Professional Documents
Culture Documents
Islamic Leasing Ijarah
Islamic Leasing Ijarah
Islamic Leasing
(“Ijarah”)
Table of Contents
WHAT IS ISLAMIC FINANCE?................................................................................................... 5
Shariah (Islamic Law)................................................................................................................. 6
Halal and Haram........................................................................................................................ 6
Takaful (Islamic Insurance)........................................................................................................ 6
Basic Principles of Islamic Finance............................................................................................ 7
Support Institutions for Islamic Finance................................................................................. 8
AAOFI....................................................................................................................................... 35
IFRS vs AAOIFI and the Malaysian Accountings Standards Board (MASB)........................ 35
Accounting under AAOIFI...................................................................................................... 36
Malaysian Accountings Standards Board (MASB)................................................................ 37
Accounting Treatment under AAOIFI................................................................................... 39
Classification and Recognition of Ijarah under AAOIFI20...................................... 39
IJARAH SUKUK........................................................................................................................ 46
Sukuk........................................................................................................................................ 46
Sukuk Trust Certificates............................................................................................. 47
Disadvantages of the Ijarah Sukuk Structure....................................................................... 48
Sukuk Trading Options .......................................................................................................... 48
Ijara and Project Finance........................................................................................... 49
Sample Transaction Structure — Leasing Assets..................................................... 49
References............................................................................................................................. 61
General Bibliography...................................................................................................... 63
4 Focused toolkit: Islamic Leasing (“Ijarah”)
Focused toolkit: Islamic Leasing (“Ijarah”) 5
WHAT IS ISLAMIC FINANCE? Unlike the segregation of duties and responsibilities that exists
in the western, non-Muslim world, in the Muslim world there is
“As a form of financial intermediation, Islamic finance no division between religion, business, the family, and the state.
incorporates several elements that guide the process of the The values, morals, norms, behaviors, and ethics applicable in
mobilization and allocation of funds to generate productive one situation permeate all the others, and this carries to the
economic activity and inclusive development. Fundamental to issues of finance. This construct binding the parts to create the
Islamic finance is the requirement that financial transactions whole is referred to as Shariah, which can be translated to mean
must be supported by real economic activity. In addition, “the way,” referring to the way Muslims should live. The way
Islamic finance promotes profit sharing and hence risk sharing. is well represented below in diagrammatic form in terms of its
These elements limit the extent of leverage and place emphasis impact on financial issues.
on transparency and disclosure in the documentation of
contracts. Embraced in its entirety, Islamic finance promises Source: Islamic Finance and Global Financial Stability, 20102
to enhance the discipline that contributes towards ensuring
growth and financial stability.” — Dr. Zeti Akhtar Aziz,
Governor, Bank Negara Malaysia 1
1 Please see end notes at the end of this focused toolkit 2 Please see end notes at the end of this focused toolkit
Overarching Principles
•• Towards achieving the objectives of Shari’ah (Maqasid al-Shari’ah)
•• Protection of religion, life, lineage, intellect and wealth
•• High ethical values—justice, fairness, trust, honesty and integrity
•• More equitable distributor of wealth
Shariah lexically means a way or path. In Islam, Shariah refers The validity of a transaction does not depend on the end result
to the divine guidance and laws given by the Holy Quran, the but rather the process and activities executed and the sequence
Hadith (sayings) of the Prophet Muhammad (Peace Be Upon thereof in reaching the end. If a transaction is done according
Him) and supplemented by the juristic interpretations by to the rules of Islamic Shariah, it is halal even if the end result
Islamic scholars. Shariah embodies all aspects of the Islamic of the product may look similar to a conventional banking
faith, including beliefs and practices. Islamic Shariah or the product.
divine law of Islam is derived from the following four sources:
It is the underlying transaction that makes something halal
1. The Holy Quran (allowed) or haram (prohibited) and not the result itself.
Support Institutions for Islamic Sovereign Ratings and Credit Ratings assess
the likelihood that an entity will repay its debt obligations in
Finance a timely manner.
The legal, regulatory, and accounting frameworks for Islamic
finance and its institutions and products are continually
evolving. In this regard, important institutions framing the
development of the global industry are as follows:
Shariah Quality Ratings assess the level of compli-
ance with the principles of Shariah.
As of November 2009, the 193 members of the IFSB include 49 Shariah Board
regulatory and supervisory authorities as well as the International
Monetary Fund, World Bank, Bank for International One distinct feature of the modern Islamic banking industry is
Settlements, Islamic Development Bank, Asian Development the role of the Shariah board, which forms an integral part of
Bank, the Islamic Corporation for the Development of the an Islamic financial institution. A Shariah board monitors the
Private Sector, Saudi Arabia, and 138 market players and workings of the Islamic financial institution and has to clear
professional firms operating in 39 jurisdictions. every new transaction from a Shariah standpoint. These boards
include some of the most respected contemporary scholars
Malaysia, the host country of the IFSB, has enacted a law known of Shariah, and the opinions of the boards are expressed in
as the Islamic Financial Services Board Act 2002, which gives the form of fatwas. The International Association of Islamic
the IFSB the immunities and privileges that are usually granted Bankers, an independent body, supervises the workings of
to international organizations and diplomatic missions. individual Shariah boards, while the association’s Supreme
Religious Board studies the fatwas of the Shariah boards
of member banks to determine whether they conform with
Shariah.
IJARAH (ISLAMIC LEASING)— In the Ijarah Aina contract, there is no option for the lessee
to acquire the asset at the end of the lease. However, there
Introduction is another type of Ijarah contract, referred to as Al-Ijarah
The word Ijarah refers to a transaction that involves giving Thumma Al-Bai (AITAB), wherein the lessee can acquire the
something on a rental basis. It can denote the paying of wages asset at the end of the lease. This second type is addressed in the
to employees (Ijarah Amal) as well as the renting of an asset second part of this paper.
(Ijarah Ain). As an introduction to the subject, in this part of In Ijarah Aina (hereafter, Ijarah), the lessor rents the assets to
the paper we will only address the second type of transaction, benefit from their use without having ownership transferred to
Ijarah Aina, and for simplicity’s sake shall refer to it as Ijarah. the lessor. The legal term for this arrangement in English is
As we shall see, the transaction is similar to what we know as “usufruct,” and the price for this use is referred to as “rent.”
“leasing” in English. (Please note that all the Arabic terms used There is no element of interest in the transaction, since
here are transliterations of the Arabic sounds into the Roman ownership of the asset always remains with the lessor, and there
alphabet. The spellings of the same terms may vary from one is no option for the lessee to gain title to the asset.
text to another as you encounter them, since they are but
approximations of the true sounds of the words in Arabic.)
Focused toolkit: Islamic Leasing (“Ijarah”) 11
Since title (ownership) to the asset is not being transferred, Ijarah: Similar to an Operational Lease
there is no sale of a tangible asset, only the sale of an intangible
asset, namely the right to its use for a specific period of time. In this type of Ijarah, the financial institution purchases and
This right to use or usufruct is known as manfaah in Arabic. maintains assets that have a high degree of marketability.
