The first dated coins that can be assigned to the Muslims are copies of silver dirhams of the Sassanian Yezdigird III, struck during the Khalifate of Uthman, radiy'allahu anhu. These coins differ from the original ones in that an Arabic inscription is found in the obverse margins, normally reading "In the Name of Allah". Since then the writing in Arabic of the Name of Allah and parts of Qur'an on the coins became a custom in all mintings made by Muslims.

Inheritance is the entry of living persons into possession of dead persons'property and exists in some form wherever the institution of private property is recognised as the basis of the social and economic system. The actual forms of inheritance and the laws governing it, however, differ according to the ideals of different societies.

The law of inheritance in Islam is based upon five main considerations:

1. To break up the concentration of wealth in individuals and spread it out in society.
2. To respect the property right of ownership of an individual earned through honest means.
3. To hammer in the consciousness of man the fact that man is not the absolute master of wealth he produces but he is its trustee and is not,therefore, authorised to pass it on to others as he likes.
4. To consolidate the family system which is the social unit of an Islamic society.
5. To give incentive to work and encourage economic activity as sanctioned by Islam.

In the pre-Islamic world and even in modern societies the law of inheritance has so many evils in it, which may be summed up in the following points:

1. Women had been completely denied the share of inheritance. They were rather regarded as part of the property of the deceased and, therefore,their right to property by inheritance was out of question.
2. In pre-Islamic Arabia and other countries where there had been tribal societies not only women were deprived of the right of inheritance but even weak and sick persons and minor children were given no share in it, as the common principle of inheritance was that he alone is entitled to inherit who wields the sword.
3. Then in certain societies there had been existing the law of primogeniture and it exists even today in some of the so-called civilised parts of the world which entitles only the eldest son to inherit the whole of the father's property or to get the lion's share.

Islam introduced so many reforms in the laws of inheritance which can be succinctly summed up as follows.

1. It defined and determined in clear-cut terms the share of each inheritor and imposed limits on the right of the property-owner to dispose of his property according to his whim and caprice.
2. It made the female, who had been prevously thought a chattel, the co-sharer with the male and thus not only restored her dignity, but safeguarded her social and economic rights.
3. It laid the rules for the break-up of the concentrated wealth in the society and helped in its proper and equitable distribution amongst a large number of persons.
4. It gave a death-blow to the law of primogeniture and thus provided the democratic basis for the division of the property of the deceased.

The above are some of the distinguishing features of the Islamic law of inheritance. While laying down the rules for the distribution of the estate of the deceased,the first principle to be observed is that the property both movable and immovable can be distributed after meeting the following obligations :

1. funeral expenses;
2. clearing off the debts incurred by the deceased;
3. payment of bequest, if any, to the extent of one-third of the total assets. It may be remembered that the Mahr of the wife, if it had not been paid, is included in the debt. Moreover, it is not lawful to make a bequest in favour of a person who is entitled to a share in the inheritance.

Four persons cannot get inheritance:

(a) a fugitive slave who has fled away from his master, 
(b) one who has murdered one's predecessor intentionally or unintentionaly
(c) one who professes a religion other than Islam, 
(d) one living in Dar-ul-Harb cannot inherit the property of one living in Dar-ul-Islam and vice versa.

According to Islam, the heirs have been divided into three classes.

(A) Dhaw-u'l-Fara'id are those persons who have a right to definite shares in assets left by the deceased. These sharers are twelve in number; four males: father, grandfather, uterine brothers and husband; and eight females: wife, single daughter, son's daughter, mother, grandmother, full sister, consanguine sister, uterine sister.

1. Father's share is one-sixth when the deceased leaves a son or a son's son, but if the deceased is not survived by a son or grandson his father will, in addition to this share (one-sixth), also get a share of being 'Asaba.
2. The grandfather's share is like that of father's share but in three conditions:
   1. According to Imam Bukhiri and Imam Muslim, the presence of father deprives even the brothers of their share in the inheritance.but this is not the case with the grandfather. Imam Abu Hanifa is of the opinion that the presence of grandfather deprives the brother of his share in the inheritance.
   2. If the father of the deceased is alive, then the share of the mother is of what is left from the share of the wife of the deceased. The presence of grandfather does not reduce the share of the mother of the deceased.
   3. The grandmother of the deceased has no share in the presence of the father of the deceased but she has a share in the presence of the grandfather.
3. The third set of sharers are uterine brothers and sisters. They are entitled to one-sixth if their number is one, and one-third if they are more than one.
4. The husband's share is one-half of the property of the deceased wife if she has no children, but in case of children it is one-fourth.
5. The wife is entitled to one-fourth if the husband dies childless; otherwise it is one-eighth.
6. Real daughter: one-half when alone, and two-thirds if more than one. If the deceased is survived by a male child also. the daughters are then treated as Asaba and the male child would get double of what falls to the lot of daughters. The granddaughters stand on the same level as daughters. But in case the deceased is survived by one real daughter and one or more than one granddaughter they would get one-sixth. The granddaughter is not entitled to any share if the deceased is survived by a son, but if he is survived by grandsons and granddaughters, they would be treated as 'Asaba and the male grandchild would get double of what goes to the female grandchild.
7. Full sister gets one-half if she is alone, and two-thirds if they are more than one.
8. Consanguine sister is entitled to one-half if one, and two thirds if more.
9. Mother is entitled to one-sixth when she has a child or grandchild, and in case of being childless she gets one-third of the share.
10. If the deceased is survived either by paternal grandmother or maternal grand- mother or even by both, they are entitled to one-sixth. The grandmother (maternal) is deprived of her share if the mother of the deceased is alive; and if father is alive the paternal grandmother is deprived of this share.

(B) When the heirs of the first group have received the respective shares, the residue of the assets falls to the share of those relatives who are called Asaba which, according to the Shari'ah, implies those relatives in whose line of relationship no female enters. This is the second group of inheritors.

There is no fixed share of the 'Asabat. If the deceased is not survived by any Dhaw-u'l-Fara'id, the whole of the property falls to their share; and If Dhaw-u'I.Fara'id are there to get their due share, the residue will be taken by the Asabat. The following are the 'Asabat:

1. Son: He is the first to get the residue in order of succession. The daughters are entitled to half of the share as given to the son. The grandsons are not entitled to any share in the presence of the son. If the son is not living, then the grandson is entitled to a share in the inheritance. If there are more than one son, the inheritance will be distributed equally amongst them.
2. The father, grandfather and the great-grandfather are included in the category of Dhaw-u'l-Fara'id. If, however, the deceased is not survived by category of a son, grandson of great-grandson, then the father will fall under the category of 'Asaba, and, in the absence of the father, the grandfather assumes that position.
3. If the deceased is not survived by son, or grandson or father or grandfather, i.e. none amongst the 'Asabat, then the brother, and in the absence of brother his son, and in the absence of son, his grandson will be entitled to share in the inheritance as 'Asaba and the female would also join them in share claiming half of the share as compared with male.
4. If unfortunately the deceased is survived by none of the above-mentioned relatives amongst the 'Asabat, then consanguine brother will be entitled to share in the inheritance and he will be preferred to full brother's son.
5. Then comes the turn of full paternal uncle.

(C) The last category of inheritors are known ad Dhaw-u'l Arham, i.e. relations connected through females, but it is in extremely rare cases that they get any share in the inheritance. The following relatives come under this category.

1. The son of the daughter and daughter of the daughter.
2. The son of the daughter of the son, and daughter of the daughter of the son and their children.
3. Maternal grandfather, maternal grandfather of the father, the grandfather of the mother, maternal grandfather of the mother, the grandmother of the mother, the children of the sisters, the sisters of the father and those of the mother, etc.

Book 11, Number 3928:

Usama b. Zaid reported Allah's Messenger (may peace be upon him) as saying: A Muslim is not entitled to inherit from a non-Muslim, and a non-Muslim is not entitled to inherit from a Muslim.

Book 11, Number 3929:

Ibn Abbas (Allah be pleased with them) reported Allah's Messenger (may peace be upon him) as saying: Give the shares to those who are entitled to them, and what remains over goes to the nearest male heir.

Book 11, Number 3930:

Ibn 'Abbas (Allah be pleased with them) reported Allah's Messenger (may peace be upon him) as saying: Give the shares to those who are entitled to them, and what is left from those wno are entitled to it goes to the nearest male heir.

Book 11, Number 3931:

Tawus reported on the authority of his father Ibn Abbas (Allah be pleased with them) narrating that Allah's Messenger (may peace be upon him) said: Distribute the property amongst Ahl al-Fara'id, according to the Book of Allah, and what is left out of them goes to the nearest male heir.

Book 11, Number 3932:

Jabir b. 'Abdullah (Allah be pleased with them) reported: I fell sick and there came to me on foot Allah's Messenger (may peace be upon him) and Abu Bakr for inquiring after my health. I fainted. He (the Holy Prophet) performed ablution and then sprinkled over me the water of his ablution. I felt some relief and said: Allah's Messenger, how should I decide about my property? He said nothing to me in response until this verse pertaining to the law of inheritance was revealed: "They ask you for a decision ; say: Allah gives you a decision concerning the person who has neither parents nor children" (iv. 177).

Book 11, Number 3933:

Jabir b. 'Abdullah (Allah be pleased with him) reported: Allah's Apostle(may peace be upon him) and Abi Bakr (Allah be pleased with him) visited me on foot in Banu Salama, and found me unconscious. He (the Holy Prophet) called for water and performed ablution and sprinkled out of it (the water) over me. I felt relieved. I said: Allah's Messenger, what should I do with my property? And this verse was revealed: "Allah enjoins you concerning your children: for the male is equal of the portion of two females."

Book 11, Number 3934:

Jabir b. 'Abdullah (Allah be pleased with them) reported: While I had been ill Allah's Messenger (may peace be upon him) visited me and Abu akr (Allah be pleased with him) was with him, and they both came walking on foot. He (the Holy Prophet) found me unconscious. Allahs Messenger (may peace be upon him) performed ablution and then sprinkled over me the water of his ablution. I felt relieved regained my consciousness) and found Allah's Messenger (may peace be upon him) there. I said:Allah's Messenger, what should I do with my property ? He gave me no reply until the verse (iv. 177) relating to the law of inheritance was revealed.

