Ijarah
Leasing is an agreement that permits one party (the lessee) to use an asset or property owned by another party (the lessor) for an agreed-upon price over a fixed period of time. It is a form of asset finance which has the benefit of using assets without the requirements of ownership. The lessee acquires the asset he needs without borrowing on interest and receives the benefits of use while the lessor receives the value of regular rental payments for a specified period plus the residual value of the asset. The lease may be written either for a short-term or for a long-term and its rules are similar to those governing sale because in both cases there is a transfer of one thing between two parties for valuable consideration. However, leasing differs from sale as its mechanism allows the separation between ownership and use; in fact, it does not involve transferring the corpus or ownership of an asset which remains with the lessor.
There are generally two types of leases: a finance lease and an operating lease. A finance lease is mainly a method of raising long-term finance to pay for assets. It provides the lessor with full recovery of its investment and a reasonable profit over the initial non-cancelable lease term. This mode enables enterprises, especially SMEs, to acquire assets, such as capital goods and high cost equipment, for which they do not have the funds to make a large up-front payment that would otherwise be involved in a direct purchase. In this type of lease, the lessor retains ownership of the equipment but transfers to the lessee substantially all of the risks and rewards of ownership of the asset. The lessee is responsible for the insurance, registration and maintenance of the equipment.
Financial leases have some similar feature to secured loans. Both allow a business to use an asset, such as equipment, over a fixed period, in return for regular payments. The business client chooses the equipment it requires and the bank buys it on behalf of the business. After all the payments have been made, the business client becomes the owner of the equipment. The lessor's rate of return is fixed and is not dependent upon the asset-value, performance, or any other extraneous costs. The fixed lease rentals give rise to an ascertainable rate of return on investment. Therefore, by spreading payments out over the lifecycle of the asset, the business is able to align the cost with the benefit derived from the use of the leased asset. The lessor generally would not provide any services relating to operation of the asset. In addition, financial leases are non-cancellable; in fact, the lessee cannot return the asset and not pay the whole of the lessor's investment.
On the other hand, when a risk is involving other than a plain financial risk in a lease, it is an operating lease. In fact, an operating lease is similar to a rental agreement, and is not a finance lease for the purpose of acquiring assets; operating leases take innumerable forms based on the risks the lessor takes or avoids, and the involvement of the lessor in operation of the asset. Operating leases are also referred to as a “non-full payout” leases, because the amount of the rental does not cover the lessor’s full capital outlay for the expected economic life of an asset, the minimum lease payments over the lease term are such as to secure for the lessor the recovery of his capital outlay plus a market return on funds invested and the lease period is always less than the working life of the asset.
The basic features that differentiate an operating lease from a financial lease are related to whether the lessor or the lessee takes on the risks of ownership of the leased assets. In fact operating leases do not put the lessee in the position of a virtual owner; the lessee is simply using the asset for an agreed period. Also, there is always a dependence on the lessee's commitment to pay, as a result, the lessor also takes is asset-based. Its rate of return in an operating lease is dependent upon the asset value, performance, or costs relating to the asset; and is always a matter of probabilities and uncertainty.
Therefore, in an operating lease, the lessor normally holds a stock of assets with high degree of marketability to provide to other entities. He may also provide any services relating to these assets, such as maintenance or operations. The assets remain property of the lessor who has the option to re-lease them every time the lease period terminates. Accordingly, the lessor bears the risk of obsolescence, recession or diminishing demand. In contrast, a financial lease provider operates like a lender except that the lessor has the additional collateral of legal ownership of the assets without any of the risks associated with ownership.
There are generally two types of leases: a finance lease and an operating lease. A finance lease is mainly a method of raising long-term finance to pay for assets. It provides the lessor with full recovery of its investment and a reasonable profit over the initial non-cancelable lease term. This mode enables enterprises, especially SMEs, to acquire assets, such as capital goods and high cost equipment, for which they do not have the funds to make a large up-front payment that would otherwise be involved in a direct purchase. In this type of lease, the lessor retains ownership of the equipment but transfers to the lessee substantially all of the risks and rewards of ownership of the asset. The lessee is responsible for the insurance, registration and maintenance of the equipment.