It rents these assets to other parties on terms and conditions
Unlike the conventional lease, an Ijarah is a “contract” whereby agreed upon for a specific time. After the termination of that
a financial institution, using Islamic principles, purchases and period, the asset will be returned to the financial institution.
then leases the asset required by the client in exchange for a The institution then leases the same asset to a new lessee and
rental fee that is not related to interest. Under the contract, the at the same time bears the risk of recession or diminishing
lessor owns the property and may have the right to renegotiate demand for the asset. At the end of the lease, it may choose to
the lease payments at various intervals agreed to in advance in scrap or dispose of the asset.
the contract with the lessee, thereby ensuring that the rental
payments are equal to the residual balance value of the asset as This type of Ijarah is suitable for expensive assets, such as
well as the opportunity cost of the lessor, that is, his forgoing airplanes, ships, industrial equipment, and agricultural
the use of the assets. The risks of ownership of the asset stay machinery. In addition, these assets take a longer time to
with the lessor. manufacture, due to the fact that there is an increasing demand
for leasing them. The financial institution benefits from the
In this structure, Ijarah’s legal characteristics are similar to those transaction by retaining ownership of the asset while at the
of a sale-and-purchase transaction, with the exception that the same time getting a return by leasing it. The lessee also benefits
physical asset is not transferred and there is a specific time limit from the transaction, since it meets his immediate need and
on the use of the asset. It should be noted that the source of funds saves him from buying the asset at a much higher cost.
used by the financial institution to finance Ijarah transactions
must be halal. Al-Ijarah Muntahiya Bittamleek (IMB): Similar to
Ijarah can be contracted on an asset that is yet to be constructed a Finance Lease
or manufactured, as long as it is fully described in the contract,
This type of Ijarah is one that ends with ownership. Here the
provided that the lessor should normally be able to acquire,
financial institution purchases the asset based on a promise
construct, manufacture, or buy the asset being leased by the
from a customer. Because the customer promises to own the
time set for its delivery to the lessee.
asset, the asset will not be returned to the financial institution
at the end of the lease period, as it is in the case of an operational
lease, but instead will be bought by the lessee. The rental is
Types of Ijarah calculated based on the value of the asset, which is financed
based on the amount of profit and the period of financing.
Islamic financial institutions use the lease for the usufruct
as an instrument of financing. They purchase the assets and The first type of Ijarah is different from IMB in that the former
rent them out to customers in return for rental. They use two does not offer an option to the customer to buy the leased asset
models, namely Ijarah and Al-Ijarah Muntahiya Bittamleek. at the end of the lease period while in the latter the option is
offered via a secondary contract. If the lessee chooses to buy
the asset, a new contract will be concluded. All the lease rentals
previously paid will constitute part of the price.
12 Focused toolkit: Islamic Leasing (“Ijarah”)
Normal steps in the transaction of an Ijarah contract are as Terms and conditions of the
follows:
Ijarah Contract
1. The client of the financial institution approaches a seller
or vendor of an asset, and obtains price and product To qualify as meeting Islamic requirements and thus as a
details. true Islamic financial product, the Ijarah contract has certain
required and certain prohibited characteristics, which are
2. The client then approaches the financial institution detailed below.
with the asset price and details and negotiates with the
institution to use the Ijarah contract. The client promises
the institution to execute the Ijarah contract, which
contains the terms that will apply after the institution Required and Prohibited Terms and
buys the asset. Conditions
3. The financial institution buys the asset from the seller
Lessee and lessor
based on the information provided by the seller to the
client. The institution pays cash, and ownership of the 1. The lessor (mujir) must be legally sane and able to enter
asset transfers to it. into the contract (“aqil”)
4. The seller delivers the asset to the client of the financial 2. The lessee (mustajir) must be an adult, not a minor, or in
institution according to the terms and conditions agreed Islamic terms must have reached puberty (baligh)
to by the institution and submits proof of delivery, with
3. The lessee must be intelligent as defined by Sharia Law.
the acceptance of the client, to the institution.
4. It is prohibited for the lessor or lessee to be coerced into
5. The client pays the agreed rental, based on the payment
entering into a contract.
plan in the Ijarah contract, to the financial institution.
5. It is prohibited for the lessee or lessor to be bankrupt or
6. Upon expiration of the time limit specified in the Ijarah
to be wasteful or spendthrift.
contract, the client returns the asset to the financial
institution.
Asset Being Leased
The legality of this type of combined structure, under Islamic
Shariah law as interpreted by fatwas, needs to be carefully 1. The asset must be capable of being described in detail.
considered depending upon the jurisdiction in which the 2. The financial institution must be the owner of the asset
contract is developed and entered into. during the life of the lease.
4. The way that the lessor of the asset will use the asset Contract (Aquad) Issues
must be known.
1. The contract needs to be written in clear and definite
5. The duration of the lease must be clearly defined. language using the past or present tense, not in the
future tense.
6. It is prohibited for benefit to be derived from the con-
sumption of any material part of the asset; benefit may 2. The acceptance of the offer of the contract must be
be derived only from its use. agreed upon with the offer, and the offer and acceptance
must be made at the same time in the same meeting.
Rental (Lease) Payments
1. The lease or rental amount, as well as currency of pay-
ment, must be clearly stated and known by both lessee
and lessor.
14 Focused toolkit: Islamic Leasing (“Ijarah”)
Assets Leased
Transfer of Title to Customer Title
to the FI does not pass at end
of Lease Term
Islamic
Financial Customer
Vendor
Institution (Lessee)
(FI)
Payment
Ijarah Installments
of Purchase Price
Focused toolkit: Islamic Leasing (“Ijarah”) 15
Termination
If the terms of the contract are not met by the lessee, the lessor
has the right to unilaterally terminate the contract. However,
if there are no defaults, the lessor cannot terminate the lease
without mutual agreement.
16 Focused toolkit: Islamic Leasing (“Ijarah”)
Comments on Differences
Lesson Learned: Warranties (Express or
and Similarities Between
Implied)
Conventional Lease Contracts
In a conventional lease, most lease agreements handle
and Ijarah warranties as follows:
1. physical assets
Prepayments in Ijarah
2. financial rights (such as the usufruct in Ijara)
Use of asset: Assets leased may not be used for In this hybrid mechanism, the Al Ijarah contract relates to
activities that contravene Shariah. the exchange of the use of the asset (the usufruct) for money,
with the exchange of goods for money. To achieve this, the
Asset Ownership remains with the financial
two contracts are sequential, Ijarah first and then Al Bai, and
ownership: institution.
together are thus referred to as this third type of contract,
Takaful To reduce the burden if losses occur. AITAB. This construct is also referred to as IMB (translated as
coverage: Suitable coverage is a comprehensive leasing ending with ownership) and is sometimes transliterated
‘All Risks’ type. into English as Ijarah Muntahia Bittamleek.
The essential terms and conditions of the AITAB contract are There is no return on money in Islam, therefore it is
the same as those of the Al-Ijarah contract, simply an agreement impossible to apply the “principles of the time value
for sale and purchase as added (al-Bai). of money,” including Net Present Value, to the profit
calculation under an AITAB contract. Since the earning
of interest (riba) is not allowed, the use of Internal Rate
of Return to express yield does not exist in an Ijarah
Example of AITAB Financing Calculations transaction.
Profit (P) = Purchase price x profit rate x period of 3. The sale and purchase agreement (al-Bai) between the
financing lessor and equipment supplier.
$1,000,000 x 0.10 x 5 = $500,000 At all stages, the full terms and conditions must be clearly
explained and understood by the client and the financial
Total lease rental = Purchase price + profit institution.
$1,000,000 + 500,000 = $1,500,000
Nature of Contract Hybrid instrument, including both a lease Same, with respect to lessee’s purchase option
contract (Ijarah) and the sale/purchase contract at the end of the lease term. Principle of “arm’s
(al-Bai). length” applies between lessor, lessee, and
equipment supplier.
Calculation of Profit Lessor charges a fixed profit and no interest. Lessor’s profit is expressed as the difference between
the present value of the lease payments minus cost
of equipment (per Base Toolkit—Lease Math)
Charges Related to the All charges are borne by lessor, without Some charges (shipping & installation, for example)
Purchase of the Leased Asset exception. may be borne by lessee.
Late Payments A fixed charge must be specified in the contract. Interest may be applied (1% per month, for
example) to late payments.
Acceptance Letter (Aquad) Lessee must enter into an acceptance letter. Same.
Asset Being Financed Must be Shariah compliant. Shariah compliance not necessary.
Insurance Must be insured using Islamic Takaful insurance. Shariah compliance not necessary.
Warranties (Expressed or May be transferred from lessor to lessee. Always for the benefit of the lessee.
