EssentialsEssentials for for

Islamic FinanceIslamic Finance

IjarahIjarah (Leasing) (Leasing)

DefinitionDefinition

LeasingLeasing is a contract in which asset is is a contract in which asset is transfers to user for an agreed period on transfers to user for an agreed period on

an agreed considerationan agreed consideration

““IjarahIjarah is a lease contract as well as a is a lease contract as well as a hire contracthire contract”. ”.

Both the contract are similar to each Both the contract are similar to each

In Islamic Finance Ijarah is a In Islamic Finance Ijarah is a lease contract under which lease contract under which financial institution leases financial institution leases equipment or a building to equipment or a building to one of its clients against one of its clients against

agreed rentals or agreed rentals or installments equal to the installments equal to the

value of the assets. value of the assets.

Lesser or LesseeLesser or Lessee

The financier is known as lesser The financier is known as lesser who financer equipment for lessee.who financer equipment for lessee.

The equipment provider through The equipment provider through

financing isfinancing is LESSOR.LESSOR.

The equipment user is The equipment user is LESSEELESSEE

Ijarah Ijarah

Ijarah basically facilitate the cost to be Ijarah basically facilitate the cost to be spread for large purchases into spread for large purchases into

affordably installments for payment.affordably installments for payment.

In Ijarah either the end of the In Ijarah either the end of the transaction is the ownership of assets transaction is the ownership of assets that acquired through lease financing that acquired through lease financing or in another case the equipment is or in another case the equipment is

returned to financierreturned to financier..

Ijarah FinancingIjarah Financing is a contract in which a is a contract in which a lessee request for an equipment or a lessee request for an equipment or a property and Lesser provide through its property and Lesser provide through its financing the specified and requested financing the specified and requested equipment or property.equipment or property.

The LesseeThe Lessee agree to pays a monthly, agree to pays a monthly, quarterly, semi-annual or annual rent to quarterly, semi-annual or annual rent to lesser for the right to use equipment a lesser for the right to use equipment a specific amount within agreed time of time specific amount within agreed time of time i.e. 12, 24, 36, 48, or 60 months OR what i.e. 12, 24, 36, 48, or 60 months OR what ever time agreed.ever time agreed.

Historical PerspectiveHistorical Perspective Although leasing began in 2010 B.C. but modern Although leasing began in 2010 B.C. but modern

leasing began in the early fifties. leasing began in the early fifties. The creation of the Investment Tax Credit in The creation of the Investment Tax Credit in

1962 encourage growth through "tax-oriented" 1962 encourage growth through "tax-oriented" leasing.leasing.

New products were quickly developed to meet New products were quickly developed to meet the growing demand. the growing demand.

Over the last 50 years, many leasing companies Over the last 50 years, many leasing companies developed non-tax oriented products such as developed non-tax oriented products such as income funds, operating leases, limited income funds, operating leases, limited partnerships, vendor programs, and end sharing partnerships, vendor programs, and end sharing in order to remain competitive.in order to remain competitive.

Equipment leasing Equipment leasing blossomed over the last 20 blossomed over the last 20

yearsyears Banking industry started leasing by Banking industry started leasing by

giving credibility to a market place which giving credibility to a market place which had been previously regarded as a last-had been previously regarded as a last-resort financing alternative.resort financing alternative.

Accounting profession produced a Accounting profession produced a documents to help standardize lease documents to help standardize lease reporting in financial statements.reporting in financial statements.

Internal Revenue Service issued Internal Revenue Service issued guidelines to aid lesser and lessees in guidelines to aid lesser and lessees in structuring leasing transactionsstructuring leasing transactions..

Why do Lease Business ?Why do Lease Business ? Cash flow -Cash flow - Monthly payments are Monthly payments are

generally smaller for leases than for loans generally smaller for leases than for loans and they usually require a smaller or no and they usually require a smaller or no down payment.down payment.

Use vs. ownershipUse vs. ownership - Many businesses - Many businesses have discovered they don't need to own have discovered they don't need to own the equipment they use.the equipment they use.

In past renting and leasing were limited. In past renting and leasing were limited.

Today's psychology it more to economics Today's psychology it more to economics rather than moralities of ownership rather than moralities of ownership

Leasing is the modem technique which can be Leasing is the modem technique which can be compared with Islamic technique of Ijarah.compared with Islamic technique of Ijarah.

Leasing is based on fundamental concept of Leasing is based on fundamental concept of Ijarah, according to which one does not have Ijarah, according to which one does not have to own an asset in order to enjoy benefits of it. to own an asset in order to enjoy benefits of it.

