Topic iv. ijarah and other non participatroty modes of islamic finance(2)
- 1. Ijarah and Other Non Participatory Modes of Islamic Finance Contract 1
- 2. Ijarah 2 Ijarah is a term of Islamic Fiqh. It means to give something on rent. In the Islamic jurisprudence, the term ijarah is used for two different situations. 1. In the first place, it means to employ the services of a person on wages given to him as a consideration for his hired services. The employers is called the mustajir while the employee is called ajir. Wages paid to the ajir are called their ujrah. 2. The second type of ijarah relates to the usufructs of assets and properties. Ijarah in this sense means to transfer the usufruct of a particular property to another person in exchange for a rent. Lessor is called mujir, the lessee is called mustajir and the rent is called ujrah.
- 3. Ijarah 3 The second type of ijarah is more relevant, because it is generally used as a form of investment, and as a mode of financing also. The rule of Ijarah, in the sense of leasing, is very much analogous to the rules of sale. In sale corpus of the property is transferred to purchaser. In case of ijarah, the corpus of the property remains in the ownership of the transferor, but only the usufruct i.e. right to use it, is transferred to the lessee. Ijarah is not mode of financing in its origin.
- 4. Basic Rules of Leasing 4 Leasing is contract whereby the owner of something transfers its usufruct to another person for an agreed period, at an agreed consideration. The subject of lease must a have valuable use. The leased property remains in the ownership of the seller, and only its usufruct is transferred to the lessee. Anything which cannot be used without consuming cannot be leased out. All the liabilities emerging from the ownership shall be borne by the lessor. All the liabilities referable to the use of property shall be borne by the lessee. Example: A has leased his house to B. The taxes relating to the property shall be borne by A. The water tax, electricity bills and all expenses relating to the use of the house shall be borne by B (the lessee). The period of lease must be determined in clear terms.
- 5. Basic Rules of Leasing 5 The lessee cannot use the leased asset for any purpose other than the purpose specified in the lease agreement. If no such purpose is specified in the agreement, the lessee can use it for whatever purpose it is used in the normal course. For abnormal usage, lessee cannot do so unless the lessor allows him in express terms. Lessee is liable for any loss caused by any misuse or negligence on the part of the lessee. The leased asset shall remain in the risk of the lessor throughout the leased period in the sense that any damage or loss caused by any factors beyond the control of the lessee shall be borne by the lessor. A joint property (A property owned by two or more persons) can be leased out. The rental shall be distributed between all joint owners according to the proportion of their shares. The leased asset should be fully identified by the parties. Example1: for the first year is fixed at Rs2000/- per month and it is agreed that the rent for every subsequent year shall be 10% more than the previous one. The lease is valid. Example 2: If in the above example A puts a condition in the agreement that the rent of Rs2000/- per month is fixed for the first year only. The rent for the subsequent year shall be fixed each year at the discretion of the lessor. The lease is void, because the rent is uncertain.
- 6. Basic Rules of Leasing 6 In long-term lease agreements it is mostly not beneficial for the lessor to fix one amount of rent for the whole period because market conditions change from time to time. In this case the lessor has two options: (a) He can contract a lease with the condition that the rent shall be increased at a specified proportion after a specified period like six months or one year. (b) He can contract the lease for a shorter period after which the parties can . renew the lease on fresh terms and conditions but the renewal shall be effected by mutual consent with full liberty to each one of them to refuse the renewal in which case the lessee is bound to vacate the leased property and return it to the lessor.
- 7. Basic Rules of Leasing 7 The rental must be determined at the time of contract for the whole period of lease. The lessor can charge different rent for different period but that amount must be agreed at the time of effecting a lease. The determination of rental on the basis of cost is allowed in Shariah. The lessor cannot increase the rent unilaterally. The rent or any part may be payable in advance. The lease period start from the date of delivery, not from the date of usage by lessee. If asset totally loss then lease will terminated. If loss is due to misuse of lessee, he will liable to pay the depreciated value of asset.
- 8. Lease as a Mode of Financing 8 Like murabahah, lease is not originally a mode of financing. It is simply a transaction meant to transfer the usufruct of a property.