Implied)
Cancellation Lease can be cancelled if equipment is lost or Lease is non-cancellable.
destroyed.
A case in point is that the contractual structuring and the Examples of the Impact of Shariah
wording of the contracts must be such as to comply with
Shariah law and with associated fatwas in the country of Rulings in Four Countries
jurisdiction and operation. Four different approaches are being followed in Shariah rulings
in different countries—Iran, Malaysia, Bahrain, and Indonesia—
based on the countries’ regulatory approaches, as follows.13
Legal Precedent—Drafting a Leasing
Contract
In the Republic of Maldives, the court ruled against a
Iran
leasing company (Maldives Finance Leasing Company, Products that can be offered by banks have been defined in
recorded in Case No. 893/MC/2008 (MFLC v regulations issued by the Council of Ministers under the Usury
Mohamed Naeem)), stating that a leasing contract that Free Banking Act 1983. The Council of Guardians performs
contained a right of the lessee to purchase the leased asset the function of a central Shariah board and provides guidelines
at the nominal price at the end of the lease term was void to the central bank and commercial banks. Commercial banks
insofar as it violated Shariah provisions, in accordance do not have a Shariah board for guidance and/or supervision in
with which one contract shall not contain two elements their day-to-day operations.
at the same time, a lease and a sale. There must be two
contracts, and the process of presenting the documents
and executing them is as important as the contracts
themselves. Malaysia
The court did not take into consideration the fact that As part of the effort to streamline and harmonize the Shariah
the leasing agreement merely pointed out that a separate interpretations among banks and takaful companies, Bank
sale agreement would be entered into and the ownership Negara Malaysia (BNM) established the National Shariah
would not be transferred under the leasing agreement Advisory Council on Islamic Banking and Takaful (NSAC)
itself. on May 1, 1997, as the highest Shariah authority on Islamic
banking and takaful in Malaysia. Among NSAC’s primary
objectives are these:
Negara Malaysia on Shariah matters, SAC is also responsible for to that of SAC. Its duty is to advise the banking institution on
validating all Islamic banking and takaful products to ensure the Shariah compliance of its banking operations; however, the
their compatibility with the Shariah principles. In addition, it Shariah Advisory Council is the ultimate arbiter. The Guidelines
advises BNM on the Shariah aspects of the operations of these on the Governance of Shariah Committees for Islamic Financial
institutions, as well as on their products and services. Institutions were issued by BNM in December 2004. These
aimed at achieving uniformity of Shariah decisions, in addition
The Malaysian Judiciary and the Regional Center for Arbitration
to creating and expanding the pool of competent Shariah
Kuala Lumpur15 uses SAC as the reference point in the event of
personnel in Islamic banking and takaful.
disputes involving Shariah issues on Islamic banking and finance.
The Central Bank of Malaysia Act of 1958 was amended in 2003 The guidelines set out the rules, regulations, and procedures for
to enhance the role and functions of SAC, which was accorded the establishing a Shariah committee and the role and scope of duties
status of a sole authoritative body on Shariah matters pertaining and responsibilities of the committee, as well as the relationship
to Islamic banking, takaful, and Islamic finance. To preserve its and working arrangement between the committee and SAC.
independence, members of SAC are not allowed to participate in The requirement to establish the committee covers all Islamic
any Shariah committee of any financial institution. banks and all banking institutions that participate in Islamic
banking schemes, takaful operators, and development financial
Shariah committees are formed internally by Islamic banking
institutions that provide Islamic banking facilities. Duties and
institutions. A Shariah committee plays a complementary role
responsibilities of a Shariah committee are as follows:
15 Please see end notes at the end of this focused toolkit
26 Focused toolkit: Islamic Leasing (“Ijarah”)
•• To advise the Board on Shariah matters in its business opera- •• To record any opinion given.
tion
In particular, the committee prepares written Shariah
•• To endorse Shariah compliance manuals opinions in the circumstances (1) where the Islamic financial
institution makes reference to SAC for advice; or (2) where
•• To assist related parties on Shariah matters for advice, upon
the Islamic financial institution submits applications to Bank
request
Negara Malaysia for new product approval in accordance with
•• To advise the Islamic financial institution to consult it on guidelines on product approval issued by BankNegara Malaysia.
any Shariah matters that have not already been resolved or
The Shariah committee is also expected to assist SAC on any
endorsed by SAC, and
matters referred by the Islamic financial institution. Upon
Focused toolkit: Islamic Leasing (“Ijarah”) 27
obtaining any advice from SAC, the Shariah committee shall Shariah Supervisory Board (DPS)
ensure that all of SAC’s decisions are properly implemented by
the Islamic financial institution. With regard to the reporting Every Islamic bank (or window) is obliged to have a Shariah
structure, the Shariah committee reports functionally to the Supervisory Board (SSB). The SSB also plays a critical role as
board of directors of the institution. This reporting structure partner of the Bank of Indonesia in Islamic banking supervision.
reflects the status of the Shariah committee as an body that is The Bank of Indonesia has set up “fit and proper” criteria,
independent of the Islamic financial institution. which include a test for new SSB members that cover their
understanding of Shariah principles and knowledge of Islamic
banking and finance in general. Furthermore, to upgrade SSB’s
roles, each Shariah supervisor is obligated to submit a report
Bahrain every six months on the finding of Shariah supervision to the
Board of Directors, the Board of Commissioners, the National
The Central Bank of Bahrain requires all banks to establish an
Shariah Council, and the Bank of Indonesia.
independent Shariah Supervision Committee complying with
AAOIFI’s governance standards for Islamic financial institutions. The regulatory authorities of some countries, like Bahrain,
All banks must comply with all accounting standards issued Sudan, and Syria, have adopted Shariah standards issued by the
by AAOIFI as well as the Shariah pronouncements issued by AAOIFI, while some others use them as guidelines.
the Shariah Board of AAOIFI. The National Shariah Board
of the Central Bank of Bahrain serves and verifies the Shariah In Pakistan, the banks are authorized to offer products based on
compliance of its own products only. There is no restriction Islamic modes under the Banking Companies Ordinance of
that the members of the National Shariah Board must serve any 1962. The Shariah Board of the State Bank of Pakistan (SBP)16
financial institution, and no limitation requiring them to serve has approved Essentials of Islamic Modes of Finance and Model
only one institution. Each bank must have a separate Shariah Agreements, which were previously issued as guidelines to all
review function to verify compliance, which may be located in Islamic banking institutions and have now been made part of
the bank’s internal audit function. the recently issued instructions for Shariah compliance in Islamic
banking institutions. Each Islamic banking institution is required
to appoint a Shariah advisor, responsible to give approval regarding
the Shariah compliance of all of the institution’s products and to
Indonesia issue Shariah rulings. SBP’s Shariah Board advises the bank in
forming its regulations on Islamic banking. In case of any difference
In Indonesia, the National Shariah Board formed by the of opinion between SBP’s Shariah Board and the Shariah advisor of
Indonesian Council of Ulemas in 1999, is an independent body an Islamic bank, the ruling of SBP’s Shariah Board is final.
duly recognized by the Bank of Indonesia and is responsible
for issuing Shariah rulings on the products of Islamic banks. In other countries, the rulings of the Shariah Supervisory
The Bank of Indonesia issues regulations for Islamic banking Boards of Islamic financial institutions are binding on the
products based on a fatwa issued by National Shariah Board. respective institutions, and regulatory authorities do not
intervene in these affairs.
