Lease Based Contracts

CONTRACT OF IJĀRAH (LEASING)

The word ijārah literally means to give something on rent. In the language of law it means
lending of some object to somebody in return for some rental against a specified period. It
can also be described as sale of usufruct for consideration. It includes letting things
moveable and immovable for hire and rendering services such as custody of property and
professional services.
1) In the first place, it means “to employ the services of a person on wages given to him as a
consideration for his hired services.” The employer is called “Mustajir” while the employee
is called “Ajir”, while the wages paid to the Ajir are called their “Ujrah”.
2) The second type of Ijarah relates to the usufructs of assets and not to the services of
human beings. 'Ijarah' in this sense means “to transfer the usufruct of a particular property
to another person in exchange for a rent claimed from him.” In this case, the term 'Ijarah' is
analogous to the English term 'leasing'. Here, the lessor is called 'Mujir', the lessee is called
'Mustajir' and the rent payable to the lessor is called 'Ujrah'. However, there are many
differences between leasing contract of Conventional Bank and Ijarah, which will be
discussed in detail.
Basic Rules
The basic rules of Ijarah are as follows:
Transferring of usufruct not ownership
In leasing, the owner transfers its usufruct to another person for an agreed period, at an
agreed consideration.
Subject matter of lease
The subject matter of lease should be valuable, identified and quantified.
All consumable things cannot be leased out
The corpus of the leased property remains in the ownership of the seller, and only its
usufruct is transferred to the lessee. Thus, anything which cannot be used without
consuming, cannot be leased out. For example money, wheat etc.
All liabilities of ownership is borne by lessor
As the corpus of the leased property remains in the ownership of the lessor, so all the
liabilities emerging from the ownership shall be borne by the lessor.
Period of lease
• The period of lease must be determined in clear terms.
• It is necessary for a valid lease that the leased asset is fully identified by the parties.
Lease for specific purpose
The lessee cannot use the leased asset for any purpose other than the one specified in the
lease agreement. However, if no such purpose is specified in the agreement, the lessee can
use it for whatever purpose it is used in the normal course.
Lessee as Ameen
• The lessee is liable to compensate the lessor for every damage to the leased asset caused
by his misuse or negligence.
• The leased asset shall remain in the risk of the lessor throughout the lease period in the
sense that any damage or loss caused by the factors beyond the control of the lessee shall
be borne by the lessor.
Lease of jointly owned property
• A property jointly owned by two or more persons can be leased out and the rental shall be
distributed between all joint owners according to the proportion of their respective shares
in the property.
• A joint owner of a property can lease his proportionate share only to his co-sharer and not
to any other person.
Determination of Rental
• The rental must be determined at the time of contract for the whole period of lease.
• It is permissible that different amounts of rent could by fixed for different phases during
the lease period, provided the amount of rent for each phase is specifically agreed upon at
the time of affecting the lease. If the rent for a subsequent phase of the lease period has not
been determined or has been left at the option of the lessor, the lease is not valid.
• The determination of rental on the basis of the aggregate cost incurred in the purchase of
the asset by the lessor, as normally done in financial leases, is not against the rules of
Shariah if both parties agree to it, provided all other conditions of a valid lease prescribed by
the Shariah are fully adhered to.
• The lessor cannot increase the rent unilaterally and any agreement to this effect is void.
• The rent or any part thereof may be payable in advance before the delivery of the asset to
the lessee, but the amount so collected by the lessor shall remain with him as 'on account'
payment and shall be adjusted towards the rent after its being due.
• The lease period shall commence from the date on which the leased asset has been
delivered to the lessee.
• If the leased asset has totally lost the function for which it was leased, the contract will
stand terminated.
• The rentals can be used on or benchmarked with some Index as well. In this case, the
ceiling and floor rentals can be identified for validity of lease.