Book 11, Number 3935:

Jabir b. Abdullah (Allah be pleased with him)reported: Whilo I was ill Allah's Messenger (may peace be upon him) came to me and found me unconscious. He(the Holy Prophet) performed ablution, and sprinkled over me the water of his ablution. I regained my consciousness and said: Allah's Messenger, my case of inheritance is that of Kalala. Then the verse pertaining to the inheritance ( of Kalala) was revealed. I (one of the narrators) said: I said to Muhammad b. Munkadir: (Do you mean this verse) "They ask you ; say: Allah gives you decision in regard to Kalala" (iv. 177) ? He said: Yes, it was thus revealed.

Book 11, Number 3936:

This hadith is transmitted on the authority of Shu'ba but with a slight variation of words.

Book 11, Number 3937:

Abu Talha reported: 'Umar b. al-Khattab (Allah be pleased with him) delivered a sermon on Friday and made a mention of Allah's Apostle (may peace be upon him) and he also made a mention of Abu Bakr (Allah be pleased with him) and then said: I do not leave behind me any problem more difficult than that of Kalala. I did not refer to Allah's Messenger (may peace be upon him) more repeatedly than in case of the problem of Kalala, and he (the Holy Prophet) never showed more annoyance to me than in regard to this problem, so much so that he struck my chest with his fingers and said: 'Umar, does the verse revealed in summer season, at the end of Sura al-Nisa' not suffice you ? Hadrat 'Umar (then) said : If I live I would give such verdict about (Kalala) that everyone would be able to decide whether he reads the Qur'an or he does not.

Book 11, Number 3938:

This hadith has been narrated on the authority of Qatada with the same chain of transmitters.

Book 11, Number 3939:

Al-Bara' (Allah be pleased with him) reported that the last verse revealed in the Holy Qur'an is: "They ask thee for a religious verdict; say: Allah gives you a religious verdict about Kalala (the person who has neither parents nor children)"(iv 177).

Book 11, Number 3940:

Abu Ishaq said that he heard al-Bara' b. 'Azib (Allah be pleased with him say: The last verse revealed (in the Holy Quran) is that pertaining to Kalala, and the last sura revealed is Sura al-Bara'at.

Book 11, Number 3941:

Abu Ishaq said that he heard al-Bara' b. 'Azib (Allah be pleased with him)say : The last complete sura revealed (in the Holy Qur'an) is Sura Tauba (i e. al-Bara'at, ix.), and the last verse revealed is that pertaining to Kalala.

Book 11, Number 3942:

Aba Ishaq reported this hadith on the authority of al-Bara' (Allah be pleased with him) with a slight variation of words, viz. the last sura that was revealed complete.

Book 11, Number 3943:

Al-Bara' (Allah be pleased with him) reported that the last verse revealed was: "They ask of thee religious verdict . . " (iv. 177).

Book 11 ,Number 3944:

Abu Huraira (Allah be pleased with him) reported that when the body of a dead person having burden of debt upon him was brought to Allah's Messenger(may peace be upon him) he would ask whether he had left property enough to clear off his debt, and if the property left had been sufficient for that (purpose), he observed funeral prayer for him, otherwise he said (to his companions): You observe prayer for your companion. But when Allah opened the gateways of victory for him, he said: I am nearer to the believers than themselves, so if anyone dies leaving a debt, its payment is my responsibility, and if anyone leaves a property, it goes to his heirs.

Book 11, Number 3945:

This hadith has been narrated on the authority of al-Zuhri through another chain of transmitters.

Book 11, Number 3946:

Abn Huraira (Allah be pleased with him) reported Allah's Apostle (may peace be upon him) having said this: By Him in Whose Hand is the life of Muhammad, there is no believer on the earth with whom I am not the nearest among all the people. He who amongst you (dies) and leaves a debt, I am there to pay it, and he who amongst you (dies) leaving behind children I am there to look after them. And he who amongst You leaves behind property, that is for the inheritor whoever he is.

Book 11, Number 3947:

Hammam b. Munabbih reported: This is what Abu Huraira (Allah be pleased with him) narratted to us from Allah's Messenger (may peace he upon him). And he narrated many ahadith, and one was this: Allali's Messenger (may peace be upon him said: I am, according to the Book of Allah, the Exalted and Majestic, nearest to the believers of all the human beings. So whoever amongst you dies in debt or leaves behind destitute children, you should call me (for help)), for I am his guardian. And who amongst you leaves property, his inheritor is entitled to get it, whoever he is.

Book 11, Number 3948:

Abu Huraira (Allah be pleased with him) reported Allah's Apostle (may peace be upon him) as saying : He who leaves property, that is for the inheritors; and he who leaves behind destitute children, then it is my responsibility (to look after them).This hadith has been narrated on the authority of Shu'ba with the same chain of transmitters.

BEATA PAXFORD is a lawyer and a Ph.d. candidate in banking law. Beata is currently writing her dissertation on Islamic banking at the Warsaw University in Poland. Her main areas of specialisation include corporate and banking law. She is an Islamic banking advocate in Poland and hopes to popularise Islamic based financing in the CEE countries.

Recent events in the world economy have sparked a global debate about so-called toxic financial instruments and the damage caused by them. Derivatives were cited as the main culprit of the recession and bankruptcies of the affected financial institutions. Nevertheless, thanks to the criticism of these detrimental derivatives, the world of banks and financial elites have finally come to see Islamic finance in a more positive light. The subject of the Islamic way of making money has been put forward as an alternative way to prosper economically without the danger of going under. Furthermore, Islamic banking has been applauded for its ethical standards and respect of moral values so much forgotten in contemporary conventional banking.

Nature of Derivatives
If one wants to look at the attitude of Islamic finance as well as Shari’ah scholars towards derivatives, one has first to fully grasp the meaning and scope of both derivatives and Islamic finance. Derivatives are financial instruments, whose value, in simple words, depends on the underlying, like e.g. currency, price of stocks, price of gold, silver; sometimes even weather conditions. Derivatives, contrary to popular belief, were not created only a few years ago. The first derivative-like contract was known a few centuries ago in England and the Netherlands. It was most similar to the present forward-contract. In a classic forward contract, the buyer purchases the item which will be obtained at a later time, e.g. fruit, vegetables. Thus, the subject matter of the contract basically does not exist at the time the contract is entered into. In the more complicated forward contracts, the buyer is entitled to demand from the seller delivery of the financial instrument upon which the transaction was based for the price agreed by the parties to the transaction. For instance, let’s say the buyer enters into a forward contract, where the underlying is US dollars. The seller obligates itself to sell a certain amount of US dollars to the buyer at an agreed price at a future date. The buyer earns if he buys the currency at higher rate than is on the market at the time the contract is being fulfilled. If the rate is lower on the market, the buyer loses.
From the aforementioned example, a few conclusions instantly come to mind. First, that the subject matter may not be in the possession of the seller at the time the transaction is entered into. Second, the contract is to be fulfilled at a future date. Third, neither the buyer nor the seller knows what the rate of the subject currency will be.
If we look at the example and the conclusions from the Shari’ah point of view, we have to admit that such a transaction would be deemed haram. Why? The transaction refers to the subject matter that may not be in possession of the seller neither at the time of entering into contract nor at the time of its fulfillment. Thus, the key resolution of the contract contains Gharar – e – Kathir and as such the whole transaction is deemed invalid. The existence of Gharar – e – Kathir or a major gharar renders the contract null and void and cannot be omitted. The Shari’ah scholars are unanimous in this respect.
Furthermore, the future fulfillment of the contract indicates that the parties are sure about the events of the future. As one of the most important aspects of Islam is that Allah is the one who knows the future, humans cannot arrogate to themselves such knowledge which is God’s domain alone. Moreover, the future is uncertain, which is why it could invalidate such a contract. Finally, neither of the parties to the contract know what the future currency rate will be, and hence it is all based on gambling and speculation. From the Islamic finance perspective, the presence of Maisir and Qimar in the contract renders it invalid.

Bai Salam Contract
Nevertheless, some say that the Islamic contract of Bai’ salam is similar to the forward contract. Yes, there are some similarities, but the whole idea behind Bai’ salam is totally different. Bai’ salam is defined as a contract, where the seller obligates itself to deliver a certain, specified thing of already defined qualities at some point in the future and the buyer pays the price upon entering into contract. To avoid any impermissible elements in Bai’ salam, the following conditions have been introduced. The whole price for a thing has to be paid at the moment the transaction is entered into. Partial payment is not permissible as it would mean the use of credit (Bai’ al – Kali bi al -Kali), which is prohibited in this context.

Moreover, payment of the whole price eliminates in a way the element of gharar on the side of the buyer who by paying the whole price ensures the purchase of the product. It also ensures that the essential reason for a salam sale, which is an urgent need, is met.
The subject matter of Bai’salam has to possess defined qualities; its quantity has to be clearly specified. Furthermore, it should be changeable. This means that the subject matter can be changed, which will not influence the contract. For instance, the seller sells 100 kg of grain. Thus, the seller can pick the grain or even buy them anywhere he wants. While in the case of a future sale of an animal, each animal possesses different qualities, so such a sale would not be permissible.
The other crucial aspect of bai’ salam is the fixed time and place of delivery. The term and the place for delivering the subject matter should be stipulated exactly in the contract to eliminate gharar and ensure its permissibility under Shari’ah. By providing the aforementioned, strict conditions, Shari’ah scholars want to ensure that the trade is done in a permissible, Shari’ah-compliant way. Moreover, it emphasizes the difference between a forward derivative and Bai’ salam. In respect of Islamic banking & finance, this type of contract is used for financing the agricultural sector. Though, it can also be used by banks to purchase a good with Bai’salam and then sell it through a parallel Salam.

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The subprime mortgage crisis, popularly known as the “mortgage mess” or “mortgage meltdown”, came to the world’s attention when a surge in US home foreclosures (repossessions) started in 2006 and spiralled seemingly out of control in 2007 and 2008. It triggered a national financial crisis that went global within two years. It has caused billions of dollars losses to banks and financial institutions that were involved in subprime lending. Besides, this crisis has plummeted stock markets across the globe.
There is a substantial amount of criticism on the lack of regulatory monitoring and excessive interest rates in the conventional banking and financing system that contributed to the subprime mortgage crisis.   

