IJARA – A more compassionate form of Leasing Suresh R. I. Perera LLB, Attorney at Law, ACMA Director Tax & Regulatory KPMG Sri Lanka

The nature of Ijara

The literal meaning of Ijarah is “to give something on rent”. As per Islamic jurisprudence the term connotes two distinct situations.

1)  The services of human beings for wages –  the “Musta’jir”(employer) employing the services of an “Ajir” (employee) on wages  or “Ujrah”  in lieu of hired services. An “Ajir” for this purpose could be anyone rendering services including  labourers, doctors and lawyers.

2)  Usufructs of assets & properties for rent – transferring the usufruct of an asset by ‘Mu’jir’ (lessor) to ‘Musta’jir’ (lessee) in lieu of ‘Ujrah’ (rent)  payable by the latter. The form of Ijara referred to herein and the category that is relevant for investment purposes connotes this form.

Ijara has proven to command a high demand among the Islamic financial instruments and perhaps is on the way to be the most popular instrument. This is the appropriate Islamic financial instrument for inter – mediate or long term financing of assets. Shari’ah Rules permits the levy of rental in lieu of granting the right to use real assets. As the financier undertakes the risk of the ownership he is entitled to receive a return by way of rental under the Shari’ah Rules. Normally the rent is so fixed, that the financial institution gets back its original investment plus a profit on it.  Finance leases or Ijara Muntahia Bittamleek (IMB) embodies an option to purchase the asset at the end of the period.

Comparison with the conventional lease
Financial Accounting Standard (FAS) 8 formulated by Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI) provides for accounting treatment for Ijara and IMB. This AAOIFI recommended Standard for Ijara and  the Standard formulated by International Accounting Standard 17 (IAS 17) for conventional leasing differ in many aspects.

A ‘lease’ as per International Accounting Standard is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments, the right to use an asset for an agreed period of time. According to IAS 17 a lease is classified as a finance lease if it “transfers substantially the risks and rewards incidental to ownership”. A lease is classified as an operating lease if it does not transfer substantially all risks and rewards incidental to ownership.

Ijara is defined as “ownership of the right to the benefit of using an asset in return for consideration”. However AAOIFI definition embodies the additional condition that the benefit should be Shari’ah complaint. Thus Ijara & a conventional lease differ in this aspect regarding the requirement to comply with Shari’ah Rules. Shari’ah does not permit Ijara for use of an asset for payment of interest and involving merchandise considered as haram nor for unlawful transactions.

AAOIFI FAS 8 also embodies a classification of the instrument into two categories. If the contract refers to a promise to the effect that the legal title would ultimately pass on to the Musta’jir’ (lessee) at the expiry, it is referred to as “Ijara Muntahia Bittamleek”. In I MB which is loosely considered  as equivalent to the conventional finance lease, at the expiry of the term the passing of the legal title to  Musta’jir’ (lessee) could occur either :

(a)  on transfer on payment of balance rentals,
(b)  as a gift,
(c)  on payment of a token or for an amount specified in the contract or
(d)  on the gradual transfer of the title.

As per AAOIFI Juristic Rules on fulfillment of the promise, for the transfer to be effective, a contract distinct from the Ijara contract should be executed. The Musta’jir has an option, which he may or may not exercise. Thus IMB would have the characteristics or the substance of a conventional lease only if the Musta’jir exercises the option. In the absence of such exercise IMB for all intents and purposes is an operating lease. Hence in legal form and in concept IMB and a conventional finance lease are not identical.
 
Perhaps the key distinction between the Ijara Muntahia Bittamleek and the conventional finance lease is that in the Islamic version the lessor undertakes full ownership risks of the corpus of the leased asset. Whilst in Islamic version the risk remains with the lessor  (Mu’jir), the passing of the risk to the lessee is a prerequisite for a lease to be classified as a finance lease under International Accounting Standards. It could be seen in Ijara the risk follows the legal title unless the damage is caused by the negligence or the misconduct of Musta’jir. As IAS looks at substance over form for accounting purposes, on passing of the risks and rewards of the asset to the lessee, the asset is recorded in the books of the lessee coupled with the right to claim depreciation. Major repairs, maintenance and insurance remains to the account of  ‘Mu’jir’ (lessor) in a Ijara, whereas these costs are passed on to the lessee in a conventional lease.

