COMPILED BY HAMDAN HJ IDRIS, BSc Econs, MBA (Islamic Banking & Finance) Certified Professional Trainer (MIM) Industr

1. COMPILED BY HAMDAN HJ IDRIS, BSc Econs, MBA (Islamic Banking & Finance) Certified Professional Trainer (MIM) Industry Expert INCEIF PRESENTED BY HJ MAHMUD HJ BUNTAT, MBA (AUOL, UK), DBM (Swansea Inst., UK), CIL (UIA) Part-time Lecturer (INCEIF) Former Head of Islamic Banking Division, OCBC Bank (Malaysia) Bhd IB1005 DEPOSITS AND FINANCING PRACTICES OF ISLAMIC FINANCIAL INSTITUTIONS CHAPTER 7 : AL-IJARAH THUMMA AL- BAY (AITAB) VEHICLE/CAR FINANCING

2. Islamic jurists (fuqaha) today have introduced hire-purchase based on Shariah principles known as al-ijarah thumma al-bay’ (AITAB), which means leasing (al-ijarah) ending with sale (al-bay’). It also means that AITAB is a contract of lease with an option to purchase the asset. Chapter 7: Financing – Al-Ijarah Thumma Al-Bay (AITAB) Vehicle/Car Financing

3. In fiqh, al-ijarah means “to give something on rent”. Literally, al-ijarah or al-ajr means substitute, compensation, recompense, indemnity, consideration, return or counter-value. Al-ijarah has two types of usufruct (manfa’at):- 1. Usufruct of property or capital assets (manfa’at al-‘ayn); and 2. Usufruct of labor, employment and service (manfa’at al-‘amal)

4. In al-ijarah of services, the employer is called musta’jir and the employee ‘ajir. The contract between the two parties involves the employment of the services of the ‘ajir based on an agreed pre-fixed wage or salary (‘ujrah) given to him as reward for the services rendered in the transaction.

5. In AITAB the contract of ijarah ‘ain is applied.The lessor is called mu’jir while the lessee or hirer is known as musta’jir and the rent payable to the lessor is called ‘ujrah. • In al-ijarah, the lessee has only the right to use the property but not the ownership of property.

6. Some basic rules of al-ijarah are as follows:- • Al-ijarah is valid only with consent of both parties to the contract. That is, to avoid gharar, the contracted usufruct or manfaat has to be absolutely ascertained. • The usufruct must be lawful and must have a valuable use. • All liabilities arising from ownership shall be borne by the lessor who owns the rental property. • The rent, period and the purpose of the lease must be clearly specified.

7. OPERATING LEASE(Modus Operandi) - Step 1 Purchase Agreement Financier Supplier Purchase Price Asset STEP 1

8. OPERATING LEASE(Modus Operandi) - Step 2 Lease Agreement Financier Customer Rental Payment Asset STEP 2

9. In theory, the contract of Al-ijarah Thumma al-Bay’ shall consist of two different contracts, namely:- 1. The contract of lease (al-ijarah ‘ain) 2. The contract of sale (al-bay’). • Al-ijarah and al-bay’ are both categorised under the contract of exchange (‘uqud al-mubadalah). The former relates to the exchange of usufruct for money while the latter involves the exchange of goods for money. AL-IJARAH THUMAA AL-BAY (AITAB)

10. In AITAB, the contract of al-ijarah runs separately from the contract of al-bay’. In AITAB, the contract of al-ijarah runs separately from the contract of al-bay’. These stages are:- Stage 1: Executing the contract of true leasing (al-ijarah ‘ain) Stage 2: Executing the contract of sale (al-bay’) at a nominal value agreed upon by both parties. • AITAB is a contract of leasing with a promise to sell the asset.

11. The AITAB product under the purview of HP ACT 1967 is also required to observe the interest-bearing mechanism. • Since AITAB has to operate within the Hire Purchase Act, it is necessary to understand some features of the Act.

12. However, it must be noted that the Hire Purchase Act 1967 remains a law governing an interest-bearing term loan granted by a bank to the borrower. • In this way, AITAB assumes identical structure as do conventional hire-purchase.

13. The bank as a lessor holds the right to sell the asset if the lessee defaulted on payments. • But ironically, the bank as an owner does not seem to fulfill its obligation as an owner of property since it is the customers who are made to maintain the property and pay tax and insurance obligations.

14. By right…it requires the bank as lessor to maintain the rental asset and fulfills other obligations as any car owner is supposed to do. • In this manner, the bank must pay for insurance and road tax as well as car maintenance • This is done to observe the true leasing.