The National Sharia Council (DSN) possess the power of
positive law. In 2005, the Bank of Indonesia also issued a Islamic financial institutions all over the world are generally
regulation on Standards of Contract, which is periodically using similar modes of Islamic finance and products, with
evaluated to stay relevant with the Islamic banking industry. minor differences of nomenclature according to their regional,
So far, the regulations (released in 2006) are concerned with legal, and other conditions. In addition to Ijara, the commonly
Ijarah, Istisna’a, and Salam contracts. Apart from coordinating used modes are murabaha, musharaka, mudaraba, diminishing
with the Bank of Indonesia, DSN also takes a role in the musharaka, salam, istisna, wakala and kafalah. There is no
Shariah Supervisory Board selection process. difference of opinion among the world’s Shariah scholars
about the permissibility of these modes. However, there are
certain differences in application and modus operandi of the
transactions among different countries.
the permissibility of certain modes and practices, like bai al Who can apply
dain (debt trading), bai al inah, tawatruq, hibah on current
accounts, and commodity murabaha. •• Individuals ages 18 and above
•• Sole proprietorships
•• Partnerships
Up to 90% New passenger car, 4WD, MPV and SUV (CBU and
CKD units):
Financing Period
Maximum of 90% of seller’s invoice Maximum 108
Up to 9 years
months
Benefits Second-hand passenger car, 4WD, MPV and SUV:
•• Based on the principles of the Ijarah contract (leasing/
renting) and the bai contract (purchase) Maximum of 85% of seller’s invoice Maximum 108
months
•• Extensive network of dealers nationwide
Unregistered reconditioned (imported) vehicle:
•• Easy payment of installment via branches, ATMs,
online
Maximum of 90% of seller’s invoice Maximum 108
•• Renewal of road tax and motor insurance
months
•• Photocopy of driving license Payments must be made for the complete installment
amount. Partial payments or incomplete installment
•• Copies of last 2 years’ income tax returns (J form or EA)
payments are not be accepted.
•• Copies of latest 2 months’ salary slips
Ijarah Home Finance18 How the Monthly Ijarah Rent Payments Are
Calculated
The initial Ijarah amount that is financed by the customer earns a
How the Purchase Price of the Ijarah profit for the investor through monthly rental payments. Traditional
Transaction Is Determined amortization calculations are utilized to determine the exact
monthly payment. These mathematical formulas are acceptable
The purchase price that is agreed to in the Promise to Purchase since there are no Sharia issues connected with mathematical
is equal to the original purchase price less the down payment calculations. The major difference between a traditional mortgage
made by the customer plus $1.00. For example, if the value of amortization and an Ijarah transaction is that the Ijarah transaction
the property is $200,000 and the customer makes a $40,000 is based on a reverse amortization calculation.
down payment, then the initial amount the customer has to
pay the investor for 100 percent ownership is $160,001. As the
customer’s ownership increases, this amount decreases, until
the final ownership payment of $1.00
The Basis of Using a Percentage landscape, sublet, or basically utilize the property for any
legal purpose that it is zoned for. The only exception may be
While it may appear contrary to Sharia, it is in fact acceptable if you engage in an activity that could harm the value of the
to describe the profit on an Islamic transaction as a percentage. property, such as demolishing a garage without rebuilding it.
The following example should clear up any confusion regarding For all practical purposes, your role is the same as that of a
the acceptability of quoting the profit as a percentage in an homeowner, because once your have fulfilled your obligations
Ijarah transaction: under the lease or promise to purchase, you become the owner
1. Suppose you have $100,000 in cash. of the property.
3. You rent the home to a tenant for $500 per month. Sharing of a Gain or Loss
4. At the end of the year, you have collected $500 x 12 or One of the basic Sharia compliance principles is that there
$6,000 in rent. should be a sharing of either a gain or loss in a financial
transaction. The Ijarah transaction is structured in such a
5. That $6,000 in rent is a 6% return on your $100,000
way that 100 percent of the gain is rightfully the customer’s.
investment.
Under Shariah, the gain or loss is shared by the parties in a
Is that 6 percent to be regarded as rent or as riba? Clearly it is transaction according to their percentages of ownership. The
rent, since it is based upon a business transaction. Now let’s Ijarah transaction abides by this principle, in that when the
look at a traditional mortgage interest transaction: gain or loss is realized, there is only one owner of the property,
and that is the customer. From a procedural perspective, at the
1. Starting with the same $100,000 cash. time of sale
2. You give someone the money. 1. the Trust will transfer the title of the property to the
3. They proceed to purchase the same home with those customer,
funds. 2. the customer will then transfer the title to the new buyer,
4. They pay you the same $500 per month, or 6% a year 3. the new buyer will then settle the transaction according
for use of the money. to the agreement with the customer, and
In this case, is the 6 percent riba? Yes, it is, since it is rent on 4. then the customer will settle with the Trust according to
money. The first example was rent on property. So it should be the agreement between the customer and the Trust (the
clear that from a Sharia perspective, it is acceptable to describe Ijarah documents).
the profit on an Islamic Ijarah transaction as a percentage.
Furthermore, it is also a requirement under the Truth in Lending The procedural steps above create a situation where the customer
Act/Consumer Protection Act, that any profit earned on a holds 100 percent title, albeit for a short time, and by doing so
residential real estate finance transaction should be described they entitle the customer to be the beneficiary of the difference
as a percentage so that a customer can clearly understand what between the two agreements, the sale to the new buyer and the
the overall cost of the financial transaction is. original promise to purchase agreement with the Trust.
Tenant or Homeowner?
In an Ijarah transaction, you are technically a tenant. You sign
a lease that obligates you to a rent payment over a period of
time. However, unlike in a typical rental property lease, you
are responsible for all the maintenance of the property and
you have all the rights and duties of a homeowner. You can sell
the property any time you wish, you can remodel, decorate,
32 Focused toolkit: Islamic Leasing (“Ijarah”)
In any case, on completion of the construction, and based on the Qualified Assets:
client’s request and promise to lease the asset, the bank, which
Residential, Office Buildings & Villa Complexes
has accepted the offer according to the terms and conditions
set out in the Forward Ijarah, will lease the asset (or its share in Documentary Requirements:
the asset) to the client and the client will receive agreed rentals.
1. Copy of valid passport.
At the end of the lease period (i.e., on maturity) and upon
meeting all its obligations under the Forward Ijarah contract, 2. Full details of personal financial information sup-
the bank will transfer the ownership of the property to the ported with documents.
client for a nominal sale price under a separate sale contract. 3. Personal bank statements for the last six months.
Details of the terms under which this product is offered are 4. Completed finance application form.
outlined below:
5. Copy of site plan.
Ijarah (Ending with Title Deed) Islamic Leasing for Micro, Small,
Muntahia Bittamleek20: and Medium Enterprises (MSME)
Ijarah is a form of leasing where a property (commercial In some Muslim communities, conventional interest-based
building / complex of villas) is leased by the lessor to the lessee microleasing, or microfinance, has been rejected, principally
in such a way that at the end of an agreed lease period, the lessee for its noncompliance with Islamic principles, particularly on
becomes the owner of the property by purchasing it from the the issue of paying interest or riba, which is forbidden under
lessor either during or at the end of the lease period at an agreed Shariah. This has contributed to the failure of government
sale price. initiatives using conventional microleasing in these
communities to overcome poverty and promote economic
Applying the above, upon the client’s promise to lease from
development. As a result, it is estimated that up to 72 percent of
the bank, the bank purchases, for itself and in its own name,
people living in Muslim-majority countries do not use formal
a property specified in the promise and then leases it to the
financial services at all (Honohon 2007)21. The extent of the
client on terms of financial lease. The lease rent is structured
market opportunity is evident when one realizes that Islamic
so that at the end of the lease period, the bank’s purchasing
microfinance represents less than 1 percent of total global
cost and profit are recovered and the bank can then transfer the
microfinance outreach (Karim et al 2008)22.
ownership of the property to the client for a nominal sale price
or as a gift, by either a separate sale or gift contract, at the end These Muslim clients, who demand products consistent with
of the lease period. Islamic financial principles, provide the base for Islamic Ijarah
for MSMEs. Products used by these institutions include Ijarah
Details of the terms under which this product is offered are
and Al-Ijarah Muntahiya Bittamleek. The structures and terms
outlined below:
of the Ijarah instruments are as outlined above.
