islamic banking legal documentation on ijarah an analysis

Islamic Banking Legal Documentation on Ijarah: An Analysis

Liliah TubingBarath a/l ManianNurul Hazirah JafriLendee IkSiti Aisyah YusoffUUM COLGIS, 2012.

1.0 INTRODUCTION

Ijarah literally means to rent or lease something. In its technical sense, the term Ijarah has two

different connotations. Firstly it is a hire contract to employ the services of a person with wages

given to him/her as a consideration for his/her hired services. Secondly it is lease contract to

transfer the usufruct of a particular property to another person in exchange for a rent claimed

from him/her.

The legality of Ijarah is deduced from the Qur’an, the Sunnah of the Prophet Muhammad

(SAW) and the consensus of the Muslim jurists (Ijma’). Several verses of the Qur’an can be

quoted as evidence for Ijarah particularly for hiring the services of a person. Among others, the

verses which mean:

And said one of them (the two women): "O my father! Hire him! Verily, the

best of men for you to hire is the strong, the trustworthy”. He said: "I intend

to wed one of these two daughters of mine to you, on condition that you serve

me for eight years, but if you complete ten years, it will be (a favour) from

you. But I intend not to place you under a difficulty. If Allah will, you will find

me one of the righteous." (28:267)

Other than that, the sunnah of the Prophet Muhammad (SAW) refers to both lease

and hire contracts as;

i. The prophet (SAW) said: “pay the hired worker his wages before his

sweat dries off” (Sunan Ibn Majah)

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ii. The Prophet (SAW) is reported to have said: "He who hires a person

should inform him of his fee.” (Al-Sunan Al-Kubra li Al-Baihaqi)

iii. Abdullah ibn Umar narrates, “Allah's Apostle gave the land of Khaibar to

the Jews to work on and cultivate and take half of its yield.” Ibn 'Umar

added, "The land was used to be rented for a certain portion (of its

yield)." (Sahih Al-Bukhari)

Ijarah has been unanimously approved by the companions of the Prophet

Muhammad (SAW) and prominent jurists of the recognized schools of Islamic law.

They view that the need to utilize the usufruct of different articles (goods and

services) is similar to the need to utilize the articles. When the contract of sale of such

goods and services is permitted, the lease of its usufruct shall also be permitted on the

grounds of public interest (maslahah) and needs.

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2.0 ADVANTAGES OF IJARAH

Ijarah provides advantages to the Lessee. First of all, Ijarah conserves the Lessee' capital since it

allows up to 100% financing. Secondly, Ijarah arrangements aid corporate planning and

budgeting by allowing the negotiation of flexible terms. Besides, Ijarah is not considered Debt

Financing so it does not appear on the Lessee' Balance Sheet as a Liability. This method of "off-

balance-sheet" financing means that it is not included in the Debt Ratios used by bankers to

determine financing limits. This allows the Lessee to enter into other lease financing

arrangements without impacting his overall debt rating.

Furthermore, all payments towards Ijarah contracts are treated as operating expenses and

therefore fully tax-deductible. Leasing thus offers tax-advantages to for-profit operations. Many

types of equipment become outdated before the end of their actual economic life. We must note

that, Ijarah contracts allow the transfer of risk from the Lesse to the Lessor in exchange for a

higher lease rate. This higher rate can be viewed as insurance against obsolescence.

As already noted, Ijarah bonds do not represent debt; they represent undivided

ownership in the leased asset. They are as such participatory trust certificates that resemble

equities. Since the sukuk are neither debt nor monetary instruments, Islamic legal difficulties that

accumulate the sale of debts or money do not arise in this case. The sukuk would, however, lose

their Shariah compliance without a share in ownership of the asset.

The determining factor of the cost of Ijarah financing is the benchmark rate used by the

lessor to assess his required return. The fact that the lessor remains legal owner of the leased

assets places him in a secure position without any need for collaterals. Since leasing companies

are not deposit takers, they tend to be less tightly regulated than banks and finance companies 1.

