLAMIC CONTRACTS

Islamic Finance Bulletin April - June 2009 Issue #24 25 BPAM

Risks Associated with Islamic Financial Contracts: Part 6 (Final) Meor Amri Meor Ayob Bond Pricing Agency Malaysia Sdn Bhd Introduction

s highlighted in the previous parts (please refer to the series of articles published in the previous

bulletins), to be a competent pricing specialist, a strong foundation in risk identification and assessment is a prerequisite. From this understanding plus an in-depth knowledge of financial engineering, the fair valuation of any financial asset can be done. This skill set is not only relevant to the conventional bond market alone, but also to the sukuk market. The purpose of this series of papers is to provide some essential reading for anyone who is serious about the science of sukuk valuation. These papers are the basis for the underlying valuation methodology for Islamic financial assets, developed by Bond Pricing Agency Malaysia Sdn Bhd (“BPA Malaysia”). This last and final part of a series of 6 commentaries will highlight, as completely as possible, all the identifiable risks associated with the Mudharabah contract.

Types of risk associated with the contract of Mudharabah A typical Mudharabah contract can be segmented into 3 transaction stages. Each stage has its own unique risks. The following sections detail the risks identified for each stage of the contract. 1. Contract The customer and the financial institution or capital provider, as partners, can establish a Mudharabah contract via the execution of the following: c. A memorandum of understanding (or

MOU), which is to be followed by the execution of multiple Mudharabah contracts; or

d. A Mudharabah contract The MOU states the intended mode of financing, i.e. a restricted or unrestricted Mudharabah financing instrument, the profit-allocation ratio and the type of guarantee that will be presented by the Mudharib (or entrepreneur) to cover losses arising from negligence, misconduct or breach of contract. The contract is non-binding and can be terminated unilaterally, except in the following situations:

A



a. when the Mudharib has already commenced the business; and/or

b. when the duration for which the contract is to remain in operation has been determined.

There are 2 types of Mudharabah: a. Unrestricted Mudharabah The capital provider allows the Mudharib to manage funds without any restrictions. The Mudharib is expected to utilise its expertise and skills in managing the funds in accordance with the investment objectives of the capital provider. b. Restricted Mudharabah The capital provider allows the Mudharib to manage funds, subject to certain restrictions such as instrument type and sectoral or country exposure. The Mudharabah capital must be in the form of cash or tangible assets that are valued by experts. The capital cannot be in the form of debt owned by the Mudharib or another party to the capital provider. The capital must be freely accessible to the Mudharib/customer for the Mudharabah contract to be valid. As the Mudharib invests the Mudharabah capital on a trust basis, it is not liable for losses except in cases of misconduct, negligence and breach of contract, whereby the Mudharib becomes accountable for the amount of the capital. The profit-allocation ratio and its calculation methodology must be clearly stated. The profit ratio must be on the basis of an agreed percentage of the profit, and not in a lump sum or percentage of the capital. However, the

lump-sum profit is allowed when both parties agree (in the contract) to distribute a lump-sum profit if it exceeds a certain ceiling. The profit-allocation ratio should be determined when the contract is concluded, and the ratio can be changed anytime. The Mudharib cannot earn fees in addition to the profit. Any fee to be earned must be from activities that are not by the customer’s part of the Mudharabah operations, and must be executed in a separate agreement. The Mudharib is not allowed to make a loan, gift or donation out of the Mudharabah funds. The Mudharib is entitled to claim travelling expenses based on standard practice, or up to the amount allowed by the capital provider. Profit can only be claimed when the Mudharabah operations are profitable. Any loss must be compensated by the profits of future operations. If the losses are greater than profits at the time of liquidation, the net loss must be deducted from the capital, which is solely borne by the capital provider. This is one of the major risks to the capital provider. Loss-making operations may require additional capital injection, and expose the capital provider to the risk of capital erosion and the opportunity to reinvest in other types of partnerships or investments. If the Mudharib commingles their own funds with the Mudharabah funds, the profits earned from both funds must be divided proportionately vis-a-vis the amount of the 2 funds. The Mudharib may also combine the Mudharabah funds with Musharakah funds, or accept funds from a third party on a Mudharabah basis, subject to the capital provider’s permission or by appointment.