Installments of both forms, Ijarah and IMB, should be presented In certain countries, like Sri Lanka, though the local
in the income statement of the lessor as “Ijara Revenue” on an tax statutes do not explicitly allow the lessor to claim
accrual basis and allocated proportionately according to the capital allowances under operating and finance leases,
term of the lease recognized in the period in which they are nevertheless under the presumption that the leased assets
due. Where the lessee acquires title through gradual sale, the are deemed to be used in the lessor’s business of leasing,
revenue decreases progressively. the lessor enjoys the right to claim capital allowances.
In these countries, the same status quo ought to prevail
The Ijarah installment paid is presented in the lessee’s income for Ijarah and IMB regarding capital allowances. In
statement as “Ijara Expense,” allocated over the lease period a scenario involving a cross-border Ijara, the lessor
recognized when due under both forms of Islamic leases. (mujir) should also be cautious about possibily creating
a permanent establishment in the lessee’s (mustajir’s)
jurisdiction.
Source: © Islamic Finance Today—Pioneer Publications (Pvt) Ltd 23
Classification and Recognition of Leases •• If the lessee can cancel the lease, the lessee’s losses associated
Under FRS 117 with the cancellation are borne by the lessee;
FRS 117 classifies all leases, for accounting purposes, into two •• If gains or losses from the fluctuation in the fair value of the
broad categories: residual value fall to the lessee; and
1. Operating leases, and •• If the lessee has the ability to continue the lease for a second-
ary period at a rent which is substantially lower than market
2. Finance leases. rent.
FRS 117 Leases, A Practical Guide to Financial Reporting
Standards (Malaysia), p. 307.
The journal entries to record the lease in the lessee book
Para 2, FRS 117, Malaysian Accounting Standards Board 2005. for the period would be as follows:
Para 8, FRS 117, Malaysian Accounting Standards Board 2005.
The criterion used in the classification is the extent to Beginning of the transactions:
which risks and rewards incidental to the ownership of a DR Leased equipment
leased asset lie with the lessor or the lessee. Risks incident to
ownership include the possibility of losses from idle capacity CR Lease payable
or technological obsolescence and variations in return due to
(Record the finance lease)
changing economic conditions. Rewards incident to ownership
may be represented by the exception in value. At the End of The Accounting Period:
Under FRS 117, a lease is classified as a finance lease if, DR Lease payable
regardless of its legal form, it transfers substantially all the risks
and rewards incident to ownership from the lessor to the lessee. DR Interest expense
A lease that does not transfer substantially all the risks and CR Cash
rewards in this way is classified as an operating lease.
(Record lease payment)
FRS 117 does not detail the concept of “transfer of substantially
all risks and rewards incident to ownership.” However, it does DR Depreciation expense
provide examples of situations where a lease would normally be
CR Accumulated depreciation
classified as a finance lease, as follows:
(Record depreciation expense)
•• Where the lease transfers ownership of the asset to the lessee
by the end of the lease term;
•• Where the lease term is for the major part of the useful life
of the asset;
CR Interest income
The Findings
The differences in the accounting treatment of Ijarah between
the Financial Reporting Standard (FRS) and the Accounting
and Auditing Organization for Islamic Financial Institutions
(AAOIFI) is an interesting topic worth discussing.
FOUR MAIN SCHOOLS OF ISLAMIC dominance in particular parts of the Muslim world and do
create subtle differences in codified texts, marriage and family
THOUGHT25 law, and some criminal punishments.
26 Please see end notes at the end of this focused toolkit 27 Please see end notes at the end of this focused toolkit
44 Focused toolkit: Islamic Leasing (“Ijarah”)
the construction part can be financed through an istisna (see and it can also be structured as a securitization.
the next section), and once the asset/project is finished, the
Banks often use back-to-back transactions:
bank can lease it or sell it on deferred payment terms to the
company that will operate it. This is similar to the back-to-back •• Under the first Istisna, a customer agrees to purchase an
istisna, but with the important difference that the buyer can asset from the Islamic bank upon completion. The purchaser
make his final payments after the asset has been constructed can pay the financial institution in advance, at completion,
and delivered to him. or over time based on a set of predetermined completion
milestones.
As an example, this structure was used in a deal for $77 million
in project financing for the Bakri Group to build two chemical •• Under the second Istisna (the “hire to produce” contract),
tankers that were to be chartered by Saudi Basic Industries the Islamic financial institution agrees to pay the manu-
Corporation. The first tranche of the financing consisted of facturer to build the asset in question. As an intermediary,
disbursements under an Istisna, and this was replaced by an the Islamic financial institution accepts the manufacturer’s
AITAB on delivery of the tankers. performance risk and the buyer’s payment risk.
requires detailed undertakings by the lessee that it will use the At least, it should limit its own liability by the indemnities
leased goods for normal business use, that it will ensure that received from the seller. Also, in the Ijarah contract, the lessee
the use of the goods will not vitiate the insurance policy, that should agree to indemnify the lessor for all costs, liabilities, and
it will not sublease or hire out the goods, that only properly obligations linked to the goods, whether or not due to its fault.
trained personnel will use the goods, that the goods will be
properly operated and maintained, and that it will return the
goods at the end of the lease in good condition, fair wear and
tear excepted. Project Financing Examples
The Dolphin Gas Project28, which includes natural gas
production in Qatar and a pipeline to the United Arab Emirates,
represents one of the largest Islamic financings of a Persian
Timing of Payments
Gulf oil and gas project to date. It involved a $1 billion Ijarah
Like most western leases, payment under the Ijarah can only and Istisna component alongside a $2.45 billion conventional
start once the good (or at least, an economically useful part debt offering.
thereof) is effectively transferred to the lessee.
An example of government-related financing in the Middle
East is the $50 million pipeline financing in Pakistan, which
used a five-year Ijarah facility.
Legal Liability
As the owner and lessor of the goods, the financial institution is
exposed to certain legal risks. The financial institution should
include in the contract a disclaimer, to the extent possible. 28 Please see end notes at the end of this focused toolkit
46 Focused toolkit: Islamic Leasing (“Ijarah”)
29 Please see end notes at the end of this focused toolkit 31 Please see end notes at the end of this focused toolkit
30 Please see end notes at the end of this focused toolkit 32 Please see end notes at the end of this focused toolkit
Sale undertaking
Purchase undertaking
Rent Lease
Originator
as lessee
Focused toolkit: Islamic Leasing (“Ijarah”) 47
Sukuk Trust Certificates The MGS issue was rated by Moody’s and by Standard and
Poor’s33. and the Sukuks were listed on the Luxembourg Stock
A good example of successfully adopting the Ijarah structure Exchange. The lease payments are determined based on a
for a truly global capital market issue was the Malaysian spread over LIBOR. Islamic scholars are comfortable with the
government’s issue of Sukuk Trust Certificates in August 2002. use of LIBOR as a lease pricing reference mechanism but not
The structure used for the transaction was clean and simple in as a means of calculating interest. A floating lease price has
order to appeal to the broadest possible base of investors. In been considered acceptable by Islamic scholars, since landlords
this instance, a special purpose company was incorporated in and tenants (in the traditional sense) can agree on raising or
Labuan called the Malaysian Global Sukuk Inc. (MGS). (See lowering lease payments on land over the period of a tenancy.
illustration below.)
Ijara Sukuks are freely tradable. As trading in debt above or
MGS is owned by a Malaysian state entity. MGS issued Sukuks below par would obviously breach the Islamic finance principle
to investors and used the funds thus raised to purchase parcels of not charging interest and the ability to trade freely in capital
of land in and around Kuala Lumpur from another Malaysian market instruments is critical to investors, there is a potential
state entity. MGS then leased those parcels of land to the further problem. However, since the Ijarah Sukuks represent
Federation of Malaysia. At the expiry of the term of the lease, an interest in the underlying assets and not debts, they can be
the Malaysian government has agreed to purchase the parcels traded above or below par freely without breaching any Islamic
of land from MGS at the face value of the initial issue amount principles.
of the Sukuks.
