Interview with Vladislav Zabrodin and Anna Leksashova – Capital Legal Services – San Petersburg

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Prospects for Islamic financing in Russia 

Russia is among the top 10 economies in the world, and its position continues to strengthen. Russia’s gold and foreign currency reserves remain the third largest in the world are Japan and China, which serves as additional protection of the  economy from financial turmoil. Russia dominates in the volume and diversity of natural  resources  and  by  volume  is  the  third  ranking  trading  partner  of  the  European Union and is its key energy supplier. The consumer market in Russia is  the largest and most rapidly growing one in Europe.    Sustainable  economic  growth,  high  investment  profitability  and  the  public’s  consumption index make Russia an extremely attractive site for foreign investment.  Russian policies remain on a stable course, government authorities are actively  implementing a policy aimed at improving the investment climate by decreasing  administrative  barriers  for  business,  creating  a  favorable  tax  climate,  and  introducing new investment mechanisms (special economic zones, public-private  partnerships).

Despite the fact that the oil and gas industry and the mineral production industry  have for a long me remained the most attractive investment sector, the actively  developing  non resource  sectors,  including  consumer  sector  projects,  retail  networks,  transport  and  communications,  transactions  with  real  estate  and  financial activities are of main interest for private investments in Russia. In other  words, the Russian economy is diversifying its industrial structure, relying less and  less on the resource sector, while developing its real and financial sector.    The Russian economy is open for reconsideration of available financial institutes  and development of new financial mechanisms. Russia, in particular, has all the  necessary traits and great potential for developing Islamic financial institutions and  products that have lately become such widespread practice in the world. The  interest in Islamic financing in Russia is determined by both economic and cultural  factors.    Loan rates offered by local traditional banks are rather high and institutions usually  do  not  take  active  involvement  in  project  implementation,  which  may  lead   participants of the financial market to consider alternative “cheaper” and more  commercially active financiers. Besides the economic component, the interest in  Islamic  financial  products  is  also  determined  by  cultural  aspects  of  the  Russian  society.  Muslims  comprise  approximately 15% of Russia’s population. In certain regions,  for example, in the regions of Tatarstan and Bashkortostan,  Muslims  comprise  as  much  as  half  of  the  population.  Therefore, creation of settlement and financial institutions in  compliance with Shariah will be well received by the Islamic  segment of Russia’s population.    Notwithstanding  the  above  factors,  Islamic  financial  institutes have yet to achieve proper expansion in Russia. It is  fair to say that there are several reasons for this. It appears  that the main difficulty lies in the low level of the public and  business community awareness of Islamic financial products  and,  subsequently,  particular  concerns  with  respect  to  implications  and  success  of  implementing  them  on  the  Russian market. At the same me, taking into account the  interest in developing Islamic financial products in Russia, the  existing difficulties,  in our opinion,  are  easy  to  eliminate.  Objectively speaking, there are no economic, political or legal  hindrances to the development of Islamic financing.    On  the  contrary,  the  Russian  legislation  encourages  investment activity and provides its participants with a high  level of economic freedom. Despite the fact that the sphere  of Islamic finance is praticcally not addressed by Russian  laws, Islamic financial products may be implemented on the  Russian market owing largely to the discretionary nature of  the Russian corporate, financial and contract law.    The main forms of investing cash in compliance with the  requirements  of  the  Russian  legislation  and  Shariah  may  include  the  institutes  of  shareholder  (participation  in  company capital), project (partnership) and debt financing  through contractual structures.    Considering  the  prospects  of  developing  the  institute  of  shareholder  financing,  one  should  note  the  possibility  of  entering  into  shareholder  agreements,  restraining  legal  capacity of the company and its executive authorities and, as  a  consequence,  the  possibility  of  using  a  special‐purpose  vehicle  (SPV)  in  commercial  activities  in  the  optimum  manner, as speculated by the Russian corporate legislation.     Attracting project financing to the Russian market, including  in the form of “musharakah” and “mudarabah” tradional  transactions, and debt financing in the form of “murabahah,” “ijarah,”  “issna,”  “salam”  and  other  transactions,  should  encounter no hindrances either.

The fundamental principle  of  Russian  civil  law  is  the  freedom  of  contract  principle,  which provides for the right of the pares to determine at  their discretion the terms and conditions of an agreement  and enter into an agreement that is either covered by law or  not covered by law, or contains elements of several types of  agreements (a mixed agreement).    In addition to choosing transaction structure, the Russian  legislation  allows  pares  to  independently  determine  the  applicable law and to agree on the jurisdiction for selling  disputes arising from the agreement. However, the pares  should take into account the imperative regulations of the  Russian  substantive  and  procedural  law,  including  those  regarding  the  exclusive  jurisdiction  of  Russian  courts  as  concerns disputes with respect to title to real estate located  in  the  Russian  Federation.  Furthermore,  the  parties  must  make sure that the decision of the respective court can be  implemented (i.e. that there is a procedure for accepting and  implementing such decision), otherwise the practical value of  a court decision made in a foreign jurisdiction is reduced to  null.    It must also be noted that despite the fiscal nature of the tax  policy, the level of tax rates in Russia is significantly lower  than in many other countries. In particular, at present, the  general profit tax rate (corporate tax) in Russia comprises  20%, value added tax is 18%, individual income tax is 13%; and a system of tax benefits and deductions with respect to  VAT  is  in  effect.  Moreover,  Russia  has  double  taxation  treaties with 77 countries, which allows choosing the country  with the most acceptable tax regime to close the transaction.    Therefore,  the  majority  of  standard  Islamic  financing  transactions,  including  those  mentioned  above  and  their  hybrid schemes may be used in the Russian Federation with  no  adverse  legal  consequences.  This  is  confirmed  by  successful investment by OJSC AK BARS Bank of syndicated  financing funds attracted in the amount of 60 million US  dollars  within  an  Islamic  murabahah  transaction.  This  transaction was recognized “Europe Deal of 2011” according  to Islamic Finance News.    Russia is also a prospective site for Islamic securities – the  “sukuk,” which could be used as a business tool for attracting  major  investors  to  infrastructure  projects.  Russia’s  advantages in this field include a large amount of assets for  an asset backed sukuk, as well as the interest of investment  banks in issuing it on a government level.

