Ijarah / Leasing

1. Ijarah / Leasing

2. Ijarah • Ijarah is a term of Islamic Fiqh • Literally, it means “To give something on rent” • The term “Ijarah” is used in two situations: • 1. It means ‘To employ the services of a person on wages’ e.g. • “A” employs “B” to work at his office, and pays him a salary for his work • “A” hires a porter at the airport to carry his luggage • 2. Another type of Ijarah relates to paying rent for use of an asset or property • The 2nd type of Ijarah is relevant to our discussion • This Ijarah is analogous to the English term “Leasing”

3. Rules governing Ijarah

4. Ijarah • Rules governing Ijarah are similar to the rules governing sale. • Because in both cases something is transferred from one person to another • The only difference is: • In case of sale, title of property is transferred to Buyer • In case of Ijarah, title remain with the Lessor • Only the use of the property is transferred to Lessee • Leasing is an acceptable transaction under Shariah • The difference between conventional Lease and Ijarah lies in the nature of the contract • The question of whether or not the transaction of leasing is Shariah compliant depends on the terms and conditions of the contract • Several characteristics of conventional agreements may not conform to Shariah thus making the transaction un-Islamic and thereby invoking a prohibition

5. Ijarah • In order to use Leasing as a mode of finance Changes need to be made to the Lease Agreement • Change of name from “Interest” to “Profit” will not suffice • Some basic parameters of the agreement have to be changed to reflect the change in the nature of the transaction

6. Ijarah Rules of Shariah governing Ijarah • 1. Leasing is a contract where the owner of an asset transfers its use to another person against an agreed price • However, ownership of the leased asset remains with the Lessor • Since ownership of the leased asset remains with the Lessor, all rights and liabilities relating to ownership are borne by the Lessor • All rights and liabilities relating to use are borne by the Lessee e.g • “A” gives his house to “B” on rent • Property taxes are to be borne by the owner • Water tax, electricity bill etc are to be borne by the Lessee

7. Ijarah Rules of Shariah governing Ijarah • 4. The period of Lease must be determined in clear terms • 5. The Lessee is responsible for damage to the asset caused by fraud or negligence • 6. Any damage to the asset not caused by the Lessee’s neglect, is to be borne by the Lessor • Normal maintenance is Lessee’s responsibility • The asset to be leased should be clearly identified • 9. Lease rentals for the entire lease period must be fixed; • Different amounts of rents can be fixed for different periods, but they must be known. • The rent may be tied to a known benchmark, acceptable to both the parties • The Lessor cannot increase the rent unilaterally • 11. The Lessor may receive the rent in advance, but such payment should be recorded as an “on Account” payment since rent can be received only for use of an asset

8. Ijarah Rules of Shariah governing Ijarah • 12. The Lease period will start when the asset has been delivered to the Lessee • - in a usable condition • - whether or not the Lessee has started using it • 13. If the leased asset is destroyed, the lease will terminate. • If the Lessee is at fault, he is liable to compensate the Lessor for the loss

9. Ijarah Conventional leases are of two types 1. Sale & Leaseback – Where the Lessee has already purchased the asset The Lessor purchases the asset from the Lessee and leases it back to him 2. Direct lease – Where the Lessee has not already purchased the asset Lessor purchases the asset from the supplier & becomes its owner, then leases the asset to the Lessee

10. Ijarah • Sometimes, the Lessor does not pay the supplier directly • But authorizes the Lessee to purchase the asset on his behalf acting as his agent • Lessee purchases the asset on Lessor’s behalf, paying from his own resources • Lessor pays Lessee for the asset, and acquires its ownership • Then leases the asset to the Lessee • In all the above cases, under conventional Lease • - The Lease rental starts from the date of payment by Lessor Regardless of when the asset is delivered • This means that Lessee has to pay rent before delivery of asset. This is not allowed in Shariah because it is the same as charging rent for money, which is Interest • Under Shariah, the correct way to charge rent is after delivery of the asset to the Lessee. Because rent is charged for use of the asset

11. Ijarah • Expenses consequent to ownership • Lessor is the owner of the asset • He is liable to pay all expenses incurred in the process of purchase of the leased asset such as • - Purchase cost • - Import duties • - Transportation to factory • - Installation cost • - Insurance • He may build all these expenses into the asset’s cost • And take them into consideration when calculating the lease rental

12. Ijarah • Liability of parties in case of loss to the asset • Lessee is liable for loss to the asset due to his negligence • Can also be made liable for normal wear and tear • But he cannot be made liable for loss caused by factors beyond his control • Conventional Finance Lease agreements do not differentiate between these situations and are therefore not in conformity with Shariah

