INTRODUCTION TO IJARA

The term Ijara is derived from the root word ‘ajr’, which means reward or wages for work done or services rendered. In the financial world, Ijara is a bilateral contract involving transfer of the use of an asset for an agreed period for a consideration. It involves two parties: the lessor or Muajir, who is the owner of the asset and the lessee or Mustajir, who uses the asset. The owner of the object temporarily transfers its usufruct to the lessee for the agreed period and the lessee should be able to derive benefit from it without consuming it. The ownership of the leased asset remains with the lessor, along with all risks pertaining to ownership. The physical possession of the asset is held on trust by the lessee, who is not liable for any loss, destruction or reduction in value of the asset, unless caused by misuse or intentional negligence by the lessee.

In Islamic jurisprudence, the term Ijara is used for two different situations. One, as in the case of a conventional lease, is the transfer of the usage of an asset, while the other is where a person is employed for some service in exchange for wages, like teachers, lawyers, and doctors. According to Islamic scholars, the Ijara contract consists of three main elements. Like all contracts Ijara also involves offer and acceptance – Ijab and Qabul. There are the contracting parties, the lessor and lessee; the subject matter of the contract, including the consideration or rent (called Ujrah) that the lessee pays for the right to use and derive benefit from an object owned by the lessor. The asset is called the Majur and the benefit derived from the asset is called Al Manfaah. It is important to note that the benefit from use of the asset is the subject matter of the contract, not the asset itself, and this benefit is guaranteed by the contract.

Ijara is very similar to a conventional lease. The majority of Islamic scholars consider Ijara as a Shariah-compliant financial instrument if the object in consideration has beneficial use and is Halal. Not every object or asset is suitable for Ijara or leasing. It needs to be tangible, non-perishable, valuable, identifiable and quantifiable. For example, perishable items like food, fuel, etc. cannot be leased, neither can money be leased.

IJARA IN ISLAMIC BANKS

Ijara is a service-based contract, used significantly to meet short and medium-term financing needs, involving either rent or hire purchase of an asset based on an agreed rental fee and period. Islamic banks offer this product to retail and business customers and some common applications involve rental of fixed assets, rental of a package of services, property financing, vehicle financing, project financing and personal financing.

To offer the Ijara mode of financing, the Islamic bank buys the object of the Ijara and leases it to its client, who may only rent the item for the concerned period or may decide to buy the item eventually. In the former case, the monthly lease payments (Ujrah) would be the rent for use of the item only; in the latter case, the monthly payments will consist of two components, the rent as in the former situation plus instalments towards the purchase of the item. After the lease period expires, the asset either reverts to the lessor, the lease is renewed or the ownership is transferred to the lessee if so agreed.

TYPES OF IJARA

Islamic banks currently offer two main types of Ijara. These are called Ijara and Ijara wa Iqtina, and most Islamic scholars unanimously consider both forms of Ijara as Shariah compliant. Like Murabaha, Ijara was not considered originally as a mode of financing, rather it was a business transaction between two parties to transfer the usufruct of an asset from one person to another for an agreed period against an agreed consideration. In conventional finance, this is the operating lease. Now, many Islamic financial institutions have adopted Ijara or leasing as a mode of financing, as an alternative to interest-based loans, and this is called a financial lease. The types of Ijara are discussed in detail below.

IJARA, REGULAR IJARA OR OPERATING LEASE

Ijara or regular Ijara are like a conventional operating lease and can also be called a true lease. These are contracts of rent only, and do not end in the transfer of ownership of the leased asset from the lessor to the lessee. Rather, the asset is returned to the lessor at the end of the Ijara period. In this kind of Ijara, the Ujrah or rentals that are charged over the Ijara period are not sufficient to recover the full value of the asset. The owner or lessor can recover the remaining value of the asset by re-leasing the asset or selling it. Both the lessee and the lessor may cancel the contract, but with due notice to the other party. Ijara can be used for renting an apartment to a tenant by a landlord or by car rental companies to rent out vehicles. The rental can be fixed for the entire lease period or may be adjusted periodically as agreed between the parties at the onset.

Banks often use a conventional index like LIBOR to determine a competitive profit rate in arriving at the Ujrah, and LIBOR may also be used to adjust the Ujrah at agreed intervals. At the end of the lease period the lessee can either return the asset or ask for an extension of the lease. An Ijara or operating lease is suitable for expensive assets such as ships, aircraft, large-scale machinery and equipment. The bank's advantage is that it retains ownership during the lease period and yet earns a good return, while the lessee is saved from an expensive purchase. The risks and responsibilities of ownership are placed on the lessor, while the lessee is liable to use and take care of the asset in a proper manner. The lessee will have to compensate the lessor for any damage caused by misuse or negligence, and not because of regular wear and tear. Depreciation and any impairment loss in the value of the asset is borne by the lessor. Any additional cost incurred directly for the processing of the Ijara will be amortized into the rental payments. Any repairs that are required during the lease period, and which are undertaken with the lessor's consent, would be the responsibility of the lessor.