Financial leases have some similar feature to secured loans. Both allow a business to use an asset, such as equipment, over a fixed period, in return for regular payments. The business client chooses the equipment it requires and the bank buys it on behalf of the business. After all the payments have been made, the business client becomes the owner of the equipment. The lessor's rate of return is fixed and is not dependent upon the asset-value, performance, or any other extraneous costs. The fixed lease rentals give rise to an ascertainable rate of return on investment. Therefore, by spreading payments out over the lifecycle of the asset, the business is able to align the cost with the benefit derived from the use of the leased asset. The lessor generally would not provide any services relating to operation of the asset. In addition, financial leases are non-cancellable; in fact, the lessee cannot return the asset and not pay the whole of the lessor's investment.
On the other hand, when a risk is involving other than a plain financial risk in a lease, it is an operating lease. In fact, an operating lease is similar to a rental agreement, and is not a finance lease for the purpose of acquiring assets; operating leases take innumerable forms based on the risks the lessor takes or avoids, and the involvement of the lessor in operation of the asset. Operating leases are also referred to as a “non-full payout” leases, because the amount of the rental does not cover the lessor’s full capital outlay for the expected economic life of an asset, the minimum lease payments over the lease term are such as to secure for the lessor the recovery of his capital outlay plus a market return on funds invested and the lease period is always less than the working life of the asset.
The basic features that differentiate an operating lease from a financial lease are related to whether the lessor or the lessee takes on the risks of ownership of the leased assets. In fact operating leases do not put the lessee in the position of a virtual owner; the lessee is simply using the asset for an agreed period. Also, there is always a dependence on the lessee's commitment to pay, as a result, the lessor also takes is asset-based. Its rate of return in an operating lease is dependent upon the asset value, performance, or costs relating to the asset; and is always a matter of probabilities and uncertainty.
Therefore, in an operating lease, the lessor normally holds a stock of assets with high degree of marketability to provide to other entities. He may also provide any services relating to these assets, such as maintenance or operations. The assets remain property of the lessor who has the option to re-lease them every time the lease period terminates. Accordingly, the lessor bears the risk of obsolescence, recession or diminishing demand. In contrast, a financial lease provider operates like a lender except that the lessor has the additional collateral of legal ownership of the assets without any of the risks associated with ownership.
Valid lease
Since leasing is a variety of sale, it is lawful in everything that can lawfully be bought and sold, and the rules of Shari´ah pertaining to sale are also generally applicable to leasing. In fact, any Islamic financing mode should be asset-based there has to be an element of risk taking. In fact, the profit is generated when an asset having intrinsic utility is sold or offered for use; and one cannot claim a profit without bearing the risk connected to the transaction. Therefore, most of the rules relating to the contract of sale come into existence also apply to Ijarah or Islamic leasing. Muslim jurists have, however, singled out some conditions the validity of an Ijarah contract with respect to the asset or service hired and the rental.
The first conditions required in a valid Ijarah are that the two sides of the exchange must both be known and specified in such a way that eliminates the possibility of disagreement and dispute; that the usufruct in question has a financial or market value; The assets from which it is almost impossible to derive any benefit from its use, cannot become the subject of Ijarah; and also the agreement does not involve unlawful activities and substances. The contracted usufruct and the rent should be ascertained clearly and agreed in advance, either for the full period of the lease or for a specified period in absolute terms.
Since leasing transfers the ownership of usufruct from the lessor to the lessee, the former must not only own the assets involved but also be able to transfer the ownership of its benefits to the lessee. If a particular asset is specified for Ijarah, the lease contract cannot be executed before getting of the asset or its usufruct. It is also a requirement of a valid Ijarah that the lease period must be specified and that the lessor retains ownership of the leased asset during the entire period of the lease. Liabilities arising from ownership will be borne by the lessor, while the liabilities relating to the use of the property leased asset will be borne by the lessee. The lessee is liable for any loss to the leased asset due to negligence, but he cannot be made liable for loss caused by factors beyond its control.
The rental can be determined, with the mutual consent of the contracting parties, on the basis of aggregate of the cost incurred by the lessor for the acquisition of the assets to be leased and based on a reasonable rate of return by reference to an agreed benchmark. If the lease is based on a floating rental rate, it is recommended to use a well known benchmark or index to determine rentals of subsequent periods in a long-term lease to avoid any dispute or injustice due to possible fluctuations in the market rate structure and binding nature of the lease contract. The floating rate, however, should be subjected to an upper limit in order to avoid the element of Gharar.