2. Early Termination Termination can be done by either party as it is a non-binding contract, when Mudharabah funds have been exhausted or have suffered losses, upon the death of the Mudharib or the liquidation of the Mudharib. The risk at this stage is capital-recovery risk; the capital provider may lose the invested capital when the Mudharabah contract is terminated. 3. Maturity Termination can be done by either party as it is a non-binding contract, when Mudharabah funds have been exhausted or have suffered losses, upon the death of the Mudharib or the liquidation of the Mudharib. The risk at this stage is capital-recovery risk; the capital provider may lose the invested capital when the Mudharabah contract is terminated.



References Ayob, Meor Amri Meor (May 1999). Rating Islamic Debt Securities: A Primer. RAM’s Special Highlights. RAM BNM (November 1999). The Central Bank and the Financial System in Malaysia - A Decade of Change. BNM BNM Annual Reports from 1996 to 2005. BNM BNM’s website: www.bnm.gov.my Bursa Malaysia (previously known as Kuala Lumpur Stock Exchange). Website: www.bursamalaysia.com Capital Market Masterplan (February 2001). Securities Commission Ismail, Mohd Izazee (March 2002). Islamic Private Debt Securities: Issues & Challenges. RAM’s Special Highlights. RAM IFSB’s website: www.ifsb.org Securities Commission (Malaysia) website: www.sc.com.my Securities Commission’s Quarterly Bulletin of Malaysian Islamic Capital Market (May, August, November 2006). Securities Commission



The author, Meor Amri bin Meor Ayob, is the Chief Executive Officer of Bond Pricing Agency Malaysia Sdn Bhd (previously known as Bondweb Malaysia Sdn Bhd). Meor has over 16 years of professional work experience as a regulator in Bank Negara Malaysia and as a credit analyst with Rating Agency Malaysia Berhad (now known as RAM Holdings Berhad).

In RAM, his last position had been Head of Financial Institutions Ratings. He has a wealth of experience, especially oin the risk elements of the bond market. He is also has vastly experienced in the sukuk market.

BOND PRICING AGENCY MALAYSIA SDN BHD (formerly known as BondWeb Malaysia Sdn Bhd) BPAM, as Bondweb Malaysia Sdn Bhd, was incorporated on 27 September 2004 under the Malaysian Companies Act 1965. It was registered as a bond-pricing agency (“BPA”) by the Securities Commission on 28 April 28 2006, and has met and exceeded the requirements outlined in the Guideline on the Registration of Bond Pricing Agencies. On 15 September 2008, Bondweb Malaysia Sdn Bhd changed its name to Bond Pricing Agency Malaysia Sdn Bhd (or BPAM). This coincides with BPAM’s aim of consolidating its position as Malaysia’s pioneer bond-pricing agency, and to further strengthen its position by focusing on its core business - evaluated bond pricing. The bond-pricing agency is an initiative by the Securities Commission of Malaysia to boost the transparency and quality of price-discovery mechanisms and valuation practices in the Malaysian bond market. BPAM was officially appointed Malaysia's first bond-pricng sgency on 18 April 2006. With this status, BPAM is recognised as one of the official sources for evaluated prices on ringgit bonds


Bond Pricing Agency Malaysia Sdn Bhd (formerly Bondweb Malaysia Sdn Bhd) No. 17-8 & 19-8, The Boulevard Mid Valley City Lingkaran Syed Putra 59200 Kuala Lumpur Malaysia Tel: +603 2772 0899 Fax: +603 2772 0808 Website: www.bpam.com.my

T O W A R D S A N I N F O R M E D M A R K E T SUKUK RATING

Islamic Finance Bulletin April - June 2009 Issue #24 30 RAM Ratings

Sukuk Rating: General Approach, Criteria and Methodology RAM Rating Services Berhad Introduction

sukuk rating is issue-specific. RAM Ratings’ credit opinions on sukuk are, likewise, issue-

specific; they essentially reflect our view of the obligor’s willingness and capacity to meet its financial commitments with regard to a particular sukuk issue, a certain class of financial obligation or a specific funding programme (for example, an MTN or CP programme) - promptly and in accordance with the terms of that specific commitment. It is possible for different sukuk issues from the same obligor to carry different ratings as issue-specific ratings, by nature, depend on the intrinsic risk profi le of the respective sukuk issue, the legal partiality of the obligation in the event of restructuring, reorganisation, bankruptcy or vis-à-vis other laws relating to creditors’ rights, as well as any credit enhancement or support for the sukuk obligation, including the creditworthiness of guarantors and terms of the guarantees. Our sukuk ratings are based on both qualitative and quantitative factors, and are premised on expectations on the obligor’s future credit profile rather than its absolute level of historic or current financial measures. In terms of priority ranking of obligations, the contractual commitments stipulated in the sukuk