IJARA WA IQTINA, IJARA MUNTAHIA BITTAMLEEK OR FINANCIAL LEASE

When the ownership of the leased asset passes to the lessee at the end of the lease period it is called Ijara wa Iqtina or Ijara Muntahia Bittamleek. This kind of Ijara is comparable with a conventional financial lease or hire purchase. The Arabic word Tamleek means ownership. This transfer of ownership may be with or without additional payment at the end of the lease period. In a financial lease, the lessor amortizes the asset over the term of the lease and at the end of the period the asset will be sold to the lessee. The lessee provides a unilateral purchase undertaking to the lessor with the purchase price specified.

There are several types of Ijara Muntahia Bittamleek, which are characterized based on the method by which the ownership is transferred between lessor and lessee. Under the rulings of the Islamic standards setting body, the AAOIFI, the transfer of ownership in case of Ijara wa Iqtina, Ijara Muntahia Bittamleek or financial lease can be done in a variety of ways. Firstly, the lessor completely amortizes the value of the asset during the lease period in the regular rental payments and no additional payment is required at the end of the lease period, allowing the lessor to gift the item to the lessee. Secondly, a fixed amount, decided at the beginning of the contract, is paid by the lessee at the end of the contract through a legal sale to become the owner of the asset. Thirdly, through a legal sale before the end of the period of the lease at a price equivalent to the remaining Ijara instalments. Fourthly, an amount decided by the market value of the asset at the end of the lease period is paid by the lessee for the ownership transfer. Fifthly, gradual transfer of the ownership of the asset is made to the lessee as the rental payments include payments towards the price of the asset. In the Islamic banking industry, the first and second options are more common.

In this kind of Ijara or financial lease the bank buys the asset based on the purchase promise included in the lease agreement with the customer. In such an Ijara, once the asset is provided to the customer for lease it is not returned to the bank at the end of the lease period, as is commonly the case in an operational lease. As such it is more convenient for banks to apply, since they are not in the business of owning assets or managing them. The Ijara Wa Iqtina, Ijara Muntahia Bittamleek or financial lease is completed when the ownership of the asset is transferred to the lessee along with all the risks and rewards incident to ownership. The lease payments are calculated considering the purchase price of the asset which is financed, the rental value of the asset and the lease period. The lease rentals can be fixed or floating. As in the case of an operating lease, LIBOR could serve as a benchmark. The Ujrah or rentals collected recover the usage rent and the purchase price of the asset in diverse ways.

1. The periodic payments made by the lessee during the lease period could include both the rent element for the use of the asset and part of the purchase price of the asset; at the end of the lease period ownership of the asset passes to the lessee.
2. On the other hand, the periodic payments made by the lessee during the lease period may consist of the rental element for the use of the asset only and the purchase price of the asset or its residual value is paid by the lessee at the end of the lease period, leading to transfer of ownership of the asset from the lessor to the lessee.
3. The Ijara contract may be renewed at the end of the lease period with new rental negotiated and the transfer of ownership may be agreed to be at the end of this lease period with rentals including portions of the purchase price of the asset, or this amount may be paid at the end of the lease period.

IJARA THUMMA AL BAY

A third name for the Islamic financial lease, or more specifically the Islamic hire purchase, being offered by the industry is Ijara Thumma al Bay. This is more commonly offered in Malaysia. Ijara Thumma al Bay consists of two totally separate contracts. The first one is an operating lease contract while the second one is a sale contract, with an agreed price to be executed at the end of the lease period.

Figure 7.1 is an overview of the Ijara contracts.

SHARIAH RULES AND GENERAL PRINCIPLES GUIDING IJARA CONTRACTS AND THEIR CHARACTERISTICS

The Shariah rulings related to Ijara contracts as identified by Sheikh Muhammad Taqi Usmani (Usmani, 1999) and other principles developing the characteristics of the Ijara contracts being offered by the Islamic banking industry are discussed below.