Furthermore, a stipulation may be inserted in the Ijarah contract making late payment by the lessee over a period of time liable to a certain amount of charity. This may provide prevention from late payment even though it does not compensate the lessor for his opportunity cost over the period of default. The lessor may also approach a competent court to award damages for any shortfall. The lessor can also demand payment of an earnest money amount as advance payment of rentals to ensure that the prospective lessee fulfils the commitment to take possession of the asset on lease when purchased by the lessor. If the Ijarah contract is not executed for any reason attributable to the lessee, the lessor can recover from the earnest money the amount of the actual losses suffered loss incurred in this agreement. And unlike normal sale which cannot be effected for a future date, Ijarah for a future date is permissible. The lease period and the lessor’s entitlement to rent, however, begin form the date on which the leased asset has been delivered to the lessee. The rent thereof may be payable in advance before delivery of the asset to the lessee. Any advance rentals must be adjusted against future rentals.
Finally, either the lessor or the lessee can make a unilateral promise to buy or sell the leased asset at the end of the lease period, or earlier, at an agreed price, provided that the lease agreement shall not be conditional upon such sale. On the other hand, the lessor may make a promise to gift the asset to the lessee upon termination of the lease, provided the lessee has fulfilled all the obligations under the contract. There must also not be any stipulation in the contract purporting to transfer of ownership of the leased assets at a future date.
The first conditions required in a valid Ijarah are that the two sides of the exchange must both be known and specified in such a way that eliminates the possibility of disagreement and dispute; that the usufruct in question has a financial or market value; The assets from which it is almost impossible to derive any benefit from its use, cannot become the subject of Ijarah; and also the agreement does not involve unlawful activities and substances. The contracted usufruct and the rent should be ascertained clearly and agreed in advance, either for the full period of the lease or for a specified period in absolute terms.
Since leasing transfers the ownership of usufruct from the lessor to the lessee, the former must not only own the assets involved but also be able to transfer the ownership of its benefits to the lessee. If a particular asset is specified for Ijarah, the lease contract cannot be executed before getting of the asset or its usufruct. It is also a requirement of a valid Ijarah that the lease period must be specified and that the lessor retains ownership of the leased asset during the entire period of the lease. Liabilities arising from ownership will be borne by the lessor, while the liabilities relating to the use of the property leased asset will be borne by the lessee. The lessee is liable for any loss to the leased asset due to negligence, but he cannot be made liable for loss caused by factors beyond its control.
The rental can be determined, with the mutual consent of the contracting parties, on the basis of aggregate of the cost incurred by the lessor for the acquisition of the assets to be leased and based on a reasonable rate of return by reference to an agreed benchmark. If the lease is based on a floating rental rate, it is recommended to use a well known benchmark or index to determine rentals of subsequent periods in a long-term lease to avoid any dispute or injustice due to possible fluctuations in the market rate structure and binding nature of the lease contract. The floating rate, however, should be subjected to an upper limit in order to avoid the element of Gharar.
Furthermore, a stipulation may be inserted in the Ijarah contract making late payment by the lessee over a period of time liable to a certain amount of charity. This may provide prevention from late payment even though it does not compensate the lessor for his opportunity cost over the period of default. The lessor may also approach a competent court to award damages for any shortfall. The lessor can also demand payment of an earnest money amount as advance payment of rentals to ensure that the prospective lessee fulfils the commitment to take possession of the asset on lease when purchased by the lessor. If the Ijarah contract is not executed for any reason attributable to the lessee, the lessor can recover from the earnest money the amount of the actual losses suffered loss incurred in this agreement. And unlike normal sale which cannot be effected for a future date, Ijarah for a future date is permissible. The lease period and the lessor’s entitlement to rent, however, begin form the date on which the leased asset has been delivered to the lessee. The rent thereof may be payable in advance before delivery of the asset to the lessee. Any advance rentals must be adjusted against future rentals.
Finally, either the lessor or the lessee can make a unilateral promise to buy or sell the leased asset at the end of the lease period, or earlier, at an agreed price, provided that the lease agreement shall not be conditional upon such sale. On the other hand, the lessor may make a promise to gift the asset to the lessee upon termination of the lease, provided the lessee has fulfilled all the obligations under the contract. There must also not be any stipulation in the contract purporting to transfer of ownership of the leased assets at a future date.
Ijarah Muntahia-bi-tamleek
In the Islamic jurisprudence, one transaction cannot be conditioned by another transaction. Ijarah and sale/purchase transactions are two different contracts and the transfer of ownership in the leased property cannot be made by a sale contract on a future date along with the Ijarah contract. Therefore a ‘Hire-Purchase’ agreement which combines both lease and sale at the time of contract, it is not suitable for Islamic banks.