What is prime and subprime mortgage?

The main difference between prime and subprime mortgages in conventional banking lies in the risk profile of the borrower and the interest rates charged on them. Subprime mortgages are loans extended to high risk borrowers to purchase real estate property. Specifically, lenders differentiate among mortgage applicants by using loan risk grades based on factors such as their credit history, previous loan defaults or bankruptcy filings, debt-to-income (DTI) ratios, and the level of documentation provided by applicants to verify their income.

Next, the lenders determine interest rates of a mortgage in a given risk grade based on the borrower’s credit risk score, for example, the Fair, Isaac and Company (FICO) score, and the size of the down payment.  Eligible borrowers for prime loans have a FICO credit score above 620, a debt-to-income ratio (DTI) not greater than 55 percent (meaning that not more than 55 percent of their net income pays for housing and other debt) and a combined loan-to-value (LTV) ratio of 90 percent, meaning that the borrower has to pay a minimum of 10 percent downpayment. Lenders charge the prevailing market interest rates to prime loan borrowers with lower credit risks.  Generally, subprime lending encompasses a variety of credit instruments including subprime mortgages, subprime car loans and subprime credit cards, among others.

Causes of subprime mortgage crisis

Excessive interest rates led to subprime mortgage crisis

There are many theories as to what led to the subprime mortgage into a crisis. Many experts and economists believe it came about through the combination of a number of factors in which subprime lending played a major part. One of the main factors is the interest rates charged on the subprime mortgage loans.  Historically low interest rates were charged in the US for mortgage loans during the initial years of 2000.

This was mainly to boost the American economy which was slowing down due to the Dot.Com crash and the September 11 attacks. The Federal Reserve Board (Fed) reduced short-term interest rates from about 6.5 percent to 1 percent. Former Chairman of the Fed, Alan Greenspan, admitted in 2007 that the housing bubble was “fundamentally engendered by the decline in real long-term interest rates”.

Many subprime mortgages were Adjustable Rate Mortgages (ARMs) in which the interest rates are subjected to revisions when the market interest rates increase. Besides that an estimated one-third of ARMs originating between 2004 and 2006 had “teaser” rates below 4 percent.  A “teaser” rate is very low but for a temporary period only and would increase significantly after the initial “honeymoon” period. These increases can sometimes be doubling the monthly repayment amount. The subprime borrowers were literally trapped in this tricky interest rate arrangement. Initially the borrowers found the interest rates to be well affordable for their income level, but when the ARMs were revised to higher rates the borrowers had no other choice than to default in their repayments.

This situation certainly could not have happened in the Islamic financing system. Islamic finance is defined as a financial system based on Islamic law known as Shari’ah. Islamic finance is limited to financial relationships involving entrepreneurial investment subject to the moral prohibition of (i) interest earnings or usury (riba) on money lending, (ii) haram (sinful activity), such as direct or indirect association with lines of businesses involving alcohol, pork products, firearms, tobacco, and vulgar entertainment, (iii) speculation, betting, and gambling (maisir), including the speculative trade or exchange of money for debt without an underlying asset transfer, (iv) the trading of the same object between buyer and seller (bay’ al inah), as well as (v) preventable uncertainty (gharar) such as all financial derivative instruments, forwarding contracts, and future agreements.

As opposed to conventional finance, where interest represents the contractible cost for funds tied to the amount of principal over a lending period, the central tenet of the Islamic financial system is the prohibition of “riba” (the interest earnings), meaning “an excess” which is interpreted as any unjustifiable increase of capital through loans. The general consensus among Islamic scholars is that riba covers not only usury but also the charging of interest and any positive, fixed predetermined rate of return that are guaranteed regardless of the performance of an investment.

Since only interest-free forms of finance are considered permissible in Islamic finance, financial relationships between financiers and borrowers are governed by shared business risk (and returns) from investment in lawful activities (halal). The participants in banking transactions are considered business partners who jointly bear the risks and profits. The transfer of funds from clients to the bank (depositing) is based on revenue-sharing usually calculated ex post on a monthly basis and the transfer of funds from the bank to the clients is based on profit-sharing (lending, financing), either at a mutually agreed-upon ratio “mudarabah” or at a mutually agreed-upon fixed rate. The word “mudarabah” means a profit sharing partnership in which one contributes the capital (bank) and the other (customer) manages the project.

Islamic banks finance only real transactions with underlying assets. Speculative investments such as margin trading and derivatives transactions are prohibited. Lending, or financing, must be backed by collateral. Collateral-free lending would normally be considered as containing a speculative element or moral hazard. Similarly, to avoid speculation and moral hazard, only investors with sufficient level of income can qualify for financing.

Islamic law does not object to payment for the use of an asset, and the earning of profits or returns from assets are indeed encouraged as long as both lender and borrower share the investment risk together. Profits must not be guaranteed based on assumption and can only accrue if the investment itself yields income. Any financial transaction under Islamic law assigns to investors clearly identifiable rights and obligations for which they are entitled to receive commensurate return. While the elimination of interest is fundamental to Islamic finance, Shari’ah compliant investment behaviour also aims to eliminate exploitation pursuant to Islamic law.

The emergence of securitization led to subprime mortgage crisis

The emergence of innovative lenders who are the non-banking and non government agency lenders is another factor that has caused the subprime mortgage crisis.  These lenders are not regulated as the traditional banks. They invented new methods of mortgage lending through securitization. The securitization can be defined as a structured finance process in which assets, receivables or financial instruments are acquired, classified into pools and offered as collateral for third-party investment. In this new mortgage process the banks and lending institution lend money to home a buyer from extended funding by selling the mortgage documents to third party investors in the security and bond markets through issuers as Mortgage Backed Securities (MBSs) or as Collateralized Debt Obligations (CDOs). The securitization of mortgage loans is a complex and multistage activity that involves a number of different players along the entire process.

Shari’ah principles prohibit selling “a debt against a debt”.  In Islamic financing the permissibility of risky capital investment without explicit interest earning has spawned several finance techniques under Islamic law. There are three basic forms of Islamic financing methods for both investment and trade finance: (i) synthetic loans (debt-based) through a sale-repurchase agreement or back-to-back sale of borrower or third party-held assets, (ii) lease contracts (asset-based) through a sale-leaseback agreement (operating lease) or the lease of third-party acquired assets with purchase obligation components (financing lease), and (iii) profit-sharing contracts (equity-based) of future assets. As opposed to equity-based contracts, both debt-based and asset-based contracts are initiated by a temporary transfer of existing assets from the borrower to the lender or the acquisition of third-party assets by the lender on behalf of the borrower.

However, this does not mean that securitization is totally prohibited in the Islamic financing system. There is permissible securitization in Islamic law, where the ownership of an asset is effectively divided into pieces and distributed in a manner similar to shares in a mutual fund. This is distinct from an Islamically non-permissible securitization of cash flows whereby investors might buy shares of interest, principal, both or margin as compared to what is based on markup interest in the conventional financing system. In the recent developments with Freddie Mac, an ijara wa iqtina (mean ‘leasing and acquisition’ and it is variably called ijara muntahi bitamlik, ‘leasing ending in ownership’ or lease to own) process has been securitized. In this case, the obligations of the lessee have been structured into a note by the holder and sold to Freddie Mac and the holder of the property has granted a mortgage to secure the note. If in the Islamic perspective, the note represents an aspect of property ownership, then the relationship is permissible.

Other factors that led to subprime mortgage crisis

There are two other factors that led mortgage lending into a crisis. They are the act of predatory lending and predatory borrowing. Predatory lending is the practice of a lender deceptively convincing borrowers to agree to unfair and abusive loan terms, or systematically violating those terms in ways that make it difficult for the borrower to defend against. Other types of lending sometimes also referred to as predatory include payday loans, credit cards or other forms of consumer debt and overdraft loans, when the interest rates are considered unreasonably high. In predatory lending the lenders charge excessive interest rates, prepayment penalties for refinancing an existing mortgage and other forms of charging excessive fees by mortgaging the same loan many times. Predatory borrowing on the other hand is a fraudulent practice of the borrower who provides  falsified income statements or lies about his income to be many times higher than the actual amount.  These actions are totally prohibited in Islamic financing law. Islamic economic models emphasize fairness. This is reflected in the requirement that everyone involved in a transaction makes informed decisions and is not misled or cheated. On a macro-economic level, Islamic models aim at social justice and the economic prosperity of the whole community. Islam encourages and promotes the right of individuals to pursue personal economic wellbeing, but makes a clear distinction between what commercial activities are allowed and what are forbidden. For example, transactions involving gambling and other socially detrimental activities are strictly prohibited.

Conclusion

While the global economic system is being rattled by the US subprime mortgage crisis, the ‘Islamic finance model’ may be the answer to this persistent economic turmoil. The current global economic crisis has opened many windows of opportunities for Islamic finance.  This crisis is seen as a big opportunity for Islamic finance as it has the capacity and capability to bring stability to the economy. This global crisis which caused colossal financial loses running in billions of dollars, would have not occurred if the Islamic principles regarding mortgage backed securities (MBSs) and collateralized debt obligations (CDOs) were in vogue in the international financial market. Islamic bonds (sukuks), carrying unique structure features, cannot fall foul of a crisis such as subprime mortgage crisis. Subprime mortgages are backed by dubiously rated collateralized debt packages which subsequently precipitated a global credit crunch.

It is the right time for the Islamic banking industry to present solutions to the global economic community in the wake of the crisis. The devastating subprime mortgage crisis would technically be unthinkable in the Islamic capital markets sector because it would be against Shari’ah principles to sell a debt against a debt. There is a very simple rule in Islamic trade, which clearly says that you cannot sell unless you possess. The present crisis has seen trillions of dollars trading without backing of assets. If such transactions followed the Islamic finance models it would have easily prevented the current economic crisis.