1. Majur or Ijara asset. Ijara can only be done for assets which have beneficial value and are Halal. Items having no usufruct at all cannot be leased. The Ijara contract must clearly stipulate that the leased asset remains under the ownership of the lessor, and only the usufruct of the asset is transferred to the lessee. As such, anything which cannot be used without consuming it is not suitable for leasing. Consumables like food or fuel cannot be leased. Similarly, money cannot be leased.
2. Moreover, the Ijara asset needs to be known to both the lessor and the lessee. The asset returned at the end of the lease should be the same one that was originally leased. The lessee may lend the leased object to a third party, but cannot rent it out or give it as a pledge or security. Any asset jointly owned by more than one person can also be leased, with the Ujrah or lease rentals being distributed to the owners in proportion to their ownership share.
3. Tangible versus financial asset. Shariah allows tangible assets to be leased but not financial assets and encourages financial capital to be converted to tangible assets, with the financier assuming the risks of ownership and then earning from them via the Ijara contract.
4. Usufruct and purpose of the Ijara asset. Al Manfaah, or the benefit derived from the Ijara asset or its usufruct, should be clearly defined to avoid any uncertainty. The Ijara asset can be used only for the purpose specified in the Ijara contract and none other. Usage of the asset should be Shariah compliant and not Haram, for example a machine cannot be leased for a pork processing factory. If no such purpose is specified in the contract, the lessee can use the asset for any purpose in the normal course of the business. However, if the lessee wishes to use it for a purpose that may be categorized as abnormal, clear permission of the lessor is required. The usufruct should be attainable from the asset; as such, perishable items or faulty items cannot be Ijara assets. Usufruct can be used by more than one lessee, but the purpose for which the asset has been leased should stay the same.
5. Ownership versus usufruct. During the lease period, ownership of the asset would be with the lessor while only the usufruct is transferred to the lessee; as such, consumables like food, money, fuel, etc. are not suitable Ijara objects.
6. Acquisition of the asset. To be Shariah compliant an Ijara contract concerning a specific asset should happen only after the asset has been acquired or is already in the ownership of the lessor, which could be the bank.
7. Ujrah or lease rentals. The lease rental needs to be calculated and decided at the time of the contract and should be known to both the lessee and the lessor in an unambiguous manner, either for the full term of the lease or for a specific period in absolute terms. The AAOIFI has allowed LIBOR as a benchmark to determine the percentage of profit the bank may ask for in calculating the lease rentals. The two main reasons to allow this are the absence of any internationally accepted Islamic profit benchmark and so that Islamic banks can compete in the lease or Ijara business with conventional banks. When rentals are flexible, they are adjusted periodically with the movement of LIBOR. This raises the question of Gharar or uncertainty. The argument is that since both parties agreed on LIBOR which is known to them, this does not amount to Gharar.
8. Shariah requires the lessee to know the price of the asset, the bank's profit margin included in the price and the amount of rent the lessee would pay. Normally, lease rentals do not become due and payable until the lease asset is delivered to the lessee. If the rent or any part of the purchase price is paid in advance before delivery of the asset to the lessee, the amount is held with the lessor ‘on account’ and adjusted against the rental payments after it becomes due. The lessor is not allowed to increase the lease rental unilaterally.
9. Period of lease. The period of the lease must be determined in clear terms. The lease period commences from the date on which the leased asset has been delivered to the lessee, irrespective of whether the lessee has started using it or not. The Ijara period is usually of short or medium term, but can also be long term if the banks are comfortable with such a contract.
10. Maintenance. The major maintenance and insurance of the leased asset is the responsibility of the lessor as owner, which could be the bank. The lessor may delegate to the lessee the task of carrying out such maintenance at the lessor's cost. Meanwhile the lessee is responsible for day-to-day operating or periodical maintenance, and keeping the asset in good condition for continued usage. The lessor is responsible for any loss, unintentional destruction or damage, depreciation of the asset, payment of taxes, etc., while the lessee is liable for any damage caused by negligence or misuse and would need to compensate the lessor.