structure firmly render the transaction a financial obligation — requiring the obligor to treat the sukuk as it would its other direct, unsecured financial commitments, thus making it indistinguishable in terms of payment priority. In this instance, RAM Ratings will equalise the sukuk rating with the obligor’s general credit rating, also referred to as a corporate credit rating (“CCR”) or senior unsecured debt rating. However, if the sukuk transaction contains terms akin to those of a secured debt structure, with priority of claim over the obligor’s assets, the sukuk rating may be notched up and rated above the obligor’s CCR - depending on the type, nature and characteristics of the security and its value relative to the sukuk obligation. Conversely, if the recovery prospects of the sukuk are notably inferior to those of the obligor’s other debts, the sukuk rating is likely to be notched down from the obligor’s CCR. A sukuk obligation is deemed to be of a lower rank or categorised as a junior obligation if it is contractually subordinated (that is, where the obligor has both senior and subordinated obligations), or if it is unsecured and there is a considerable class of secured

A



creditors positioned ahead of it (where the obligor has both secured and unsecured obligations), or if it is structurally subordinated, where it is a debt at the holding company’s level and the operating subsidiaries have their own financial commitments. Under such circumstances, the junior sukuk will be rated lower than the issuer’s CCR to reflect its subordinated claim priority over the obligor’s assets in the event of liquidation or receivership. The concept of notching is only meant to differentiate recovery prospects, as a default is likely to interrupt payments on all of the issuer’s financial obligations. Purchase Undertaking The incorporation of a purchase undertaking in a sukuk transaction is an important rating factor, as it changes the risk metrics of the transaction and fundamentally shifts the credit-risk driver to the entity providing the undertaking. The purchase-undertaking agreement in an Ijarah-based transaction, for instance, embodies a contractual obligation from the seller-lessee to repurchase the leased assets from the issuer-lessor at the end of the lease period; or, in the event of an early termination, at an agreed price typically amounting to the sum of outstanding sukuk, by executing a purchase (Bai’) contract. RAM Ratings’ analytical framework for a sukuk transaction that is backed by a purchase obligation will centre on the obligor’s capacity to meet its purchase commitments. The terms and provisions of the purchase-undertaking agreement are also taken into account; this is to

ascertain the issue of timeliness of payment. Emphasis is also placed on the relative ranking of the purchase obligation from the obligor vis-à-vis its other debts and financial commitments. This is to determine if the obligor’s financial commitments under the purchase agreement are similar to its obligations to, and rank pari passu with, its other liabilities. If that is established to be the case, and assuming we are satisfied with all the other terms of the transaction, then the sukuk’s assigned rating will be equivalent to the obligor’s CCR. This differs from the rating of asset-backed sukuk, where the assigned rating is not dependent on the originator’s credit standing. In a typical transaction involving a special-purpose vehicle (“SPV”) as the issuer, it is also important to determine whether the SPV serves any other purpose besides acting as a conduit to facilitate the flow of funds to the sukuk investors. Any competing claim or interference from third parties may interrupt the smooth operation of the underlying business, impair its cashflow and undermine the issuer’s ability to adequately meet its obligations to the sukuk holders in a timely manner. Similarly, if the transaction incorporates an external enhancement — for example, if the sukuk is wrapped by a guarantee from a financial institution or enhanced by way of a put option from a third party — the assigned rating will normally reflect the creditworthiness of the entity or party providing the credit support. This is due to the unconditional and



irrevocable nature of the accompanying guarantee backing the sukuk transaction. Shariah-compliance Our analytical task relating to sukuk transactions includes an examination of Shariah-related issues, to the extent that it is necessary to appreciate the contractual terms, operations and mechanisms of the underlying contract(s) supporting the sukuk transaction to be rated, and also to identify Shariah-related matters that may have a credit impact or a bearing on the risk profile of the sukuk. In this regard, the evaluation of the Shariah-related aspects and contracts forms an added assessment factor to our analytical framework for sukuk. As a matter of practice, a declaration from Shariah advisors or scholars ascertaining the Shariah-compliant nature of the transaction is ordinarily obtained prior to the final assignation of a rating. Our ratings are based on the compliance of the terms and obligations of the sukuk issue under applicable legal and regulatory settings, and commercial codes governing business and contractual matters, as opposed to the jurisdiction of the Shariah courts. As a matter of practice, expert opinions ascertaining the legal issues in respect of the transaction will customarily be obtained. Sukuk Rating Scale and Definitions RAM Ratings maintains 2 rating scales for sukuk issues. Long-term sukuk ratings range from the highest category of AAA to the lowest, D. Ratings within the AA to C categories may also include subscripts

to indicate their relative standing within the respective brackets. A long-term rating is accorded to a sukuk with an initial maturity period exceeding 12 months, such as MTNs and bonds.