13. Variable rentals in Leases Ijarah • Lessor would like to get a return on his asset in line with the market • Hence, agreeing on a fixed rent for a long-term lease may not be desirable • Because if returns in the market change, the rent will not change with them and the Lessor will not get a return on his investment in line with the market • This problem can be overcome in two ways • 1. The Lease contract may stipulate a regular increase in rent • Say, 5% per year • 2. The lease contract may be for a shorter period after which the parties can renew the lease at revised terms with both parties having the right to refuse the renewal

14. Ijarah A third option is also available The Lease rental may be tied-up with a benchmark Which is so well-known that there is no room for dispute e.g. Inflation index issued by the government of the country Such that when inflation increases by 5% the rent increases by 5% Based on the above principle Some Islamic banks use the market rate of interest as the benchmark e.g. The SBP Discount Window rate, the T-bill rate etc. e.g. SBP discount + 3% p.a., T-bill + 5% p.a. Because they want to earn the same profit rate as the market

15. Ijarah • Objection: By using the Interest Rate as a benchmark the transaction becomes similar to an interest based transaction • Response: • As long as the basic requirements under Shariah are being complied with any benchmark can be used to price the transaction • Benchmarking the transaction’s pricing to an interest-based rate does not render it Haram • The basic difference between an interest-based financing and a valid Lease transaction does not lie in their pricing • The basic difference is: • In case of a lease, the Lessor assumes the full risk of the ownership of the asset. And also cannot charge rental if the asset loses its utility

16. Ijarah • In case of an interest based transaction the financier is not concerned with the asset’s ownership-related risks • And will keep charging its dues even if the asset loses its utility or gets destroyed • As long as this basic difference is maintained • The transaction cannot be classified as an interest bearing transaction No matter how it is priced • Penalty cannot be charged on delay in payment of lease rentals • Reason:Once the lease rent has become due • It is a loan payable by the Lessee to the Lessor and is subject to all rules prescribed for debt. • And therefor cannot be increased to compensate for delay in payment. However, the lessee may be asked to pay a penalty (as charity) to the Lessor which the Lessor should deposit into a charity account.

17. Ijarah • Termination of Lease • If the Lessee contravenes any term of the Lease agreement the Lessor may unilaterally terminate the agreement • If there is no contravention, the agreement can only be terminated by mutual consent • Conventional Financial Lease agreements give termination right to Lessor in all cases. This is contrary to Shariah laws • Insurance of the leased assets • Insurance is a cost related to ownership of the assets • And therefore should be borne by the Lessor • However, the Lessor may build this factor into the asset’s cost, while calculating the lease rent and increase the lease rent

18. Process of Ijarah Transfer of Title VENDOR CUSTOMER ISLAMIC BANK Payment of Purchase Price Agreement-1 . . MECHANICS • The customer approaches the Bank with the request for financing and enters into a promise to lease agreement. • The Bank purchases the item required for leasing and receives title of ownership from the vendor • The Bank makes payment to the vendor

19. Process of Ijarah Transfer of Title Transfer of Title VENDOR CUSTOMER ISLAMIC BANK Payment of Purchase Price Payment of Rental Fees Agreement-2 . . MECHANICS • The Bank leases the asset to the customer after execution of lease agreement. • The customer makes periodic payments as per the contract • Title transfers to the customer at the end

20. Ijarah Murabaha Title Holder Financier Customer Comparison of Ijara and Murabaha Rate Fixed/Variable Fixed Prepayment Allowed Yes No/Controversial Refinance Available Yes No Asset Risk Financier Customer Late Payments Controlable Loss to the Bank

21. IJARA

25. MUDARABAH

26. Definition • This is a kind of partnership where one partner gives money to another for investing in a commercial enterprise. • The investment comes from the first partner who is called “Rabb-ul-Maal” (Investor) while the management and work is an exclusive responsibility of the other, who is called “Mudarib” (Working Partner) and the profits generated are shared in a predetermined ratio.

27. Types of Mudarabah • Al Mudarabah Al Muqayyadah (Restricted Mudarabah) • Al Mudarabah Al Mutlaqah (Unrestricted Mudarabah)

28. Al Mudarabah Al Muqayyadah (Restricted Mudarabah) Rabb-ul-Maal may specify a particular business or a particular place for the mudarib, in which case he shall invest the money in that particular business or place. This is called Al Mudarabah Al Muqayyadah (restricted Mudarabah).

29. Al Mudarabah Al Mutlaqah(Unrestricted Mudarabah) • Rabb-ul-maal gives full freedom to Mudarib to undertake whatever business he deems fit, this is called Al Mudarabah Al Mutlaqah (unrestricted Mudarabah) • However, he is not authorized to:   a) keep another Mudarib or a partner • b) mix his own investment in that particular Mudarabah without the consent of Rabb-ul Maal.

30. Authority of Rabb-ul-Maal Rabb-ul-Maal has authority to:  a)Oversee the Mudarib’s activities and b) Work with Mudarib if the Mudarib consents.

