LEASING IN ISLAM
AFZAL ELAHI
The leasing industry today, is worth over a trillion dollars in the West alone.
The market for equipment leasing, in the developed countries, has grown to in excess of $100 billion annually. This phenomenal growth over the last forty years is attributed mainly to fiscal benefits which leasing confers on the lessor who owns an asset, and the lessee who acquires the asset for its gainful use.
The lessor, as an owner of the asset, is entitled to certain tax benefits, while the lessee can treat rental payments as expense. Both the lessor and the lessee are able to reduce their tax liability. To benefit from such fiscal advantage, even financial institutions have accepted the opportunity to act as owner/lessors.
The tax authorities are prepared to forego the immediate tax revenues and allow the lessor and the lessee tax savings. It was and still is a potent fiscal measure to encourage investment in capital assets such as equipment and machinery which when in use, produces goods and services.
Leasing as a Trading Activity
The tax incentives, in fact, created the demand for the assets – the lessor who has the financial resource buys it, the manufacturer sells it, and the lessee uses it. In the absence of such incentive, possibly, the lessor might have invested his funds elsewhere and earned interest or dividend income
By opting for the leasing, the lessor in addition to assuming financial risks, also exposes himself to risks associated with the ownership of the asset. Th e lessor is, in fact, a trader in the asset – he has brought the asset, he will eventually sell it as well. Leasing, therefore is a trading activity and not just a method of financing asset needs.
Fourteen hundred years ago, God “permitteth trading and forbiddeth Riba (interest)” (the Qur’an 2:275). Instead of providing a tax incentive. He took away the lessor’s choice of investing in interest-based money market instruments.
The lessor’s choice was further narrowed to either equity-driven or asset-based investments when hoarding and speculation were also forbidden. Riba was eliminated for the greater benefit of the society and the foundations of Islamic banking were laid down.
Historical Development
Leasing has been in existence since time immemorial. Sumerians (residents of Southern Iraq) leased agricultural fields and oxen 3000 years ago. Roman ship owners leased their vessels for trade in the Mediterranean. Centuries ago, real estate was commonly leased in England, and in the United States, the Bell Telephone Company wisely leased telephones starting its existence in 1877. However, it was in 1952 that leasing was institutionalised in the United States as an industry under the name of the US Leasing Corporation.
Incredible as it may sound, leasing in Islam was institutionalised some fourteen centuries ago. In order to avoid Riba, when the first investor entrusted his funds to a Mudarib (Trustee) in exchange for a “Suq” (share certificate), he was acquiring a commercial paper which was partially securitised by certain asset-based leases. Mudarib received funds from Rab A1 Maal (investors) and invested them in Musharaka (equity participation), Ijara (a true or operating lease) and Ijara Wa Iqtina (a finance lease).
Documentary evidence of Ijara and Ijara Wa Iqtina contracts relating to earlier period of Islam is available. It clearly demonstrates a binding contractual arrangement, simple in form yet comprehensive in substance – explicit and truly equitable as to the rights and obligations of the parties.
Because such Ijara and Ijara Wa Iqtina were executed by the Mudaribs (trustees), the Mudaribs had to abide by the terms of their Mudaraba (trust agreement) contracts with the investors. For example, in one instance the Mudarib was prohibited by the investor from investing his funds in live stock for resale or for hire. At that time, investment in live stock offered one of the few investment opportunities with potential for capital growth.
In fact, the investor, determined his placement criteria and restricted the Mudarib’s choice. The investor forced the Mudarib to investigate the purpose for which the funds were to be used. In the event the funds were to be advanced to a merchant under Musharaka (joint venture on equity participation basis). The Mudarib was to make sure that the merchant did not deal in live stock. The Mudarib was in turn, exercising a control over the use of the funds.
Exercising an effective control over the use of the funds is the raison d’etre of Islamic banking. It is one step ahead of conventional banking which only ascertains the purpose for which the funds are to be advanced, but does not extend a control over the use of funds.
In conventional banking, once a loan documentation has been executed and funds advanced, the bank does not retain control over the use of the funds. The borrower can easily use the hinds for purposes other than the one for which they were advanced. In Islamic banking, under the Ijara and Ijara Wa Iqtina arrangements the use of the funds is effectively controlled.
Islamic Leasing and Types of Leases
The right of ownership, together with the retention of title to the asset in the name of the lessor, is a precondition of leasing in Islam. An instalment sale or a deferred sale of assets would not be regarded as leasing in Islam because the sale of an asset is completed and the title passes to the buyer. Placing a mortgage over an asset would not be leasing as the ownership and title to the asset would continue to remain with the mortgagee. Similarly, a lessee does not buy an asset he only acquires its possession and the right to use it. He enjoys the benefits of use without being an owner.
These two distinct features of leasing automatically require that the asset is clearly and individually identified and that it can be put to use to produce goods and services which are sold to third parties to generate revenues in the form of cash flow over a certain period of time.
From this cash flow the periodic lease rentals/payments are met by the lessee. A lease contract or an agreement is therefore a contractual arrangement between a lessor and a lessee in which both the lessor and the lessee mutually agree to a monetary or other consideration for the use of an asset.
Sharia allows the purchase of personal and real property for subsequent rental on freely negotiated and mutually agreed terms and conditions between a lessor and a lessee provided such terms and conditions do not contravene a multitude of Islamic principles related to fair trade, equity etc. Ijara and Ijara Wa Iqtina meet such Sharia requirements for leasing and almost all leasing arrangements can be covered by these two distinct forms of contracts or a combination thereof.