Taking into account  that in Russia the securities are only recognized as securities  if they are classified as such by the legislation of the Russian  Federation, the question concerning the possibility to issue  sukuk within the country remains open. Nevertheless, it is  possible to issue sukuk backed by Russian assets through  SPVs in offshore territories. Russian law practically does not  contain  any  prohibitions  on  foreign  legal  entities  owning  assets (such as real estate). The existing prohibitions concern  mainly agricultural land and land in Russia’s border zones.     The Government of the Republic of Tatarstan has signed a  respective  Memorandum  of  Understanding  with  Kuwait  Finance House Bank (Malaysia) Berhad and Amanah Raya  Berhad on issuing sovereign sukuk bonds for the Republic of  Tatarstan.  For  purposes  of  this  Memorandum,  Tatarstan  announced  issuance  of a  sovereign  sukuk  (issued  by  the  region)  from  100  to  200  million  US  dollars  through  the  offshore  territory  of  Luxemburg  and/or  Malaysia.  The issuance of debut Islamic bonds (sukuk) on one of the Islamic  financial markets .

Asian or Middle East markets   was also  announced by the VTB financial group. These transactions  should demonstrate the possibility of placing a Russian issuer  on  the  Islamic  securities  market  and  stimulate  other  participants of the Russian market.    Implementation of Islamic finances on the Russian market is  possible  through  banking  and  non‐banking  financial  institutions, including banks, non‐bank credit organizations,  SPVs,  investment  companies,  mutual  investment  funds,  leasing and insurance companies. However, speaking of the  prospects  of  developing  Islamic  banking  in  Russia,  one  cannot ignore the following issues.    First,  the  Russian  banking  system  is  based  on  the  bank  obtaining  its  revenue  in  the  form  of  interest  on  the  transaction  amount,  while  the  fundamental  principle  of  Islamic banking is prohibition of interest (“riba”). Second, the  Russian  legislation  establishes  a  direct  prohibition  on  participation  of  a  credit  organization  in  manufacturing,  trading  and  insurance  activities,  which  eliminates  the  possibility  for  them  to  carry  out  such  transactions  as  murabahah,  isstina’a  and  salam  that  are  traditional  for  Islamic banking.     At  the  same me,  these  circumstances  do  not  represent  insurmountable  barriers,  since  the  banking  legislation  contains no restrictions with respect to bank participation in  the  charter  capital  of  other  companies  engaged  in  manufacturing, trading and insurance activities. Therefore,  an Islamic bank may operate in Russia without any credits or  deposits, but with project financing and investment accounts  as an investment and settlement bank, and apply Islamic  financing tools by investing in projects through SPVs.    The prospects of developing Islamic financing in Russia are  not strictly theoretical, as they are confirmed by successful  examples  of  creating  and  operating  Islamic  financial  institutes  and  products.  The  Tatarstan  International  Investment Company (a joint venture of Russia and Islamic  Development Bank), Open Mutual Investment Fund BKS –  Halal Fund (Kazan) and AMAL Financial House (Kazan) have  already  been  created  in  the  course  of  implementing  the  Islamic financial infrastructure in Russia. Within the “Islamic  window” OJSC Bank Express (Dagestan) offers halal financial  products, OJSC ISK Euro‐Policy has started to offer Islamic  insurance products (“takaful”) since 2012, and so on. The  interest of the government, business community and Russian  people in Islamic finances has been on the increase year aer  year.    For  the  last  couple  of  years  the  government  and  major  participants of the Russian financial market have been paying  great attention to developing Islamic finances in Russia and  establishing  close  trade  and  economic  relations  with  the  Middle  East  and  Asia.  Since  2005  Russia  has  been  an  observer of the Organization of Islamic Cooperation, which  facilitated  significant  improvements  on  the  political,  economic  and  cultural  arenas  and  closer  relations  with  Islamic countries. Round tables, forums, annual conferences,  summits  (for  example,  International  Islamic  Conference,  Kazan summit) and seminars are dedicated to the issue of  developing  Islamic  financing.  Such  activities  indirectly  confirm Russia’s interest in alternative financial tools, and  Islamic  financing  which  focuses  on  real  economic  activity  instead of speculative activity has a promising outlook on  the Russian market. Thanks to the abundance of a resource  base, the amount of Muslim population and geographical  proximity to the countries of Central Asia and Middle East,  Russia has the potential to become one of the major Islamic financing markets in Europe.

We expect these prospects to  become reality in the foreseeable future.