Islamic Financing in Russia: Legal Regulation

September 30, 2023

BRACE ©

In the current political and economic environment, Russian entrepreneurs are increasingly interacting with Eastern partners, including those from countries that observe Sharia law. In the Islamic world, there are numerous prohibitions on financial operations; however, despite this, an increasing number of partners from other countries are conducting business with such counterparties.

On August 4, 2023, to create the necessary conditions for carrying out partner financing activities in Russia, Federal Law No. 417-FZ On Conducting an Experiment to Establish Special Regulation to Create Necessary Conditions for Carrying Out Partner Financing Activities in Certain Subjects of the Russian Federation and on Amending Certain Legislative Acts of the Russian Federation was signed (the "Law No. 417-FZ", the "Law on Partner Financing", the "Law on Islamic Financing").

In accordance with Law No. 417-FZ, the experiment is being conducted in the territories of the Republic of Bashkortostan, the Republic of Dagestan, the Republic of Tatarstan (Tatarstan), and the Chechen Republic [1], with the duration of the experiment defined by the Law on Islamic Financing as the period from September 1, 2023, to September 1, 2025.

Which Transactions Constitute Partner (Islamic) Financing?

Activity regarding partner financing is recognized as the performance by participants in the experiment of transactions (operations) that meet the prescribed requirements and provide for:

• raising funds and (or) other property of individuals and legal entities in the form of a loan, by placing bonds, accepting property into trust management, and (or) accepting a contribution (share) to the authorized (share, pooled) capital of the participant in the experiment;
• granting funds in the form of a loan to individuals and legal entities;
• financing individuals and legal entities through the sale and purchase of goods (including real estate) on terms of installment (deferred) payment for goods, with the collection of remuneration for providing such installment (deferred) payment;
• financing individuals and legal entities by providing property under a financial lease (leasing) agreement, making a contribution (share) to the authorized (share, pooled) capital of legal entities, or carrying out joint activities under a simple partnership agreement or investment partnership agreement;
• issuing sureties (guarantees) for third parties.

Islamic Banking in Russia

The political situation and sanctions pressure from Western countries against Russia have fostered the development of business activities with Eastern partners. An experiment on partner financing is being conducted in the territories established by the Law on Islamic Financing, the goals of which are:

• determining the effectiveness of special regulation for providing financial services in the designated territory of the experiment and assessing the feasibility of implementing special regulation into the legislation of the Russian Federation;
• preparing proposals for amending Russian legislation regarding the creation of necessary conditions for carrying out partner financing activities.

In accordance with Clause 2 of Article 4 of the Law on Islamic Financing, the status of a participant in the experiment may be acquired by a credit organization, a non-credit financial organization carrying out types of activities specified in Federal Law No. 86-FZ dated July 10, 2002, On the Central Bank of the Russian Federation (Bank of Russia), a consumer cooperative, a socially beneficial foundation, an autonomous non-profit organization, a business company, or a partnership that are residents of Russia, provided that the location of the relevant legal entity and (or) its branch is the territory of the experiment, i.e., the Republic of Bashkortostan, the Republic of Dagestan, the Republic of Tatarstan (Tatarstan), or the Chechen Republic. This requirement does not apply to a credit organization that has an internal structural unit opened in accordance with Russian legislation in the territory of the experiment for carrying out partner financing activities. For the purposes of this article, the term "resident" is used in the meaning established by Federal Law No. 173-FZ dated December 10, 2003, On Currency Regulation and Currency Control. Information Message of the Ministry of Finance of Russia No. IS-uchet-45 dated September 12, 2023, New Developments in Accounting Legislation: Facts and Comments (the "MinFin Information Message No. IS-uchet-45") also indicates that a participant in the experiment may be a Russian legal entity that is a resident of Russia, if its location and (or) the location of its branch is the territory defined by Law No. 417-FZ (credit and non-credit financial organization, consumer cooperative, socially beneficial foundation, autonomous non-profit organization, business company, and partnership).

The provision of services within the framework of partner financing will become possible for persons included in the registry of participants in the experiment. To this end, the Bank of Russia makes a decision to enter information about the legal entity into the registry of participants in the experiment based on an application and documents attached thereto [2], the list of which and requirements for which are established by the Bank of Russia.