There are business examples which benefited There are business examples which benefited from their investment in fixed assets and from their investment in fixed assets and made substantial capital profits from the sale made substantial capital profits from the sale of assets or been able to improve their of assets or been able to improve their balance sheets by the revaluation of assets. balance sheets by the revaluation of assets.

The Modern Concept of The Modern Concept of IjarahIjarah

Primarily profitability of a business Primarily profitability of a business lies in the effective utilization of its lies in the effective utilization of its resources. Therefore USE is resources. Therefore USE is important rather OWNERSHIP. important rather OWNERSHIP.

For exampleFor example Investment appraisal made on some Investment appraisal made on some

new venture. The choice of new venture. The choice of purchasing or leasing is partially a purchasing or leasing is partially a matter of arithmetic and partially a matter of arithmetic and partially a question of the availability of the question of the availability of the capital.capital.

ComparisonComparison A comparison between leasing and A comparison between leasing and

other similar forms of transactions, other similar forms of transactions, such as rental, will give a clearer such as rental, will give a clearer picture.picture.

"Rent a Car business is a contract "Rent a Car business is a contract according to which the objects are according to which the objects are leased to individuals or a number of leased to individuals or a number of users for a much shorter period than users for a much shorter period than their actual useful life. their actual useful life.

In contract law, the "In contract law, the "rental contractrental contract" " specifies the lease and the usage for an specifies the lease and the usage for an indefinite period. indefinite period.

Like IBM's computer sales system which has an Like IBM's computer sales system which has an overwhelming world market share.overwhelming world market share.

To promote sales in an attempt to outstrip its To promote sales in an attempt to outstrip its competitors, with the belief that it could control competitors, with the belief that it could control the progress of technological innovation of the progress of technological innovation of computers. computers.

Users of equipment leased on a rental system Users of equipment leased on a rental system are major enterprises with continuous usage of are major enterprises with continuous usage of rented equipment in a short-lived, but the lesser rented equipment in a short-lived, but the lesser is charged with the responsibility for is charged with the responsibility for maintenance.maintenance.

In the case of "rental" the lesser is moreover In the case of "rental" the lesser is moreover charged with the responsibility for coping with charged with the responsibility for coping with the products obsolescence, so that it may be the products obsolescence, so that it may be termed as a service-oriented business. termed as a service-oriented business.

Economic Role of ljaraEconomic Role of ljara Lease financing due to its special features Lease financing due to its special features

supplement existing conventional forms of supplement existing conventional forms of financing and further increase speed financing and further increase speed investment in the private sector.investment in the private sector.

There is a large requirement of balancing There is a large requirement of balancing and modernizing for existing industry.and modernizing for existing industry.

Lease financing through balancing and Lease financing through balancing and modernization of existing industry improve modernization of existing industry improve the capacity utilization, quality, production the capacity utilization, quality, production cost, profitability, internal generation of cost, profitability, internal generation of cash for future investment and cash for future investment and international competitive capability to international competitive capability to increase exports.increase exports.

Lease financing is most suited to Lease financing is most suited to the programs of balancing, the programs of balancing,

modernization and replacement. modernization and replacement. It would involve a small dosage of It would involve a small dosage of

investment which would carry investment which would carry relatively smaller investment risks relatively smaller investment risks but would result in a quick value but would result in a quick value

added production. It would added production. It would increase capacity utilization and increase capacity utilization and thus contribute to the growth of thus contribute to the growth of

the economythe economy..

Leasing is the contractLeasing is the contract Asset transfer to another for use on an agreed Asset transfer to another for use on an agreed

period with financial consideration.period with financial consideration. The subject of lease must have a valuable use.The subject of lease must have a valuable use. It is necessary for a lease contract that body It is necessary for a lease contract that body

of leased property remains in the ownership of leased property remains in the ownership of the seller and only its usage is transferred of the seller and only its usage is transferred to the lessee.to the lessee.

Any thing that cannot be used cannot be Any thing that cannot be used cannot be leased.leased.

Lease cannot be affected in respect of money, Lease cannot be affected in respect of money, edibles, fuel and ammunition etc. due to edibles, fuel and ammunition etc. due to consuming nature of products.consuming nature of products.

If anything of this nature is leased out, If anything of this nature is leased out, it would be consider as a loan with all it would be consider as a loan with all rules concerning the transaction of rules concerning the transaction of loan that would accordingly be applied. loan that would accordingly be applied.

Any rent charges on this invalid lease Any rent charges on this invalid lease would be treated as interest that is would be treated as interest that is usually charged on a loan. usually charged on a loan.

All the liabilities emerging from the All the liabilities emerging from the ownership shall be borne by the lesser, ownership shall be borne by the lesser, but the liabilities referable to the use but the liabilities referable to the use of the property shall be borne by the of the property shall be borne by the lessee.lessee.