Variable Rentals in Long Term Leases

In the long-term lease agreements, it is mostly not in the benefit of the lessor to fix one
amount of rent for the whole period of lease, because the market conditions change from
time to time. In this case, the lessor has two options:
(a) He can contract lease with a condition that the rent shall be increased according to a
specified proportion (e.g. 5%) after a specified period (like one year).
(b) He can contract lease for a shorter period after which the parties can renew the lease at
new terms and by mutual consent with full liberty to each one of them to refuse the
renewal, in which case, the lessee is bound to vacate the leased property and return it back
to the lessor.

Relationship between contracting parties

It should be clearly understood that when the lessee himself has been entrusted with the
purchase of the asset intended to be leased, there are two separate relations between the
institution and the client, which come into operation one after the other. In the first
instance, the client is an agent of the institution to purchase the asset on latter's behalf. At
this stage, the relation between the parties is nothing more than the relation of a principal
and his agent. The relation of lessor and lessee has not yet come into operation.
The second stage begins from the date when the client takes delivery from the supplier. At
this stage, the relation of lessor and lessee comes to play its role. These two capacities of
the parties should not be mixed up or confused with each other. During the first stage, the
client cannot be held liable for the obligations of a lessee. In this period, he is responsible to
carry out the functions of an agent only. But when the asset is delivered to him, he is liable
to discharge his obligations as a lessee.

Insurance of the leased assets

If the leased property is insured under the Islamic mode of Takaful, it should be at the
expense of the lessor and not at the expense of the lessee, as is generally provided in the
agreements of the current 'financial leases'.
Difference between conventional lease and ijarah
Conventional Leasing Ijarah
1 Conventional lease combines sale and In ijarah, lease and sale are two
lease in one contract, (Hire-purchase) independent contracts.
which is not allowed in Shariah.
In conventional lease, asset is
automatically transferred to
customer.
2 The bank is not responsible for any The bank bears all ownership related
loss to the asset. risk/loss if such loss is not caused by the
negligence of the customer.
3 Rent is charged and demanded prior No rent can be charged and demanded
to delivery of the asset. prior to the delivery of the asset.
4 If asset is destroyed or stolen, Islamic bank does not charge any rental in
conventional leasing company this case.
continues charging rental.
5 The conventional lease agreements Since Ijarah is a binding agreement
give unilateral right to bank to therefore, neither party can terminate it
 terminate the Lease Agreement without mutual consent unless if there is
without any reason. a breach of contract by either party.
6 Penalty on late payment is charged. Penalty on late payment cannot be
charged.

Modern applications of ijārah

There are two main types of ijārah (leasing) practiced by the modern banks namely finance
lease and operating lease.

1. Finance lease

The finance lease 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 assets by the lessee. The
lessor retains the ownership of the asset and the lessee has possession and use of asset on
payment of specified rentals over a period. Though the lessor is the legal owner, the lessee
is given the exclusive rights to the use of the asset for the duration of the contract. The
rentals during the fixed primary period are sufficient to amortize 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 options for a secondary
period of lease in which the rentals are reduced to nominal amount. The period of lease
usually ranges from 5 to 15 years depending on the useful life of the asset.

Since all the risk is borne by the lessee, instead of lessor in finance lease, it makes the
contract objectionable from the sharī‘ah point of view. In sharī‘ah, risks of damage and
obsolescence is exclusively borne by the lessor. Besides, the leased item or equipment
cannot be returned to the lessor during the primary period of lease. The lessee cannot
cancel the contract even if he finds the item unuseful during the term. The fact that the rent
is related to the approximate useful life of the item and that the lessor recovers the entire
cost of equipment plus some profit, make this contract doubtful from Islamic point of view.

2. Operating lease:

This is “non-full payment” lease as rentals are insufficient to enable the lessor to recover
fully the initial capital outlay. The residual value is recovered through disposal or re-leasing
the equipment to other users. In this lease major consideration is given to the use of
equipment. Unlike the finance lease system, the lessee can cancel the contract before it
expires without paying any penalty. Under this arrangement the risk of damage and
depreciation is borne by the lessor.