31. Different Capacities of the Mudarib • Ameen (Trustee): The money given by Rabb-ul-maal (investor) and the assets required therewith are held by him as a trust. • Wakeel (Agent) : In purchasing goods for trade, he is an agent of Rabb-ul-maal. • Shareek (Partner): In case the enterprise earns a profit, he is a partner of Rrrrrabb-ul-maal who shares the profit in agreed ratio.

32. 4. Zamin (Liable): If the enterprise suffers a loss due to his negligence or misconduct, he is liabel to compensate the loss. 5. Ajeer (Employee): If the Mudarabah becomes Void due to any reason, the Mudarib is entitled to get a fee for his services.

33. Capital of Mudarabah • The capital in Mudarabah may be either cash or in kind. If the capital is in kind, its valuation is necessary, without which Mudarabah becomes void.

34. Distribution of Profit & Loss • It is necessary for the validity of Mudarabah that the parties agree, right at the beginning, on a definite proportion of the actual profit to which each one of them is entitled. • They can share the profit at any ratio they agree upon. • However in case the parties have entered into Mudarabah without mentioning the exact proportions of the profit, it will be presumed that they will share the profit in equal ratios. • Some incentives my be given to the Mudarib.

35. Distribution of Profit & Loss • Apart from the agreed proportion of the profit, the Mudarib cannot claim any periodical salary or a fee or remuneration for the work done by him for the Mudarabah. • The Mudarib & Rabb-ul-Maal cannot allocate a lump sum amount of profit for any party nor can they determine the share of any party at a specific rate tied up with the capital.

36. Distribution of Profit & Loss EXAMPLE If the capital is Rs.100,000/-, they cannot agree on a condition that Rs.10,000 out of the profit shall be the share of the Mudarib nor can they say that 20% of the capital shall be given to Rab-ul-Maal. However they can agree that 40% of the actual profit shall go to the Mudarib and 60% to the Rab-ul-Maal or vice versa.

37. Distribution of Profit & Loss • If the business has incurred loss in some transactions and has gained profit in some others, the profit shall be used to offset the loss at the first instance, then the remainder, if any, shall be distributed between the parties according to the agreed ratio.

38. Termination of Mudarabah • Mudarabah can be terminated any time by either of the two parties by giving notice. • If Mudarabah was for a particular term, it will terminate at the end of the term. • Termination of Mudarabah means that the Mudarib cannot purchase new goods for the Mudarabah. However, he may sell the existing goods that were purchased before termination.

39. Distribution at Termination • If all assets of the Mudarabah are in cash form at the time of termination, and some profit has been earned on the principal amount, it shall be distributed between the parties according to the agreed ratio. • If the assets of Mudarabah are not in cash form, they will be sold and liquidated so that the actual profit may be determined.

40. If there is a profit, it will be distributed between Mudarib and Rab-ul-Maal. • If no profit is left, Mudarib will not get anything.

41. Collective Mudarabah • “Collective Mudarabah” means a joint pool created by many investors and handled over to a single Mudarib who is normally a juristic person. • Collective Mudarabah creates two different relationships: • Relationship between investors inter se, which is Shirkah or Partnership. • Relationship of all the investors with mudarib, which is mudarabah.

42. When Mudarib is a Juristic Person • Who is the Mudarib? • Shareholders? • Management or Directors? • Juristic Person • Expenses of Mudarabah • Direct expenses are borne by the Mudarabah pool. • Indirect expenses are borne by the mudarib.

43. Running Mudarabah • Investors come in and go out at different dates • Profits are calculated on daily product basis. • Redemption before maturity • If the assets of mudarabah are in illiquid form, an investor may redeem his share by selling it to the pool.. • If the assets are in liquid form, a provisional amount may be given to him subject to final settlement

44. Musharakah

45. Musharakah • Musharaka is a form of partnership between two parties • Where each party contributes to the capital of the partnership in equal or varying proportions • Either to establish a new venture • or share in an existing one.

46. Musharakah • Principles for Distribution of Profit • Profit of each partner can be agreed as a % of the return from the business. • Profit should be identified as a % of the actual return and not in absolute terms. • Share of active partners can be more than share of sleeping partners. • The share of the sleeping partner cannot be more than the share of the active partner.

47. Musharakah Principle of Loss Scholars in Islam have a consensus on the principle that in case of a loss the share borne by each partner cannot exceed his share in the investment. Hazrat Ali (RA): “Profit should be on a mutual basis and loss should be shared in the ratio of investment.”

48. Musharakah The structure of a Musharaka Contract ISLAMIC BANK PARTNER (Customer) 60% Ownership 40% Ownership MUSHARAKA

49. Musharaka

50. Diminishing Musharaka