Leasing offers the advantage of not requiring collateral and thus of simpler recovery procedures

since ownership of the asset lies with the lessor. The lessor is only exposed to a low level credit

risk from the lessee as the lease transaction is, by definition, asset-backed loan2. Since the lessor 1 Cf, Ibrahim Warde, “Islamic Finance: A Quarter-Century Assessment,” in Proceedings of the Fourth Harvard University Forum on Islamic Finance, (September 30–October 1, 2000) 194; Mohammad Muzaffar, “Ijarah: Financing on the Basis of Hire Purchase and Leasing,” Encyclopedia of Islamic Banking and Insurance, 143.

2 See Ebrahim, M.S. & Joo, T.K, et al. "Islamic banking in Brunei Darussalam" , International Journal of Social Economics 28, no.4, (2001): 314-337.

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purchases the required equipment often at the request of the lessee and obtains it directly from

the supplier, the possibility of misuse of funds and assets is minimized. Leasing is thus not

only asset-backed but also purpose-driven and can contribute to long term economically

beneficial investment. Relatively simple documentation keeps transaction costs down, allowing

leasing companies to achieve high leasing volume more efficiently. Lower costs are also to some

extent a corollary of the fact that leasing is backed by its own assets, which make it independent

of collateral taking procedures3.

Ijarah is also a flexible facility since the lease payments can be short-term or long-term4.

Financing and pricing can be on a fixed or floating basis, unlike fixed-term or fixed-date trading

contracts such as murabahah and istisna‘. Due to the flexibility of Ijarah this facility has

experienced a rapid growth so that the price of a sold item may not be adjusted upwards or

downwards once the sale is complete, even if the payment of price is deferred.5

Beside the method of sale and lease back also permissible in Ijarah.6 The lessee sells the

asset to the lessor and leases it back. In this case the Ijarah contract cannot be executed unless

and until the Islamic Financial Institution as lessor has acquired the underlying asset. Assets

leased under this technique can be sold back to the original owner. This technique is commonly

used as an underlying transaction in Ijarah sukuk.

Ijarah sukuk is a security that represents ownership of an equal share in the usufruct of an

asset that is well defined, existing and known, tied to an Ijarah contract as defined by Shariah.

The sukuk gives the owner the right to own the underlying assets, receive rent and dispose the

sukuk without any impact on the sukuk issuer's right to use the asset. There are ownership risks

related to this instrument; for example owners have to bear all costs related to the basic

characteristics of the assets and the lessee is responsible for bearing the cost of maintenance7.3See Nafel al-Hathal, “Innovation in Ijarah Financing”, Conference paper presented at Labuan International Summit on Islamic Financial & Investment Instruments, (16-18 January, 1997): 4.4 See Mohd Hashim Kamali, et al, “A Syariah Analysis of Issues in Islamic Leasing,” Islamic Economy 20, no 1, (2007): 16-17.5 See Adam, Nathif J. and Abdul Kader Thomas. Islamic Bond, Your Guide to Issuing, Structuring and Investing in Sukuk. London: Euromoney Books.(2004):31, 27. 6 See Ayub, M.(n.d.), Securitization, sukuk and fund management potential to be realized by Islamic Financial Institutions. http://islamiccenter.kaau.edu.sa/7iecon/Ahdath/Con06/_pdf/Vol2/48%20Muhammad%20Ayub%20Securitization,%20Sukuk.pdf. (accessed July 2, 2008). Cited in Dinna Rohmatunissa, et al . “Design of Ijarah Sukuk”, presented paper for the Degree of MA in Finance and Investment, the University of Nottingham,(2001):29-30.7 See Manaf, I.A. Islamic bonds (sukuk): Its introduction and application.

