Islamic bond dividends received by foreign investors may be declared tax-free as early as end-2011.
Japanese regulations do not forbid the issuance of Islamic bonds but these funding instruments are often not commercially viable without tax breaks on dividends received. The transfer of assets tends to attract tax, which can make Islamic finance transactions more costly than conventional deals.
Japanese brokerage Nomura Holdings sold $100 million of Islamic leasing bonds in Malaysia in July and Sumitomo Corp is said to be arranging the first Islamic funding deal in Japan.
Islamic finance practitioners expect the regulatory change to encourage more interest and drive sukuk issuance.
"The range of investors' portfolio variation can be expanded and the underlying demand may be stimulated," said Etsuaki Yoshida, a deputy chief of Africa office at Japan Bank of International Cooperation.
The $1 trillion Islamic finance sector saw a burst of interest about two years ago after the global financial crisis prompted a search for alternative sources of funding but interest has since cooled slightly as conventional debt markets reopened.
Non-Muslim countries such as Singapore, Australia, France and Hong Kong have either amended or are working on changes to their regulatory framework to accommodate Islamic finance, which avoids interest payments in favour of asset sales or rentals to underpin financial transactions.
But efforts to develop Islamic financial markets have met resistance in South Korea and India.