The method acceptable to Shari´ah is that the ownership remains with the lessor along with all liabilities emerging from ownership. As a result, Islamic banks take the asset risk, bear the ownership related expenses and give or take responsibility for transfer of the asset to the lessee upon termination of the lease. This is done under Ijarah Muntahia-bi-tamleek which includes a promise by the lesser to transfer the ownership of the leased property to the lessee. The transaction basically remains that of Ijarah and the transfer of ownership is kept separate from the main Ijarah contract. Under this arrangement, the bank purchases the asset for the client who then leases the asset from the bank; at the end of the lease term, the transfer of the asset ownership to the lessee is kept separate.
Ijarah shares many common features with financial lease and hire-purchase arrangements. It involves a lessor purchasing an asset and renting it to a lessee for a specific time period at an agreed rental and at the end of the lease period transferring the ownership of the asset to the lessee. However, Ijarah Muntahia-bi-tamleek is different from the conventional leases where the rentals start accruing as soon as the payment for purchase of the asset being leased is made by the lessor; while in Ijarah Muntahia-bi-tamleek, rentals start at the time when the asset is supplied to the lessee in useable form. Also, if the price of the asset is paid to the lessee instead of the supplier, there must be an agency (Wakalah) agreement between the parties prior to the lease agreement that gives authority to the lessee to purchase the asset on behalf of the bank. If the asset is destroyed before its delivery to the lessee in useable form, the loss will be that of the bank and not of the agent. Therefore, the risk of the asset will be that of the bank as long as the client serves as its agent for purchase of the asset while in conventional lease all risks are borne by the lessee.
In addition, is different from a hire purchase and finance lease in the sense that it is an arrangement that does not comprise two contracts in one bargain; in fact, leasing is the real and the major contract; therefore, it is subject to all Shari´ah rules of an ordinary operating Ijarah contract. The transfer of ownership is processed through a separate sale or gift contract. This other part of the deal is only a unilateral promise not binding on the promissee and as such it is not a transaction until actually entered into by the parties. In addition, Ijarah Muntahia-bi-tamleek is a fair arrangement based on justice for both the parties; the lessor recovers cost of the leased asset and also the profit in the form of rentals while the lessee can get ownership title of the asset at the end of the lease period. The lessee is also protected from the loss by the lessor would bear all responsibility for loss of the leased asset, in case of absence of negligence on the part of the lessee.
The method acceptable to Shari´ah is that the ownership remains with the lessor along with all liabilities emerging from ownership. As a result, Islamic banks take the asset risk, bear the ownership related expenses and give or take responsibility for transfer of the asset to the lessee upon termination of the lease. This is done under Ijarah Muntahia-bi-tamleek which includes a promise by the lesser to transfer the ownership of the leased property to the lessee. The transaction basically remains that of Ijarah and the transfer of ownership is kept separate from the main Ijarah contract. Under this arrangement, the bank purchases the asset for the client who then leases the asset from the bank; at the end of the lease term, the transfer of the asset ownership to the lessee is kept separate.
Ijarah shares many common features with financial lease and hire-purchase arrangements. It involves a lessor purchasing an asset and renting it to a lessee for a specific time period at an agreed rental and at the end of the lease period transferring the ownership of the asset to the lessee. However, Ijarah Muntahia-bi-tamleek is different from the conventional leases where the rentals start accruing as soon as the payment for purchase of the asset being leased is made by the lessor; while in Ijarah Muntahia-bi-tamleek, rentals start at the time when the asset is supplied to the lessee in useable form. Also, if the price of the asset is paid to the lessee instead of the supplier, there must be an agency (Wakalah) agreement between the parties prior to the lease agreement that gives authority to the lessee to purchase the asset on behalf of the bank. If the asset is destroyed before its delivery to the lessee in useable form, the loss will be that of the bank and not of the agent. Therefore, the risk of the asset will be that of the bank as long as the client serves as its agent for purchase of the asset while in conventional lease all risks are borne by the lessee.
In addition, is different from a hire purchase and finance lease in the sense that it is an arrangement that does not comprise two contracts in one bargain; in fact, leasing is the real and the major contract; therefore, it is subject to all Shari´ah rules of an ordinary operating Ijarah contract. The transfer of ownership is processed through a separate sale or gift contract. This other part of the deal is only a unilateral promise not binding on the promissee and as such it is not a transaction until actually entered into by the parties. In addition, Ijarah Muntahia-bi-tamleek is a fair arrangement based on justice for both the parties; the lessor recovers cost of the leased asset and also the profit in the form of rentals while the lessee can get ownership title of the asset at the end of the lease period. The lessee is also protected from the loss by the lessor would bear all responsibility for loss of the leased asset, in case of absence of negligence on the part of the lessee.
