ISLAMIC REPUBLIC OF AFGHANISTAN

ISLAMIC REPUBLIC OF AFGHANISTAN Ministry of Rural Rehabilitation and Development Afghanistan Rural Enterprise Development Program Islamic Finance Product DevelopmentThe Ijārahmuntahiyàbi-tamlīkprepared by Alberto G Brugnoni – ASSAIF

CONTENTS • ESSENTIALS OF IJARAH • ESSENTIALS OF IJARAH MUNTAHIYA BI-TAMLEEK • SHARIAH LEGITIMACY AND AAOIFI SHARIAH STANDARD • CONVENTIONAL V. IJARAH • DOCUMENTATION OF IJARAH • THE TRANSFER OF THE LEGAL TITLE OF THE ASSET • CURRENT APPLICATIONS OF IJARAH IN ISLAMIC BANKS • ACCOUNTING ISSUES • KEY DIFFERENCES BETWEEN IFRS AND AAOIFI

ESSENTIALS OF IJARAH • Ijarah is to offer for a consideration the usufruct of a thing of value from which benefit can be derived without consumption, while retaining the ownership of the leased assets and assuming risks pertaining thereto. It has the following features: • The corpus of leased commodity remains in the ownership of the lessor and only its usufruct is transferred to the lessee • Any thing which cannot be used without consuming the same cannot be leased out like money, edibles, fuel, etc. • Only such assets which are owned by the lessor can be leased out except that a sub-lease is effected by the lessee with the express permission of the lessor • Until such time that assets to be leased are delivered to the lessee, lease rentals do not become due and payable • During the entire term of the lease, the lessor must retain title to the assets, and bear all risks and rewards pertaining to ownership • If any damage or loss is caused to the leased assets due to the fault or negligence of the lessee, the consequences thereof shall be borne by the lessee

ESSENTIALS OF IJARAH • The consequences arising from non-customary use of the asset without mutual agreement will also be borne by the lessee • The lessee is also responsible for all risks and consequences in relation to third party liability, arising from or incidental to operation or use of the leased assets • The insurance of the leased asset should be in the name of lessor and the cost of such insurance borne by him • A lease can be terminated before expiry of the term of the lease but only with the mutual consent of the parties • Either party can make a unilateral promise to buy/sell the assets upon expiry of the term of lease, or earlier at a price and at such terms and conditions as are agreed, provided that the lease agreement shall not be conditional upon such sale • Alternatively, the lessor may make a promise to gift the asset to the lessee upon termination of the lease, provided the lessee has fulfilled all his obligations

ESSENTIALS OF IJARAH • However, there shall not be any stipulation in the lease agreement purporting to transfer of ownership of the leased assets at a future date • The amount of rental must be agreed in advance in an unambiguous manner either for the full term of the lease or for a specific period in absolute terms • Assignment of only the lease rentals is not permissible except at par value • Contract of lease will be considered terminated if the leased asset ceases to give the service for which it was rented. However, if the leased asset is damaged during the period of the contract but is capable of being repaired, the contract will remain valid • A penalty can be agreed ab initio in the lease agreement for delay in payment of rental by the lessee. In that case, lessee shall be liable to pay penalty calculated at the agreed rate in percent per day/annum. However, that penalty shall be used for the purposes of charity • The banks can also approach competent courts for award of damages, at discretion of the courts, which shall be determined on the basis of direct and indirect costs incurred, other than opportunity cost • Also, security or collateral can be sold by the bank (purchaser) without intervention of the court

ESSENTIALS OF IJARAH MUNTAHIYA BI-TAMLEEK • This is a lease that ends with the ownership of the asset • There are several types of ijarahmuntahiya bi-tamleek. These are characterized based on the method by which the ownership transfers to the user: • for no consideration (through a gift) • for token consideration • for price specified in the lease • for remaining amount (if lease is terminated before period) • gradual transfer

SHARIAH LEGITIMACY AND AAOIFI SHARIAH STANDARD • Shariah allows a fixed charge relating to tangible assets because by converting financial capital into tangible assets the financier has assumed risks for which compensation is permissible • Since the distinguishing feature of ijarahis that assets remain property of the Islamic bank, it faces the risk of having them remain unutilized for long period of time after the lease period expires • The bank bears risk of recession or diminishing demand for these assets • By retaining ownership of asset the bank runs the risk of premature obsolescence (collapse or full depreciation)

CONVENTIONAL V. IJARAH

DOCUMENTATION OF IJARAH • The IjarahAgreement is the basic document which contains all terms and conditions pertinent the ijarahof a particular asset • The ijarah agreement shall be signed after the lessor has taken the possession the asset and not earlier • addendums to the Ijarah Agreement: • description of the ijarah asset: containing detailed description of the leased asset • schedule of ijarah rentals: this schedule contains a table which shows the amount and date of payment of each rental • receipt of asset: this document confirms that customer has taken possession of the leased asset as described in the ‘Description of Ijarah Asset. This document is only signed by the lessee on receipt of asset • promissory note: after signing of Ijarah Agreement, the amount of rentals become debt (dyan) to the lessee. This is the lessee’s acknowledgement of this debt and a promise to pay

DOCUMENTATION OF IJARAH • Undertaking to purchase the leased asset: this documents contains undertaking from the lessee to purchase the leased asset at the purchase price on the purchase date. It may contain a schedule showing a purchase price during the Ijarah term on which the lessee can purchase the asset by making lump sum payment • Other documents: Undertaking for Personal use of Ijarah Asset; Trust Receipt; Authorization to take possession of Leased Asset; Sale Deed, etc.