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http://islamiccenter.kaau.edu.sa/7iecon/Ahdath/Con06/_pdf/Vol2/48%20Muhammad%20Ayub%20Securitization,%20Sukuk.pdf



According to Al-Amine (2001)8 cited in Journal of Design of Ijarah Sukuk by Dinna

Rohmatuninisa, Ijarah sukuk has four characteristics. First and foremost, Ijarah bonds can be

traded in the market at prices determined by market forces, such as general market and economic

conditions, the financial market, opportunity cost and the price of real investment. The Ijarah

bond is also subject to risk related to the ability and desire of the lessee to pay the rental

payment, and the market risk arising from the potential changes in asset pricing, maintenance

and insurance cost. Secondly, due to the presence of maintenance and insurance expenses that

cannot be perfectly known in advance, the expected return on some forms of Ijarah sukuk cannot

be completely fixed and determined at the beginning of the contract. Thirdly, Ijarah sukuk is

completely negotiable and tradable in the secondary market. Fourthly, Ijarah sukuk offers a high

degree of flexibility, derived from the approach to issuance management and marketability. The

flexibility rules in Ijarah mean that securitization of the Ijarah contract is the key factor to

solving the liquidity management problem. Therefore, sukuk has both the characteristics and the

necessary conditions to be a successful security.

In short, the basic advantages of Ijarah and how it can be used to avoid some of the

controversial features of bay‘ al-‘inah and bay‘ al-dayn have generated much interest in Ijarah

based financing and sukuk in recent years. Ijarah can also be used as an incentive to economic

development as it is usually long term and offers potential for stimulating productive industries.

The fact that Ijarah is not dependent on collaterals also means that it has greater in-built stability

to contain inflationary pressures in the economy.

http://www.sebi.ac.id/. (Accessed February 27, 2008). Ibid. p31.8 See Al-Amine, M.B.M. "The Islamic bond market: Possibilities and challenges", International Journal of Islamic Financial Services 3,no. 1.(2001)

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http://www.sebi.ac.id/


3.0 APPLICATION OF IJARAH PRODUCTS

3.1 Guidelines for Application of Ijarah Products

Ijarah products are used in many banks such as Maybank, Bank Rakyat, Bank Muamalat, Bank

Islam and Bank Negara Malaysia. Moreover, HakimahYaacob said that ijarah also is used in tax

application under Income Tax (Deduction for Expenditure on Issuance of Islamic Securities)

Rules 2007 - 11 Jan 2007. This Rules9provides tax deduction for expenditure incurred on the

issuance of Islamic securities approved by the Securities Commission, pursuant to:(a)

'mudharabah, musyarakah, ijarah, istisna' or (b) Any other Shariah principle approved by the

Minister.10

There are guidelines made Bank Negara Malaysia for application of al-Ijarahthumma al-

Bai` in Vehicle Financing in which the Islamic financial institution will conclude an ijarah

agreement with the customer. Under this agreement, the Islamic financial institution will appoint

the customer as an agent to purchase the vehicle identified by the customer. Subsequently, the

Islamic financial institution will lease the vehicle to the customer for a specified period. Upon

expiry of the lease period, the customer has the option to purchase the vehicle from the Islamic

financial institution. If the customer opts to purchase the vehicle, the Islamic financial institution

and the customer will conclude a sale contract and the ownership of the vehicle will be

transferred from the Islamic financial institution to the customer.

With regards to the Ownership Status of Ijarah Asset, the lessor is the owner of the

ijarah asset whereas the lessee is only entitled to the usufruct of the asset. Since in the current

practice the lessor’s name is not registered in the asset’s title, the SAC was referred to on the

issue as to whether the lessor possesses the ownership of the leased asset.

9 The Income Tax (Deduction For Expenditure On Issuance Of Islamic Securities) Rules 200710Tax Incentives In Islamic Finance In Malaysia. By HakimahYaacob.[2010] 1 Lns(A) Iii. Malaysia. Www.Clj.Com

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3.2 Application of Ijarah Products in Product Line

Based on Range of Islamic Banking Products and Services in Malaysia11 (in which there are

many categories of products), ijarah product is used in financing and trade finance12 categories.