To enter information about a legal entity intending to become a participant in the experiment (the "Applicant") into the registry, the Applicant must submit an application to the Bank of Russia for entering information about the Applicant into the registry (the "Application for Entry into the Registry"), containing the following information:

• full and abbreviated (if any) names in Russian (for an Applicant that is a non-profit organization), full and abbreviated (if any) corporate names in Russian (for an Applicant that is a commercial organization);
• OGRN (Main State Registration Number) of the Applicant;
• INN (Taxpayer Identification Number) of the Applicant;
• address of the Applicant within the location specified in the Unified State Register of Legal Entities (EGRUL);
• address of the Applicant's official website on the Internet (if any);
• phone number of the Applicant;
• email address of the Applicant (if any);
• information about the Applicant's branch located in the territory of the experiment (full and abbreviated (if any) names, address within the location specified in the EGRUL) (if the Applicant has such a branch);
• information about the internal structural unit of the Applicant, which is a credit organization, opened in accordance with Russian legislation in the territory of the experiment for carrying out partner financing activities (name, registration number) (if the Applicant has such an internal structural unit);
• the Applicant's request to enter information about it into the registry;
• an inventory of documents attached to the Application for Entry into the Registry, containing information on the name and number of sheets of each document attached to the Application for Entry into the Registry, and the number of sheets of the set of documents as a whole.

Furthermore, an Applicant that is not a credit organization or a non-credit financial organization must attach the following documents to the Application for Entry into the Registry (the "Applicant's Documents"):

The Applicant's constituent document in the version effective as of the date of submission of the Application for Entry into the Registry to the Bank of Russia.

Documents confirming the Applicant's compliance with the requirements of the Law on Islamic Financing

• A document containing the calculation of the amount of own funds (net asset value) of the Applicant, compiled on a date no earlier than 5 business days prior to the date of submission of the Application for Entry into the Registry to the Bank of Russia (the "Calculation Date").
• The balance sheet prepared by the Applicant as of the Calculation Date.
• A document on the availability as of the Calculation Date of accounts, deposits, and (or) balances of funds and (or) precious metals in accounts, deposits, and (or) statements of the Applicant's deposits.
• Statements issued as of the Calculation Date for depot accounts recording the Applicant's securities, and (or) extracts from the registers of securities holders for personal accounts of the securities holder opened for the Applicant in such registers, and (or) other documents confirming ownership of securities included in the calculation of the amount of own funds (net asset value) of the Applicant (if the assets accepted for the calculation of the amount of own funds (net asset value) of the Applicant include securities).
• Documents confirming the Applicant's ownership of real estate included in the calculation of the amount of own funds (net asset value) of the Applicant, as well as a valuation report of said property compiled by an appraiser in accordance with the legislation on valuation activities (if the assets accepted for the calculation of the amount of own funds (net asset value) of the Applicant include real estate).
• A document of the Applicant, compiled in free form, regarding the assets accepted for the calculation of the amount of own funds (net asset value) of the Applicant, including the following information: a) information on the composition, structure, and value of assets accepted for the calculation of the amount of own funds (net asset value) of the Applicant, including breakdowns of accounts receivable (if the assets accepted for the calculation of the amount of own funds (net asset value) of the Applicant include accounts receivable); b) International Securities Identification Number (ISIN) (if any), quantity of securities, name of issuers of securities (persons obligated under securities), book value of securities (if the assets accepted for the calculation of the amount of own funds (net asset value) of the Applicant include securities).
• A document containing information about the shareholders (participants) of the Applicant owning more than 10 percent of the shares (stakes) of the Applicant, shareholders (participants) of the Applicant owning 10 or less percent of the shares (stakes) of the Applicant and being part of a group of persons owning more than 10 percent of the shares (stakes) of the Applicant.
• Documents specified in Regulation of the Bank of Russia No. 625-P dated December 27, 2017 [3].
• Documents regarding the person performing the functions of the sole executive body of the Applicant: (Decision of the authorized body of the Applicant on the appointment (election) to the position, including the temporary assignment of duties, of the sole executive body of the Applicant; Questionnaire of the person performing the functions of the sole executive body of the Applicant, containing the following information about the person).