Ijara
Ijara is similar to the modern-day operating lease – a lessor either owns a capital asset for hiring out or acquires it for a lessee to hire at a rate and term which does not usually cover cost and profit of the lessor. The lessor expects to retrieve the asset and lease it again and again until the asset is fully amortised or is sold.
Rolling stock, vessels and vehicles, medical equipment, computers and some times aircrafts, are leased under Ijara. A lessor must have remarketing expertise to be a successful lessor under an Ijara or an operating lease. Ijara contracts are capitalised on the books of the lessor and never on the books of the lessee.
Ijara is different from an operating lease as it is defined in the United States for tax purposes. In the United States, a lessee or his representative is not allowed to become the owner of the leased asset at any stage during or after the expiry of the lease term.
However, the lessee can, with the agreement of the lessor, purchase the asset. In most of the Ijara arrangements, the lessee pays for the use of the asset and the lessor earns rental payments. The Ijara term can vai7 from one hour to several years. Usually, under the Ijara arrangement, the lessor provides maintenance, insurance cover, and is often the operator of the asset if the asset happens to be equipment of machinery such as an oil rig, or an aircraft.
Ijara Wa Iqtina
As the name implies, Ijara Wa Iqtina is a lease agreement combined with an obligation of the lessee to purchase the asset under lease during the lease term or at the termination of the lease. If the asset is to be acquired any time during the lease term, the lease must clearly provide for it.
In addition, there should be a clear understanding as to the purchase price. In the standard Ijara Wa Iqtina agreement of Dar Al-Maal Al-Islami, there is a provision for an investment account. The lessor who is usually a Mudarib, maintains such an investment account in the name of the lessee but blocked-in favour of the lessor.
The lessee deposits certain agreed upon funds in the investment account. As and when the amount of deposits and accrued income on such deposits equal the aggregate amount of the then outstanding lease payments, the lease is terminated, and the lessee becomes the owner of the asset. There are some scholars who prefer to have the terms of the Ijara in one contract and call option of the lessee in a separate contract.
Whatever the format, the Ijara Wa Iqtina is highly equitable and fully protects the equity rights of the lessor and the lessee. Whereas the lease payments assure the lessor of a fair price for the use of the asset, the investment deposit provides him with an added comfort against earlier lease termination due to default by the lessee.
In the absence of high inflation, value of a capital asset usually tends to depreciate faster during the initial stages of a lease. In the event of a lessee’s inability to meet the terms of the lease, the lessor is protected, to an extent, by the funds in the investment account, against such decrease in the value of the asset. The lessee on the other hand is assured of becoming the owner of the asset.
In the event the lessee can no longer continue to meet the lease payments, Ijara Wa Iqtina would safeguard lessee’s equity interest in the asset. If the lessee had built in adequate equity in the asset and accumulated a decent balance in the investment account, he should be able to either buy the asset or sell his residual interest in the asset.
No such equitable feature is available in any of the conventional leasing arrangements. For example, in the United States, only a trustee in bankruptcy is able to realise on such equity interest under certain specific provisions of bankruptcy legislature.
Ijara Wa Iqtina and Finance Lease
The Ijara Wa Iqtina is, with few exceptions, similar to the Finance Lease, which is currently being standardised under a UNIDROIT convention on international financial leasing. The UNIDROIT convention should bring about an order to the legal interpretation of international leasing transactions.
To date, finance leases are interpreted differently in different developed countries. A consensus is now finally building around the text of a Finance Lease proposed by UNIDROIT.
Institutions like the Islamic Development Bank, Islamic investment companies and Islamic holding companies that operate internationally may examine these leasing arrangements in order to adopt the features that conform to their principles and ideology.
Features of Finance Lease
The finance lease or “full payout lease” that is generally practised in most of the developing countries is based on a contract between the lessor and the lessee for hire of a specific asset selected from a manufacturer or vendor of such an asset by the lessee.
The lessor retains the ownership of the asset and the lessee has possession and use of the asset on payment of specified rentals over a period. Though the lessor is the legal owner, the lessee is given the exclusive right to the use of the asset for the duration of the contract. The rentals during the fixed primary period are sufficient to amortise the capital outlay of the leasing company and provide an element of profit.
The primary period is closely related to the estimated useful life of the asset and the lessee is normally responsible for all operating costs such as maintenance and insurance. The lessee has also the option for a secondary period of lease in which the rentals are reduced to a nominal amount. The period of lease usually ranges from 5 to 15 years depending upon the useful life of the asset.
Operating Lease
As compared with finance lease or full pay-out lease operating lease is more akin to shortterm hire-purchase arrangement is also referred to as non-full pay-out lease as rentals are insufficient to enable the lessor to recover fully the initial capital outlay. The residual value is recovered through disposal or releasing the equipment to the other users.
Advantages of Ijara wa Iqtina
The mode of Ijara wa Iqtina has certain advantages over equity participation or shirk that an interest-free bank may have to adopt. This not only protects the investment of the bank but also ensures a reasonable return on investment. The lessee, on the other hand, enjoys tax concessions on the use of leased equipment without showing any addition to the value of its assets. Purchase of the lease article is affected when the asset has no taxable value. Thus, the mode serves the interest of both the lessor and the lessee.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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