RAM Ratings’ short-term sukuk ratings are also graded into several categories, ranging from P1, which denotes a very high level of safety with regard to timely settlement of short-term obligations, to D, being the lowest. Short-term ratings are accorded to sukuk with an initial maturity period of 12 months or less, such as CPs, note-issuance facilities or revolving underwritten facilities. The assigned rating relates to the programme designed to sell these notes, and is based on the facility limit.



In the event of a CP/MTN programme, RAM Ratings will assign both short- and long-term ratings. These ratings are inter-related as they are founded on the fundamental credit profile of the sukuk obligor and based on the same analytical framework. Long-term investment-grade ratings of AAA to BBB3 generally correspond to the short-term rating scale of P1 to P3; non-investment-grade long-term ratings of BB1 and below are mapped against the short-term scale of NP. Where a long-term rating intersects with 2 possible equivalent short-term ratings, the final assignation of the short-term rating will depend on the overall credit quality and strength within the long-term rating category, as well as our assessment of the obligor’s credit and liquidity profiles in the near or intermediate term. Liquidity considerations play an important role in our evaluation of the corresponding short-term rating.

Premised on the Shariah conditions governing contracts of exchange, including contracts of sale, the ratings assigned by RAM Ratings to debt-oriented and Ijarah-based sukuk reflect our opinion on the issuer’s capacity and willingness to meet its financial commitments in a full and timely manner, in accordance with the terms of the underlying Islamic contract. In contrast, given the nature of partnership-based sukuk and recognising the Shariah stipulations on risk-reward sharing, the ratings assigned by RAM Ratings to Musharakah and Mudharabah sukuk reflect our opinion on the capacity and willingness of the issuer to meet the payment of capital and expected returns on a full and timely basis, in accordance with the terms of the investment contract.

This is an excerpt from the Malaysian Sukuk Market Handbook - Your Guide to the Malaysian Capital Market.



RAM RATING SERVICES BERHAD (“RAM Ratings”) Incorporated in 1990 as the pioneer in the provision of credit-rating services for the Malaysian capital market, RAM Ratings’ portfolio encompasses a vast range of local and foreign corporates, multinationals, banks, insurance companies, government-linked and other public-financed entities, myriad complex investment vehicles and the ringgit-denominated securities they issue, structured-finance transactions backed by receivables or other financial assets, and Islamic securities (commonly known as sukuk). As one of the region’s most experienced rating agencies, RAM Ratings plays a leading role in providing crucial and independent credit opinions that are sought after by investors and other market participants, with a view to being more confident about their investment and financial decisions. Underscored by its renown in the rating business, RAM Ratings’ credit assessments have been habitually used as points of reference by regulators, the financial community and the investment fraternity. RAM Ratings is a public limited company and is wholly owned by RAM Holdings Berhad. Its ultimate shareholders comprise major financial institutions in Malaysia, Asian Development Bank and Fitch Ratings.


RAM Rating Services Berhad (763588-T) Suite 20.01, Level 20 The Gardens South Tower Mid Valley City Lingkaran Syed Putra 59200 Kuala Lumpur Malaysia Tel: +603 7628 1000 Fax: +603 7620 8251 Website: www.ram.com.my

T O W A R D S A N I N F O R M E D M A R K E T MARKET STATISTICS

Islamic Finance Bulletin April - June 2009 Issue #24 35 Market Statistics

Malaysian Islamic Capital Market

Malaysian Rated Corporate Sukuk Market League Table of Lead Managers as at 30 June 2009