15. Customer cannot be forced to pay the remaining balance if he fails to pay rentals. • He can inform the bank his intention to terminate the contract and not liable to return the lessor any sum of money. • This is done to conform to the concept of true leasing.

16. AITAB offers the customer a full-financing scheme. He does not have to put up a down payment as practiced by current AITAB under HP Act 1967. • Car maintenance rests on the bank as lessor. However, if the engine broke down due to negligence of customer, he shall be liable for the repair expenses.

17. Rental under true AITAB will be much higher than that under current AITAB model. The rental shall include cost of rental assets and cost of maintenance as mentioned above. • Prospective customers will be glad to use the true AITAB model. Although the rental is a lot higher, customers will be less burdened with payments that lessor should be paying in first place.

18. In the HP agreement, the bank claims to be a prospective owner. But why has it been able to transfer the obligation of maintenance to the customers while securing the legal rights of repossession and disposal? • AITAB Car Financing, and indeed AITAB generally, includes a clause to apply the provisions of the Hire Purchase Act 1967 that does not contradict Shari'ah.

19. Under AITAB (disallowed by AAOIFI), a minimal late payment fee of 1.00% p.a. of the installment due may be imposed whereas a Conventional HP will charge a fee of 8.00% p.a. AAOIFI Shari’a Standard No.3, item 2/1 (b), p.32/ • AITAB lease payments are calculated on the basis of the Rule of 78/Sum of Digits calculation

20. The following characteristics are a feature of AITAB; • Asset ownership as legal title remains with the lessee. • Economic risk – no market risk or capital depreciation risk. • repayments are determined according to the rule of 78, and the profit rate is pegged to the interest rate. • Major maintenance & repair is assumed by the lessee, but operational risk remains with the lessee not the lessor.

21. AITAB (Modus Operandi) Step 1 Purchase Agreement Financier Supplier Purchase Price Asset STEP 1

22. AITAB (Modus Operandi) Step 2 Lease Agreement / 2nd Schedule HPA 1967 Financier Customer Rental Payment Asset STEP 2

23. AITAB (Modus Operandi) Step 3 Sale Agreement Financier Customer Sale Price Asset STEP 3

24. Some jurists have observed that an Islamic lease is a pure operating lease with operating costs for the account of the lessor, but this is not the case with AITAB, which would make it a financial lease.

25. Under the Rule of 78, profit is calculated for the life of the financing and then allocated to each month by proportion using reverse sum of the digits methodology. You start by adding up the numbers of months for the note. For example, in a 12 month financing, counting month 1, plus month 2, and so forth through month 12 is: 78 • An example: 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 • This totals 78, and hence the name, rule of 78. Rule 78

26. For an example: • Let's look at the example of a $90,000 financing at 5% profit rate for 1 year. Under the Rule of 78, we first add up the 12 months:- 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 + 11 + 12 = 78 • Finally, we divide the profit total by the sum of the digits (78) and apply in reverse proportion.

27. The profit rate for 1 year RM 90,000x 5% = RM 4,500 • The monthly installment is (RM 90,000+ RM 4500) /12 = RM7,875.00

28. The monthly profit being charged is as follows:- • Month # 1: RM 4,500 x (12/78) = RM 720 • Month # 2: RM 4,500 x (11/78) = RM 675 • Month # 3: RM 4,500 x (10/78) = RM 585 • Month # 4: RM 4,500 x (9/78) = RM 540 • ........ and so on until 12st month • Month #12: RM4,500 x (1/78) = RM 90

29. AAOIFI has summarized the legitimacy of ijarah as derived from al-Quran, “said one of them ‘Oh my father, engage him on wages” and “if you had wished, surely you could have taken wages for it”; Shari’a Standards (2004-2005), Shari’a Standard No.9, Appendix (B), p.151 - Al-Quran 28:26 - Al-Quran 18:77

30. Whilst it might be argued that istisna is a form of ijarah, the distinction made by AAOIFI is simply that “the subject of a lease is its usufruct and not the asset itself.” • Istisna would be used to construct a bicycle, and ijarah would be used to hire the bike, but not the wheels of the bike.

31. The Majallah defines ijarah as “hire to be paid for a thing, i.e. the price for the benefit.” • the Majallah also defines it more closely as “the sale (bai’) of a known benefit in return for its known equivalent.”

32. And in the case of termination, if the lessee defaults in punctual payments, foreclosure and recovery of rentals from the security might seem to be no different to the risks associated with secured lending. - Shari’a Standards (2004-2005), Shari’a Standard No.9, Art.7, item 7/2/2, p.145 - Shari’a Standards (2004-2005), Shari’a Standard No.9, Art.6, item 6/5, p.144

33. Have a good day  • May God bless you • Thank you & Wassalam