The Concept of Lease – Ijara

The instrument of Ijarah brings Shari’ah compliance to the traditional lease contracts of commercial institutions. Elements of Riba or gharar present in many lease contracts make them invalid from Shari’ah perspective. The concept of Ijarah has been validated by Shari’ah scholars in light of Quran and Sunnah. The Ijarah could be for hiring of services of individuals or for tangible assets. Ijarah when used in the context of Islamic banks primarily deals with leasing of tangible assets. In case of assets, the lease may also define an option for lessee to buy the asset at residual value at the end of the contract. The following are the Shari´ah essentials of a valid lease:

1. Only assets that remain in their original form can be leased under Ijarah. That includes machinery, transport vehicles, buildings, factories, etc. Consumable item, yields of a crop, or raw material for a manufacturing process cannot be leased.
2. Ijarah is a binding contract and neither of the contacting parties can terminate or modify the contract without the consent of the other party. The contract should, subject to mutual consent, allow for termination or modification in case of a total loss or damage to the asset during the lease term.
3. The element of gharar should be removed from the contract by assuring that the asset being leased is known through inspection, viewing or specification.
4. A “lease to own” contract must be split into two separate contracts as the traditional contracts to transfer ownership at the end of a lease are not valid in Shari’ah.
5. The leased asset is a trust of the lessor and must be used only to derive the usual benefits as specified in the contract. The product should not be abused. The usual wear and tear is expected though.
6. The contracting parties must be sane, adult, and be able to consent to the transaction.
7. The contract must allow options to cancel the contract after a stipulated time, after inspection, or upon discovery of undisclosed defect in the asset.
8. The lessor must own the product being leased and be able to lease the product to the lessee for intended benefits.
9. The terms of the agreement from both sides must be clearly mentioned and explained to avoid chances of dispute.
10. The lease agreement must not involve activities or substance considered haram in Shari’ah. 

Ijarah is used by Islamic banks to enable customers to acquire the right to use assets which they do not intend to own or do not wish to commit capital money for. Assets leased under Ijarah include durable goods, buildings, factories, machinery, equipment, and transport vehicles.

The bank acquires a specified asset upon receiving a request from a customer who is interested in leasing the asset. The rental value is usually set to recover the cost of the asset over the lease period plus reasonable markup to generate profit for the bank. This implies that the lease agreement is for the lifecycle of the leased asset. At the end of the lease the asset could be sold or gifted to the lessee. This type of agreement is called as Ijarah-wa-iqtina or Ijarah Muntahia-bitamleek, or a lease which terminates with lessee acquiring ownership.

Ijarah wa-iqtina is similar to common financial, operating, and lease-purchase agreements but also made to comply with Shari’ah principles. For example, the transfer of ownership to the lessee at the end of the lease should be separate from the lease contract. The Ijarah contracts are assembled in a way for the lessor to benefit from the rentals received and recovery of the total cost of the asset. The lessor may make a unilateral promise to sell the asset to the lessee for a residual or nominal price or give it as gift. The promise is, however, not binding on the lessee. This arrangement protects both the lessor and the lessee. Lessor gets to recover his cost and earn some profit in rentals, while the lessee gets the use of the asset with the option of acquiring the asset at the end of the lease.

Ijarah-wa-iqtina is used by Islamic banks as a mode of finance; however, care must be exercised to assure Shari’ah compliance. Some of the issues that are required for a compliant Ijarah contract include the following:

1. The renal can not start until the lessee has the asset in his possession and he is able to put it to beneficial use.
2. The purchase price must be paid by the bank to the supplier. However, the bank may not have the expertise in taking delivery of the asset and inspecting it. In that case, the bank may sign an agency agreement with the customer and assign him to acquire the asset on bank’s behalf. The agency agreement must be separate from the lease agreement and must be in place prior to purchase and lease of the asset.
3. The bank being the lessor and owner assumes the ownership risk.
4. As mentioned above, the lease and purchase cannot be in one agreement. Neither can one agreement be dependent on another agreement. Lease and purchase must be two independent contracts.