RM Million % CIMB Investment Bank Berhad 11,667 41.7% AmInvestment Bank Berhad 7,200 25.7% RHB Investment Bank Berhad 3,451 12.3% MIMB Investment Bank Berhad 2,140 7.6% Public Investment Bank Berhad 1,667 6.0% Maybank Investment Bank Berhad 700 2.5% OCBC Bank (Malaysia) Berhad 400 1.4% OSK Investment Bank Berhad 400 1.4% MIDF Amanah Investment Bank Berhad 350 1.3% 27,975 100%

The value of consortium issues have been equally divided by the number of lead managers of a consortium

Source : RAM Ratings/ FAST

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Sukuk Rated by RAM Ratings

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T O W A R D S A N I N F O R M E D M A R K E T RINGGIT SUKUK MARKET REPORT

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Information on this page is intended solely for the purpose of providing general information on the Ringgit Bond market and is not intended for trading purposes. None of the information constitutes a solicitation, offer, opinion, or recommendation by Bond Pricing Agency Malaysia Sdn Bhd (formerly Bondweb Malaysia Sdn Bhd) (“BPAM”) to buy or sell any security, or to provide legal, tax, accounting, or investment advice or services regarding the profitability or suitability of any security or investment. Investors are advised to consult their professional investment advisors before making any investment decision. Materials provided on this page are provided on an "as is" basis, and while care has been taken to ensure the accuracy and reliability of the information provided in this page, BPAM provides no warranties or representations of any kind, either express or implied, including, but not limited to, warranties of title or implied warranties of fitness for a particular purpose, accuracy, correctness, non-infringement, timeliness, completeness, or that the information is always up-to-date.

Ringgit Sukuk Market Report

Sukuk - Total Traded Amount for the Quarter ended 30 June 2009

Sukuk - Total Sukuk Outstanding (RM mil) by Class: 30 June 2009


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Sukuk New Facilities created for the Quarter ended 30-June-2009

Facility Code Facility Name Instrument Maturity Date Facility Limit

200900021 DANGA RM10.0B ISLAMIC SECURITIES PROGRAMME MTN 24-Apr-34 10,000,000,000

200900028 TIA RM5.0B IMTN MTN 27-May-39 5,000,000,000

200900020 PUTRAJAYA RM1.5B SUKUK MUSYARAKAH MTN MTN 22-Apr-33 1,500,000,000

200900025 SEAFIELD RM1.50B IMTN PROGRAMME MTN 25-May-29 1,500,000,000

200900024 THP 10-YR RM200.0 MILLION MMTN MTN 10-Dec-18 200,000,000

200900038 TALAM CORP BAIDS RM134.2 MIL BONDS 28-Jun-19 134,213,337

200900023 DAWAMA RM120.0M SENIOR SUKUK MUSYARAKAH MTN PROGRAMME

MTN 26-Apr-13 120,000,000

200900022 DAWAMA RM20.0M JUNIOR SUKUK MUSYARAKAH MTN PROGRAMME MTN 25-Apr-14 20,000,000

Top 10 Sukuk Tender Result for the Quarter ending 30-June-2009

Stock Name Issue Date

Maturity Date

Actual Issue

Successful Yield

Successful Price

PROFIT-BASED GII 3/2009 30.12.2014 30-Jun-09 30-Dec-14 4500 3.902 100.002

PROFIT-BASED GII 2/2009 13.04.2012 13-Apr-09 13-Apr-12 4000 3.077 100.000

BNMN-IDB 94/2009 68D 01.09.2009 25-Jun-09 1-Sep-09 200 1.941 99.640

BNMN-IDB 93/2009 49D 11.08.2009 23-Jun-09 11-Aug-09 200 1.925 99.742

BNMN-IDB 91/2009 49D 06.08.2009 18-Jun-09 6-Aug-09 200 1.926 99.742

BNMN-IDB 92/2009 70D 27.08.2009 18-Jun-09 27-Aug-09 200 1.926 99.632

BNMN-IDB 89/2009 49D 04.08.2009 16-Jun-09 4-Aug-09 200 1.941 99.740

BNMN-IDB 90/2009 70D 25.08.2009 16-Jun-09 25-Aug-09 200 1.938 99.630

BNMN-IDB 87/2009 56D 06.08.2009 11-Jun-09 6-Aug-09 200 1.948 99.702

BNMN-IDB 88/2009 70D 20.08.2009 11-Jun-09 20-Aug-09 200 1.947 99.628


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10 Most Active Bonds Traded between 01-Apr-2009 and 30-June-2009

