Purifying Islamic equities: the interest tax shield

Abstract

Purpose

This paper aims to add to the debate regarding the appropriate methodology to purify tainted components from shari’ah-compliant equities.

Design/methodology/approach

Based on the Qur’anical prohibition against riba and an analysis of the purification methodology recommended by Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) shari’ah Standard 21, this paper highlights the shortcomings in Standard 21 and references the corporate finance literature to argue for the need to also purify the interest tax shield from debt.

Findings

Purification is a pivotal element of the Islamic investment process, yet Standard 21 permits a loose interpretation which causes portfolios to be under-purified. Standard 21 also makes no mention of the interest tax shield from debt even though the benefits are at odds with the principles of social justice in Islam. That there is no mention of the interest tax shield from debt in the (limited) literature on the purification of Islamic equities is puzzling.

Practical implications

This paper has implications for the Islamic funds industry and for devout Muslim investors.

Originality/value

The specific contribution of this paper is the identification of the interest expense tax shield (well-established in the corporate finance literature) as a significant non-compliant riba-related component that needs to be considered in the purification process.

Citation

Brendan Mulcahy, M. (2014), "Purifying Islamic equities: the interest tax shield", International Journal of Islamic and Middle Eastern Finance and Management, Vol. 7 No. 4, pp. 473-484. https://doi.org/10.1108/IMEFM-11-2013-0120