IJARA: THE ISLAMIC ALTERNATIVE FOR LEASING

SYED MUHAMMAD SHAHID
Feb 04 - 10, 2008

The author is Serving Manager Operations of NBP, Islamic Banking Branch, Lahore and doing Diploma in Islamic Banking & Insurance from Institute of Islamic Banking & Insurance, London

Ijara is a term of Islamic fiqh. Lexically, it means 'to give something on rent'. In the Islamic jurisprudence, the term Ijara is used for two different situations. 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 employer is called 'musta'jir' while the employee is called 'ajir'. The second type of Ijara relates to the usufructs of assets and properties, and not to the services of human beings. Ijara in this sense means 'to transfer the usufruct of a particular property to another person in exchange for a rent claimed from him.' In this case, the term Ijara is analogous to the English term 'leasing'. Here the lessor is called 'Mu'jir', the lessee is called 'musta'jir' and the rent payable to the lessor is called 'ujrah'.

Leasing, or ijara, in the Islamic system, is a mode of investment by which assets such as machinery, equipment and other durables are made available by a bank (or other financial intuitions) to businesses for an agreed period at and agreed rental. It is allowed y the shari'ah because it does not involve interest payments. The bank makes its money from the profit charged on the cost of the asset, this profit being included in the installments.

The process in initiated when a corporate or individual client asks the bank to buy the asset and rent it to him. Under the ijara agreement, a contract is drawn up between the two parties specifying the lease period, the amount and timing of lease payments and the responsibilities of both parties during the life of the lease the lessee is normally responsible for all operating costs, including the maintenance of the asset, leases may be simple rentals or more elaborate contractual arrangements committing the parties to future actions.

The asset in question may be owned by the bank or jointly by the bank and the lessee, but possession and use is given exclusively to the lessee, who pays its value plus an agreed rental in installments over a fixed period. When the installments have been paid in full, the ownership of the asset passes to the lessee. The lessee may have the right to buy the asset during the lease period, although he is not obliged to buy it all. But as the price of the asset declines over the term of the contract, the lessor does not take a great risk in regard to the residual value of the asset.

TYPES OF LEASE

There are two type of lease.

1. a " finance' or full pay out" lease; and
2. An operating lease

A "FINANCE" OR FULL PAY OUT" LEASE

In the finance lease, the lessor buys a specific asset from a manufacturer selected by the lessee. The lessor retains the ownership of the asset but the lessee has the exclusive possession and use of it on payment of the specified rent over an agreed period.

In this type of contract, the lessee deals directly with the supplier of the asset in all matters relating to the goods and assumes the risk of loss on receiving possession of it. The period of the contract is known as the "primary period" and the repayments during this period cover the cost of the asset plus an agreed amount of profit for the lessor. The lessee has the option of a" secondary period" of the lease, but since the primary period is closely related to the life of the asset, the rental for the secondary period is reduced to a nominal amount.

AN OPERATING LEASE

The second type of lease, the operating lease, is similar to a short term hire purchase agreement and is also referred to as a "non-full payout" lease, because the amount of the rental does not cover the lessor's full capital outlay. This he eventually recaptures by selling the asset at the end of the period of the contract or re-leasing it to other users, this type of lease has usually been used for specific kind of equipment such as a warrantor of the asset, although the lessee does have to agree to conditions about it utilization and maintenance.

A variation of the leasing method is known as ijara wa iktina, or lease-purchase. In this system, the lessor buys an asset, leases it to the lessee and the lessee pays agreed installments over a fixed period. But in this case he is obliged to buy the asset at the end of period; in this type of leasing; the asset is bought by the lessor but owned jointly by both parties, subject to the provision of security and surety. The lessor receives value (after depreciation) of the asset in proportion to the outstanding share in total investment. The cost of insurance and of predetermined wear and tear may also be shared proportionally between the two parties on the basis of their outstanding investment. Maintenance, however, may be entirely the responsibility of the lessee.

PENALTY FOR LATE PAYMENT OF RENT

In some agreements of financial leases, a penalty is imposed on the lessee in case he delays the payment of rent after the due date. This penalty, if meant to add to the income of the lessor, is not warranted by the Shari-ah. The reason is that the rent after it becomes due, is a debt payable by the lessee, and is subject to all the rules prescribed for a debt. A monetary charge from a debtor for his late payment is exactly the riba prohibited by the Holy Qur'an. Therefore, the lessor cannot charge an additional amount in case the lessee delays payment of the rent.

However, in order to avoid the adverse consequences resulting from the misuse of this prohibition, another alternative may be resorted to. The lessee may be asked to undertake that, if he fails to pay rent on its due date, he will pay certain amount to a charity. For this purpose the financier / lessor may maintain a charity fund where such amounts may be credited and disbursed for charitable purposes, including advancing interest-free loans to the needy persons. The amount payable for charitable purposes by the lessee may vary according to the period of default and may be calculated at per cent, per annum basis.

For Islamic banks, Leasing is an attractive mode of investment for the following reasons:

1. Assets acquired under these contracts are usually of high quality. Marketable, maintain their market value well above book value, are movable and are easily disposable for cash in case of default.

2. Although it is longer-term financing instrument, a leasing contract can be reviewed periodically. The financing party is thus not tied down to a fixed return which may not be in his investment goals. The rent can be tied to any of index agreed to.

3. Because of the good quality of the asset, lessor does not have to depend so much on the creditworthiness of the lessee, since he always has the recourse of selling the asset in case of default.

Islamic banks are able to offer leasing certificates to their depositors as specific investment certificates as a form of declining equity. Lease payments include two elements: capital repayments and profit. If both these are refunded to the certificate holder, net of bank costs, he recoups part of his capital as the lease gets closer to maturity. But it is possible to design certificates which pay the holder dividends only; so that the bank can reinvest the incoming capital repayments in other lease contracts.

For these reasons, there is growing use of all these types of leasing as a mode of Islamic finance. They provide flexible means of serving customers' various needs while enabling the financing institutions to invest in equity which gradually becomes more liquid.

REFERENCE:

Lesson notes on Islamic Financial Instruments by Institute of Islamic Banking & Insurance, London.