Islamic Finance CH 7

• Ijara comes from the Arabic root word 'ajr,' which references reward or wages for labor/services.
• In finance, it's a bilateral agreement to use an asset for a given period for some consideration.
• There are two parties involved; the owner (lessor or Muajir) and the user (lessee or Mustajir).
• The lessor temporarily gives up the asset use to the lessee for a defined period, and the lessee benefits from it without consuming it.
• The lessor retains ownership and its associated risks, and the lessee holds the asset in trust.
• The lessee is liable for asset loss/destruction/value reduction only if caused by misuse or negligence.

Ijara In Islamic Jurisprudence

• Ijara is used in two scenarios: transferring asset usage (like a conventional lease) or employing someone for wages.
• Islamic scholars say this contract has three elements: contracting parties (lessor/lessee), offer and acceptance (Ijab and Qabul), and the subject matter.
• The subject includes the asset and payment/rent (Ujrah) for the right to use the lessor's asset, and the asset is called Majur.
• The benefit derived from the asset is called Al Manfaah, the subject of the contract (not the asset itself), and is guaranteed by the contract.
• This is similar to a conventional lease and is deemed Shariah-compliant if the object has beneficial use and is halal.
• Assets suitable for Ijara must be tangible, non-perishable, valuable, identifiable, and quantifiable.
• Items like food, fuel, or money can't be leased.

Ijara In Islamic Banks

• This is a service-based contract for short/medium-term financing via rent/hire purchase with agreed fees and terms.
• Banks provide this to retail and business clients for fixed assets, service packages, vehicle/property/project/personal financing.
• The bank buys the asset and leases it to the client, who may rent it or opt to buy it, payments (Ujrah) may cover rent only or include installments for eventual purchase.
• After the lease, the asset reverts to the lessor, the lease is renewed, or ownership transfers to the lessee.

Types of Ijara

• Two main Shariah-compliant types exist that are offered by Islamic banks: Ijara and Ijara wa Iqtina.
• Originally, Ijara was a business transaction for transferring asset usufruct for an agreed period/fee, but not for financing.
• It's equivalent to an operating lease, but many financial institutions now use it as an alternative to interest-based loans, known as a financial lease.

Ijara/Regular Ijara/Operating Lease

• Like a conventional operating lease and a "true lease", these are purely rental contracts: the lessor does not transfer asset ownership to the lessee.
• After the contract, the asset reverts back to the lessor and rent (Ujrah) does not cover the full asset values.
• Lessors can re-lease/sell the asset to recover its remaining value, plus, both parties can cancel the contract with due notice.
• Banks may use LIBOR to determine/adjust the Ujrah, and clients can return the asset or extend the lease at the end of the period.
• This type is suitable for expensive assets, and banks retain ownership/earn returns, while the lessee avoids expensive purchases.
• Lessors bear ownership risks, while lessees must properly use/care for the asset and they should compensate it for damages caused by misuse/negligence.
• The lessor bears depreciation/impairment losses, and processing costs are amortized into rental payments.
• Any repairs during the lease period are the lessor's responsibility (with consent).

Ijara Wa Iqtina/Ijara Muntahia Bittamleek/Financial Lease

• Ownership transfers to the lessee at the end, akin to a financial lease/hire purchase (the Arabic word Tamleek means ownership).
• The transfer may or may not need additional consideration.
• In a financial lease, the lessor amortizes their asset/sells it to the lessee after the lease term.
• The lessee provides a "unilateral purchase undertaking" to buy the asset for a specified price.
• AAOIFI says the transfer can occur in multiple ways:
  • The lessor fully amortizes the asset during the initial lease term and gifts the item to the lessee at no additional cost.
  • The lessee pays a fixed amount (decided initially) at the end of the lease to legally purchase the asset.
  • A legal sale takes place prior to the end of the lease term, in an amount equivalent to the remaining Ijara installments.
  • The lessee pays the asset's fair market value at the end of the lease period for ownership transfer.
  • Gradual transfers of ownership occurs as rental payments include price payments, making the first two practices more common in the banking industry.
• The bank buys the asset based on the customer's purchase promise in the lease agreement, not returning it at the end of the process.
• This is common in standard operational leases and more convenient for banks, as these are not in the business of owning/managing assets.
• The Ijara Wa Iqtina/ Ijara Muntahia Bittamleek/financial lease completes when the asset's ownership transfers to the lessee, as well risk/rewards.
• The lease payments factor in the purchase price, rental value, and lease term, and it follows float/fixed lease rentals, and the Ujrah recovers use/purchase price in diverse ways.
  • Periodic payments include the rental element plus part of the asset's purchase price; at the end of the lease, ownership transfers to the lessee.
  • Periodic payments cover the rental with the purchase/residual value at end of lease, which transfers ownership from lessor to lessee.
  • Contracts may be renewed with new rental agreements, or the asset transfer at the end of this term, including rental and asset portions (paid at lease end).

Ijara Thumma Al Bay

• This third type of Islamic financial lease or "Islamic hire purchase" is popular in Malaysia and consists of two separate contracts.
• The first is an operating lease, while the second is a sale contract with a price that is pre-agreed upon and completed at the end of the lease.