& Sukuks
Sukuk
holders
48 Focused toolkit: Islamic Leasing (“Ijarah”)
•• Since the asset is tied up for the term of the transaction, the
Sukuk Ijarah Mowsufa Bithima—The owner of a
owner of the asset cannot divest it freely and there could be
tangible asset to be acquired and subject to a lease contract
negative pledge implications in putting the asset into the
may mobilize the acquisition cost of such an asset through
transaction.
Sukuk issues.
•• There could be ongoing Shariah audits in connection with
the asset. This can be time consuming and costly for the Sukuk Manfaa Ijarah—The owner of leasehold rights
issuer. of existing leased assets may sell the usufruct of such assets
through Sukuk issues.
Sukuk
holders
Stage 1: Contract for cash sale (Bay’ Mutlakah) Ijara and Project Finance
•• SPV purchases property (e.g. hospitals) from obligator Islamic financing structures are increasingly used in the project
(government). (1) finance domain, particularly in projects in the Middle East. In
most Islamic financing, incorporated within a multi-sourced
•• The assets purchased by the SPV are funded by the issuance
project financing, the Islamic financing element of the project
of sukuk (trust certificates) which represents beneficial own-
is provided pari passu with the other senior debt. Istisna
ership in the assets and the lease. (3)
and Ijarah elements are frequently used. The following is an
•• Government receives cash proceeds. (7) example of a transaction structure.
Islamic SPV
The Islamic SPV agreed to pay for the project assets by phased
payments (equivalent to advances of finance) to the borrower. If
the borrower failed to deliver the project assets by the due date,
it was liable to pay liquidated damages.
Following delivery of the project assets under the terms of the The Islamic finance providers, the Islamic SPV, and the
Istisna, the Islamic SPV agreed to lease the project assets to the borrower acknowledged that the payments made by the Islamic
borrower for the period of the lease and the borrower agreed to facility agent directly to the borrower (sourced from the
pay lease payments (equivalent to debt service) to the Islamic SPV. Islamic finance providers under the Islamic facility agreement)
As owner of the assets, the SPV had de facto security over them. were payments satisfying the Islamic SPV’s obligation to pay
consideration for the project assets under the Istisna agreement.
Akin to the restrictions and covenants placed upon the borrower
according to conventional debt facilities, the borrower undertook The Islamic SPV owned the assets and appointed the borrower
to use the leased project assets solely for the purposes contemplated as its service agent to operate and maintain the leased project
in the Islamic facility agreement. Furthermore, The Islamic SPV assets, keep such assets fully insured, and pay any applicable
and the Islamic facility agent made no representation or warranty ownership taxes, thereby restoring certain of the risks of asset
as to the project assets so that risk of title, defects, and so on all ownership to the borrower.
rested with the borrower, who waived any claim caused by the
The Islamic SPV undertook to sell the leased assets to the
project assets. The Islamic SPV’s rights to take any enforcement
borrower upon payment of a lease termination payment (a
action (e.g., remedies following events of default) were governed
discharge of all outstanding amounts owed, effectively allowing
by the terms of the inter-creditor agreement.
prepayment of the Islamic facility and release of the rights of
The borrower was entitled to terminate the Ijarah voluntarily the Islamic finance providers upon discharge of the Islamic
by giving notice. Upon termination, including payment of financing).
the final lease payment (i.e., maturity), the Islamic SPV was
The borrower undertook to purchase the leased project assets
to sell the project assets to the borrower according to the sale
from the Islamic SPV upon payment of a lease termination
undertaking (see below) and the Islamic facility agreement.
payment (effectively an acceleration of the Islamic facility).
Subject to the terms of the inter-creditor agreement and the
other non-Islamic documents, the Ijarah could be terminated Given the principles behind Islamic financing outlined above,
following certain events of default. the Islamic finance providers were not party to the other
finance documents. However, each of the Islamic finance
During the term of this Ijara, the ownership of the project assets
providers was, through the Islamic facility agent, bound by the
remained with the Islamic SPV. The borrower could require the
inter-creditor agreement with the non-Islamic lenders and was
Focused toolkit: Islamic Leasing (“Ijarah”) 51
therefore subject to the inter-creditor provisions governing the to make a payment connected to the delay. If an Islamic finance
relationship between the lenders. These provisions included the provider received a payment that was solely attributable to the
method of voting and decision-making; arrangements for joint borrower’s delay in payment, that participant was required to
consultation and actions regarding approval rights and waivers; hand over the net amount (after deducting the actual costs
limitation of the parties’ rights of enforcement upon default; and expenses suffered or incurred by it as a consequence of
and the application of proceeds upon enforcement. the borrower’s failure to comply with the applicable Islamic
finance document) to such charitable foundation or scientific
This Islamic facility agreement contained various representation
or medical institution as it selected.
and warranties, covenants and events of default by the borrower.
The diagram below illustrates a typical project finance
Unlike conventional financing, the Islamic facility agreement did
transaction that incorporates an Islamic financing structure.
not provide a guaranteed interest rate of return, as the prohibition
of interest is a significant principle of Islamic financing. As an Construction phase 1—The borrower develops, constructs,
alternative, the Islamic finance documents provided for advance and sells project assets to the Islamic SPV. As consideration,
amount payments (providing an effect similar to interest the Islamic SPV makes phased payments to the borrower
calculated on the outstanding principal on or before the lease (equivalent to loan advances).
began) and a lease variable element (providing an effect similar to
Post-construction phase 2—The Islamic SPV leases project
interest calculated at any time after the lease began).
assets to the borrower. The borrower makes lease payments
While the Islamic finance documents did not contain any (equivalent to debt service).
express provision for the payment of default interest, failure
by the relevant party to pay any amount owing under the
applicable Islamic finance document resulted in an obligation
Intercreditor
Islamic finance Islamic facility agreement Non-Islamic
providers agent lenders
t
en
e s tm y
Inv genc ent
a em
re
ag
Purchase Islamic
undertaking facility
Islamic SPV agreement
Sale
undertaking
Service agency
agreement
Istisna’a
Construction phase1 Borrower
Project assets Ijara
Post-construction phase2
52 Focused toolkit: Islamic Leasing (“Ijarah”)
Standard & Poor’s Ratings the adequacy of the lease payment stream that will service
the rated Ijarah Sukuk, and, where the underlying obligor
of Ijarah Sukuk is a government, its commitment to such transactions as an
As the above makes clear, Ijarah Sukuk are financial obligations important and continuing source of financing.
issued by a lessor and backed primarily by a lease stream from a Standard & Poor’s has rated Ijarah Sukuk transactions
credit lessee. Since Shariah frowns on the payment of interest, backed by various types of underlying credit lessees, including
Ijarah Sukuk transactions work by passing a lease stream through sovereign governments, regional governments, corporations,
to the holder of the Ijarah Sukuk, rather than being structured and multilateral lending institutions. Standard & Poor’s also
as an interest-bearing loan secured by a pledge of assets. rates financial institutions that provide Islamic banking and
Ijarah Sukuk are one of many forms of Sukuk (notes) compliant insurance services.
with Shariah on the provision and use of financial products and In most cases, Standard & Poor’s has assigned Ijarah Sukuk the
services. It should be noted that only an appropriate Islamic same ratings as it assigns to the lessees creating the payment
body may recognize the compliance of the terms of any Sukuk stream. This practice reflects the unconditional, irrevocable
issuance with Shariah and that individual investors should nature of the lease, any third-party lease guarantees, sale and
make adequate inquiries as to Shariah compliance. Standard purchase agreements, and/or financial hedges that are found
& Poor’s rating process does not address Shariah compliance. in the transaction. Ratings lower than those given to the lessee
are assigned where there are diminished recovery prospects,
greater risks associated with lease payments, or other factors
supporting such a distinction. Higher ratings are unlikely
Ijarah Sukuk ratings
without additional risk-mitigating features, in the case of
sovereigns, although for corporates Ijarah Sukuk may resemble
Background
certain characteristics of secured loans and be notched up
This section describes ratings of Ijarah Sukuk, typical accordingly.
transaction configurations, and factors affecting the ratings.