STOCK NAME LAST TRADED PRICE

LAST TRADED YIELD/DISCOUNT

TOTAL VOLUME

TRADED LAST QTR

PROFIT-BASED GII 2/2009 13.04.2012 100.31 2.96 5017

PROFIT-BASED GII 2/2008 30.06.2011 103.24 2.68 2459

PROFIT-BASED GII 2/2006 14.07.2011 103.86 2.68 1326

PROFIT-BASED GII 3/2009 30.12.2014 99.80 3.94 1217

PROFIT-BASED GII 1/2007 15.03.2010 100.97 2.21 872

RANTAU IMTN 15.03.2011-MTN 1 101.89 3.25 822

PROFIT- BASED GII 3/2008 14.02.2014 101.81 3.84 625

TIA IMTN T4 27.05.2039 100.45 5.72 600

BNMN-IDB 33/2009 91D 09.06.2009 99.86 1.82 575

BNMN-IDB 53/2009 63D 16.06.2009 99.82 1.84 510

YTM Curves as at 30 June 2009

Tenure LT Islm-Gov-GII

LT Islm-Quasi Gov-Khazanah

LT Islm-Corporate-

AAA

LT Islm-Corporate-

AA2

3m 1.84 1.97 2.66 3.29 6m 1.87 2.00 2.76 3.42 1y 1.99 2.08 3.14 3.88 2y 2.42 2.55 3.54 4.31 3y 3.06 3.06 3.95 4.75 5y 3.87 4.14 4.57 5.41 7y 4.06 4.35 5.00 5.88 10y 4.34 4.67 5.46 6.38 15y 4.70 5.03 5.88 6.84 20y 5.06 5.39 6.30 7.30


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5-YEAR YTM Historical Chart (weekly closing, last 6 months)

YTM Spread (5-YEAR GII) as at 30 June 2009 YTM Matrix – Item Spread Principle: Islamic Date: 30 June 2009

Class1 Class2 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 15Y 20Y

Government GII 1.84 1.87 1.99 2.42 3.06 3.87 4.06 4.34 4.70 5.06

Quasi Government Khazanah 0.13 0.13 0.09 0.13 0.00 0.27 0.29 0.33 0.33 0.33

Corporate AAA 0.82 0.89 1.15 1.12 0.89 0.70 0.94 1.12 1.18 1.24

Corporate AA2 1.72 1.78 2.04 2.11 2.11 1.69 1.96 2.21 2.41 2.62

Malaysian Sukuk Market Handbook Your Guide to the Malaysian Islamic Capital Market ISBN: 978‐983‐44255‐0‐0

Published by RAM Rating Services Berhad

As a pioneer in the Islamic finance industry, Malaysia has been setting benchmarks while assuming a pivotal role on the sukuk pitch. The nation’s Islamic capital market has been experiencing exponential growth, and we are well poised as the world’s most competitive and attractive sukuk market, underscoring Malaysia’s significance as the largest and most innovative global sukuk marketplace.

The Malaysian Sukuk Market Handbook, published by RAM Rating Services Berhad (“RAM Ratings”), is a comprehensive guide that serves as a practical tome for institutions and professionals keen on unlocking maximum value from the domestic Islamic capital market. The contributors to this handbook are eminent personalities from various backgrounds, well known in their respective fields of expertise. This handbook – the first of its kind ‐ also strives to broaden the sukuk investor and issuer bases, and covers inter alia the applicable Shariah principles, the Malaysian regulatory framework, the role of Shariah advisers, legal and tax considerations, rating approaches, market infrastructure and details of hallmark sukuk transactions.

RAM Ratings, a leading credit‐rating agency in Asia, was incorporated in 1990 as the pioneer of the Malaysian capital market in this sphere. In sukuk transactions, our task involves both quantitative and qualitative analysis vis‐à‐vis evaluating the financial strength of obligor institutions with such underlying structures, as approved by Shariah scholars. RAM Ratings’ portfolio encompasses a vast range of local and foreign corporates, multinationals, Islamic and conventional banks, takaful and insurance companies, government‐linked and other public‐financed entities, myriad complex investment vehicles and the ringgit‐denominated securities they issue, structured‐finance transactions backed by receivables or other financial assets, and sukuk. As one of the region’s most experienced rating agencies, RAM Ratings is a leader in the provision of crucial and independent credit opinions that are sought after by market participants as regards their investment and financial decisions.

For further enquiries, kindly contact Ms Noor Maliana Mansor at +603‐76281029 or [email protected].

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