Compassion underlying Ijara

Perhaps the compassion of Ijara is manifested over its counter part when it concerns the asset being out of order for a period due to major defects. During the period the asset is out of order, Ijara rentals would be in suspension so that ‘Musta’jir’ (lessee), who cannot benefit from the use of the asset is provided relief. Shari’ah also prohibits the levy of penalty in an Ijara arrangement for delayed payments, unlike in a conventional lease.
The issue of delayed payments may be addressed in an Ijara contract by various means such as inclusion of a donation clause, by acceleration of installments or by the cancellation of the contract. The compassionate attitude towards charging ‘Ujrah’ (rent) from the Musta’jir’ (lessee) is manifested at the commencement of the charge itself. In a conventional lease the payment obligation may commence from the date of execution from contract for funding. But in the Islamic version the obligation for the payment commences only upon the delivery of the asset to Musta’jir or upon enabling the use thereof by him.

Accounting under AAOIFI
The nature of Ijara rental or ‘Ujrah’ is that it represents consideration for the right to use an asset. ‘Ujrah’ does not consist of a capital component and an interest element. Hence the application of accounting methodology adopted for conventional lease rentals under International Accounting Standards of recording ‘lease rentals receivable’ and ‘interest in suspense’ in the books of the lessor would pose an issue in accounting for ‘Ujrah’. FAS 8 formulated by AAOIFI stipulates that both assets rented on the basis of Ijara & IMB to be recorded in the books of the Mu’jir (lessor). The two categories of assets should be shown in the Statement of Financial position under the heading “investments in Ijara assets” and “Ijara Munthia Bitamleek Assets” respectively on initial recognition at cost and at book value thereafter.
 
The right for the depreciation claim follows the recording of the asset in the books of the lessor and unlike in a conventional finance lease under IAS, the depreciation entitlement for both forms are vested on the Lessor. Whilst depreciation of Ijara assets shall be on the basis of the depreciation policy of the lessor, in calculating the depreciation of Ijara Bitamleek Assets residual value shall be taken as zero, if the lessee’s acquisition of ownership at the end of the period is through gift. On the other hand if the transfer to the lessee is at a token or amount specified in contract, the said amount should be subtracted in determining the depreciable cost.     

Installments of both forms, i.e Ijara & IBM should be presented in the income statement of the lessor as “Ijara Revenue” on accrual basis allocated proportionately according to the term of the lease recognized in the period in which they are due. Where the lessee acquires title through gradual sale the revenue decreases progressively.  

The Ijara installment paid is presented in the lessee’s income statement as “Ijara expense” allocated over the lease period recognized when due under both forms of Islamic leases.

Tax issues involving Ijara
The cost of Ijara in comparison to a loan may be high due to the associated transactional taxes on additional steps involved. The legal / notary fees and stamp duty involved on the dual transfer of title (in Ijara Munthia Bittamleek) and the property transfer tax may increase the cost of the entire structure in many jurisdictions.

The exposure of the Ijara rentals to VAT as opposed to the VAT exemption enjoyed by interest is another factor that may have an impact on the pricing. Though interest paid on a loan from a bank does not attract any withholding tax under most of the tax systems found in the world, Ijara rental would be exposed to withholding tax.

In certain countries like Sri Lanka, though the local Tax Statute does not explicitly provide for the claiming of capital allowances by the lessor under operating as well as finance leases, under the presumption that the leased assets are deemed to be used in the lessor’s business of leasing, the lessor enjoys the right for claiming capital allowances. In these countries the same status quo ought  to prevail for Ijara and IMB regarding capital allowances. In a scenario involving a cross border Ijara, Mu’jir (lessor) should also be cautious on the possibility of creation of a permanent establishment in Musta’jir’s jurisdiction.   

Structuring using Ijara
The apparently simple and straightforward Ijara contract could be adopted to achieve many ends. An Ijara could be the retail structure of a Sukuk – Al – Ijara, that permits the originator to raise funds as well as Sukuk holders to trade in the Sukuk certificates to enable the liquidity management. Ijara is also a means for unlocking and realizing the capital value of an asset to fulfill the working capital needs of an organization. An organization that already owns an asset may sell it to the financier for immediate funds and continue to use it under an Ijara agreement on payment of periodical rentals.

© Islamic Finance Today – Pioneer Publications (Pvt) Ltd