Under the categories of financing of fund based, ijarah is used in asset financing-I asset-

backed financing-i (for example Maybank13),contract financing-I (for example Bank Islam14 and

bank rakyat15),industrial hire purchase-i, leasing-i, plant & machinery financing-i, project

financing-i, syndicated financing-i, vehicle/automobile financing-i whereas in fee-based product

line, ijarah is used in letter of credit-i. In trade finance categories, ijarah is used in letter of

credit-i.

3.3 Application of Ijarah Products in Maybank

3.3.1 Ijarah Term Financing-i

Ijarah Term Financing-i is based on the Shariah contract of Ijarah Muntahia Bi al-Tamlik

(leasing ending with ownership). Under this contract, the customer will sell the beneficial

interest of the assets/properties to the Bank and the Bank will pay the customer the purchase

price which is equivalent to the financing amount. The Bank will then lease the Ijarah

11Range Of Islamic Banking Products And Services In Malaysia: Http://Www.Mifc.Com/Index.Php?Ch=38&Pg=104&Ac=28&Bb=268 (accessed On 11.59pm On Wednesday, 10th Oct 2012)12The Science That Describes the Management of Money, Banking, Credit, Investments and Assets for International Trade Transactions, Definition of Trade Finance: Http://Www.Investopedia.Com/Terms/T/Tradefinance.Asp#Axzz28rhqgrh8. (accessed On 11.59pm On Wednesday, 10th Oct 2012)13 Http://Maybankislamic.Com.My/B_Imbt.Html14 Http://Www.Bankislam.Com.My/En/Pages/Procurementcontractfinancing-I.Aspx?Tabs=515 Http://Www.Bankrakyat.Com.My/Web/Guest/Contracttijari

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assets/properties to customer at an agreed rental amount for a specific tenure. Upon expiry of the

leasing period the Bank will sell the assets to the customer at a price agreed by both parties.

The purpose is to finance the purchase of leasable and completed property/asset such as

building, vessel, plane or land and to re-finance the above properties/assets.

There are many requirements to apply this product. The person who may apply is an eligible

individual or non-individual customer, local and foreign. The pricing is as per the existing

pricing for Islamic Term financing of which can be offered under:

Fixed rate (Profit Code: 19 - Profit); As per the Islamic term financing rate. The rate will

remain fixed throughout the financing tenure. The rate will be determined based on

tenure, Cagamas Standard Rate, Borrower Risk Rating amortizing type of the fixed rate

financing.

Floating rate (Profit Code: 34 - IBBLR); Base Financing Rate + margin/spread (at par

with the conventional rate i.e. the spread may range from 0.25% to 2.5%.

A combination of fixed rate and floating rate.

3.3.2 Al Ijarah Thumma Al Bai (AITAB)

Apart from ijarah term financing, the Maybank also provides for other ijarah products such as

Al Ijarah Thumma Al Bai (AITAB). Basically Aitab is Product which is based on shariah

principles which provides for car financing based on the principle of ijarh Thuman Al Bai. The

margin of finance is up to 90% and the financing period may up to 9 years. As to the benefits of

the AITAB it can be said that it was a principle which compliance with shariah which offer

leasing and contract of purchase. More over it can be said that the AITAB principle was an

extensive network of dealers of nationwide. The example types of goods that financed by

Myabank was, new motorcycle, second hand motor vehicles, reconditioned motor Vehicles.16

16 Maybank 2u.com

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Basically any individual who attained the age of 18 years old, and any other person who’s

age above 18 may apply for the AITAB financing. Apart from them, sole proprietorships’,

Partnerships companies, and also private and public Limited companies also may enter into

contract according to AITAB financing System. Basically the terms of financing will be

determined according to types of the goods financed by the Maybank. For example, different

vehicles have a different repayment duration based on the total amount of loan. Terms and

condition were applied regarding the financing of AITAB based on the guidelines issued by

Bank Negara Malaysia in Operating the AITAB system.