For the effective functioning of Islamic financing in Russia, Law No. 417-FZ provides for supervisory functions of the Bank of Russia, which regulates the activities of participants in the experiment, as well as controls and supervises compliance by participants in the experiment with the requirements of the Law on Partner Financing and regulatory acts of the Bank of Russia issued in accordance therewith when carrying out partner financing activities. In doing so, the Bank of Russia performs the following functions:

• maintains the registry of participants in the experiment in the manner determined by the legislation of the Russian Federation;
• receives necessary information from participants in the experiment about their activities, as well as accounting (financial) statements (in the manner established by this Federal Law), exercises control and supervision over compliance by participants in the experiment, when carrying out partner financing activities, with the requirements of the Law on Islamic Financing, other federal laws, and other regulatory legal acts, and regulatory acts of the Bank of Russia.

To perform the designated functions, the Bank of Russia, in relation to a participant in the experiment:

• requests from state statistics bodies, state control and supervision bodies and receives from them information on the financial and economic activities of the participant in the experiment;
• requests and receives information about the participant in the experiment from the Unified State Register of Legal Entities via the unified system of interdepartmental electronic interaction;
• conducts inspections of the compliance of the activities of the participant in the experiment with the requirements of Law No. 417-FZ, other federal laws, and other regulatory legal acts, the control and supervision of compliance with which falls within the competence of the Bank of Russia, and regulatory acts of the Bank of Russia in the manner established by the Bank of Russia;
• requires the management bodies of the participant in the experiment to eliminate identified violations;
• sends binding instructions to the participant in the experiment, including instructions to eliminate identified violations, instructions to limit the activities of the participant in the experiment, and instructions to replace the person performing the functions of the sole executive body;
• requests from the participant in the experiment documents necessary for resolving issues within the competence of the Bank of Russia;
• excludes information about the participant in the experiment from the registry of participants in the experiment in cases provided for by Law No. 417-FZ;
• performs other functions in accordance with Law No. 417-FZ.

It is important to note that Law No. 417-FZ has been in effect since September 1, 2023, and the legal framework for the execution of the regulatory document is in the formation stage. For example, to inform participants in the experiment, a draft Instruction of the Bank of Russia On the Procedure for Informing Clients of a Participant in the Experiment about Its Partner Financing Activities, on the List of Information Subject to Disclosure at Client Service Locations and on the Official Website of the Participant in the Experiment in the Information and Telecommunication Network "Internet", as well as on the Procedure and Terms for Disclosing Such Information has been prepared [4].

Accounting of Partner Financing Activities

Accounting of partner financing activities and accounting objects arising from such activities is maintained by participants in the experiment, other than credit and non-credit financial organizations, in accordance with applicable Federal Accounting Standards (FSBU) and Accounting Regulations (PBU), as well as the Chart of Accounts for Financial and Economic Activities of Organizations and the Instruction for its Application, approved by the Order of the Ministry of Finance of Russia [5].

Specifics of accounting in connection with carrying out partner financing activities are established by Instructions of the Bank of Russia dated August 14, 2023, No. 6504-U On Specifics of Accounting for Participants in the Experiment Being Non-Credit Financial Organizations in Connection with Carrying Out Partner Financing Activities and the Procedure for Drawing Up Accounting (Financial) Statements by Participants in the Experiment when Carrying Out Partner Financing Activities for Non-Credit Financial Organizations and No. 6505-U On Specifics of Accounting for Participants in the Experiment Being Credit Organizations in Connection with Carrying Out Partner Financing Activities.

It is important to note that if a participant in the experiment carries out other activities not related to partner financing activities, the participant in the experiment, when maintaining accounting records, ensures separate accounting of property raised and placed by the participant in the experiment when carrying out partner financing activities, other property raised and placed by the participant in the experiment when carrying out other activities, as well as property of the participant in the experiment. Moreover, repeated violation by a participant in the experiment of the requirement for separate accounting of property is one of the grounds for the Bank of Russia to exclude information about the legal entity from the registry of participants in the experiment [6].