ExampleExample Mr. Ahmed leased his House to Mr. Ahmed leased his House to

Mr. Badar. All taxes on the house Mr. Badar. All taxes on the house shall be borne by Mr. Ahmed as shall be borne by Mr. Ahmed as

he is the owner While water tax, he is the owner While water tax, electric bills and all expenses electric bills and all expenses

pertain to the use of house shall pertain to the use of house shall be borne by Mr. Badar the lessee.be borne by Mr. Badar the lessee.

The terms and conditions of The terms and conditions of the agreement would remain the agreement would remain

as:as:

Period of lease must be determined Period of lease must be determined in clear terms. in clear terms.

Lessee cannot use leased asset for Lessee cannot use leased asset for any purpose other than a purpose any purpose other than a purpose specified in the lease agreement. specified in the lease agreement.

If purpose not specified in the If purpose not specified in the agreement, lessee is allowed to use agreement, lessee is allowed to use assets it for whatever purpose in the assets it for whatever purpose in the normal course. normal course.

If Lessee use it for an abnormal If Lessee use it for an abnormal purpose he cannot do so unless the purpose he cannot do so unless the lesser allows him in specific terms.lesser allows him in specific terms.

The lessee is liable to The lessee is liable to compensate lessee for any harm compensate lessee for any harm caused to leased asset by any caused to leased asset by any lapse or carelessness from the lapse or carelessness from the part of the lessee.part of the lessee.

Leased asset shall remain in the Leased asset shall remain in the risk of lesser throughout lease risk of lesser throughout lease period.period.

Any harm or loss caused by the Any harm or loss caused by the factors beyond the control of the factors beyond the control of the lessee shall be borne by the lessee shall be borne by the lesser.lesser.

Asset jointly owned by two or more Asset jointly owned by two or more person can be leased out and rental shall person can be leased out and rental shall be distributed between joint owners be distributed between joint owners according to the proportion of their according to the proportion of their respective shares in the property. respective shares in the property.

Lessee is not responsible for interfere Lessee is not responsible for interfere with any kind of share and distribution of with any kind of share and distribution of share amount. share amount.

Lease in proportion share only allowed to Lease in proportion share only allowed to the co-share only not to any other the co-share only not to any other individual. individual.

It is necessary for a valid lease that the It is necessary for a valid lease that the leased asset is fully identified by the leased asset is fully identified by the parties.parties.

ExampleExample “ “A said to B “I lease you out my carsA said to B “I lease you out my cars”.”.

Lease is void unless leased car is clearly Lease is void unless leased car is clearly identified.identified.

Rental must be determined for whole period of Rental must be determined for whole period of lease at the time of contracting a lease.lease at the time of contracting a lease.

It is permissible that different amounts of rent It is permissible that different amounts of rent are fixed for different phases during the lease are fixed for different phases during the lease period, provided that the amount of rent for period, provided that the amount of rent for each phase is specifically agreed upon at the each phase is specifically agreed upon at the time of lease agreement.time of lease agreement.

If the rent for a prior phase of the lease period If the rent for a prior phase of the lease period has not been determined or left at the option for has not been determined or left at the option for the lesser, the lease will not be validthe lesser, the lease will not be valid..

ExampleExample

Mr. A leases his house to Mr. B Mr. A leases his house to Mr. B for a period of 5 years. for a period of 5 years.

The rent for the first period is fix The rent for the first period is fix at an amount on monthly basis at an amount on monthly basis

and it is also agreed that the rent and it is also agreed that the rent of every subsequent year shall be of every subsequent year shall be 10% more than the previous one.10% more than the previous one.

The leases remains valid The leases remains valid

In this example Mr. A laid down a In this example Mr. A laid down a condition in the agreement that rent of condition in the agreement that rent of an amount per month is fixed for the first an amount per month is fixed for the first year only. year only.

Rent for subsequent year shall be fixed Rent for subsequent year shall be fixed each year at the option of the lesser.each year at the option of the lesser.

The lease is void, because the rent would The lease is void, because the rent would be uncertain.be uncertain.

Mostly in the long-term lease agreement Mostly in the long-term lease agreement it is not in the benefit of the lesser to fix it is not in the benefit of the lesser to fix one amount of rent for the whole period one amount of rent for the whole period due to the fact the market conditions due to the fact the market conditions differ from time to time. differ from time to time.

In this case, the lesser has two options, either In this case, the lesser has two options, either (a) He can contract a lease with a condition that (a) He can contract a lease with a condition that

the rent shall be increased at a specified the rent shall be increased at a specified proportion after a specified period. Like six proportion after a specified period. Like six months or one year.months or one year.