- 9. 9 In lease-and-purchase financing schemes, the lessor makes a unilateral binding promise to sell or gift the asset to the lessee at the end of the ijara period. The lessee has the option to buy – take – the asset or not. It is important that the lessor’s promise is made separate from the ijara – leasing – contract, as it is prohibited in shari’ah to combine two sales in one contract. This also ensures that ownership rights (e.g., not selling) of the lessor are not violated. Periodic payments include two components: (1) the return of part of the capital invested in the purchase of the asset and (2) the compensation for the usufruct – rent.
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- 12. Securitization of Ijarah 12 Ijarah can be securitized and lessor can issue ijarah certificate. The certificate holder holds the proportionate ownership in the leased asset and he will assume the rights and obligations of the lessor to that extent. These certificates can be negotiated and traded in freely in the market. These certificates easily convertible into cash. These certificates help in solving the problems of liquidity faced by banks. Some certificates representing the holders claim only on rental income, this is not allowed in Shariah. Ijarah certificates are designed to represent real ownership of the leased assets, and not only a right to receive rent.
- 13. Securitization of Ijarah 13 Ijarah can be securitized and lessor can issue ijarah certificate. The certificate holder holds the proportionate ownership in the leased asset and he will assume the rights and obligations of the lessor to that extent. These certificates can be negotiated and traded in freely in the market. These certificates easily convertible into cash. These certificates help in solving the problems of liquidity faced by banks. Some certificates representing the holders claim only on rental income, this is not allowed in Shariah. Ijarah certificates are designed to represent real ownership of the leased assets, and not only a right to receive rent.
- 14. Salam and Istisna 14 Basic conditions of sale: 1. The commodity must be existing. 2. Seller should have acquired the ownership. 3. The seller should possess it, either physically or constructive. There are only two exceptions to this general principles in Shariah. One is Salam and the other is Istisna.
- 15. Salam: Prepaid forward sale 15 Salam is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future in exchange of an advanced price fully paid at spot. Price is cash, but the supply of the purchased goods is deferred. Buyer is called rabb us salam, the seller is muslam ilaih, the cash price is ras ul mal and the purchased property is commodity is termed as muslam fih. Salam was allowed by Holy Prophet (PBUH) subject to certain conditions. The basic purpose of this sale was to meet the needs of the small farmers who needed money to grow their crops and to feed their family up to the time of harvest. Traders are also allowed to sell their goods in advance because they cannot take loan on interest. Buyer also benefit from salam because normally the price of salam is lower than price in spot sales.
- 16. Conditions of Salam 16 Buyer pays the price in full to the seller at the time of effecting the sale. The salam is to fulfill the basic need of the seller, so full payment of the price is necessary in salam. Salam can be effected in those commodities only the quality and quantity of which can be specified exactly. Example, precious stones cannot be sold on the basis of bay’ al-salam. This is because every piece of precious stones is normally different from the other either in its quality or in its size or weight and their exact specifications is not generally possible; Salam cannot be effected on a particular commodity or on a product of a particular field or farm which must be delivered at spot. Example: if wheat is purchased in exchange of barley, it is necessary that the delivery of both be simultaneous Quality of the commodity is fully specified leaving no ambiguity which may lead to a dispute. The quantity of the commodity is agreed upon in unequivocal terms.
- 17. Conditions of Salam 17 The exact date and place of the delivery must be specified in the contract. According to some school of fiqh, the commodity remains available in the market from day of contract up to date of delivery. However some other school of fiqh are of view the availability of commodity at the time of the contract is not a condition for salam. According to some school of fiqh, the time of delivery is at least one month from the date of agreement. Other school of figh opposed it that holy Prophet (PBUH) has not specified a minimum period for the validity of contract.
- 18. Salam as Mode of Financing 18 Salam was allowed by Shariah to fulfill the need of farmers and traders. Salam is basically mode of financing for small farmers and traders. This mode of financing can be used by the modern banks and financial institutions, especially to finance the agricultural sector. Price of salam may be fixed at lower rate than spot. So the difference between the two prices may be a valid profit for banks. Bank may ask security or guarantee. The only problem in salam is that the banks will receive the commodity, not the money.