The grounds for the Bank of Russia to exclude information about a legal entity from the registry of participants in the experiment are:

• repeated violation by the participant in the experiment of the requirements of Law No. 417-FZ, other federal laws, and (or) regulatory and other acts of the Bank of Russia;
• violation by the participant in the experiment of prohibitions established by Law No. 417-FZ;
• repeated violation by a participant in the experiment, which is not a credit organization or a non-credit financial organization, of requirements for the minimum amount of own funds (net assets);
• reduction by the participant in the experiment of the amount of own funds (net assets) below the minimum amount of own funds (net assets) for at least one hundred eighty calendar days;
• repeated failure by the participant in the experiment to comply with instructions of the Bank of Russia;
• repeated violation by the participant in the experiment of requirements established by Federal Law No. 115-FZ dated August 7, 2001, On Countering the Legalization (Laundering) of Criminally Obtained Incomes and the Financing of Terrorism, and (or) repeated violation of requirements of regulatory legal acts of the Russian Federation issued in accordance with said Federal Law;
• repeated submission by the participant in the experiment of substantially unreliable reporting data contained in the statements;
• non-performance by the participant in the experiment of any of the operations provided for by Law No. 417-FZ within six months;
• non-compliance of the sole executive body of a participant in the experiment, which is not a credit organization or a non-credit financial organization, with the requirements established by Article 8 of Law No. 417-FZ;
• non-compliance of a shareholder (participant) of a participant in the experiment, which is not a credit organization or a non-credit financial organization, a person exercising control over such shareholder (participant), a person performing the functions of the sole executive body of such shareholder (participant), or a person exercising control over such shareholder (participant), being legal entities, with the requirements established by Article 9 of the Law on Islamic Financing.

For the purpose of segregating and summarizing information on partner financing activities, a participant in the experiment carrying out such activities alongside other activities may maintain accounting records of partner financing activities on a separate balance sheet. In this case, synthetic account 79 "Intra-business settlements" is used, to which a sub-account "Settlements on partner financing activities" is opened. Systematized information on partner financing activities is formulated in the form of separate accounting statements. Indicators of separate accounting statements disclosing information on partner financing activities are included in the accounting statements of the participant in the experiment [7].

Accounting statements of a participant in the experiment are prepared in the general manner established by the Federal Law On Accounting, PBU 4/99 [8] Accounting Statements of an Organization, and Order of the Ministry of Finance of Russia No. 66n dated July 2, 2010, On Forms of Accounting Statements of Organizations.

A legal entity is obliged to start maintaining accounting records of partner financing activities from the day of acquiring the status of a participant in the experiment, i.e., from the day information about it is entered into the registry of participants in the experiment by the Bank of Russia. Partner financing activities are subject to reflection in the accounting statements of the participant in the experiment starting from the annual accounting statements for the reporting year in which the compiler of these statements acquired the status of a participant in the experiment. Accounting of partner financing activities is maintained continuously until the legal entity loses the status of a participant in the experiment (i.e., until the day information about it is excluded from the registry of participants in the experiment by the Bank of Russia) or until the completion of the experiment provided for by Law No. 417-FZ.

Legal Risks of Islamic Financing

Despite the caution of transactions conducted within the framework of Islamic financing, like any business activity, Islamic financing is also subject to risks that may arise during partner financing, for example, currency risk (change in currency exchange rate), late payments, impossibility of increasing the fixed markup, etc.

To minimize and eliminate these risks, the Bank of Russia may establish additional requirements for the activities of a participant in the experiment, including ratios, the procedure for their calculation and their values, additional requirements for the procedure for determining the amount of own funds (net assets), risk coefficients for individual types of assets, the maximum limit of remuneration of the participant in the experiment and (or) other payments (including in favor of third parties) collected when carrying out partner financing activities, maximum values of funds raised and placed when carrying out partner financing activities, requirements for the organization of the risk management system and internal control of the participant in the experiment, the list of information subject to disclosure on the official website of the participant in the experiment in the information and telecommunication network "Internet", as well as the procedure and terms for disclosing such information [9].

Prohibitions in Islamic Banking

Islamic banking uses a system of prohibitions defined by religious rules, considering which, when conducting partner financing, it is prohibited to:

• establish remuneration expressed in the form of an interest rate;
• allow uncertainty in the subject matter of the transaction;
• finance activities related to the production of tobacco and alcohol products, weapons, ammunition, trade in such goods, as well as gambling.

Despite the established prohibitions, substitution of rules explicitly prohibited by religious norms is permitted; for example, the interest rate is replaced by establishing remuneration in the form of a variable value, the meaning of which changes depending on the results of the specified transactions (operations).