© Islamic Finance Today – Pioneer Publications (Pvt) Ltd

These principles broaden the definition of MF from micro-credit to provision of an array of financial services, such as, savings, insurance and remittance as a panacea for the poor and the under-privileged to move out of poverty into a state of increasingly better standard of living. The principles advocate free pricing of the services. They emphasize that access to MF and not cost of MF should be under focus in designing and implementing a poverty alleviation strategy. The strategy should aim at sustainability through a shift from a charity-based donor-dependent approach to a market-based for-profits approach emphasizing systemic efficiency and transparency and restricting use of donor funds to temporary support in the initial stage of an MFI and capacity building. Recent writings advocate use of charity for providing social safety nets for the extremely poor who are unbankable and therefore, unserved by the for-profit MFIs. The principles also underscore inclusiveness and integration of MF with the formal financial system.

How should one deal with poverty under Islam? All principles or laws in Islam owe their origin to its holy book – the Quran and the sayings and deeds of its Prophet (peace be upon him) encapsulated in books of Hadith. Consider this saying of the Prophet (peace be upon him) that forcefully drives home the message. "There is no asceticism in Islam". Islam views poverty to be a curse to be eradicated through productive efforts unlike some world religions and philosophies that celebrate asceticism. There is therefore, a convergence between the objectives of Islam and the avowed aims of "best practices" MF.
While poverty eradication remains the cherished goal of Islam and MF "best practices" is there a degree of commonality too in their approaches and strategies to poverty alleviation? Lessons from real-life experiences reflected in the "best practices" MF indicate a dual approach – use of charity as well as "for-profit" micro finance. At the same time, donor funds should complement private capital, not compete with it. The charity-based approach should be restricted to either providing temporary start-up support designed to get an institution to the point where it can tap private funding sources, or devoted to capacity building to take care of the shortage of strong institutions and managers. A charity-based approach is also needed for providing social safety net to the extremely poor and the destitute and therefore, unbankable.

How does the above compare with the Islamic approach to dealing with the poor and alleviating poverty?

Zakah and sadaqah as instruments of charity occupy a central position in the Islamic scheme of poverty alleviation. Zakah is the third among five pillars of Islam and payment of zakah is an obligation on the wealth of every Muslim based on clear-cut criteria. Rules of Shariah are fairly clear and elaborate in defining the nature of who are liable to pay zakah and who can benefit from zakah. The first and foremost category of potential beneficiaries is the poor and the destitute. A greater degree of flexibility exists with respect to beneficiaries of sadaqah.

The primary issue with zakah and sadaqah-dependent institutions is the issue of sustainability as they are essentially rooted in voluntarism. Funds mobilized through charity could fluctuate from time to time and may not lend themselves to careful planning and implementation.
The issue of sustainability is addressed in the institution of awqaf through creation of permanent and income-generating physical assets. Awqaf  has historically been the major vehicle for creating community assets. There are however, restrictions on development and use of assets under waqf for pre-specified purposes that introduce rigidity into the system.

While Islam strongly encourages charity from the giver’s point of view, it seeks to minimize dependence on charity from the beneficiary’s point of view and restricts the benefits to flow to the poorest of poor and the destitute, who are not in a position to generate any income and wealth. 
A famous hadith not only underscores the above, but also demonstrates how to design and implement a strategy of poverty alleviation. The essence of the hadith is broken down into numbered statements so as to highlight the key principles and components of the strategy that follows from the hadith.

A man of the Ansar community came to the Prophet (peace be upon him) and begged from him.

(#1)
He (the Prophet) asked: Have you nothing in your house? He (the man) replied: Yes, a piece of cloth, which we wear, or which we spread (on the ground), and a wooden bowl from which we drink water.

(#2)
He (the Prophet) said: Bring them to me. He (the man) then brought these articles to him and he (the Prophet) took them in his hands and asked to the assembly of people: Who will buy these? A man said: I shall buy them for one dirham. He (the Prophet) asked twice or thrice: Who will offer more than one dirham? Another man said: I shall buy them for two dirhams.

(#3)
He (the Prophet) gave these to him and took the two dirhams and, giving them to the man of the Ansar, he said: Buy food with one of them and hand it to your family, and buy an axe and bring it to me.

(#4) He then brought it to him. The Prophet (peace be upon him) fixed a handle on it with his own hands

(#5)  and said: Go, gather firewood and sell it, and do not let me see you for a fortnight.

(#6)
The man went away and gathered firewood and sold it. When he had earned ten dirhams, he came to him and bought a garment with some of them and food with the others.

(#7)
The Prophet (peace be upon him) then said: This is better for you than that begging should come as a spot on your face on the Day of Judgment. Begging is right only for three people: one who is in grinding poverty, one who is seriously in debt, or one who is responsible for compensation and finds it difficult to pay.  (Sunan Abu Dawood, Kitab al-Zakah, Book 9, Number 1637)
The components of this hadith can be seen to emphasize the following fundamental conditions of a successful microfinance programme:

#1. Access of the poorest of the poor to the programme:
The Prophet (peace be upon him) was the spiritual as well as the political leader of the Muslims and he was accessible to the poor and the needy at all times for economic and financial assistance;

#2. Careful assessment of the financial health of the poor; enquiry blended with empathy; insistence on contribution and beneficiary stake:
Many failed MF programmes owe their failure to inadequate evaluation of the client’s financial condition. Provision of micro finance does not stand to reason for a person in need of social safety nets resulting in the funds being consumed away instead of being invested. The poor come in disparate categories with varying needs of consumption and productive investment and risk of delinquency and default. Microfinance programmes involving indiscriminate funding of the poor such as most government-managed ones are destined to fail.

This is one of the cornerstones of MF "best practices" that assert the government should have no role in direct or indirect provision of financial services and its role should be restricted to providing a supporting and enabling environment. Insistence on beneficiary stake is of course, a device to reduce moral hazard and enhance efficiency.

#3. Transformation of unproductive assets of the beneficiary into income-generating ones through rigorous valuation (on the basis of price discovery through auction method); Involvement of the larger community in the process:
Often the poor own high-market-value assets, such as, land in a prime city location without being able to derive income or benefit from the asset. While ownership of land does provide them with a bulwark against unforeseen adversities, this is an uneconomical and wasteful method of insurance. What is desirable here is a way to transform the unproductive asset into a productive one that could generate income. The original asset is not lost but transformed into an income-generating one.
The price at which the original asset is disposed of must be fair and should not take the form of a distress sale resulting in loss of value to the seller. Contemporary finance theorists find the auction system to be the most efficient process of discovery of the intrinsic worth or the fair price.
The involvement of the larger community in the poverty alleviation programme is also highly desirable for success of the programme. For many contemporary successful MFIs, the right strategy is to involve grass-root NGOs in the process.

#4. Meeting of basic needs on a priority basis and investment of the surplus in a productive asset:
Once again this highlights the need to take into account the consumption needs of the clients before expecting them to create wealth. The realization about the need for a social safety net and to link the same to micro finance at a later stage has come only recently in the MF industry.

#5. Direct involvement of the programme in capacity building in the run-up to income generation and technical assistance to the beneficiary; Commitment of top management of the programme:
This part of the hadith demonstrates a unique form of commitment and involvement on the part of the Prophet (peace be upon him) in the programme of poverty alleviation. The involvement could not be more direct and the commitment more pure.

#6. Technical assistance in the form of imparting requisite training to the beneficiary for carrying out the business plan/ income-generating project; monitoring through a time-bound schedule and impact assessment through a feed-back mechanism:
The need to establish an effective linkage between financial assistance and technical assistance is emphasized among MF professionals as never before. Also the importance of impact assessment can be hardly overemphasized.

#7. Transparent accounting of operational results and liberty to use part of income to meet higher needs.

In short, the Islamic approach to poverty alleviation is more inclusive than the conventional one. It provides for the basic conditions of sustainable and successful microfinance, blending wealth creation with empathy for the poorest of the poor. There are certain aspects of the Islamic approach that need added emphasis. One, transparency through meticulous accounting and proper documentation is a fundamental requirement of financial transactions in the Islamic framework. As the holy Quran asserts:

“O ye who believe! When you deal with each other, in transactions involving future obligations in a fixed period of time, reduce them to writing” and “Let a scribe write down faithfully as between the parties” (2:282)

The import and significance of this verse is often not fully understood. Indeed, lack of proper documentation and accounting by beneficiaries is a major challenge confronting microfinance. Proper accounting and accurate measurement of results of operations or profits is a pre-requisite for profit-sharing based mechanisms. They are no less important for lending operations. Indeed MF "best practices" emphasize on documentation and transparency as a fundamental requirement for success of any MF project.

Two, as discussed earlier, a common feature of successful microfinance experiments is group-based financing and mutual guarantee within the group. This is a highly desirable feature of Islamic societies. Mutual cooperation and solidarity is a norm central to Islamic ethics. The second verse of Surah Al Maida in the holy Quran says:

"Assist one another in the doing of good and righteousness. Assist not one another in sin and transgression, but keep your duty to Allah"  (5:2)
The following hadith by the Prophet (peace be upon him) reinforces this principle of cooperation and mutual assistance.
“Believers are to other believers like parts of a structure that tighten and reinforce each other." (Al-Bukhari and Muslim)
Our discussion so far, has excluded the issue of product design. Conventional MF products are interest-based. Islamic MF products must be free from interest and several other elements forbidden under Islamic law. Contemporary mainstream Islamic finance has expended considerable effort in developing Shariah-compliant products and services for deposit mobilization, financing, remittance etc. using Shariah-nominate contracts that are free from the forbidden elements. These products with minor modifications if required, can be used for MF as well. Islamic scholars strongly favour "free pricing" of these products and services as the same is a fundamental norm. It may be noted that MF "best practices" also argue against price ceilings, even though the justification provided may be quite different.

Based on the discussion above, one finds that the Islamic approach to poverty alleviation should involve several layers of intervention. All kinds of assistance should be preceded by enquiry and assessment of financial health of the client. A charity based intervention inherent in the institutions of zakat and sadaqa is recommended to take care of consumption needs of the extremely poor and the destitute and create a social safety net, notwithstanding the never-ending debate on the desirability of using zakah funds for investment and financing. The other institution of charity – the awqaf  is ideal for creation and preservation of assets that can build capacity and provide technical assistance for skill improvement and development of human resources. The social safety net and technical assistance may then be linked to financial assistance. The financial assistance should aim at wealth-creation using Shariah-compliant for-profit modes with free pricing. The entire process of course, would need to be completely transparent with proper documentation, accountability and responsibility with a time-bound schedule. Along the way, less or zero-productivity assets may need to be transformed into  more productive ones while ensuring minimal transaction costs. Provision of financing could involve formation of groups and be made in a graduated manner.