Risks of a Leased Asset

Risk management is an essential element of all banking operations including Islamic banks. Ijarah concept requires the Islamic bank to own the leased asset for the duration of the contract. This makes them exposed to asset based risks along with all the risks of leasing, which traditional banks may not have to face. Most of these risks are mitigated through takaful Islamic insurance. The cost of takaful is usually included in the payment structure. Only if the loss is due to negligence and takaful is not applicable then the bank will have to cover its losses from the lessee. However, it takaful does apply but not to cover the losses, the bank has to absorb the loss.

The following are the risk associated with Ijarah and means to mitigate them.

1. Maintaining Shari’ah compliance is of utmost importance to Islamic banks. In order to protect against the risk of their Ijarah contracts becoming invalid, they should be always reviewed by qualified Shari’ah scholars.
2. The bank being the owner faces the market and price risk until the asset is put to use by the lessee. If prices change or customer fails to take delivery, the bank would be liable. This risk can be lowered by due diligence in purchasing required for all commercial activity and also while drawing up the lease contract. The bank could demand an earnest money deposit or a tangible asset based guarantee to mitigate this risk.
3. There is a general risk of physical damage, theft, or loss due any uncontrollable event. This risk can be mitigated through takaful insurance. However, the contract must specify that if the asset is damaged due to practices beyond its intended use then the customer is liable.
4. Market price of rental or inflation could result in losses for the bank. To mitigate this risk, the rental amount should be reviewed periodically to revise it up or down based on market conditions. The rental could be tied to a benchmark to protect the bank.
5. The customer may stop making payments as agreed. The mitigation in that case would be for the bank to take the asset back and claim any losses from the customer. The Shari’ah rules dictate that no further rental payments should be collected from the customer in that case. This risk can be also mitigated through earnest money deposits or other guarantees.
6. The customer may not be able to meet the payment schedule on time. As opposed to traditional lease contracts, Islamic banks cannot charge late payment penalty based on the time of delay and the interest rate. Shari’ah scholars though allow these banks to charge a fixed amount late payment penalty but the amount collected should be transferred to charity. This risk can be also mitigated through earnest money deposits or other guarantees.

Rental Payments vs Interest

Ijarah is the transfer of a capital asset from the owner to a user for a specified period of time for an agreed upon amount. It has been practiced from ancient times for buying professional services or to lease a product. The validity of Ijarah has been established through Quran, Hadith, Ijma, and Ijtehad, which are the sources of Islamic jurisprudence and scholars have allowed it for applications in modern Islamic finance.

Due to similarity to interest based transactions, doubts could be raised that the rental payments are just another way to collect interest. However, that is not the case. The owner, an Islamic bank for this discussion, remains the owner for the duration of the lease and earns the profit or loss from the transaction. In some contracts, the asset is sold to the lessee at the end of the lease under a separate contract.

One basic requirement of Shari’ah based transactions is that money should not be treated as a commodity and no fixed rate should be imposed on it by the financier. The bank purchases a product based on customer’s request and takes physical possession assuming all the risks of ownership. Then the bank leases the product to the customer at an agreed upon fair market rental value. The rental value assures that the bank can make a reasonable profit from the contract. Some long term lease contracts allow for renegotiation of the lease payments to match the market conditions and residual value. In interest bearing loans, the payment is usually fixed until the loan is paid off.

In case of delay or default on the payment, the bank does not make additional profit from penalties. In contrast, in a conventional interest based transaction, the customer borrows the money from the bank at a fixed interest rate and pays it back over time. The bank may hold a lien on the purchase until full payment is made to protect in case of default. The customer also pays late payment charges in case of delay which go to increase the profits for the bank. In case of Islamic lease, there may be a penalty for late payment in the contract, but it is to be given out as charity.