Ijarah / Leasing

•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 discussionThis Ijarah is analogous to the English term “Leasing”

Ijarah

Rules governing 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

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

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

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

Rules of Shariah governing IjarahIjarah

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

8. 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

Rules of Shariah governing IjarahIjarah

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

Rules of Shariah governing IjarahIjarah

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

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 LesseeIn 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

Ijarah

• 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

Expenses consequent to ownership

Ijarah

• 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

Liability of parties in case of loss to the asset

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 ways1. The Lease contract may stipulate a regular increase in rentSay, 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

Variable rentals in LeasesIjarah

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 principleSome 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

A third option is also availableIjarah

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

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 rentalsReason: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.

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 assetsInsurance 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

Ijarah

CUSTOMER

MECHANICS

ISLAMIC BANK

The Bank makes payment to the vendor

The Bank purchases the item required for leasing and receives title of ownership from the vendor

The customer approaches the Bank with the request for financing and enters into a promise to lease agreement.

VENDOR. .

Agreement-1

Process of Ijarah

CUSTOMER

MECHANICS

ISLAMIC BANK

The customer makes periodic payments as per the contract

The Bank leases the asset to the customer after execution of lease agreement.

VENDOR

Title transfers to the customer at the end

. .Agreement-2

Process of Ijarah

   Ijarah

 Murabaha

 Title Holder

 Financier

 Customer

Rate Fixed/Variable Fixed

Prepayment Allowed

Yes No/Controversial 

Refinance Available

Yes No 

Asset Risk Financier Customer

Late Payments

Controlable Loss to the Bank

 

Comparison of Ijara and Murabaha

IJARA

MUDARABAH

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.

Types of Mudarabah

1. Al Mudarabah Al Muqayyadah(Restricted Mudarabah)

1. Al Mudarabah Al Mutlaqah(Unrestricted

Mudarabah)

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).

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.

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.

Different Capacities of the Mudarib

1. Ameen (Trustee): The money given by Rabb-ul-maal (investor) and the assets required therewith are held by him as a trust.

2. Wakeel (Agent) : In purchasing goods for trade, he is an agent of Rabb-ul-maal.

3. Shareek (Partner): In case the enterprise earns a profit, he is a partner of Rrrrrabb-ul-maal who shares the profit in agreed ratio.

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.

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.

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.

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.

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.

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.

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.

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.

• 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.

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.

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.

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

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.

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.

Musharakah

Principle of LossScholars 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.”

Musharakah

The structure of a Musharaka Contract

ISLAMIC ISLAMIC BANKBANK

ISLAMIC ISLAMIC BANKBANK

PARTNERPARTNER(Customer)PARTNERPARTNER(Customer)

MUSHARAKAMUSHARAKAMUSHARAKAMUSHARAKA

60% Ownership40% Ownership

Musharaka

Diminishing Musharaka

Diminishing Musharaka involves taking share in the ownership of a specific asset and then gradually transferring complete ownership.

Three components

Joint ownership of the Bank and customer

Customer as a lessee uses the share of the bank

Redemption of the share of the Bank by the customer

DIMINISHING MUSHARAKADIMINISHING MUSHARAKA

CUSTOMER

The Bank enters into a Musharaka (Joint Ownership) agreement with the customer and both of them pay their respective shares to the seller of the asset.

Customer pays rent for the use of banks share in the property

The customer approaches the Bank with the request for Project/Machinery financing

BANK

Joint Ownersh

ipMusharak

a

Rent

DIMINISHING MUSHARAKADIMINISHING MUSHARAKA

CUSTOMER

The Bank enters into a Musharaka (Joint Ownership) agreement with the customer and both of them pay their respective shares to the seller of the asset.

Ownership of the asset is gradually transferred to the customer upon payment of asset price.

Customer pays rent for the use of banks share in the property

The customer approaches the Bank with the request for Project financing

BANK

Joint Ownersh

ipMusharak

a

Gradual Transfer of Ownership

DIMINISHING MUSHARAKADIMINISHING MUSHARAKA

DIMINISHING MUSHARAKA

Offers the most viable solution for housing finance.

As discussed, under this mode, the Financial Institution and client jointly purchase the house. The share of the bank is divided into a number of units and it is agreed that the client will purchase the units of the share of the bank gradually, thus increasing his own share until all the units of the Bank are purchased by him so as to make him the sole owner of the asset after a specified period.

During the financing period bank’s share is leased to the client who pays rent for using bank’s share in the asset

Housing Finance

IJARAH

Ijarah is an Islamic alternate of Leasing.

Under the mode, Bank purchases property for the client and give the property on lease to the client for an agreed period against an agreed rent.

After the agreed time period ownership of the asset is transferred to the client.

Housing Finance

MURABAHA

Murabaha is most commonly used mode of finance in Islamic Banking.

Financing under the mode is simple, Bank purchases property for the client from the market and sells the property to the client after adding profit thereon.

Ownership of the asset is transferred to the client at the inception of the transaction .

Housing Finance

Comparison of Three Options    Diminishin

g Musharaka

 Ijarah

 Murabaha

 Title Holder

 Joint Title  Financier  Customer

Rate Fixed/Variable

Fixed/Variable

Fixed

Prepayment Allowed

Yes 

Yes No/Controversial Refinance

AvailableYes 

Yes No 

Asset Risk Joint Financier Customer

Late Payments

Control able Control able Loss to the Bank

Comparison of Housing Finance Products

Mudaraba

• Mudaraba is a partnership agreement in which the investor

(the Rab-ul-mal) provides the necessary finance

• While the recipient of the funds (the Mudarib or the

Manager) provides the know-how towards carrying out the

venture

There are 2 types of Mudaraba

• Restricted Mudaraba

• Unrestricted Mudaraba

Mudaraba

Restricted Mudaraba:

• Rubb-ul-maal may specify a particular business for

the Mudarib,

• Mudarib can invest the money in that particular

business only.

Unrestricted Mudaraba:

• Rubb-ul-mal gives full freedom to Mudarib to

undertake whatever business he deems fit.

Types of MudarabaMudaraba

Distribution of Profit

• It is necessary for the validity of Mudaraba that

the parties agree at the time of entering into the

contract on the ratio in which the actual profit

will be shared

• Loss is borne only by Rabbul mal because the

Mudarib does not invest anything.

• Mudarib’s loss is considered to be wasted effort

Mudaraba