11. Risks and liabilities related to the Ijara object. All risks and liabilities related to ownership are the lessor's, while those related to physical possession and usage of the asset are the lessee's. The lessee will compensate the lessor for any damage to the asset due to misuse or negligence, but not for the regular wear and tear related to usage. Meanwhile any damage beyond the control of the lessee will be borne by the lessor. The risk of obsolescence is also there. The leased asset shall remain at the risk of the lessor throughout the lease period in the sense that any harm or loss, caused by factors beyond the control of the lessee, shall be borne by the lessor.
12. Lessor's obligations. The lessor is required to make the leased asset available for the lessee. The lessor also needs to guarantee the asset against any defects, and is also obliged to pay for all major maintenance expenses and for the insurance of the leased asset.
13. Lessee's obligations. The lessee's obligations include using the leased asset according to the contractual conditions and safeguarding the asset. They are also required to make the lease rentals on time and are responsible for operational expenses related to the asset. The lessee is also responsible for all risks and consequences related to third-party liability, arising from or incidental to the use of the leased assets. Moreover, all obligations arising from the lessee using the asset for non-customary use, and for use not stipulated in the Ijara contract without mutual consent, will be borne by the lessee.
14. Sub-lease. The lessee is permitted, only with the consent of the lessor, to sub-lease the asset to a third party. If the asset is jointly owned, then the consent of all lessors is required.
15. Default. If the lessee defaults, then the lessor has the right to repossess. All expenses related to repossession are the responsibility of the lessee. Default by the lessee can happen if they fail to make the regular lease payments, or do not maintain the asset in the condition agreed in the contract, or fail to observe or perform any of the provisions of the lease, or if the lessee is going through a winding-up process, etc. The lease agreement could include in advance a penalty for delay in lease payment. In case of Ijara, the bank can enforce the lessee to pay this penalty for a delay in making the lease payments calculated at the agreed rate (%) per day/annum, but the bank or lessor cannot benefit from it and needs to give it to charity to meet with Shariah requirements. If required, the lessor or bank can take the issue to the relevant courts for award of damages from the lessee, decided at the discretion of the courts, and based on the direct and indirect costs incurred due to the default.
16. Guarantee or security. When funds are supplied by financiers like banks or are invested in assets that are leased, these funds are owned by depositors, and therefore the bank has a prime responsibility to protect its interests and those of its depositors, by securing its investments and reducing the credit risks. In Islam, the concepts of guarantee or Kafalah and security or AI-Rahn are allowed under certain conditions to provide safety to the financier's investments. In case of the Ijara contract, the lessor can ask for either a personal or corporate guarantee from the lessee or ask for some form of security to secure the rental payments, or as security against misuse or negligence and subsequent damage of the asset. A physical asset can be taken as security or mortgage, like land, buildings, machines, etc. Lien or charges can be taken as security also. A guarantee can be taken by the lessor in the form of a sum of money from the lessee that would be held against any damages to the leased asset, with no amount deducted from this sum except for any actual damages suffered by the asset. A penalty can also be charged for delayed payment of rentals, though this needs to be given to charity. Security or collateral can also be sold by the lessor or bank without the intervention of the court to recover unpaid rentals or damages to the asset.
17. Sale of leased asset. The lessor has the right to sell the leased asset but needs to inform the buyer of the lease agreement and ensure the lease continues as binding and irrevocable. All terms and conditions, rights and liabilities agreed upon in the lease contract are transferred to the new owner. In case the original lessor or the new owner would like to cancel the lease agreement, due notice as stipulated in the Ijara contract must be given.
18. Termination. The Ijara contract terminates naturally once the lease period is over. It can also be terminated for various other reasons. The Ijara contract terminates if the asset is destroyed without the fault of either the lessor or the lessee. The lease contract automatically terminates, and the lessee does not need to pay any further rentals if the leased asset loses its functionality and cannot be repaired, due to no fault of the lessee. In case the loss of functionality is due to misuse or negligence of the lessee, compensation needs to be made to the lessor for the loss of the value of the asset and its rentals. However, if the leased asset is damaged but can be repaired, the Ijara contract will remain valid. The Ijara contract can also be terminated before the end of the term of the lease with the mutual consent of both parties. The two parties may mutually agree to terminate the Ijara contract before it begins to operate.

