Welcome to another edition of our newsletter series, “Wealth Planning for Islamic Faithfuls.”
We continue with our discussion on the typology of Islamic financial instruments as we seek to ensure our wealth as Muslim faithful are Halal.
MURABAHAH (Cost Plus)
This refers to a sale of a good or property with an agreed profit against a deferred or a lump sum of payment. There are two contracts in Murabahah: the first contract is between the client and the bank, whereas the second contract is between the bank and supplier. The client (purchaser) orders a certain commodity through the bank, the bank then buys the commodity from the supplier and sells it to the client with specified profit whereby the client can make a lump sum or a deferred payment to the bank.
In simpler terms, If a seller agrees with his purchaser to provide him a specific commodity on a certain profit added to his cost, it is called a murabahah transaction. The basic ingredient of murabahah is that the seller discloses the actual cost he has incurred in acquiring the commodity, and then adds some profit thereon. This profit may be in lump sum or may be based on a percentage.
The payment in the case of murabahah may be at spot, and may be on a subsequent date agreed upon by the parties. Therefore, murabahah does not necessarily imply the concept of deferred payment, as generally believed by some people who are not acquainted with the Islamic jurisprudence and who have heard about murabahah only in relation with the banking transactions.
Murabahah, in its original Islamic connotation, is simply a sale. The only feature distinguishing it from other kinds of sale is that the seller in murabahah expressly tells the purchaser how much cost he has incurred and how much profit he is going to charge in addition to the cost.
Istisna’ means asking someone to construct, build or manufacture an asset. In Islamic finance, istisna’ is generally a long-term contract whereby a party undertakes to manufacture, build, or construct assets, with an obligation from the manufacturer or producer to deliver them to the customer upon completion. In practice, the key advantage of an istisna’ contract is that it can provide flexibility to the customer, where payments can be made in instalments linked to project completion, at delivery or after project completion. In contrast to istisna’, for salam contract the payment must be made in full, in advance.
Infrastructure projects are the main examples of istisna’ application. This includes construction of power plants, factories, roads, schools, hospitals, building and residential developments. The parties to an istisna’ contract are the Producer or Manufacturer; the Bank (i.e., the financier); and the Customer (i.e., purchaser of goods).
STRUCTURE OF ISTISNA
Simple Istisna Structure: It is assumed here that the buyer has the required financing to directly coordinate with the manufacturer on the project. If the buyer does not have the financing, then the parallel istisna’ structure can be used. The simple Istisna can be illustrated in the following mechanism:
1. The customer (buyer) approaches the manufacturer (seller) to construct a specified asset for him. They agree on specifications of the asset, the price, and the date of delivery at the time of contract execution.
2. The customer pays the price to manufacture in cash or instalments according to their agreement.
3. After the completion of manufacturing process, the manufacturer delivers the completed asset to customer on delivery date.
Parallel Istisna Structure: This involves the customer (the buyer); the Islamic bank (the seller); and the manufacturer (in some cases it can also involve sub-contractors), where the buyer can obtain financing from the Islamic. The following steps are involved in parallel istisna Scontract.
1. The customer wants to purchase the certain assets to be manufactured or constructed (for example house) and approaches the Islamic bank for financing.
2. The Islamic bank (as seller / manufacturer) enters into istisna contract with customer. The price is determined as bank’s cost-plus profit margin.
3. The Islamic bank (buyer) enters the parallel istisna (second istisna) contract with the contractor to construct the asset (house) as per the agreed specifications with customer.
4. The Islamic bank pays the cost of construction to the contractor in the second istisna contract.
5. After the completion of manufacturing process, the Islamic bank delivers the asset to the customer (ultimate buyer) upon the delivery date. Sometimes, the Islamic bank appoints the contractor its agent to deliver the asset to the customer on its behalf.
6. The customer pays the price of istisna asset to the Islamic bank in form instalments or lump sum according to their agreement.
This is a situation in which two parties are involved therein: the lessee and leaser. The leaser (bank) is the real owner of the asset or property and it is rented out to the lessee until full payment is received. The lessee has the option to keep the asset at contract maturity or give it back to the bank. If all payments are received, the lessee can keep the asset but at a higher price than the usual asset price.
Therefore, if A has employed B in his office as a manager or as a clerk on a monthly salary, A is musta’jir, and B is an ajir. Similarly, if A has hired the services of a porter to carry his baggage to the airport, A is a musta’jir while the porter is an ajir, and in both cases the transaction between the parties is termed as ijarah.
This type of ijarah includes every transaction where the services of a person are hired by someone else. He may be a doctor, a lawyer, a teacher, a labourer, or any other person who can render some valuable services. Each one of them may be called an ‘ajir’ according to the terminology of Islamic law, and the person who hires their services is called a ‘musta’jir’, while the wages paid to the ajir are called their ‘ujrah’.
This is another contract where full payment for a good is paid in advance but the delivery of the good is made at an agreed future date. If these institutions want to earn a halal profit, they shall have to deal in commodities in one way or the other, because no profit is allowed in Shariah on advancing loans only. The way this can be done are:
1. Firstly, after purchasing a commodity by way of salam, the financial institutions may sell it through a parallel contract of salam for the same date of delivery. The period of salam in the second (parallel) transaction being shorter, the price may be a little higher than the price of the first transaction, and the difference between the two prices shall be the profit earned by the institution. The shorter the period of salam, the higher the price, and the greater the profit. In this way the institutions may manage their short-term financing portfolios.
2. Secondly, if a parallel contract of Salam is not feasible for one reason or another, they can obtain a promise to purchase from a third party. This promise should be unilateral from the expected buyer. Being merely a promise, and not the actual sale, their buyers will not have to pay the price in advance. Therefore, a higher price may be fixed and as soon as the commodity is received by the institution, it will be sold to the third party at a pre-agreed price, according to the terms of the promise.
3. A third option is sometimes proposed that, at the date of delivery, the commodity is sold back to the seller at a higher price. But this suggestion is not in line with the dictates of Shariah. It is never permitted by the Shariah that the purchased commodity is sold back to the seller before the buyer takes its delivery, and if it is done at a higher price, it will be tantamount to riba which is totally prohibited. Even if it is sold back to the seller after taking delivery from him, it cannot be pre-arranged at the time of original sale. Therefore, this proposal is not acceptable at all.
We would continue examining Islamic wealth planning for Islamic faithfuls in subsequent editions of this Newsletter.
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Shukran Jazeelan for reading.