Shariah Rules/General Principles Guiding Ijara Contracts

• Sheikh Muhammad Taqi Usmani identified different Shariah rulings that related to Ijara contracts, plus the Islamic banking industry also has its own developing characteristics.
  • According to point 1, Ijara can only be used for halal assets with benefitial value, where the leased asset remains as the property of the lessor, and only the usufruct is transferred to the lessee.
  • According to point 1, items which are unable to be used without being consumed, should not, and cannot, be leased; moreover, money cannot be leased.
  • Moreover (point 2), both parties (lessor and lessee) should be aware of the Ijara asset, and the returned asset must be identical to the one in the original lease, with Ujrah payments proportional to ownership share for jointly owned assets.
  • Shariah (point 3) only allows tangible and not financial assets; also encourages tangible/financial capital conversions, and the financier assumes related ownership risks to earn from the Ijara contract.
  • "Al Manfaah" (point 4), involves clearly defined Ijara asset/usufructs, so the asset can be used for its specified purpose and in a Shariah-compliant manner or other. If unspecified, the lessee can use it for normal business purposes.
  • The lessee must get the lessor's permission to use the asset for abnormal use, and the usufruct attainable/cannot be faulty or consumable (point 4).
  • Ownership (point 5): lessors retain asset ownership, while only transferring usufruct to the lessee, prohibiting Ijara for consumables like food/fuel/money.
  • Acquisition (point 6): contract happens only after the lessor (bank) has acquired the asset and is in the asset's ownership.
  • "Ujrah" or lease rentals (point 7): need to be clearly defined for the entire lease term/specific period, and AAOIFI allows the flexible LIBOR as a benchmark.
  • Shariah Requirements (point 8): the lessee must know the asset price, bank's profit margin, and rental amount, and rentals begin after asset delivery.
  • Shariah Requirements (point 8): If advance payment is made, it's held 'on account' and adjusted against rentals, and the lessor cannot unilaterally increase the rental, plus a lease term has to be clearly defined.
  • Shariah Requirements (point 9): the lease starts once the asset is delivered regardless of usage, is typically short/medium term, but can also be long term if the banks are comfortable.
  • Maintenance (point 10): lessor/bank handles major upkeep/insurance on the leased asset, which can be delegated to the lessee at the lessor's cost.
  • Maintenance (point 10): Lessee handles day-to-day operating/periodical upkeep to maintain good working order.
  • Maintenance (point 10): The lessor is responsible for damages beyond the lessee's control.
  • Risks/Liabilities (point 11): Lessor bears the risks related to the object by bearing the risk of obsolescence, while the lessee bears the risks related to physical possession/usage by compensating for misuse/negligence.
  • Lessor obligations (point 12): making the asset available, guaranteeing for defects, and paying for maintanence and insurance.
  • Lessee obligations (point 13): includes complying with the contract, safeguarding assets, paying rental fees on time and related operational expeneses.
  • Sub-lease (point 14): the lessee can sub-lease to a third party with the consent of the lessor(s).
  • Default (point 15): the lessor can repossess the asset (at the expense of the lessee) if the lessee defaults due to failing to maintain the contract's initial condition or comply with the requirements.
  • Default (point 15): lease agreements may contain advance penalties for late payments, and the bank can enforce penalties/grant them to charity.
  • Guarantee/Security (point 16): the bank secures its funds by getting a third party guarantee for potential damages or by gaining security such as a lien/mortgage.
  • Sale (point 17): the asset can be sold if the agreed terms are transferred to the new owner.
  • Termination (point 18): Once the contract ends, the Ijara terminates which can also happen if the asset is damages.

Documentation

• Ijara Agreement: The main document for the Ijara contract, including all related terms is signed after the lessor takes possession of the lease, and must include description of the asset, schedule of the lease etc.
  • Other documents
    • Receipt of asset: Acknowledges receipt by the lessee and proves the lessor has delivered the asset.
    • Demand Promissory Note: The signee acknowledges responsibility for rental payments.
    • Purchase Undertaking: Undertakes purchases on a specified agreed date.

Ijara vs. Conventional Lease

• Has similarities and differences in conventional banking (see Table 7.1 in text).

Ijara vs. Conventional Loan

• In Ijara, ownership of the items is not transfered to the lessor, and they must have the same borrowed asset to return; money isn't returned in the same notes, and consumables are retained in full.

Ijara Wa Iqtina vs. Diminishing Musharaka

• In Ijara wa Iqtina, the lessor keeps property ownership for the duration of the contract.
• But in diminishing Musharaka, ownership changes as each payment schedule reduces the bank's and increases the client's ownership.
• In practical Islamic banking, Ijara contracts are used for short/medium-term financing needs with durables like vehicles/equipment.
• An operating lease may rent equipment or property, while a financial lease or Ijara wa Iqtina finances retail or business needs.

Calculation Of Lease Rentals

• A formula is TLR = CF + (CFi n), where TLR = total lease rentals (total amount of rentals paid over the entire lease period), CF = cost of finance or cost of acquiring the lease asset, i = rate of return per annum, n = period of financing in years.

Key Concepts

• Ajr: root word meaning reward for labour
• Al Manfaah: Benefit derived from the asset.
• Majur: the asset itself
• Ujrah: rent
• Mustajir: Lessee