Before we conclude that the Islamic approach to MF and the MF "best practices" converge in many respects with the notable exception of product design, it is important to sound a note of caution. The above analysis is based on a rather tiny sample of ahadith. Therefore, care must be taken to avoid rigidly labeling the suggested approach as "the Islamic approach" to MF. The purpose of the present discussion is simply to demonstrate that there may not be any inherent conflict between the Islamic approach and much of the MF "best practices". At the same time, the religious and cultural sensitivities of the poor Muslim clients must be given due importance while designing financial products and services. This should be emphasized as an imperative for achieving the goal of poverty alleviation through enhanced financial inclusion in Muslim societies.

© Islamic Finance Today – Pioneer Publications (Pvt) Ltd

Early Origins

Takaful is not something new to the Islamic world. It has been going on for centuries, ever since the days of the Holy Prophet Muhammad (Peace Be Upon Him) and the early Caliphs. We know that in those days there were ships and trade caravans and they used to be exposed to the same risks that we face today. Ships could be sunk, caravans could be raided or catch fire etc. Given these dangers to trading activity, the early pioneers of Takaful were wise enough to formulate a system of mutual protection so that the members of a particular caravan or trade delegation could be assured of recovery in case they suffered a loss due to unavoidable circumstances. Thus the members of these trading enterprises would enter into a formal pact stipulating that in case of loss to one party, the others would contribute to make up that loss.

The only essential difference between Takaful at that time and Takaful today is that whereas they used to pay only after the loss, we today charge a considerate amount of what is known as a contribution before the loss, and at the end of the year after all the claims have been settled, it is returned back to the participants.

This early practice of Takaful or mutual indemnification even found expression in the first Constitution of Medina (Mithaq al-Madina) in the days of the Prophet and was the second system that was formally institutionalized by the Caliph Umar, the first being the Baitul Mal or Public Treasury. These developments at the state level meant that Takaful came to be formalized into a more secure system, with more accountability and more checks and balances. During this period, a number of Takaful products were evolved based not only around diya or blood money, but also dawaniya which was a sort of professional indemnity to governors and state functionaries.

Thus the system of Takaful became an integral part of trade and commerce in those days and this situation continued for several centuries upto the end of the First World War. The fall of the Ottoman Caliphate shortly thereafter meant that Takaful, along with the other state institutions that had safeguarded Muslim interests fell on bad times. While Takaful receded to the background, conventional insurance imposed by the western colonial powers took its place, and this continued for several decades. It was only in the 1970s with the revival of Islamic banking modes in the Middle East that modern-day Takaful also developed. The first Takaful company was set up in Sudan in 1979 which was almost simultaneously followed by another set up in Bahrain. The rapid growth of Takaful ever since, even in the non-Muslim world, only goes on to prove that it has withstood the test of time and is a viable alternative to conventional insurance.

Definition of Takaful

The word Takaful is derived from the Arabic root word kafala ‘mutual guarantee or protection’ and this drives home the basic difference between Takaful and Conventional Insurance. This difference is two-fold. One is the difference in concept and the other is the difference in contract.

The conceptual difference is that conventional insurance by its very definition is a risk-transfer mechanism. Takaful on the other hand does not entail risk transfer, but rather the socially more responsible task of risk-sharing. As for the contractual difference, if one looks at any insurance policy, it is a contract because it fulfils the ingredients of a contract and there exist two parties to the contract. There is an insurable interest involved and there is a consideration by way of premium. Therefore it is a contract of sale. In consideration of premium, the risk is transferred to the insurance company and in case of loss the insurance company pays cash in compensation for such loss the value of the item concerned. It is also a contract of exchange where money is exchanged for money.

Takaful on the other hand is not a risk transfer mechanism. The contract of Takaful is not a contract of sale or of exchange, but is rather a membership contract. One pays a contribution to become a member of a common pool and by virtue of becoming a member of that fund such a person is entitled to certain benefits under the rules of that fund. By this means Takaful distributes risks and losses to a larger number of participants which could mitigate the otherwise very damaging losses if borne individually. When we compare these two forms of insurance, conventional insurance and Takaful, we would soon come to realize why one is prohibited and the other permitted. In Islam, money for money exchange is prohibited because there is an element of direct interest that comes into play since there is always a lesser or greater amount on one side of the balance sheet.

Thus if you were to pay a premium of 10 Euros and get a claim for 10,000 Euros, you are getting far more than you have given and in the same currency that you exchange. So it is an exchange of the same species and it is getting more than what you have given. Hence it is direct Riba. There is also indirect riba in case of investments where conventional players can invest in riba-bearing instruments, while Takaful companies can only invest in Shari’ah-compliant, non-interest-bearing instruments. However, it must be stressed that investment is not the core business of an insurance company. It is a side business. The main core businesses are risk management, underwriting, claims handling etc.

Besides, there is an element of maisir or gambling in conventional insurance. This is because the insured would lose the money paid for the premium when the event which has been insured against does not occur and because the company would suffer a deficit if the claims happen to be higher than the premium paid. Since the gain of one party here is contingent upon the loss of the other or vice versa, it is, to put it in simple terms, gambling, and hence prohibited. As Lord Mansfield observed in Carter v.Boehm – 1766): “Insurance is a contract upon speculation. Good faith forbids either party from concealing what he privately knows, to draw the other into a bargain, from his ignorance of that fact, and his believing to the contrary”. In the case of Takaful, however, there is no such conflict of interests as it is a common fund. If you draw out of it by way of benefit in the case of a claim, it is drawing out of a fund of which you are a member and to which you have contributed.

What commercially differentiates Takaful from conventional insurance and makes it commercially more viable even to non-Muslims is the fact that there is also the surplus element at the end of the year in the case of Takaful. The remaining money after all claims have been met do not belong to the shareholders, but rather to the participants and therefore has to be given back. In the case of conventional insurance, this concept is lacking. Thus Takaful is more participatory and all concerned could benefit from this equitable arrangement.

Justification for Takaful

As Muslims we believe that one’s destiny is ordained by Allah. At the same time we are told by the Almighty in the Qur’an laysa lil insani illa ma sa ‘aa (Man can have nothing but what he strives for). Thus God ordains that we strive to safeguard our interests. There is also a tradition that once an Arab bedouin proceeded to a tent along with the Prophet leaving his camel untied. When the Prophet asked him why he did so, he replied “I place my trust in Allah” whereupon the Prophet immediately admonished him “Tie your camel first, then place your trust in Allah”. Thus there are precautions we have to take while placing our trust in Allah. For instance, we lock our cars while parked and shut our doors and windows when going out. One could even find a tradition to justify life insurance. According to a hadith related by Anas bin Malik, the Prophet is reported to have said : It is better for you to die leaving your offspring wealthy rather than leaving them poor, asking for help from others”. This shows that to make provision for our offspring even in our absence is a responsibility we should bear. Today’s Shari’ah scholars are unanimous in declaring that there is nothing unislamic in Takaful, be it general or life.

Takaful Models

There are basically three different types of Takaful models, namely, the Mudaraba model, the Wakala model and the Wakala-Waqf model. The Mudaraba model is based on Mudaraba, an Islamic mode of equity partnership and is basically a risk-sharing mechanism where the surplus is shared between the Takaful company and the participants in a predetermined manner. The sharing of such surplus and the profit so generated may be in a ratio of 5:5, 6:4 etc as mutually agreed between the contracting parties. Generally these risk-sharing arrangements allow the Takaful operator to share in the underwriting results from operations as well as the favourable performance returns on invested premiums. This model started off in Malaysia, the reason being that in Malaysia they started with Life Takaful and the Mudaraba model was more appropriate for life investments. This same model was continued when they entered general Takaful.

Meanwhile, the scholars in the Middle East formulated the Wakala or Agency model which is still the predominant form of Takaful in that part of the world. The Wakala model is a fee-based mechanism where the Takaful operator is only entitled to take out a fee upfront as the contribution, though it may also charge a fund management fee and performance incentive fee. Unlike in the Mudaraba model, it is not entitled to any part of the surplus, all of which belongs to the participants. It does not participate or share in any underwriting results as these belong to the participants as surplus or deficit.

In Pakistan, one benefit of being a late starter is that its scholars have been able to have a close look at both models and have refined these further to constitute what is known as the Wakala-Waqf model. The scholars who formulated this model felt that there should be a separate legal entity on whose behalf the Takaful operator should act as an agent (Wakil) and were inspired by the Islamic institution of Waqf or Perpetual Endowment to serve the purpose.

The Waqf is created by the shareholders of the Takaful company who would put in the seed money. Such seed money must remain as Waqf and cannot be used for claims, though it could be utilized for investments. The contributions received would also be a part of this fund and the combined amount would be used for investment, with the profits so earned being deposited into the same fund. Losses to the participants are paid by the company from the same fund while operational expenses incurred for providing the service are also met from it. Here, both the Takaful operator and the participants share a relationship through the Waqf. Since the Takaful operator will manage the enterprise on behalf of the Waqf it is entitled to a Wakala or agency fee. The participants are also governed by the Waqf rules, so that whatever claims they have, they get by virtue of being a member of that Waqf.

Although these various models are peculiar to certain countries or regions due to the historical developments we have outlined above, we also see some significant shifts of late. For instance, in Malaysia, a new player, Takaful Ikhlas works on the Wakala model, showing that they are flexible and are moving from a Mudaraba-based to Wakala model as they find it is more viable, and there is no reason why they would not be able to effect further refinements to this model as the Pakistani experience has shown.

New Developments

Many are the developments that are taking place in the Takaful industry worldwide. For instance, we have BancaTakaful which is somewhat similar to bank insurance where banks and insurance companies synergise, with banks selling insurance products over their counters and insurance companies tailoring their products to blend with banking products such as investment instruments.