- 19. Salam as Mode of Financing 19 There are two ways banks can benefit from salam i. After purchasing, the financial institutions may sell it through a parallel contract of salam for the same date of delivery. The period of second salam is shorter and price is little higher than first transaction. The shorter the period of salam, the higher the price, and the greater the profit. ii. If parallel salamis not possible, they can obtain a promise to purchase from a third party. This promise is unilateral from the expected buyer. iii. A third option proposed, at the time of delivery the commodity is sold back to the seller at a high price. But this option is not in line with Shariah.
- 20. Some Rules of Parallel Salam 20 In parallel salam, the bank enters into two different contracts, in one bank is the buyer and in other bank is the seller. Both contracts must be independent to each other, not be contingent on each other. Example Parallel salam is allowed with third party only. Buyback contract is not allowed in Shariah. Buy back is not allowed even if the purchaser in the second is a separate legal entity. Example
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- 22. Istisna: Commission to manufacture 22 Istisna is the second kind of sale where a commodity is transacted before it come into existence. It means to order a manufacturer to manufacture a specific commodity for the purchaser. If the manufacturer undertakes to manufacture the goods for him with material from the manufacturer, the transaction of istisna comes into existence. For the validity of istisna, price is fixed with the consent of parties. Before the start of the work any one of the parties may cancel the contract after giving a notice to other. However after the manufacturer has started the work, the contract cannot be cancelled unilaterally.
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- 24. The Structure of an Istisna’ Contract 24
- 25. Difference between Istisna and Salam 25 The subject of istisna is always a thing which needs manufacturing, while salam can be effected on any thing, no matter whether it needs manufacturing or not. It is necessary for salam that the price is paid in advance, while it is not necessary in istisna. The contract of salam once effected cannot be cancelled unilaterally, while the contract of istisna can be cancelled before the manufacturer starts the work. The time of delivery is an essential part of the sale in salam while it is not necessary in istisna that the time of delivery is fixed.
- 26. Difference Between Istisna and Ijarah 26 Manufacturer in istisna under takes to make the required goods with his own material. If the material is provided by the customer, and the manufacturer is required to use his labor and skill only, the transaction is not istisna. In the above case it will be a transaction of ijarah whereby the services of a person are hired for a specified fee paid to him. If the commodity conforms to the specifications agreed upon between the parties at the time of contract, the purchase is bound to accept the goods and he cannot exercise the option of seeing.
- 27. Time of Delivery 27 In istisna time of delivery is not fixed. However, the purchaser may fix a maximum time. After maximum time passed, he will not bound to accept the goods and to pay the price. In some modern agreements there is a clause, that if manufacturer delays the delivery after the appointed time, he shall be liable to a penalty which shall be calculated on daily basis. Classical jurists seem to be silent about this question. The price in istisna may be tied up with the time of delivery, if delivery delayed the price can be reduced. Example
- 28. Istisna as a Mode of Financing 28 Istisna can be used for providing the facility of financing in certain transactions, especially in the house finance sector. If the client has his own land and he seeks financing for the construction of a house, the financier may undertake to construct the house at the open land. It is not necessary in istisna that the price is paid in advance, nor is it necessary that it is paid at the time of delivery, it may be deferred to any time according to the agreement of the parties. Time of payment may be fixed in whatever manner they wish. The payment may also be in installments.
- 29. Istisna as a Mode of Financing 29 It is not necessary that the financier himself constructs the house. He can enter into a parallel contract of istisna with a third party. Financier may hire the services of contractor. In both above cases financier can determine cost and fix the price. As a security, the title deed of house or land or any other property may be held by financier for security. Installments may start after the contract of istisna and continue even after house handed over to client.
- 30. Istisna as a Mode of Financing 30 The financier is responsible for the construction of the house in full conformity with the specifications detailed in the agreement. In case of any discrepancy, the financer is responsible for alteration and further cost. Istisna can be used for project financing, for installing plant or machinery in factory. The plant needs to be manufactured.
- 31. Commodity Murabaha: Tawarruq 31 Tawarruq is a structure made up of a set of sale- based transactions, and aiming to generate a cash loan to a bank’s customer. Hybrid sale contract where a customer approaches a financial institution to purchase a commodity with payment arranged in instalments and in turn sells the commodity to a third party for cash
- 32. 32 Permissibility of Tawarruq is subject to: - The person must be in real need of money - No other permissible alternative available - The contract being free of any modicum of riba - The customer having full possession of the commodity