Potential of Ijarah
There are many Islamic finance structures where Ijarah can be used. Islamic banks use this mode of financing with the purpose of enabling customers to use durable goods and equipment such as ships, housing, heavy machines and plants in productive enterprises who may be unable to buy them for their production purposes. Ijarah has also huge potential as a financing mode for retail, corporate and the public sectors and can also play a crucial role in promoting Islamic finance industry. It can be used as incentive to economic development as it is usually long term and offers potential for stimulating productive industries.
Leasing is an attractive mode of investment for Islamic banks because assets acquired under these contracts are usually of high quality, marketable and maintain their market value well above book value; therefore, the bank does not have to depend so much on the creditworthiness of the lessee, given that as a recourse, it can sell the asset to dispose for cash in case of default. And since the Islamic bank acquires the desired asset only when a client requests it and commits himself to enter into a lease contract with the bank, the possibility of misuse of funds and assets is minimized and the bank can make a profit by setting the rent at a level that covers, over the lease period, the purchase price as well as a return in line with the current rate of mark-up. In fact, Islamic banks can get variable and floating return on long term investments. And although Ijarah is a longer-term financing instrument, a leasing contract can be reviewed periodically. The financing party thus not tied down to a fixed return that may not be in its investment goals.
Furthermore, Ijarah offers the advantage of not requiring collateral and thus of simpler repossession procedures since ownership of the asset lies with the lessor. It also means that it has greater in-built stability to contain inflationary pressures in the economy. The lessor is only exposed to a low level credit risk from the lessee as the lease transaction is, by definition, asset-backed. Ijarah has also become popular due to a tax advantages as the rental can be offset against corporate tax by the lessee.
Finally, Ijarah can be used indirectly for Sukuk issues by the corporate and the government sectors. Ijarah Sukuk represent leased assets without actually relating the holders to any corporate body or institution. Securitisation on the basis of Ijarah is an alternative tool to interest based borrowing provided it uses durable and useable assets. For example, an aircraft leased to an airline can be represented in bonds and owned by a number of Sukuk holders, each of them individually and independently collecting their periodic rent from the airline company. The Sukuk holders are not owners of a share in a company that owns the leased asset, but simply a sharing owner of a part of the aircraft itself. Islamic banks are also able to offer leasing certificates to their depositor clients as specific investment certificates as a form of declining equity. These mechanisms facilitate the formation of fixed assets and can contribute to long term economically beneficial investment.
Leasing is an attractive mode of investment for Islamic banks because assets acquired under these contracts are usually of high quality, marketable and maintain their market value well above book value; therefore, the bank does not have to depend so much on the creditworthiness of the lessee, given that as a recourse, it can sell the asset to dispose for cash in case of default. And since the Islamic bank acquires the desired asset only when a client requests it and commits himself to enter into a lease contract with the bank, the possibility of misuse of funds and assets is minimized and the bank can make a profit by setting the rent at a level that covers, over the lease period, the purchase price as well as a return in line with the current rate of mark-up. In fact, Islamic banks can get variable and floating return on long term investments. And although Ijarah is a longer-term financing instrument, a leasing contract can be reviewed periodically. The financing party thus not tied down to a fixed return that may not be in its investment goals.
Furthermore, Ijarah offers the advantage of not requiring collateral and thus of simpler repossession procedures since ownership of the asset lies with the lessor. It also means that it has greater in-built stability to contain inflationary pressures in the economy. The lessor is only exposed to a low level credit risk from the lessee as the lease transaction is, by definition, asset-backed. Ijarah has also become popular due to a tax advantages as the rental can be offset against corporate tax by the lessee.
Finally, Ijarah can be used indirectly for Sukuk issues by the corporate and the government sectors. Ijarah Sukuk represent leased assets without actually relating the holders to any corporate body or institution. Securitisation on the basis of Ijarah is an alternative tool to interest based borrowing provided it uses durable and useable assets. For example, an aircraft leased to an airline can be represented in bonds and owned by a number of Sukuk holders, each of them individually and independently collecting their periodic rent from the airline company. The Sukuk holders are not owners of a share in a company that owns the leased asset, but simply a sharing owner of a part of the aircraft itself. Islamic banks are also able to offer leasing certificates to their depositor clients as specific investment certificates as a form of declining equity. These mechanisms facilitate the formation of fixed assets and can contribute to long term economically beneficial investment.