In similar fashion, Takaful companies tailor their products to blend with banks’ modes of financing like in the case of Takaful Pakistan which has taken the initiative in providing coverage to banks to cover their Murabaha contracts. This is because in Murabaha which is a much practiced mode of personal financing involving cost plus mark-up, there is an exposure to risk since the property would belong to the bank before it is transferred to the client and if any loss takes place before such transfer it is at the expense of the bank concerned.

Other recent developments include Micro Takaful for crops which covers those entering into Salam contracts for financing crops and Istisna contracts for SMEs. Micro-Takaful could also be tailored to suit the needs of the underprivileged sections of society including blue collar workers in the urban areas, especially in the area of heath and education. Takaful firms could also tie up with banks operating in the rural sector, providing cover not only for the micro credit offered by them, but also for the underlying assets. Recent times have also seen the emergence of Retakaful as a viable and Shari’ah-compliant alternative to Reinsurance. Just as much as Reinsurance allows insurance companies to achieve greater capacity and balance by the geographical spread of risk, so do Retakaful companies in similar manner. A few years ago, there existed only a handful of Retakaful firms and hardly one or two of them were rated. Thus they could provide only a very limited capacity, prompting the Shari’ah scholars of the day to permit Takaful firms to resort to conventional reinsurers as a provisional measure.

Today however most of the leading reinsurance companies like Munich Re, Hanover Re and Swiss Re have set up Retakaful facilities. The renowned German Reinsurers Munich Re and Hanover Re have set up Retakaful offices in Kuala Lumpur and Bahrain respectively while the well known Japanese Reinsurers Mitsui Sumitomo and Tokyo Marine have set up theirs in Singapore. Thus it is no exaggeration if we say that Takaful has today come of age.

Present State of Takaful

Takaful has ever since its modern-day introduction caught on in many countries and not just in the Middle East or South East Asia. Among the latest entrants are Russia and South Africa. Russia set up its first Takaful company in 2005 spearheaded by Renet Bekkin while 2006 saw South Africa’s first Takaful company being formed based on the Wakala-Waqf model. More recently we saw the emergence of Salaam Halal, Britain’s first independent Takaful operator. In Sri Lanka we would find that Amana Takaful has taken the initiative in introducing many a Takaful product to the market. What is particularly remarkable is that as much as 35 percent of the firm’s clientele are non-Muslims. Indeed it is a remarkable fact that during the first five years of its existence the firm showed triple digit growth which is a record and they have continued to demonstrate commercial viability by distributing a surplus to their shareholders.

Today there are around 150 Takaful companies operating in over 40 countries and their average growth rate which is around 25 percent is higher than that of conventional insurance companies.

© Islamic Finance Today – Pioneer Publications (Pvt) Ltd

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

The global Islamic financial sector has witnessed an encouraging growth over the last decade and is currently estimated to be at around US$1trillion. It is predicted to be the world’s fastest-growing financial sector for the coming years with an estimated global potential of US$4trillion. Sukuks have turned out to be an important driver to raise finance under the Islamic mode of financing. In today’s business practice, the term Sukuk means a claim similar to that represented by a trust certificate. In essence, the Sukuk is a financial instrument that sits above a Shari’ah-compliant underlying structure which generates an income for the holder of the instrument. Islamic finance has many qualities that could lend themselves to securitization as a means of raising funds. Shari’ah compliant tools must have asset-driven returns for example, which is a notable feature of securitization.

Sukuk structures

There are many structures that can generate the revenue paid to Sukuk holders. Most of the Sukuk issuances to date have been wholly asset-based rather than asset-backed. In an asset-based Sukuk, the Sukuk holders rely for payment on the company seeking to raise finance (the originator), in the same way as they would under a corporate bond issue. In an asset-backed Sukuk, the Sukuk holders rely on the assets of the Sukuk for security. The issuance of convertible and exchangeable Sukuks are more recent developments. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is mainly responsible for formulating and implementing international Islamic finance standards in the market. There are about 14 different types of Sukuk described as permissible in the AAOIFI Shari’ah standards on Sukuk. Currently the AAOIFI, based in Bahrain, has issued 68 standards and is supported by more than 160 institutional members.

In terms of the types of Sukuks issued, Sukuk al Ijara was the most popular amongst corporate and governments wanting to raise funds in the Islamic debt markets. Sukuk al Ijara issues contributed 43.6% of total issues, followed by Sukuk al Musharaka at 27.5%, and then Sukuk al Mudaraba at 1 .4%. Some of the popular types of Sukuks discussed here include Sukuk al Murabaha, Sukuk al Ijara, and Sukuk al Musharaka.

Sukuk al Murabaha: This is a process of direct structuring of securities wherein a Special Purpose Vehicle (SPV) invests the funds raised through the sale of Sukuk in Murabaha operations. The company purchases the asset from the SPV on a Murabaha basis, and the future periodic installments paid by the company to the SPV account for the repayment of the cost and the profit component. 

Sukuk al Ijara: The company seeking to raise finance through the issuance of Sukuk al Ijara (the originator) sells certain assets to the issuer. The issuer, then, pays for the assets using the proceeds of the Sukuk issuance and holds title to the assets on trust for the Sukuk holders. The issuer leases the assets back to the originator for a fixed period of time and for a rent. At maturity, the originator may have the right to purchase the assets back from the issuer at a price which would represent the redemption value for the Sukuk holders at maturity.

Sukuk al Musharaka: Several corporate entities refer to these Sukuk as Musharaka Term Finance Certificates (MTFCs). Under the Sukuk al Musharaka, the Sukuk holders contribute a capital amount to the issuer. The issuer then enters into a joint venture with the party seeking finance (the originator) where the issuer provides the capital received from the Sukuk holders, and the originator supplies the assets and/or their own capital required for the business to function.

The profits from the Musharaka business are distributed to the issuer and the originator at a predetermined basis. Any losses are shared in proportion to the capital contribution, and the issuer pays a periodic distribution amount to the Sukuk holders from the Musharaka profit distribution.

Sukuk gaining new heights

The increase in demand, along with the standardization of Islamic financial instruments, is expected to fuel the growth of the Sukuk market. According to Moody’s, the Sukuk market would hit US$200bn by 2010 and is predicted to grow by up to 35% during 2008. UAE and Malaysia continue to remain the most active markets for Sukuk. As per Zawya report, Gulf States raised US$18.7bn or 55% of the total US$33.4bn Sukuk issued world-wide in 2007. With the Sukuks constituting more than 40% of all bonds issued in Malaysia, the country has fast developed its market name in the Islamic world. In Malaysia, Sukuk bonds had surpassed conventional bonds for three years running with an annual turnover of above US$15bn. Growing wealth in the Middle East is increasingly demanding Shari’ah-compliant products in the Middle East and Asian regions. Such opportunities will also provide investors a chance to diversify their investments rather than being concentrated in the developed countries only.

It is estimated that investors from the GCC and Asia Pacific regions currently hold US$267bn in Shari’ah-compliant assets. The rising demand for Islamic financial products has led the financial managers to increasingly look into innovative structuring of Shari’ah-compliant financial products that will better fulfill the needs of clients. The prospects of Gulf-based pension funds and insurance industry looking at investments in Sukuks as part of their investment strategy could provide an invaluable impetus to the development of the Islamic finance industry. Indeed, the Sukuk market is the fastest emerging form of Islamic finance, estimated to be increasing at an annual average rate of 40% spurred by the high levels of surplus savings and reserves in the Middle East and Asia.

According to the London-based Trowers and Hamlins, despite an increase in return from US bonds, Western investors have become even more interested in investing in Gulf Sukuk because of their strong real value and low risk. It said the issuance of corporate Sukuk in the region, which controls more than 45% of the world’s recoverable oil resources, has jumped by nearly 20-fold over the past five years because of strong appetites for such tools.By mid-2008 the firms in the GCC have raised US$6.2bn (or 61%) in 22 issues of the total Sukuk. It is expected that the Sukuk issuance in the UAE could cross the US$9bn mark during the year. According to the available data from DIFC, the total value of Sukuks is estimated at around US$88bn, while US$13bn worth is listed on the Dubai International Financial Exchange (DIFX). Although as per S&P report the total Sukuk issuance stood at US$14bn in the eight months ending Aug. 31, down from US$23bn in the same period in 2007, the analyst still expected that the Sukuk issuance will reach US$20-25bn in 2008 given the good pipeline.

With the development of secondary markets, Sukuk offerings are appearing on specialized exchanges such as the DIFX, the Labuan Exchange in Malaysia, and the Kuwait Stock Exchange has also shown interest by setting up a market for conventional and Islamic bonds. According to a study done for the International Monetary Fund (IMF), a strong demand from Muslim countries and conventional global institutions for Shari’ah-principled bonds would boost the potential for Sukuk despite the global credit crises. However, it stated that some critical constraints relating to continued legal uncertainty and regulatory divergences ought to be addressed.

Many corporate issues—particularly large ones—are quasi-sovereign and as such are seen to benefit from an implicit sovereign guarantee. Thus, although these issues may be linked to an underlying asset, investor appetite is driven primarily by the sovereign nature of the risk. It also helps to explain successful large scale placements that have been made in recent years, including two Dubai-based issues of US$3.5bn in 2006. Currently, the top originators are the Nakheel, PCFC, Aldar Properties, and DP World from UAE, SABIC from the Kingdom of Saudi Arabia, and Nucleus from Malaysia. Together they represent about 31% of total world Sukuk issues. The majority of the Sukuks carry good ratings as per the global rating agencies like Moody’s, S&P, and Fitch. The DP World second Sukuk with an issue size of US$1.5bn carried ratings of A1 by Moody’s and A+ by S&P; DIFC Sukuk with an issue of US$1.25bn had ratings of A1 by Moody’s and A+ by S&P; Aldar Properties Sukuk II with an issue size of US$3.75bn carried ratings of A3 by Moody’s and A- by S&P; and DEWA Sukuk with an issue size of US$3.2bn carried ratings of A1 by Moody’s and AA- by Fitch.