In order to apply for the ITAB financing the person, who intended to enter into contract,

required to submit some documents such as,

Photocopy of identity card

Photocopy of driving license

Copies of last two years income tax returns

Copies of latest 2 months salary slip

Last three month bank statements

Photocopy od sellers identity card and driving license

Photocopy of registration card only for secondhand cars

Performa invoice from sellers

Other documents which is necessary for the financing process

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4.0 RECOMMENDATION ON IJARAH17

There are many advantage and disadvantage of Ijarah. However there should be improvement in

using or the application of Ijarah. As we know, Ijarah is a contract that based on Islamic rules

and it should be conducted properly by the parties involved. The Banking Institution also has the

responsible to make sure the contract not to be abused.

The first recommendation is in the case Ijarah extended to include the whole agreed upon

contract period, the rent would be as consider agreed upon distribution of the total price, leased

asset cost and profit on periodical terms. This is because since the lessee has owned the leased

asset he would not bother for the distribution mechanism, as all are entitles.

The second recommendation is if the period of Ijarah is terminated before its due date for

any reason, the Ijarah would be as consider a just estimation of rent within the limit of estimated

equivalent price. Consequently the lessee will not pay more than the equivalent of usufruct

during the period of usufruct.

Next recommendation is to involve in the micro finance scheme. Microfinance means

program that extend small loans to very poor people for self employment projects that generate

income in allowing them to take care of themselves and their families (Microcredit Summit,

1997). This program has been recognized by the World Bank. Under Ijarah, the Ijarah Muntahia

Bitamleek is suitable to the micro finance scheme. The contract is based on where the transfer of

ownership will take place at the end of the contract and pre-agreed between lessor and the lessee.

The contract is suitable for the micro entrepreneurs that are in need of assets or equipments. Here

the Islamic Bank will purchase the assets required by the entrepreneurs and rent the assets to

qualified entrepreneurs. Then the entrepreneurs can just rent the asset over a period of time and

pay the rentals at regular intervals. The entrepreneur as a lessee will be responsible to safeguard

the asset whereas the lessor will monitor their usage.

Fourthly, the contract under Ijarah should be denominated as Ijarah with purchase

promise instead of Ijarah with purchase option. The reason is because option in Islamic Fiqh

gives the option holder freedom of choice either to purchase or not. It is not permissible to seize

17 Bank Negara Malaysia, “Syariah Resolution in Islamic Finance”, Http://www.bnm.gov.my/microsites/financial/pdf/resolutions/shariah_resolutions_2nd_edition_EN.pdf. (acessed on 10.31pm on Sunday 11th Nov 2012)

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http://www.bnm.gov.my/microsites/financial/pdf/resolutions/shariah_resolutions_2nd_edition_EN.pdf


the insurance amount paid at the start of lease contract if he refused to purchase. This is due to

the fact that the advance amount is considered in effect as trust which is permitted to dispose of,

so it should be returned to him as per his request.

Another recommendation is, Ijarah should related to usufruct in consideration of rent

where some contracts include clear statement that the lessee should not except the lessor to incur

any of the responsibilities often incurred by the owner (the lessor), whether these responsibilities

are related to maintenance or repair or providing any service to the property which this is not

accepted by Shariah. The usufruct should be existing and capable of utilization throughout the

Ijarah contract. The liability of the lessor should not be disavowed and overburdened on the

lessee because the entitlement of rent is arising from utilizing usufruct. Here the lessee may bear

the liabilities arising from operation and periodical maintenance.

The sixth recommendation is in the case of taxes. In some of the Ijarah contracts, it stated

about the lessee would bear all taxes related to ownership of the property. The right way is that

all charges of ownership should be borne by the owner, while other taxes to be borne according

to the verdict of the authority which imposed them or according to agreement of the concerned

parties. Moreover the lessee bear all taxes related to ownership of the property is impermissible

by the Shariah.

The last recommendation is that contracting expenses should be borne by the two parties.

In most contracts, the lessee should bear any legal expenses related enforcement of any rights or

liabilities related to such contract. This is unacceptable as both of parties participated in the

contract, which its usufruct would benefit both of them, so one party should not bear expenses

without involving the other.