OrOr (b) He can contract the lease for a shorter (b) He can contract the lease for a shorter

period after which the parties of lease in fresh period after which the parties of lease in fresh terms and conditions, but the renewal shall be terms and conditions, but the renewal shall be affected by mutual consent with full liberty to affected by mutual consent with full liberty to each one of them to refuse the renewal. each one of them to refuse the renewal.

In such case the lessee is bound to vacate the In such case the lessee is bound to vacate the leased assets and return it back to the lesser.leased assets and return it back to the lesser.

Lesser cannot raise rent unilaterally for Lesser cannot raise rent unilaterally for that reason any agreement to the that reason any agreement to the contrary is null and void.contrary is null and void.

Rent or part thereof may be payable in Rent or part thereof may be payable in advance before delivery of asset, but advance before delivery of asset, but the amount collected by lesser shall the amount collected by lesser shall remain with him as account payment remain with him as account payment and shall be adjusted to the rent after it and shall be adjusted to the rent after it is due.is due.

Lease period shall commence from the Lease period shall commence from the date on which leased asset has been date on which leased asset has been delivered to lessee, no matter whether delivered to lessee, no matter whether the lessee has started using it or not.the lessee has started using it or not.

If leased asset has totally lost the If leased asset has totally lost the function for which it was leased for function for which it was leased for and no repair is possible then lease and no repair is possible then lease shall terminate on the day on which shall terminate on the day on which

such loss has been caused. such loss has been caused.

However, if the loss caused by the However, if the loss caused by the misuse or by the negligence of the misuse or by the negligence of the

lessee he will be liable to lessee he will be liable to compensate the lesser with the compensate the lesser with the

depreciated value of the asset as it depreciated value of the asset as it was immediately before the loss.was immediately before the loss.

Like other modes of financing, lease is not Like other modes of financing, lease is not originally treated as one. originally treated as one.

It is simply a transaction meant to transfer the It is simply a transaction meant to transfer the use of an asset from one person to another for use of an asset from one person to another for an agreed consideration. an agreed consideration.

Certain financial institutions have adopted Certain financial institutions have adopted leasing as a mode of finance used in place of leasing as a mode of finance used in place of interest.interest.

This kind of lease, generally known as the This kind of lease, generally known as the financial lease notable from the operating lease financial lease notable from the operating lease that has many basic features of actual leasing that has many basic features of actual leasing transactions with which it is distribute with. transactions with which it is distribute with.

When the financial institutions on interest free When the financial institutions on interest free modes established in the recent past they modes established in the recent past they found that leasing was a recognized mode of found that leasing was a recognized mode of finance throughout the world.finance throughout the world.

On the other hand, they realized that leasing On the other hand, they realized that leasing was a lawful transaction according to Shariah was a lawful transaction according to Shariah and it could be used as an interest free mode of and it could be used as an interest free mode of finance. finance.

Leasing has been adopted by the Islamic Leasing has been adopted by the Islamic Financial Institutions, yet very few of them paid Financial Institutions, yet very few of them paid attention to the fact that the financial lease has attention to the fact that the financial lease has a number of characteristics more similar to a number of characteristics more similar to interest as the actual lease transaction.interest as the actual lease transaction.

They started using same model agreements for They started using same model agreements for leasing as were in vogue among the traditional leasing as were in vogue among the traditional financial institutions without any modification, financial institutions without any modification, while a number of their provision was not in while a number of their provision was not in conformity with the Shariah.conformity with the Shariah.

The primary advantage of Ijarah over the The primary advantage of Ijarah over the conventional forms of borrowing to conventional forms of borrowing to finance equipment is that the ownership finance equipment is that the ownership of the asset remains with the lesser. of the asset remains with the lesser.

The financing is largely unrelated to the The financing is largely unrelated to the size of assets and the capital base of the size of assets and the capital base of the lessee, depending principally on the lessee, depending principally on the ability of cash flow to service payments of ability of cash flow to service payments of lease rentals.lease rentals.

Ijarah is probably the most suitable mean to Ijarah is probably the most suitable mean to raise investment funds especially for industries raise investment funds especially for industries where rapid technological innovation is either where rapid technological innovation is either underway or desired, top class firms which are underway or desired, top class firms which are quickly expanding their business or small & quickly expanding their business or small & medium enterprises and firms which have medium enterprises and firms which have normally insufficient assets and capital base to normally insufficient assets and capital base to meet normal collateral requirements of most meet normal collateral requirements of most other forms of long term financing. The basic other forms of long term financing. The basic security under the Ijarah arrangement is the security under the Ijarah arrangement is the "ownership of the equipment". The title of "ownership of the equipment". The title of ownership to the equipment remains with the ownership to the equipment remains with the leasing company but in case of serious default, leasing company but in case of serious default, the equipment is repossessed the equipment is repossessed