Ijārah in Islamic banks

1. Ijārah muntahiyah bittamlIk

It is a leasing of movable or immovable property with eventually transferring the title in the
leased asset to the lessee. It may also be defined as an agreement combined with an
undertaking by the lessee to purchase the asset during the lease or at the termination of the
lease.

The financial institution on the request of client purchases a movable or immovable

property and rent it to him who pays an agreed sum in installments over an agreed period.
He gives an undertaking that he will buy the property at the termination of lease period. By
virtue of this undertaking, he buys the asset and becomes owner of the asset.

Steps of lease transaction in Islamic banks

 Bank buys a car, say, worth 2 million rupees.

 Bank pays ownership related cost i.e. registration, takaful cost.

 Leases it to customer for agreed monthly rentals, say, Rs.34,000/-. Rentals cover cost
price plus some profit.

 Lease period is 5 years, for instance

 Bank takes an undertaking from the client that he will buy car on the expiry of lease
period.

 Bank takes 15% security deposits amounting to Rs.3,60000/-

 After 5 years, bank sells it to customer against security deposit.

The lease purchase or lease that ends with possession is a new mode innovated by the
Islamic banks. What distinguishes this transaction is that the bank does not hold assets on
its own, instead, it purchases the asset on request from its customer who is interested to
own an asset through lease that ends with possession. At the end of the lease period,
ownership is transferred to the lessee.

The bank mostly calculates total rentals on the basis of the cost of asset plus the profit.
Rentals are payable over a period of time as agreed between the bank and the customer. In
practice, there are two basic ways, through which the asset becomes the property of the
lessee at the end of the lease period:

1) A lease contract with a promise to grant the asset to the lessee after paying all the rental
installments. The grant must be obtained in a separate contract.

2) A lease contract with a promise to sell the asset to the lessee in exchange for a nominal
or actual price. The lessee pays at the end of the lease period in addition to paying all the
rental installments agreed upon.

The Practical Steps of a Lease Purchase Operation

The following are the practical steps of a lease purchase operation:

 1. The purchase contract of assets

The bank: In pursuance of the customer's desire to draw a contract of lease ending with
ownership, the bank purchases the asset from the seller, pays the price and gets its
possession.

The seller: Agrees on the sale, signs the bill and agrees with the bank about the place of
delivery.

2. Delivery and receipt of the commodity

The seller: Delivers the asset to the bank directly or to any party designated by the bank in
the contract.

The bank: Authorizes its customer to receive the asset and demands a notification of arrival
and satisfaction of the required specifications.

3. The lease contract

The bank: Leases the asset to the customer and promises customer the possession of the
asset if he pays all the rental installments (a promise to grant or a promise to sell for a
nominal or actual price).

The lessee: pays the rental installments at the agreed upon periods.

4. Transfer of ownership

The bank: At the end of the lease period and after the lessee pays all the installments due,
the bank assigns the asset to the benefit of the lessee as a grant or sale as promised.

The lessee: Ownership of the asset transfers to the lessee.

2. Direct leasing:

This is a mode whereby the Islamic banks allow the customer to use the capital assets
owned by the banks for a limited period of time ranging from few days to few months
depending upon the type of asset in question. In return the lessee pays a monthly or annual
rental fee.

Areas of Applications

The Islamic banks use the lease with option to purchase especially real estate, computers,
machinery and equipment. By so doing, the Islamic banks give their customers the freedom
of choice to acquire the assets they need from the sources they select in the light of their
experience and personal evaluation.

The lessee in this case enjoys the possession and use of the asset during the lease period
and it is certain that ownership of the asset will be transferred to him it at the end of the
lease period. The bank also, retains the ownership of the asset and it assigns it to the lessee
only on receipt of rental installments agreed upon.