These factors include the status and responsibilities of the
special purpose entity (SPE) typically found in Ijarah Sukuk,
Focused toolkit: Islamic Leasing (“Ijarah”) 53
How do Ijarah Sukuk ratings compare with for a determined price (the purchase price).
those of the lessee? 2. The SPV raises financing to purchase the assets by issu-
Ijarah Sukuk should receive the same rating as the underlying ing Ijarah Sukuk to investors in an amount equal to the
lessee if the transaction cash flows survive reasonable stress purchase price. The Ijarah Sukuk represent an equity
scenarios short of a payment default by the lessee, if the lessee interest in the SPE’s assets, which may be indirect or
views Ijarah (leasing) financing as indistinguishable in terms of direct depending on the type of SPE.
priority with conventional debt-based financing, and if recovery 3. The SPV then leases the assets to the lessee, an affili-
prospects are similar to those in a debt-based transaction. ate of the seller, or directly back to the seller itself, in
Where there is a material risk of government appropriation, as exchange for periodic lease payments. These lease pay-
is the case for government leases in a variety of jurisdictions, or ments should match the obligations of the SPE under the
other financial or operating risk, the rating of the Ijarah Sukuk Ijarah Sukuk.
may be below that of the lessee.
4. At maturity, or on a dissolution event, the SPE sells the
Standard & Poor’s does not exclude the possibility of rating assets back to the seller at a predetermined value. That
Ijarah Sukuk above the rating of the lessee. This is most likely value should be equal to any amounts still owed under
to occur when the lessee has a ratable corporate credit profile the terms of the Ijarah Sukuk.
and the credit characteristics of the Ijarah Sukuk resemble, for
credit purposes, those of secured debt, allowing the rating to be Other transaction configurations are possible. For example,
notched up above that of the lessee, depending on the strength the SPE may sublease back to the lessee the assets that have
of the security. To notch up the rating where the lessee is a been first leased to the SPE by the same lessee. Typically,
sovereign entity (or where the lessee seeks a rating above that the head lease has a longer maturity than the sublease. Such
of the sovereign of domicile), some features of the transaction configurations do not include the sale of assets and may be
would have to mitigate the risks posed by a potential sovereign preferred when the sale of an asset is difficult, either legally or
default, including the risk of the sovereign restricting access for political reasons (for example, a sovereign may not wish to
by the issuer to foreign exchange needed for payments to the sell the country’s main airport).
holders of the Ijarah Sukuk. In such an instance, an offshore
Additionally, depending on the extent of Shariah compliance,
mechanism for collecting cash flows generated by the assets is
prior to maturity the lessee may have the right to call for the
likely to be necessary for the Ijarah Sukuk to achieve a rating
assets upon certain amounts due under the Ijarah Sukuk as well
higher than that of the sovereign of domicile.
as other expenses, and the SPE might have the right to tender
the assets back to the lessee. The lease may also be supported by
How are most rated Islamic financings affiliate guarantees. Currency or other hedges may also play a
configured? part in transaction dynamics.
Standard & Poor’s has rated two broad types of Islamic
financing: (1) Ijarah Sukuk, where the whole transaction, Do Standard & Poor’s ratings address Shariah
including the ownership structure as well as the notes, is compliance?
Shariah-compliant; and (2) the ‘ownership’ Shariah-compliant
Standard & Poor’s bases its credit rating opinion on the
structure, where the bonds are issued by an unaffiliated SPE
compliance of an Ijarah Sukuk transaction with applicable
with the proceeds used to acquire the assets from the lessee/
commercial law, and the rating therefore does not reflect the
seller, combined with a put/tender feature. In this second
compliance of the transaction with Shariah. English law, New
configuration, the securities themselves may not necessarily be
York State law, and the commercial codes of the countries
Shariah-compliant.
where the assets are located have, in part, governed transactions
Most Ijarah Sukuk that Standard & Poor’s has rated are set up rated by Standard & Poor’s.
in the following manner:
Various scholars charged with interpreting the Holy Qur’an
1. The seller sells certain assets, such as an office build- and other fundamental Islamic writings offer opinions on the
ing, land, or an airport, to a special purpose vehicle (the conformity of transactions with the principles of Shariah. Were
SPV) that may be affiliated or unaffiliated with the seller a transaction to be governed solely by Shariah, such a transaction
(depending on the degree of compliance with Shariah) might be difficult to rate because of the lack of predictability
54 Focused toolkit: Islamic Leasing (“Ijarah”)
Criteria Guidelines
Standard & Poor’s criteria for rating Ijarah Sukuk take into
consideration four main elements, which can be expressed in
the form of questions, as follows.
3. Do the transaction’s cash flows provide for Most important to note, outside of the religious and political
the full and timely payment of the obligations to allure of Islamic banks, is that people are choosing their services
for the safety they are perceived to offer.
holders of Ijarah Sukuk?
However, in order for Islamic financial institutions to be
Standard & Poor’s compares the terms and conditions of
competitive with conventional products and attractive to
the asset lease and those of the Ijarah Sukuk, analysing how
customers, Islamic financial products must meet the risk/
potential shortfalls are covered in the transaction. For example,
reward profiles of investors and issuers, while fulfilling the
shortfalls that might arise from foreign currency exposure
tenets of Sharia and remaining sufficiently cost-effective.
can be covered by the lease (as supplemental rent), by a lease
Additionally, Islamic financial institutions must educate their
guarantee from another creditworthy entity, or by a hedge.
personnel to understand the tenets of Islamic law that pertain
Usually, government lessees agree to cover, on a timely basis,
to finance, and must train them to comply with Sharia as they
any additional expenses related to taxes, levies, duties, fees,
serve their Islamic customer population.
and charges, whenever they arise. Another important credit
consideration is whether the sold assets are free of any lien, While the size of Islamic finance and banking activities,
pledge, mortgage, security interest, deed of trust, charge, or estimated to range from $500 billion to $1 trillion, is still a
other encumbrance. fraction of conventional banking and finance activities,
estimated annual growth rates of 10 to 15 percent seen in
Risks to the leased assets from loss or damage can be mitigated
recent years emphasize the potential market for such activities.
by insurance, though the terms and exceptions, as well as risk
Amidst this growing market opportunity there are several
of insurer’s default, must be examined carefully.
inherent risks, not the least of which is the attraction of “reverse
engineering” traditional financial products to become Islamic
4. If the lessee is a government, is its financial products. If this is done by personnel not well versed
commitment to its Ijarah Sukuk similar to its in the Islamic financial system, then risks abound.
commitment to other types of debt financing?
The most well-known aspect of an Islamic financial system is
‘Willingness-to-pay’ considerations are of particular importance the prohibition against paying or receiving interest (riba) on
for sovereign lessees. Historically, financially distressed capital. Essentially, any positive, fixed, predetermined rate
sovereign lessees have occasionally discriminated among their tied to the maturity and the amount of principal, which is
pari passu financial obligations. Standard & Poor’s examines guaranteed irrespective of the performance of the investment,
the extent to which the government includes Ijarah Sukuk in is considered riba and is therefore prohibited.
government accounts as debt obligations, indistinguishable
in terms of priority from conventional debt. ‘Willingness’ This prohibition is not to be confused with a rate of return
considerations are supported by Ijarah Sukuk financing being or profit on capital, since earning and sharing profit is very
designed to target investors interested in Shariah-compliant much encouraged within Islam. Moreover, profit, determined
instruments, rather than to create a new stratum of obligation. ex post, symbolizes the creation of additional wealth through
successful entrepreneurship, whereas interest, determined ex
ante, is a cost that is accrued irrespective of the outcome of
Conclusion—New Product business operations, and may create wealth even if there are
business losses.