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5.0 CONCLUSION

The pillars of an Ijarah contract basically are the presence of two parties, offer and

acceptance, reimbursement or compensation and specified usage. Without any of the

above the contract is not valid. A point to note here is the necessity to specify the

reimbursement and the usage. If these are missing, the contract is valid only if the two

parties agree on them later. Al-Ijarah contract is more widely used nowadays than

ever before, primarily due to the creation of large commercial enterprises since the

dawn of the industrial revolution.

Though there are various definitions of Al-Ijarah given by the scholars of

jurisprudence, they all agree that this contract is a contract on using the benefits or

services in return for compensation. It can be seen that Ijarah is not a mode of

financing in its origin. It is a normal business activity like sale. However, due to

certain reasons, and in particular, due to some tax concessions it may carry, this

transaction is being used in the Western countries for the purpose of financing also.

Instead of giving a simple interest - bearing loan, some financial institutions started

leasing some equipment’s to their customers. While fixing the rent of these

equipments, they calculate the total cost they have incurred in the purchase of these

assets and add the stipulated interest they could have claimed on such an amount

during the lease period. The aggregate amount so calculated is divided on the total

months of the lease period, and the monthly rent is fixed on that basis.

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REFERENCES

Adam, Nathif J. and Abdul Kader Thomas. Islamic Bond, Your Guide to Issuing, Structuring and Investing in Sukuk. London: Euromoney Books, (2004):31,27.

Al-Amine, M.B.M, et al, “The Islamic bond market: Possibilities and challenges", International Journal of Islamic Financial Services 3,no. 1 (2001).

Al-Hathal, Nafel, et al. “Innovation in Ijarah Financing”, Conference paper presented at Labuan International Summit on Islamic Financial & Investment Instruments, (1997): 4.

Ayub, M.” Securitization, sukuk and fund management potential to be realized by Islamic Financial Institutions”. http://islamiccenter.kaau.edu.sa/7iecon/Ahdath/Con06/_pdf/Vol2/48%20Muhammad%20Ayub%20Securitization,%20Sukuk.pdf. (accessed July 2, 2008).

Bank Negara Malaysia. Shariah Resolution In Islamic Finance: http://www.bnm.gov.my/microsites/financial/pdf/resolutions/shariah_resolutions_2nd_edition_EN.pdf (accessed on 10.31pm on Sunday 11th Nov 2012)

Ebrahim, M.S. & Joo, T.K, et al, "Islamic banking in Brunei Darussalam", International Journal of Social Economics 28, no. 4, (2001): 314-337.

Islamic Business Research Centre at http://www.kantakji.com/fiqh/Files/Finance/Ijarah.htm (accessed on 10 Oct 2012)

Kamali, Mohd Hashim , et al, “A Syariah Analysis of Issues in Islamic Leasing,” Islamic Economy 20, No 1, (2007): 16-17.

Malaysia International Islamic Finance Centre MIFC “Range of Islamic Banking Products and Services in Malaysia”, http://www.mifc.com/index.php?ch=38&pg=104&ac=28&bb=268 (accessed on 11.59pm on Wednesday, 10th Oct 2012)

Manaf, I.A. “Islamic bonds (sukuk): Its introduction and application.” http://www.sebi.ac.id/. (accessed February 27, 2008). Ibid. p31.

Rohmatunissa, Dinna, et al, “Design of Ijarah Sukuk”, presented paper for the Degree of MA in Finance and Investment, the University of Nottingham,(2008):28-31.

Warde, Ibrahim, “Islamic Finance: A Quarter-Century Assessment”, Edinburgh University Press, Edinburgh. (2000).

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http://www.sebi.ac.id/

http://www.mifc.com/index.php?ch=38&pg=104&ac=28&bb=268

http://www.kantakji.com/fiqh/Files/Finance/Ijarah.htm





islamic banking legal documentation on ijarah an analysis

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