UAE Laws and Islamic Finance

Laws of the UAE and Islamic Finance

Ijarah (Finance and Operating Leases) In Islamic Finance

According to Norton Rose, Ijarah involves the act of leasing in which the owner of the asset transfers its manfa’a or usufruct to another person to use for an agreed period and for an agreed rent.

The ownership of the leased equipment remains in the hand of the lessor.  Under the Sharia’h concept of leasing finance,  the bank purchases the asset required by the customer and then leases the asset to the customer for a given period.  A master agreement may be drawn up covering a number of Ijarah transactions between the bank and the customer and setting out the general terms and conditions of agreement between the two parties.  In this case, there may either be a separate lease contract for each transaction in a specific written document signed by the two parties or alternatively, the two parties may exchange notices of offer and acceptance by referring to the terms and conditions in the master agreement. (The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan.  (2003))

According to Norton Rose, the subject of the lease must be valuable, identifiable, and quantifiable.  Anything which cannot be used without being consumed cannot be leased.  As title to the leased asset remains in the ownership of the lessor, all liabilities arising from its ownership must be borne by the lessor.  The Lessee cannot use the leased asset for any purpose other than that stated in the lease agreement and use of the leased asset must be Sharia’h compliant.

The Advantages of Ijarah *(According to Wikipedia)

Ijarah provides the following advantages to the Lessee:

  • Ijarah conserves the Lessee’ capital since it allows up to 100% financing.
  • Ijarah gives the Lessee the right to access the equipment on payment of the first installment. This is important as it is the access and use (and not ownership) of equipment that generates income.  (Ijarah 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  — http://www.financialislam.com).
  • Ijarah arrangements aid corporate planning and budgeting by allowing the negotiation of flexible terms.
  • Ijarah is not considered Debt Financing so it does not appear on the Lessee’ Balance Sheet as a Liability. This method of “off-balance-sheet” financing means that it is not included in the Debt Ratios used by bankers to determine financing limits. This allows the Lessee to enter into other lease financing arrangements without impacting his overall debt rating.
  • All payments towards Ijarah contracts are treated as operating expenses and are therefore, fully tax-deductible. Leasing thus offers tax-advantages to for-profit operations.
  • Many types of equipment (i.e computers) become obsolete before the end of their actual economic life. Ijarah contracts allow the transfer of risk from the Lessee to the Lessor in exchange for a higher lease rate. This higher rate can be viewed as insurance against obsolescence.
  • If the equipment is used for a relatively short period of time, it may be more profitable to lease than to buy.
  • If the equipment is used for a long period, but has a very poor resale value, leasing avoids having to account for and depreciate the equipment under normal accounting principles.

According to Norton Rose, an Ijarah can be an operating lease where the lessee has the right of occupation of the leased premises or it may be a finance lease where the lessee has the right to acquire title to the asset upon expiration of the 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.  (www.financialislam.com)

Operating Lease

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  “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.

Financial v. Operating Lease

The basic features that differentiate an operating lease from a financial lease are related to whether the lessor or the lessee takes on the risk 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. There is always dependence on the lessee’s commitment to pay and as a result, what the lessor takes is asset-based.  In contrast to a financial lease,  the 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.

In an operating lease, 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.  (www.financialislam.com)

Financial Lease

Modern Islamic Finance often combines leasing with purchase in a single contract called hire-purchase known as Ijarah wa Iqtina, Ijarah Thummah Bai, or Al-Ijarah Al Muntahiah. (The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan.  (2003))

Ijara Wa Iqtina, Ijarah Thummah Bai, or Al-Ijarah Al Muntahiah allows for financing of a short, medium or long-life asset.   

Ijarah wa Iqtina

Ijarah wa Iqtina is basically a contract under which an Islamic bank provides equipment, buildings, or other assets to the client against an agreed rental agreement together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset transfers from the lessor to the lessee. It is important to note that the undertaking or the promise does not become an integral part of the lease contract so as to make the contract conditional upon the undertaking. The rentals as well as the purchase price are fixed in such a manner that the bank gets back its principal sum along with profit over the period of lease. (Wikipedia)

According to Norton Rose, during the lease period of the Ijarah wa Iqtina, the lessor’s investment in the asset can be amortized while the lessee’s equity can be protected by the ability to call for title to be transferred from the lessor to the lessee at anytime during the lease term upon payment of a purchase price amount.  (Norton Rose)

Validity of the Ijarah Contract:

Besides the conditions of sanity, adolescence, freedom and mutual consent of the contracting parties, the following conditions must be net for an Ijarah contract to be valid:

  1. The goods rented should be present and capable of being handed over to the lessor after the completion of the contract of hire;
  2. The usufruct of the goods or services being hired should have value;
  3. The rent of hired goods should be specifically fixed.  According to the jurists, rent will be due when the following conditions are met:
    1. Complete acquisition or attainment of the usufruct of the hired goods/capital equipment; or
    2. Ability of the lessee to use the usufruct of the hired goods (though he may not enjoy it actually);
  4. The contract of Ijarah should not comprise any such condition according to which rent or wages might be paid from the article manufactured.  Similarly, the contract stipulating the rent consisting of a similar usufruct is invalid.  If a person hires land to cultivate in return for the right (on the part of the lessor) of cultivating another land, it is invalid.  However, if two articles of two different usufructs are thus exchanged in the contract of hiring, it is valid.
  5. The usufruct of the hired article must be specified.  Specification of the usufruct includes the following items:
    1. The period of the use of usufruct.  The lessor may lease his goods or services for a long period.  The property of Waqf, however, may not be hired for more than three years.  Imam Malik (RA) maintains that a long period for the use of the usufruct is not advisable because it may lead to dispute and conflict.  According to some Hanbalites, there is no need to state the start and end dates for the term of usufruct.  Notwithstanding this, in the author’s view, it is necessary to state the start and end date for the lease period because any absence of the date could be interpreted as a monthly Ijarah wherein the lessor has the right to terminate the lease at anytime;
    2. The purpose of the hired goods;
    3. Rent (its nature and amount);
    4. The article being hired should be physically fit for hire;
    5. Any excuse, from a Sharia’h point of view, should not creep into the contract of hiring of which will invalidate it;
    6. The lessor should hand the hired article over to the lessee in its complete form and shape;
    7. The lessor must have full possession an legal ownership of the article he is hiring out;
    8. Existence of the hired article should continue throughout the contract period;
    9. The benefit for an Ijarah must be lawful according to the Sharia’h.

(The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan.  (2003))

Ijarah Thumma Bai

Ijarah Thumma Bai means an act of hiring followed by sale and purchase.

Parties enter into contracts that come into effect serially with the purpose of  conducting a lease/ buyback transaction. The first contract is an Ijarah that outlines the terms for leasing over a fixed period of time.  Upon expiry of the leasing period, the lessee enters into a second contract to purchase the goods from the lessor at an agreed price.   This is a Bai or sale contract that triggers a sale or purchase once the term of the Ijarah contract is complete.

The bank generates a profit by determining in advance the cost of the item, its residual value at the end of the term, and the time value or profit margin for the money being invested in purchasing the product to be leased for the intended term. The combining of these three figures becomes the basis for the contract between the Bank and the client for the initial lease contract.  (Wikipedia and The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan.  (2003))

The structure of a contract can be such as follows:  The tenant pays, in addition to lease a sum, which goes towards buying the leased property.  The tenant is given credit for her payments by becoming the gradual owner of the property, with the result that the proportion of her payments that goes towards rent also reduces continually over time.

The method of transferring title in the leased asset from the lessor to the lessee must be evidenced in a document separate from the Ijarah contract document using one of the following methods:

  1. By means of a promise to sell for a token or other consideration or by accelerating the payment of the remaining amount of rental or by paying the market value of the leased property;
  2. A promise to give it as a gift (for no consideration) or in other words as a Hibah; or
  3. A promise to give it as a gift, contingent upon the payment of the remaining installments.

The separate document evidencing transfer of title cannot be taken as an integral part of the Ijarah contract.  (The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan.  (2003))

 

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 is not suitable for Islamic banks.

The method acceptable to Sharia’h 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, Ijarah Muntahia-bi-tamleek  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 major contract.  Therefore, Ijarah Muntahia-bi-tamleek  is subject to all Sharia’h rules of an ordinary operating Ijarah contract. The transfer of ownership is processed through a separate sale or gift contract. This 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 parties; the lessor recovers the 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 loss by the lessor, who bears all responsibility for loss of the leased asset except in the case of negligence on the part of the lessee.  (www.financialislam.com)

 

Interesting References on Ijarah

 

Ijarah by Maulana Taqi Usmani

http://www.kantakji.com/fiqh/Files/Finance/70031.pdf

 

Interesting Articles on Ijarah including Fatwa on Ijarah

http://www.isra.my/fatwas/topics/commercial-banking/financing/ijarah.html

Ijarah

http://www.islamic-world.net/economic/ijarah/ijarah.html

Ijarah by Dr.Abdul Sattar Abu Ghuddah

Secretary General, Unified Shariah Panel Dallah Al-Barakah Group

http://www.albaraka.com/media/pdf/Research-Studies/RSIJ-200706201-EN.pdf

Ijarah

http://www.financialislam.com/ijarah.html

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