THE TRANSFER OF THE LEGAL TITLE OF THE ASSET • Free as a gift: conditional on settlement of installments; at the end of the ijarah period • Atoken amount: executable contract wherein rent of asset and ijarahperiod are fixed; promise to enter into sale contract; sale contract is to be concluded at the end of ijarahperiod, if the lessee wishes and has paid the agreed token amount; the token amount should be agreed mutually by both parties; rent should be adjusted if lessee fulfilled his obligation but the legal title is not transferred • An amount specified in the lease: it is a contract that includes: ijarah contract and a promise to enter into sale contract. The sale contract includes the price (value) of the sold asset; the payment of the sale price of the asset is after the expiry of the Ijarah period; the lessee is entitled to ownership of asset after paying the agreed specified amount • Price equivalent to the remaining ijarah installments: this arrangement includesan ijarah contract, a promise to transfer the legal title of the asset any time lessee wishes, transfer for amount equivalent to remaining ijarahinstallments. It is an ijarah contract until the title of asset is transferred to the lessee. The ijarah contract elapses for the remaining period when the title of the asset is transferred to the lessee. A sale contract is needed to make the transfer of title of the asset effective

THE TRANSFER OF THE LEGAL TITLE OF THE ASSET • Gradual transfer of title: this arrangement includes the lease and sale contract and the promise to transfer the legal title gradually during the ijarah period. It requires determination of asset price (asset value) in sale transaction. Price of the asset is allocated over the period of Ijarah. It requires specification of rent for the leased asset. Title of the asset is transferable through Ijarah duration. Full transfer of title at the end of Ijarah period. Gradual title transfer needs sale contract for each transferred portion. Rent should decrease as lessee acquires a share in the leased asset. If the contract is revoked, then the asset is jointly owned • Sale & leaseback: arrangement of selling an asset to another party and then leasing it from him. Sale transaction must not be conditional on the execution of the lease transaction. However, both parties can have common understanding between them. Also, it is permissible if one party promises the other to lease to/from him the asset

CURRENT APPLICATIONS OF IJARAHIN ISLAMIC BANKS • Bank buys equipment/machinery and lease it out to its client who may opt to buy them eventually. The monthly payments will consist of two components: • rental for the use of the equipment • installments towards the purchase price • Original amount of rent for the assets is fixed in advance • the rentals during the lease term are sufficient to amortize the investment of the leasing company and provide an element of profit • Client can also negotiate for purchase of the asset at the end of the period • the lease rentals paid in advance will be part of the price less the bank remuneration

ACCOUNTING ISSUES • The AAOIFI standard FAS 8 suggests the accounting treatment for both Ijarah and Ijarahmuntahiya bi-tamleekbe similar to an operating lease transactions with certain exceptions whereas the IFRS International Accounting Standard (IAS) 17 accounts for Ijarahmuntahiya bi-tamleekas a financing transaction, just like finance lease. This has huge implications. In addition there are the Malaysian Accounting Standard Board (MASB 100) and the Islamic Financial Accounting Standard (IFAS - 2) • in the conventional finance lease, the leased asset is recognized in the books of the lessee plus a corresponding liability (lease payments), while the lessor derecognizes the leased asset from his books and recognizes receivables asset (lease payments to be received). This is because all the risks and rewards incidental to legal ownership are assumed to be transferred by the lessor to the lessee • the leased assets in Ijarahmuntahiyabi-tamleekare recognized in the books of the lessor and not capitalized in the lessee books. Consequently, the leased assets are depreciated in the books of the lessor. In other words, all Ijarah contracts are treated as operating leases under the AAOIFI standards

KEY DIFFERENCES BETWEEN IFRS AND AAOIFI CLASSIFICATION OF LEASES • IFRS (IAS 17) Lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership • AAOIFI (FAS 8) All leases should be classified as an operating lease. Ijarah ending with a transfer of ownership should be treated as two separate transactions of operating lease and sale, and not as a finance lease

KEY DIFFERENCES BETWEEN IFRS AND AAOIFI LEASES IN THE FINANCIAL STATEMENTS OF LESSEES • IFRS (IAS 17) At the commencement of the lease term, lessees shall recognize finance leases as assets and liabilities in their statements of financial position at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each determined at the inception of the lease. The discount rate to be used in calculating the present value of the minimum lease payments is the interest rate implicit in the lease, if this is practicable to determine; if not, the lessee’s incremental borrowing rate shall be used. Any initial direct costs of the lessee are added to the amount recognized as an asset • AAOIFI (FAS 8) In case of Ijarah ending with a transfer of ownership, the lessee would recognize lease payments as expenses throughout the lease term. When the asset is transferred to the lessee, the lessee would recognize the asset acquired

KEY DIFFERENCES BETWEEN IFRS AND AAOIFI LEASES IN THE FINANCIAL STATEMENTS OF LESSORS • IFRS (IAS 17) Lessors shall recognize assets held under a finance lease in their statements of financial position and present them as a receivable at an amount equal to the net investment in the lease • AAOIFI (FAS 8) In case of Ijarah ending with a transfer of ownership, the lessor would present an asset in its statement of financial position, and recognize lease installments as revenue throughout the lease term. When the asset is transferred to the lessee, the lessor may recognise a gain or loss on disposal

ISLAMIC REPUBLIC OF AFGHANISTAN