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This module will introduce the following basic Islamic modes of financing:
Diminishing Musharaka
Ijarah
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Ijarah / Leasing
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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
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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”
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Ijarah
Rules governing Ijarah
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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%
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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
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Ijarah
Objection: By using the Interest Rate as a benchmarkThe transaction becomes similar to an interest based transaction
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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
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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
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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
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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
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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
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Diminishing Musharaka
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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
Diminishing Musharaka
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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
Diminishing Musharaka
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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
Diminishing Musharaka
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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
Diminishing Musharaka
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This process allows financier to
Claim rent according to his proportion of ownership in the property
Earn a periodic return commensurate with his investment
Diminishing Musharaka