Shari’ah Compliance Risk

Besides other risks related to financial products and services, Islamic financial products carry a specific risk termed Shari’ah compliance risk (broadly abiding to Shari’ah laws). Specifically, the risk refers to the loss of asset value as a result of the issuers’ breach of its fiduciary responsibilities with respect to compliance with Shari’ah. There could be several such instances of wilful or innocent breaches. The dissolution clauses of the Sukuk prospectus define events that will make the Sukuk deed null and void due to Shari’ah non-compliance. For example, if the Sukuk is based on a hybrid of Ijara and Istisna’ assets, Ijara must always be more than Istisna’ in the pool, otherwise the Sukuk deed will dissolve. Thus broadly speaking, Shari’ah compliance risk must be defined as a rate of return foregone in comparison to the market rates, as a result of complying with the Shari’ah. The issue hence is that of competitiveness and survival in capital markets as a Shari’ah compliant asset class. A recent controversy that has raised concern in the international markets for the growth of the Sukuk market has been following the news that a group of Islamic scholars decreed that most bonds were not Shari’ah-compliant.

Increasing popularity among non-Muslims

Sukuk offerings, while still concentrated in the Gulf States and Malaysia, are rapidly growing businesses with involvement by private companies, state enterprises, sovereign governments, Islamic financial institutions, and also non-Muslim international institutions. The increasing interest of non-Muslim participants in Islamic Shari’ah-compliant financial system, further promotes the growth of such facilities.

The World Bank issued its first local-currency dominated Malaysian Ringgits 760mn (around US$200mn) Sukuk in 2005. A noteworthy and pioneering sovereign Sukuk offering was carried out by the provincial government of Saxony Anhalt in Germany. The German Sukuk raised €100mn from both Middle Eastern and European investors. Gordon Brown from the United Kingdom, is said to have remarked on making London the ‘gateway’ for Islamic finance in Europe.  The demand for Islamic financial investment structures continues, particularly related to the property sector. In a global first, the Singapore listed Cambridge Industrial Trust is being transformed into an Islamic property trust. The National Australia Bank has also shown interest to invest US$35mn for a stake in one of the world’s first listed industrial property trusts according to Shari’ah law. It will be the first publicly listed Shari’ah-compliant Real Estate Investment Trust (REIT) in Singapore.

Hong Kong is among the latest to announce its incursion into Islamic finance and plans to send missions to Kuwait, Saudi Arabia and United Arab Emirates to more closely work on such projects. It is also been reported that the Hong Kong Airport Authority is considering a Sukuk issuance. In Japan, the Financial Services Authority has proposed an amendment to the banking law that will allow Japanese banks to offer Islamic finance products through a subsidiary. Globally, it is during the last decade that multinational financial institutions like Deutsche Bank, Citigroup, Barclays, and HSBC have also entered the sector.

Going forward, we expect Islamic finance instruments especially Sukuk to maintain its growth trajectory. However, as the industry grows, more transparency and uniformity (as per the compliance to Shari’ah rules) is required in the Islamic financial products. With the increasing number of international financial institutions participating in the Islamic finance industry, the product and service innovation will benefit both corporates and consumers. Such ventures will not only benefit the development of the Islamic financial system but will also enable the major world economies to tap capital from the oil-rich Muslim states.

© Islamic Finance Today – Pioneer Publications (Pvt) Ltd

All the available indicators point out to Malaysia as a pioneer in the structuring of Sukuks. Today, however, very many English Magic Circle firms such as Baker Mckenzie LLP, Clifford Chance LLP, Denton Wilde Sapte LLP, Norton Rose LLP  and others practicing in the Middle East are heavily involved in structuring Shari’ah compliant,  innovative, multi-million dollar Sukuk variants for the benefit of their clients. Baker & Mckenzie LLP for instance was involved in structuring the $ 800 million debut Sukuk launched by Saudi Arabian petrochemical giant Saudi Basic Industries Corporation (SABIC) in 2006 and it’s subsequent $ 2.1 billion  Sukuk.

This Islamic financial instrument is not confined to Middle Eastern countries and has expanded beyond the borders of the Islamic world. In 2004, the Provincial Government of Saxony – Anhalt in Germany issued the first Sukuk by a Western Government to raise 100 million Euros from investors in Europe and the Middle East. It is a growing investment option in the UK and across the Atlantic in the USA. The first Sukuk to be issued in the USA was reported in 2006. The emergence of Sukuks in Japan, Singapore, Germany and other European Union countries speaks volumes of the success of this equity instrument among investors.

Why is Sukuk emerging at such a rapid pace ? Perhaps one reason is that this tool provides an investment opportunity for the highly liquid investors in oil rich Middle Eastern markets to earn a return in accordance with their religious principles. From the perspective of other non – Islamic countries, Sukuk provides an opportunity to benefit from an untapped resource – Liquidity in the Islamic world. The following words of Mr.Edwin E. Hitti, President of Hong Kong’s Arab Chamber of Commerce and Industry demonstrates the enthusiasm to promote Hong Kong as a Sukuk hub and the desire to attract the high liquidity of the Middle East to Hong Kong.

“Hong Kong is late in coming to the game, but it’s just a matter of the legal system being put in place to accommodate the Islamic Product”. It is high time countries like Sri Lanka too entered the fray and competed for the attraction of foreign funds into their economies by eliminating the regulatory and tax impediments for the flourishing of Sukuk in their capital market. A Sovereign Sukuk is an alternative for Governments to raise funds as opposed to the much talked about US$ 500 million debut international bond issued for instance by the Central Bank of Sri Lanka recently. 

A challenge to the policy makers ! Would they have the vision to grab this golden opportunity or opt to dwell in the land of ignorance ? The requisite tax and regulative changes would introduce certainty in the minds of investors and pave the way for the smooth development of the Sukuk market in Sri Lanka. 

Different types of Sukuks

What is a Sukuk ? For readers who are not familiar with the instrument, it is a form of an asset-backed security in compliance with the Shari’ah. In short, it is an equity instrument as opposed to most of the common interest bearing debt securities available in the market and therein lies the attraction of a Sukuk to devout followers Islam. An investor in a Sukuk participates in the risk and in the reward. Thus the return to the investor is not in the form of interest, which is considered haram.

The Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI) defines a Sukuk as “Certificates of equal value representing after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity”.

Sukuk does not refer to a uniform structure and there are many variants based on different types of Islamic modes of financing used in structuring; Sukuk Al Ijara,  Musharaka Sukuk, Mudaraba Sukuk, Murabaha Sukuk etc.

All these bear a common characteristic; A Special Purpose Vehicle (SPV) issues Sukuk certificates to the investors to raise funds and the coupon payments to the investors are sourced by a cash flow stemming from another Islamic financial instrument such as Ijara, Musharaka, Mudaraba or Murabaha as the case may be. Perhaps Sukuk Al Ijara is the most common variant in practice and is described below.    

Sukuk Al Ijara

Sukuk Al Ijara is known for its simplicity. 

The owner of a physical asset (e.g. a building) who is in need of liquidity creates a SPV and sells the building to the SPV for immediate cash and enters into an Ijara arrangement with the SPV for payment of Ijara rentals in the future. The transfer of the title of the building and the risk and rewards associated with ownership results in the asset ceasing to exist in the balance sheet of the originator or the original owner of the building

The SPV sources the funds for the purchase of the building by issuance of Sukuk Al Ijara certificates to the investors. Unlike security certificates issued in a conventional securitization, Sukuk Al Ijara certificates are not debt instruments . The investors receive pro rata ownership of the building acquired by the SPV and shares in the rental income also on the same basis.

The investors share in the profit or losses derived from the success or failure of the underlying asset. It’s an undivided beneficial ownership of real property that is reflected by a Sukuk certificate. On the occurrence of a dissolution event or at maturity the physical asset is sold to the original owner by the SPV. Ijara Sukuk certificates could be traded in a secondary market as these are negotiable at par, premium or discounts without violating any applicable Shari’ah rules. 

The USD 1 billion Sukuk issued by the Dubai Civil Aviation (DCA) is an example based on the Ijara – based model. Assets including land and building belonging to the Dubai International  Airport were transferred for consideration to an SPV incorporated in the Dubai Airport Free Zone  and in turn the SPV leased the assets through an Ijara to the DCA and the Government of Dubai. A separate service agreement was executed in order for the DCA to act as the agent to maintain and insure the assets.

Readers familiar with the three types of conventional securitizations i.e. Pass through, Pay through and Asset backed (AB), would appreciate that Sukuk Al Ijara somewhat resembles the pass through structure. In both scenarios the asset ceases to exist in the balance sheet of the originator as the risk and rewards associated with ownership transfers to the SPV. However in Sukuk Al Ijara, it is a physical asset that becomes the subject matter of the transfer as opposed to a debt or a financial claim.  
 
To say the least this prima facie simplicity perhaps is misleading. Sukuk Al Ijara structure could span across multiple jurisdictions. Structuring of this Sukuk variant across multiple jurisdictions by locating the SPV in a country different to that of the originator and issuance of Sukuks certificates to investors in a third country or investors from various countries would warrant the analysis of tax, accounting and regulatory status in each country. A daunting and fascinating task for the consultants involved indeed !

The true sale of assets to a SPV may experience obstacles in jurisdictions where regulations impose limitations on foreign ownership of assets and / or levy high ownership transfer taxes. E.g. the 100%  transfer tax applicable on transfer of immovable property to  non citizens in Sri Lanka.

Tax issues

Sukuks are exposed to major direct and indirect tax hurdles in many jurisdictions. Realizing the importance of developing Sukuk markets in their respective jurisdictions, many countries have enacted  tax legislations to facilitate and provide reliefs for Sukuk structures. One such notable jurisdiction is the UK, where legal form prevails and is considered sacred in the determination of tax ramifications as opposed to the substance of the transaction.

The range of tax exposures of Sukuks includes the classification of the nature of payments to Sukuk holders as dividends, interest or principal and the applicability of withholding taxes on these payments. There may be issues even as to the nature of the transactions, i.e. whether it is an equity investment, loan or a sale of asset depending on the associated legal documents.
 