DOCUMENTATION RELATED TO THE IJARA CONTRACT

Ijara agreement. The main document to be created for the Ijara contract would be the Ijara agreement, including all terms and conditions of the Ijara. This agreement is signed by the two parties only after the lessor is in possession of the lease asset and not before. Documents to be added to the Ijara agreement would be as follows.

1. Description of the Ijara asset. Providing complete specifications of the asset.
2. Schedule of Ijara rentals. Providing the exact dates of the start and end of the Ijara contract as well as the specific dates of the lease rentals and amounts.
3. Receipt of asset. Confirms that the lessor has acquired and delivered the asset to the lessee and is an acknowledgement of receipt by the lessee.
4. Demand promissory note. Once the asset is accepted by the lessee the rental payments are due and this is an acknowledgement of this and a promise to pay on time.

Undertaking to purchase leased asset. This document is an undertaking from the lessee to purchase the leased asset on an agreed purchase date and at an agreed purchase price. The document would also include a schedule of the various dates at which instalment payments build up to the purchase price, or the lump sum paid in one go.

Other documents. Besides the two documents mentioned above, an Ijara contract may also require the lessee to sign an undertaking to use the Ijara for personal purposes if they are a retail client. The lessor would provide an authorization to the lessee to take possession of the asset and both parties would sign a sales deed when the Ijara concludes in transfer of ownership, as is most common when the lessor is a bank.

MAIN DIFFERENCES BETWEEN IJARA AND A CONVENTIONAL LEASE

Although Ijara has many similarities with leasing in conventional banking there are some differences also, and these are highlighted in Table 7.1.

DIFFERENCES BETWEEN IJARA AND A CONVENTIONAL LOAN CONTRACT

In Ijara the ownership of the borrowed item is not transferred to the borrower, who needs to return the same item at a stipulated time. Meanwhile, in a loan, ownership of the borrowed money is transferred to the borrower, which does not have to be returned as the same notes of money. As in borrowing of consumables like food items, once they are consumed the same items are not returned. In the case of physical property like a vehicle in Ijara, the same property is returned.

DIFFERENCES AND SIMILARITIES BETWEEN IJARA WA IQTINA AND DIMINISHING MUSHARAKA

In Ijara Wa Iqtina, ownership of the asset remains with the lessor during the entire lease period. In contrast, in diminishing Musharaka, the ownership percentages are clearly defined and at each payment schedule the financier's percentage reduces and the client's percentage increases. The similarity between the two products is that in each payment made by the client there are two parts, one part is a rental payment for the part of the property owned by the Islamic bank and the second part is an instalment towards purchasing the asset or part of it owned by the bank.

PRACTICAL APPLICATIONS OF THE IJARA CONTRACT

Ijara contracts are used by banks to finance, most commonly, the short and medium-term financing needs of retail and business customers. Common lease assets are consumer durables like TVs, fridges, vehicles, computers, equipment, machinery, etc.

The Ijara or operating lease is usually executed to rent out property, by ‘rent-a-car’ companies, for agricultural equipment and major assets like aircraft. A financial lease, Ijara wa Iqtina or Ijara Muntahia Bittamleek can serve as an alternative measure of financing retail or business needs.

Calculation of Lease Rentals

A specific formula is used to calculate the lease rentals, called the Ijara formula:

where:

• TLR = total lease rentals (total amount of rentals paid over the entire lease period)
• CF = cost of finance or cost of acquiring the lease asset (total cost of asset in Ijara wa Iqtina, or part of the cost in operating Ijara)
• i = rate of return per annum (flat per annum profit rate the bank intends to make)
• n = period of financing in years (the total lease period in years)
• Monthly lease rentals = TLR/n × 12

KEY TERMS AND CONCEPTS

• Ajr
• Al Manfaah
• Conventional lease
• Ijara
• Ijara Muntahia Bittamleek or Ijara wa Iqtina
• Lessee or Mustajir
• Lessor or Muajir
• Majur
• Operating lease or regular Ijara
• Ujrah
• Usufruct

CHAPTER SUMMARY

Ijara is a financial contract where the owner of an asset, the lessor, allows the lessee to use the asset in return for a consideration for a specific period. Ijara is a service-based contract used by Islamic banks to meet the short and medium-term needs of retail and corporate customers. Islamic banks offer regular Ijara, which is like an operating lease, involving renting only and Ijara wa Iqtina or Ijara Muntahia Bittamleek, which is like a financial lease, where ownership of the asset is transferred along with renting.

The Shariah rules and general principles that guide the Ijara contract include the Ijara asset, which should be beneficial and Halal and a tangible rather than a financial asset. The lessor owns the asset while the lessee has the usufruct of the asset in exchange for a lease consideration for a lease period. The ownership-related risks and liabilities, as well as insurance expenses, are the responsibility of the lessor, while those related to the usage of the asset are the responsibility of the lessee. The lessee may sub-lease with the consent of the lessor, and the lessor may demand a security or guarantee from the lessee and charge a penalty for default, but this needs to be given away to charity. An Ijara contract may terminate before the end of the contract term if both parties agree mutually, or if terminated unilaterally reasonable notice must be given.

An Ijara contract involves an Ijara agreement, description of the asset, rental payment schedule, receipt of the asset and a promissory note from the lessee to pay the rentals, as well as an undertaking to purchase the asset in case of Ijara wa Iqtina.

The main differences between Ijara and a conventional lease involves the link to religion, signing of a contract after acquiring and registering the asset, differences in the rights and liabilities of the lessor and lessee, start of the rental payments, rescheduling of the rentals, penalty in case of default in payment and rentals in case of theft or loss of the asset. The differences also involve insurance and maintenance responsibilities, and the manner in which the ownership of the asset is transferred.

END OF CHAPTER QUESTIONS AND ACTIVITIES