Islamic Finance: Musharika and Ijara show slight differences in service agency rule

Last week we learned about the workings of an agency in Murabaha and Ijara transactions. In fact, we were in the middle of discussing how a lessee under an Ijara transaction also plays the role of service agent in carrying out the tasks of major repair and maintenance and insurance, albeit at the cost of the lessor who is obviously the owner of the leased asset.

Sometimes the cost of major repair and maintenance could be large if it is a high value asset such as a plant, vessel or aircraft. If the lessee carries out the above tasks as service agent on behalf of the lessor (owner), how is he reimbursed for the costs incurred by him in doing so?

In any case, Sharia emphasises that the service agent should not remain out of pocket for the amount spent by him in carrying out the jobs assigned to him by the principal (lessor).

As such, the Islamic banks have devised a procedure under the guidance of Sharia scholars whereby the cost incurred by the service agent may be reimbursed to him. Such an amount is then added by the bank to the amount of lease rent for the next period.

Let us try to understand it by way of an example. Assume that the lease rent of an aircraft is Dh5 million per quarter. The lessee, in the capacity of service agent, has spent Dh0.5 million during the current lease period on carrying out major repair and maintenance besides the insurance expenses.

The principal (owner and lessor) will be required to reimburse the service agent (lessee) by the said amount and at the same time increase the rent for the following rent period by this amount, thus making the lessee pay an amount of Dh5.5 million as lease rent for the following quarter.

Sharia scholars have approved this mechanism on the simple basis that the rent charged by the owner of an asset is always reflective of the cost incurred by him in keeping the asset in good usable condition.

Lease period

It is not necessary that the service agency contract also comes to an end upon completion of the agreed lease period. In fact, it is normal that the service agent continues to be responsible to the principal for a reasonable time even after the end of the lease period until the principal (lessor) has received all his dues. This is particularly useful to the principal in a situation where an insurance claim, lodged by the service agent, is in process.

In a situation where an Islamic bank is the co-owner in an asset along with the customer, the bank appoints the customer as its service agent to carry out major repair and maintenance, and insurance.

As previously covered in detail in these columns, a customer gradually purchases the bank's share of the ownership in a Musharika(co-ownership in an asset) transaction. At the same time, he is also required to lease the bank's part of ownership in the asset.

As such, the customer actually makes two periodical payments to the bank - one towards part purchasing the bank's ownership in the asset and the other being rent on leasing out the remaining part of the bank's ownership in the asset.

Share ownership

It is interesting to note that in Musharika, the bank and customer play a triple role.

The bank is first a co-owner, then lessor and, finally, the principal. Similarly, the customer is also co-owner of the asset, then a lessee for the part of the bank's ownership in the asset and at the same time the service agent.

In the last capacity, the customer is also looking after his own interest since his share of ownership in the asset is on a gradual rise. Please note that the three contracts run parallel.
In Musharika, too, the customer, acting as service agent, incurs certain costs in carrying out major repair and maintenance besides the insurance.

However, such costs are shared between the bank and the customer pro rata, according to their share of ownership in the asset at that time.

Similar to Ijara, the service agent (customer) is eligible to get the reimbursement of the bank's share of such costs. On the other hand, the bank, too, is entitled to add such costs back to the next lease rental period.

It is worth noting that as the customer's ownership in an asset increases, his eligibility to claim reimbursement in the capacity of the bank's service agent is reduced.

The writer is head of risk management at Dubai Islamic Bank