A comparison of the tax efficiency of raising funds via Sukuks as opposed to conventional debt instruments reveal that in the absence of Sukuk – specific tax legislation, the latter may be at a disadvantage as interest paid on debt instruments are eligible for tax relief. In many jurisdictions cash flows received by the SPV by way of Ijara rentals or a cash flow bearing any other character such as distributions out of Mudaraba would be exposed to income tax. On the other hand payments made by it to the Sukuk holders would not qualify for tax deductions as they are not in the nature of interests. In case of a Sukuk Al Ijara the payment to the investors represent their fractional entitlement to the rent and in Mudaraba Sukuk the payment is the investors’ fractional entitlement of the income from Mudaraba.

Where the structure spans across the territorial borders of different jurisdictions, analysis of Treaties for relief from Double Taxation would inevitably be a part of the process. Are cross border payments to investors to be governed by the Article applicable to dividends, interest or business profits while the cross border cash flows may be exposed to withholding tax laws. In addition, these payments would also have to comply with the respective Exchange Control Regulations. 

Do investors create a permanent establishment in the other jurisdiction by virtue of pro rata holding of beneficial ownership in underlying assets transferred by the originator to the SPV ? The Sukuk – holders in another territory receive their fractional entitlement of revenue from these assets by virtue of the certificate ! Another complicated issue that warrants the attention of a tax consultant. 

As mentioned previously a Sukuk certificate provides the holder a proportionate beneficial ownership of assets. This may expose a Sukuk holder trading in Sukuk certificates into many uncertainties. A person trading in Sukuk is essentially engaged in buying & selling fractional ownership in interest in assets. Would the Sukuk trader be liable for the whole gamut of taxes associated with transfer of property viz, income tax, VAT, stamp duty, transfer tax etc ? 
 
Tax reforms
 
The Malaysian legislature perhaps has taken the lead in the  introduction of Sukuk specific legislation among Asian countries. Policy makers in UK who manifested their “Islamic finance friendly” approach by the introduction of tax reforms through Finance Acts 2005 & 2006 continue to demonstrate their commitment for the elimination of tax bars for this alternate mode of financing. Tax reforms such as Alternate Finance Investment Bond (AFIB) in UK introduced by Finance Act of 2007 and the expansion of Qualifying Debt Securities (QDS) Scheme in Singapore to cover “Islamic Debt Securities” create a conducive environment for the development of Sukuk hubs.

UK

The Finance Act of 2007 in UK has paved the way for tax relief for payments to the investors by treating it as tax deductible interest. Structures resembling Sukuks (subject to certain rules) are termed as Alternate Financial Investment Bonds (AFIB) and from the perspective of the issuer, is considered to establish a loan relationship for tax purposes.

The recent UK legislation has also successfully resolved the uncertainties that prevailed in trading of Sukuks by deeming Sukuks as “securities” for tax purposes and elimination of VAT and stamp duty on transfer of certificates.

Malaysia

Malaysia, a Sukuk hub in Asia seems to have addressed most of the tax hurdles within the tax framework. Stamp duty has been exempted for Sukuk issuance through Malaysia. It also provides an exemption for profits received by resident investors from foreign currency denominated Sukuk issued in Malaysia. Malaysian law also provides for profits derived by a non resident from foreign currency denominated Sukuks issued in Malaysia to be free from withholding tax. 

Sri Lanka

How would Sukuks sit on the fascinating web of taxes in Sri Lanka ? The Author does not intend to engage in an analysis of the tax ramifications in totality but to point out only the obvious.  Similar to many other jurisdictions, the statute book in Sri Lanka does not contain much securitization specific legislation, though a draft of a legislation is in place.

Whilst promoting securitization specific legislation, it is paramount that the process ensures that a Special Purpose Vehicle is not subjected to income tax. Unlike in a securitization, payments made by the SPV to the investors do not qualify for tax relief as they are not in the nature of interest and the levying of income tax on SPV could result in eroding  the  economies of a Sukuk structure.  The possible exposure of the cash flows received by the SPV from Islamic financing technique used (Ijara rentals etc;) to Economic Service Charge, (Sri Lanka’s equivalent of Alternate Minimum Tax in other jurisdictions) is intrinsically  linked to the right of the SPV to claim capital allowances on the  assets transferred to it. The proposition that SPV is engaged in a business is mandatory for the application of the charge as well as the right to claim the tax relief.

The transfer of the title in the above example from the originator to the SPV initially and back to the originator at the end of the term would expose the transaction for dual stamp duty liability in jurisdictions where stamp duty is levied on transfer of immovable property such as Sri Lanka. Thus one critical tax reform that should be introduced to facilitate Sukuk in Sri Lanka is an exception of stamp duty via an amendment to Provincial Council Finance Statutes that levy stamp duty on transfers of immovable property to and from the Originator and SPV. Applicability of VAT on these transfers would also warrant attention, especially in the context where  the Sri Lankan VAT statute contains many restrictions on claiming of input tax including a ceiling on allowable input tax to 85% of output tax. A 100% Transfer tax on acquisition of ownership of immovable property by foreigners could also pose a burden on Sukuk mechanisms where immovable property is involved.

Conclusion

An instrument used to impart liquidity, Sukuks, sometimes referred to as ‘Islamic Bonds’, are used for long term and mid term funding requirements of financial institutions, blue chip corporates and Governments. Whilst capital markets across the globe have accepted this Shari’ah compliant instrument as a viable alternative to bonds and syndicated loans, issuers must take cognizance of likely tax consequences in the applicable jurisdictions.

Sukuks enjoy, perhaps, level playing fields with their conventional counterpart bonds in jurisdictions such as Malaysia, Singapore, United Kingdom and other countries due to the positive responses by the policy makers by way of the requisite reforms to their respective tax systems. The eagerness of these countries to develop Islamic financing and establish ‘Sukuk hubs’ in their respective jurisdictions to attract liquid petrodollars in the Islamic world perhaps is an indicator for the policy makers in jurisdictions where Sukuks & other Islamic instruments are still in an embryonic stage to get their act together.

© Islamic Finance Today – Pioneer Publications (Pvt) Ltd

Sukuk could be said to have evolved due to the needs of Islamic Banks and Financial institutions to diversify their investments and for meeting their immediate liquidity requirements. The evolution of Sukuk and its phenomenal growth over the past few years as a secondary market tool could be said to have been facilitated by the fact that it is based on real assets and that it could be bought and sold.

Sukuk is an Arabic term and is the plural of sakk which means ‘a certificate’ This mode of financing involves the securitization of a tangible asset so that investors could share in its profits and risks for which purpose a certificate vesting ownership in such investors is issued. This would entitle investors to a portion of the income in proportion to their investment. Although often termed ‘Islamic bonds’ Sukuk differs from a conventional bond in that there should be a true sale where the asset that has been sold should not remain in the books of the seller and should be transferred to the purchaser.

Sukuk is of various types and includes Ijarah-based Sukuk, Istisna-based Sukuk, Salam-based Sukuk, Mudarabah-based Sukuk and Musharaka-based Sukuk. The most popular form of Sukuk is by far sukuk based on Ijarah (Islamic Leasing) due to its flexibility and the lower risk it entails since the asset is already in existence and the income more or less guaranteed from the leased assets, making it easier to convince investors that they will get some good returns from it. There are basically two types of Ijarah-based sukuk, namely, that which is based on the ownership of the underlying asset ( ijarah ayan) or that which is based on the sale of its usufruct (ijarah manafi).

In ijarah manafi certificates are issued for the ownership of the usage of the asset and not the underlying asset itself. The returns from this type of investment come by way of the rent paid by the lessee which is distributed among the investors in proportion to their investment. In ijarah ayan, certificates are issued to investors conferring ownership of the underlying asset itself. Sovereign sukuks issued by states are normally of this type and comprise of the sale of public-related property such as airports, hospitals and schools to private investors.

Although there is unanimity as to the permissibility of sukuk by the Shari’ah scholars specializing in Islamic Banking & Finance, a controversy recently arose as to its permissibility following a highly sensationalized interview with a prominent Shari’ah scholar Mufti Taqi Usmani where he is reported to have stated that as much as 85 percent of the sukuks currently available in the market do not comply with Shari’ah requirements. All indications however are that he was misquoted and his statements taken out of context. In fact Mufti Usmani recently clarified his position at the Annual Shari’ah Conference organized by AAOIFI held in Bahrain from the 27th-28th May where he explained that he was referring to an undertaking in a Mudarabah or Musharakah-based sukuk where it is not allowed for any party to guarantee the performance of the sukuk.

According to Dr.Burhan Arbouna, Head of Shari’ah Compliance, UIB and a well known scholar on Islamic Finance what often happens in Mudarabah- and Musharaka-based Sukuks is that there is some sort of undertaking to repurchase the asset in question at the nominal value which creates a Shari’ah compliance issue.  He contends that in these types of transactions, if there is an undertaking to purchase depreciated assets at the nominal value rather than the market value of these assets where depreciation would inevitably be taken into consideration, it becomes a sort of riba-based guarantee which is prohibited in Islam. However this does not mean that all Mudarabah- and Musharakah-based Sukuks are non-Shari’ah –compliant. What is necessary is that these should avoid undertaking to repurchase the assets at nominal value though an undertaking could be given to repurchase at market value.

Sukuks are today a leading instrument for mobilizing funds by both governments and corporates. Malaysia has taken a lead in the issuance of Sukuk and has pioneered a number of unique and innovative Sukuks that show much promise for the future. Bahrain has also played a big role in the development of the Sukuk market on the basis of both Ijarah and Salam. In this connection the Bahrain-based Liquidity Management Center (LMC) has played a significant role in issuing, arranging and creating secondary markets for sukuk. Recent years have also seen a Sukuk issued by Kuwait Finance House based on Ijarah and Istisna and a Sukuk issued by Darul Arkan of Saudi Arabia which is lead arranged by Unicorn Investment Bank. Qatar too has issued a Sovereign Sukuk.

These developments show that Sukuks are widely seen by governments as a promising tool to mobilize funds for public utility developments such as infrastructure development projects and by corporates as an instrument for tapping into the ready liquidity currently available in the Middle East and elsewhere. AAOIFI Standards for Sukuk have been in place for the past 5 years and it is likely that greater stringency will be needed as the industry progresses and expands to new areas.

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