Islamic Financing Abroad

Islamic financing in the international business community is a popular source of investment. Despite the fact that the basic norms of Islamic financing are limited by religious norms and rules, Islamic financing is applied universally. In Islamic countries, Islamic banking is applied in various directions: insurance, storage of valuables, advance payments, etc. Let us consider the main ones:

• Islamic Mortgage ("Murabaha").In accordance with an agreement between the bank and the client, the bank purchases real estate for the client, which remains pledged to the bank until the principal amount and remuneration for services provided by the bank are paid. The remuneration represents income in the form of a fixed sum – a markup for organizing, managing the transaction, and expenses incurred.
• Islamic Leasing ("Ijara").Islamic leasing differs from leasing in the generally accepted format in that the lessee pays lease payments rather than interest. At the same time, the property remains in the ownership of the bank and is transferred for temporary use to the lessee under the agreement.
• Joint Venture ("Musharaka").Considering the Islamic prohibition on receiving interest, in a joint venture, investors receive a share in the profit from the bank instead of interest. Investors' funds are transferred to the bank, which invests them in a specific project.
• Islamic Deposit ("Mudaraba").The client independently chooses the type of activity, while the bank acts as a guarantor under such financing that such investments are permitted. Profit under an Islamic deposit from a joint project is distributed between the bank and the client.
• Installment Plan ("Bay' bi-thaman ajil").Represents a phased settlement with the bank, essentially a traditional installment plan.
• Interest-Free Loan ("Qard al-Hasan").In this case, the client receives funds from the bank without interest under the mandatory condition of timely repayment of the received funds. For such a service of the bank, the client determines the amount of the markup for its services themselves.
• Contract for Future Asset Delivery ("Istisna").A purchase and sale transaction of an asset is carried out based on a specific request and characteristics of the goods. The goods are delivered not immediately, but in the future.
• Islamic Securities ("Sukuk").Islamic securities represent interest-free bonds backed by a specific tangible asset. The yield of such bonds depends on the profit generated by the underlying asset.

A mandatory and main condition for using Islamic financing is compliance with the religious norms of Sharia. For more effective interaction between entrepreneurs of different religious norms, Law No. 417-FZ has been enacted in Russia, which allows compliance with not only Islamic religious norms but also civil law norms in this sphere for a specific period and in a specific territory of the country.

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References

[1] Clause 3 of Article 1 of Law No. 417-FZ.

[2] Instruction of the Bank of Russia No. 6503-U dated August 11, 2023, On the Maintenance by the Bank of Russia of the Registry of Participants in the Experiment to Establish Special Regulation to Create Necessary Conditions for Carrying Out Partner Financing Activities.

[3] Regulation of the Bank of Russia No. 625-P dated December 27, 2017, On the Procedure for Coordination by the Bank of Russia of the Appointment (Election) of Candidates to Positions in a Financial Organization, Notification of the Bank of Russia on the Election (Termination of Powers), Appointment (Release from Office) of Persons Included in the Composition of Management Bodies, Other Officials in Financial Organizations, Assessment of Compliance with Qualification Requirements and (or) Requirements for Business Reputation of Persons Included in the Composition of Management Bodies, Other Officials and Founders (Shareholders, Participants) of Financial Organizations, Submission by a Member of the Board of Directors (Supervisory Board) of a Financial Organization of Information to the Bank of Russia on Voting (Non-Participation in Voting) Against the Decision of the Board of Directors (Supervisory Board) of the Financial Organization, Submission of a Request for Provision of Information by the Bank of Russia and Submission by the Bank of Russia of a Response on the Presence (Absence) of Information in Databases Provided for by Articles 75 and 76.7 of Federal Law No. 86-FZ dated July 10, 2002, "On the Central Bank of the Russian Federation (Bank of Russia)", as well as on the Procedure for Maintaining Such Databases.

[4] Prepared by the Bank of Russia, Project ID 04/15/08-23/00140544.

[5] Order of the Ministry of Finance of the Russian Federation No. 94n dated October 31, 2000, On Approval of the Chart of Accounts for Financial and Economic Activities of Organizations and the Instruction for its Application.

[6] Clause 1 of Article 7 of Law No. 417-FZ.

[7] Clause 8, Clause 9 of the MinFin Information Message No. IS-uchet-45.

[8] Order of the Ministry of Finance of Russia No. 43n dated July 6, 1999, On Approval of the Accounting Regulation "Accounting Statements of an Organization".

[9] Clause 10 of Article 3 of Law No. 417-FZ.