ijarah and diminishing musharakah - lecture 10

1

This module will introduce the following basic Islamic modes of financing:

Diminishing Musharaka

Ijarah

2

Ijarah / Leasing

3

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 salary for his

work

•“A” hires a porter at the airport to carry his luggage

4

Ijarah

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”

5

Ijarah

Rules governing Ijarah

6

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

7

Ijarah

Ijarah as a mode of financing

Leasing is an acceptable transaction under Shariah

The difference between conventional Lease and IjarahLies 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-IslamicAnd thereby invoking a prohibition

8

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

9

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

2. However, ownership of the leased asset remains with the Lessor

10

Ijarah

3. 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 ownerWater tax, electricity bill etc are to be borne by the Lessee

11

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

7. Normal maintenance is Lessee’s responsibility

12

Ijarah

8. The asset to be leased should be clearly identified

9. Lease rentals for the entire lease period must be fixed; However,

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

13

Ijarah

10. The Lessor cannot increase the rent unilaterally

11. The Lessor may receive the rent in advancesuch payment should be recorded as an “on Account” paymentsince rent can be received only for use of an asset

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 was at fault, he is liable to compensate the Lessor for the loss

14

Ijarah

Conventional leases are of two types

Sale & Leaseback – Where the Lessee has already purchased the asset

The Lessor purchases the asset from the Lessee

And leases it back to him

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

15

Ijarah

Sometimes, the Lessor does not pay the supplier directly

But authorizes the Lessee to purchase the asset on his behalfActing 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

16

Ijarah

In all the above cases, under conventional LeaseThe Lease rental starts from the date of payment by LessorRegardless of when the asset is delivered

This means that Lessee has to pay rent before delivery of assetThis is not allowed in ShariahBecause it is the same as charging rent for moneyWhich 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

17

IjarahExpenses 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 costImport dutiesTransportation to factoryInstallation costInsurance

He may build all these expenses into the asset’s costAnd take them into consideration when calculating the lease rental

18

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

19

Ijarah

Variable rentals in Leases

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

20

Ijarah

Variable rentals in Leases

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

21

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%

22

Ijarah

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

e.g SBP discount + 3% p.a., T-bill + 5% p.a.

Because they want to earn the same profit rate as the market

23

Ijarah

Objection: By using the Interest Rate as a benchmarkThe transaction becomes similar to an interest based transaction

24

Ijarah

Response:As long as the basic requirements under Shariah are being complied

withAny 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 isIn case of a lease, the Lessor assumes the full risk of the ownership of the assetAnd also cannot charge rental if the asset loses its utility

25

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 utilityOr 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

26

Ijarah

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 to the

Lessor

Which the Lessor should deposit into a charity account

27

Ijarah

Termination of Lease

If the Lessee contravenes any term of the Lease agreement

The Lessor may unilaterally terminate the agreement

However, 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

28

Ijarah

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 costWhile calculating the lease rent

And increase the lease rent

29


30

Basic concept:

• Financier and client participate in joint ownership of property or commercial enterprise

• Client agrees to purchase financier’s share periodically

• Purchases financier's share over a period

• Till ownership is completely transferred to client


31

1. House financing

Client wants to purchase house

Client invests 20% of cost

Financier invests 80% of costs

House is owned by both, but used by client


32

Client pays rent to the financier for use of his property

Client purchases financier’s share periodically according to agreed schedule

Each payment consists of two portions

Price of Financiers’ share being purchased

Rent on Financier’s share outstanding


33

As the financier’s proportion of ownership declines

The rent payable by client decreases accordingly

This process continues till the client purchases entire share of financier


34

This process allows financier to

Claim rent according to his proportion of ownership in the property

Earn a periodic return commensurate with his investment


ijarah and diminishing musharakah - lecture 10

Documents