IsDB

Resolution:

All praise is due to Allah, the Lord of the Universe; and may blessings and peace be upon Prophet Muhammad, the final Prophet, and upon his Household and Companions.

The Islamic Development Bank Group Sharīʿah Committee, in its 52nd Ordinary Meeting held at the Headquarters of the Islamic Development Bank in Jeddah, Kingdom of Saudi Arabia, on Wednesday, 28 Jumādā al-Ākhirah 1435H (28 April 2014G);

Having reviewed the following inquiry from the Islamic Corporation for the Development of the Private Sector (ICD):

“The ICD is providing financing worth USD 28 million for the construction of a dairy plant in one of its Member Countries. The ICD will purchase the equipment from specialized vendors through the client, who will act as the ICD’s appointed agent in this regard. The ICD will then lease the equipment to the client for a period of seven years, at the end of which the ICD promises to sell the equipment to the client at a nominal value of USD 1.

The financing agreements were signed one month ago, and the client has made significant progress in fulfilling the prerequisites necessary for execution and disbursement of the financing. This Sharīʿah-compliant ijārah is governed by the following standard contracts:

• An agency agreement whereby the ICD appoints the client as its agent for the purchase of equipment from vendors.
• A lease agreement whereby the ICD, as lessor, leases the equipment to the client (lessee).
• A service agency agreement pursuant to which the ICD appoints the client to carry out major maintenance and insurance on behalf of the ICD.
• A promise to purchase signed by the client.
• A promise to sell signed by the ICD.

The responsibility for insurance and major maintenance remains with the ICD, as owner and lessor of the equipment; however, it is understood that it is permissible for the ICD to delegate such responsibilities to the lessee under a separate service agency agreement.

Tax implications

Tax laws classify lease transactions, subject to certain conditions, into two types: finance leases and operating leases. As the ICD is not based, from a taxation perspective, in the relevant country, the client is required to pay withholding tax on profits on behalf of the ICD in either case (finance or operating lease). In addition, a 5% tax on the total amount is imposed on operating leases. This value-added tax (VAT) is conservatively estimated to exceed USD 2 million over the lease term.

Before signing the agreement, the tax consultant initially considered that, based on the intention of the parties and the distribution of economic risks and benefits, the transaction would be treated as a finance lease, thereby exempting the client from VAT. However, this opinion was subject to final review of the financing documents to ensure compliance with taxation criteria.

After finalizing the lease contracts, the tax consultant conducted a detailed analysis and concluded that the lease would likely be classified as an operating lease, due to the lessor’s responsibility for major maintenance. Consequently, the client would be subject to substantial tax obligations that could undermine the feasibility of the transaction.

The tax consultant therefore recommended amending the lease contract by removing references to major maintenance responsibilities so that it may be treated as a finance lease for tax purposes.

Question to the Committee

Is it permissible to remove the clause relating to responsibility for major maintenance from the lease contract, given that insurance and major maintenance obligations are clearly stipulated in a separate service agency agreement?

If such deletion is not permissible, the Sharīʿah Committee is kindly requested to propose an alternative Sharīʿah-compliant structure, noting that such tax constraints may render Islamic leasing products less competitive in many Member Countries, not only in this jurisdiction.

The Committee is further requested to provide guidance that would support the ICD in promoting Islamic finance as a viable alternative to conventional financing modes.”

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After thorough deliberation and after listening to expert presentations and clarifications, the Committee decided the following:

Decision

1. From a Sharīʿah perspective, it is permissible not to stipulate in the lease contract the lessor’s obligation to perform major and essential maintenance, as Sharīʿah rulings on ijārah apply regardless of whether such obligations are explicitly stated in the contract. This is further supported by the fact that a separate service agency agreement stipulates the lessee’s undertaking to perform major maintenance on behalf of the lessor.
2. It is impermissible for both the lessee to issue a binding promise to purchase and the lessor to issue a binding promise to sell, where both relate to the same asset under the same circumstances. However, it is permissible for:
   • the lessee to undertake a promise to purchase in cases of default or breach, and
   • the lessor to undertake a promise to sell for the transfer of ownership at the end of the lease term, provided the lessee fulfills all payment obligations.

And Allah is All-Knowing.