Development
It is within this context that one should consider the
There are an estimated 1.61 billion Muslims worldwide, development of new Ijarah products.
making Islamic banking one of the fastest growing segments of
the financial industry. To provide further clarity in terms of development of new
products as well as new institutions to market Ijarah products
According to Standard and Poor’s surveys, 20 percent of one should take into consideration IFSB 9.0.
the customers in the Gulf region and Southeast Asia would
choose an Islamic banking product over a similar conventional
product. There are significant middle-class urban and
suburban populations that already use conventional banking,
and therefore present ripe opportunities for Islamic banks.
56 Focused toolkit: Islamic Leasing (“Ijarah”)
Focused toolkit: Islamic Leasing (“Ijarah”) 57
Principle 3: Capabilities
An IIFS shall ensure that it has in place the necessary systems
and procedures, and that its employees have the necessary
knowledge and skills, to comply with these principles and other
IFSB standards.
58 Focused toolkit: Islamic Leasing (“Ijarah”)
Islamic Financial Glossary haram: Unlawful, forbidden (see halal). Describes activities,
professions, contracts and transactions that are explicitly
al adl: A trusted and honourable person, selected by both prohibited by the Qur’an or the Sunnah.
parties to a transaction. A trustee.
hawala: Bill of exchange, promissory note, cheque or
al Maqasid al Shariah: The objective of Shariah. draft. A debtor passes on the responsibility of payment of his
debt to a third party who owes the former a debt. Thus, the
amana/amanah: Literally means reliability, responsibility of payment is ultimately shifted to a third party.
trustworthiness, loyalty and honesty, and is an important Hawala is used in developing countries as a mechanism for
value of Islamic society in mutual dealings. It also refers to settling international transactions by book transfers.
deposits in trust, sometimes on a contractual basis.
ijarah/ijara: Lease, hire or the transfer of ownership
bai/bay: Contract of sale, sale and purchase. of a service for a specified period for an agreed lawful
consideration. This is an arrangement under which an Islamic
financial institution leases equipment, a building or other
bai al-salam: Advance payment for goods. While normally
facility to a client for an agreed rental.
the goods need to exist before a sale can be completed, in
this case the goods are defined (such as quantity, quality,
workmanship) and the date of delivery fixed. Commonly ijarah muntahla bittamleek/ ijarah wa iqtina: A
applied in the agricultural sector where money is advanced for leasing contract used by Islamic financial institutions that
inputs to receive a share in the crop. includes a promise by the lessor to transfer the ownership of
the leased property to the lessee, either at the end of the lease
or by stages during the term of the contract.
diminishing musharaka: A form of partnership that
ends with the complete ownership of a partner who purchases
the share of another partner in that project by a redeeming ijtihad: Literally effort, exertion, industry, diligence. As a
mechanism agreed between both of them. legal term, it means the effort of a qualified Islamic jurist to
interpret or reinterpret sources of Islamic law in cases where
no clear directives exist.
fatwa (pl. al fatawa): An authoritative legal opinion
based on the Shariah.
Istisna/istisna’a: A contract of sale of specified goods to
be manufactured with an obligation on the manufacturer
fiqh: Practical Islamic jurisprudence. Can be regarded as the
to deliver them on completion. It is a condition in istisna
jurists’ understanding of the Shariah. There are four Islamic
that the seller provides either the raw material or the cost of
schools of jurisprudence: al-Shafie, al-Hanafi, al-Maliki and
manufacturing the goods.
al-Hanbali.
gharar: Uncertainty in a contract or sale in which the goods maisir/maysir: The forbidden act of gambling or playing
games of chance with the intention of making an easy or
may or may not be available or exist. Also, ambiguity in the
unearned profit.
consideration or terms of a contract—as such, the contract
would not be valid.
manfa’a: A form of contract in which one party gains the
right to use or benefit from the use of an asset.
hadith: The narrative record of the sayings, doings and
implicit approval or disapproval of the Prophet.
mudaraba/mudarabah: A form of contract in which
one party (the rab-al-maal) brings capital and the other (the
halal: Permissible, allowed, lawful. In Islam, there are
mudarib) personal effort. The proportionate share in profit is
activities, professions, contracts and transactions that are
determined by mutual consent, but the loss, if any, is borne
explicitly prohibited (haram) by the Qur’an or the Sunnah.
by the owner of the capital, unless the loss has been caused
Barring these, all others are halal. An activity may be
by negligence or violation of the terms of the contract by
economically sound but may not be allowed in Islamic society
the mudarib. A mudaraba is typically conducted between
if it is not permitted by the Shariah.
Focused toolkit: Islamic Leasing (“Ijarah”) 59
an Islamic financial institution or fund as mudarib and qard al hasan/qard hassan: A virtuous loan in which
investment account holders as providers of funds. there is no interest or mark-up. The borrower must return the
principal sum in the future without any increase.
mudarib: The managing partner or entrepreneur in a
mudaraba contract (see above), see also rab almal. rab-al-maal: The investor or owner of capital in a
mudaraba contract (see above).
murabaha: A contract of sale with an agreed profit mark-up
on the cost. There are two types of murabaha sale: in the first rahn: A mortgage or pledge.
type, the Islamic financial institution purchases the goods and
makes them available for sale without any prior promise from a riba: Interest. Sometimes equated with usury, but its
customer to purchase them, and this is termed a normal or spot meaning is broader. The literal meaning is an excess or
murabaha. The second type involves a promise from a customer increase, and its prohibition is meant to distinguish between
to purchase the item from the financial institution, and this is an unlawful exchange in which there is a clear advantage
called murabaha to the purchase order. In this latter case, there to one party in contrast to a mutually beneficial and lawful
is a pre-agreed selling price that includes the pre-agreed profit exchange.
mark-up. Normally, it involves the financial institution granting
the customer a murabaha credit facility with deferred payment
terms, but this is not an essential element.
riba al-buyu: A sale transaction in which a commodity is
musharaka/musharakah: An agreement under which exchanged for the same commodity but unequal in amount
the Islamic financial institution provides funds that are or quality, or the excess over what is justified by the counter-
mingled with the funds of the business enterprise and possibly value in an exchange/business transaction.
others. All providers of capital are entitled to participate in
management but are not necessarily obliged to do so. The sadaqa: Voluntary charity.
profit is distributed among the partners in a pre-determined
manner, but the losses, if any, are borne by the partners in salam: A contract for the purchase of a commodity for
proportion to their capital contribution. It is not permitted to deferred delivery in exchange for immediate payment.
stipulate otherwise.
60 Focused toolkit: Islamic Leasing (“Ijarah”)
Shariah /Shari’a/Shari’ah: In legal terms, the law zakah/zakat: A tax that is prescribed by Islam on all
as extracted from the sources of law (the Qur’an and the persons having wealth above an exemption limit at a rate
Sunnah). However, Shariah rules do not always function as fixed by the Shariah. Its objective is to collect a portion of
rules of law as they incorporate “obligations, duties and moral the wealth of the well-to-do and distribute it to the needy.
considerations that serve to foster obedience to the Almighty.” The way it is distributed is set out in the Qur’an. It may
be collected by the state, but otherwise it is down to each
shirkat al-aqad: A joint-venture partnership. individual to distribute the zakat.
wadiah: A deposit.
References
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62 Focused toolkit: Islamic Leasing (“Ijarah”)
a) FRS 117 Leases, A Practical Guide to Financial Reporting Standards (Malaysia), page307,
d) http://www.masb.org.my/
e) http://www.masb.org.my/index.php?option=com_content&view=article&id=321%3Afrs117-pg3&catid=6%3Amasb-exclude-
private&Itemid=32
27) Islamic Project Finance, Chadbourne and Parke LLP, Islamic Project Finance: Structures and Challenges, February
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Durham University, Institute for Middle Eastern and Islamic Studies, http://www.assaif.org/content/download/586/4393/
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Focused toolkit: Islamic Leasing (“Ijarah”) 63
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