Another interesting offshoot of the Musharakah genre is the retreating or fading partnership where one partner’s equity stake rises at the cost of the other. This is the Shariah acquiescent innovation in Islamic finance and is mostly applied where Ijarah cannot be used owing to a tax-unfriendly environment, in order to support the acquisition of an immovable asset, largely for home finance purposes, in line with Shariah principles.
Let me explain. A majority of the jurisdictions in the world are supportive of the conventional lending environment where the borrower pays interest on the loan. Then there is the tax rebate granted by the state based on the amount of interest paid by the borrower during a fiscal year. So, by default, the interest-based lending and borrowing practice gets promoted at the state level.
Imagine doing Ijarah Muntahiya Bil Tamleek (Islamic financial leasing) in such an environment. What shall be the outcome? Firstly, the rent paid by the lessee shall be considered taxable on the landlord who will obviously pass it on to the lessee, and on top of that, the lessee shall not be eligible for any tax rebate which is granted on the basis of interest paid by the borrower. Who will want to opt for such a double-dented solution when the conventional interest-bearing mortgage shall provide benefits which are totally opposite to applying an Ijarah transaction?
As such, the diminishing partnership or Musharakah Mutanaqisah is the most suitable solution for such dominions until such time that the country amends its laws to exempt all Islamic financing transactions from the different kinds of taxes so as to provide a level-playing field to Islamic financial institutions and their customers. This is the reason that the UK has legislated it under ‘diminishing shared ownership’ in terms of the alternative financing arrangement.
In a diminishing partnership transaction, the partners enter into a Musharakah agreement to jointly own an asset or a project or commercial entity. This type of Musharakah is recognized as the co-ownership (Shariah term Sharikat Melk) arrangement. In other words, each partner owns an undivided prorated ownership in the asset. At the same time, one of the partners (usually the minor partner) provides an irrevocable unilateral undertaking (promise to purchase) favoring the other partner to the effect that it will buy in piecemeal the counterparty’s undivided ownership in the asset over a period of time based on a payment schedule attached to the undertaking.
Kindly note that such a pledge cannot be made part of the Musharakah agreement due to the following reasons:
a. Shariah principles do not permit combining two or more contracts into one, and
b. The undertaking talks about a recurring future event where both considerations, ie the transfer of part ownership of the asset in question and the payment of the relevant price, are deferred to a future date. This is the reason that such promises are always unilaterally signed in the Islamic financial transactions. If the promise is made part of the Musharakah agreement, this will turn the agreement into a bilaterally signed forward document and hence null and void from a Shariah perspective.
The partner who has provided the undertaking shall, on each scheduled date, make payment to the other partner whose ownership shall diminish or fade to the extent on each such date in favor of the partner paying the amount.
Assumption: Party A approaches party B which is an Islamic bank operating in the UK and both agree to jointly purchase a residential property in London. Party A provides 25% of the purchase price and the rest is contributed by party B, thereby arriving at the ownership equation as 25:75 in favor of party B. Party A furnishes a unilaterally signed undertaking to purchase party B’s ownership over a period of time, say 10 years.
Party A continues to make regular payments and each time it pays the amount, a part of the property ownership gets transferred from party B to party A. The time comes that party A has made full payment to party B at which time the ownership equation stands at 100:0 in favor of party A. The amounts paid by party A on the agreed dates were comprised of party B’s cost in buying the asset jointly with party A, together with the profit for party B on the sale of the part ownership. At the end of the diminishing Musharakah period, party B would have recovered the entire actual investment made by it in the property along with the profit. At this juncture, party B shall transfer the registered title to party A.
If you recall, I have mentioned on several occasions in past articles that the beauty of Islamic financing contracts is that they provide risk mitigation from within the structure of the contracts. I would like to invite you to spot how this aspect is strongly present in a diminishing Musharakah paradigm.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.
Sohail Zubairi is the senior advisor with the Dubai Islamic Economy Development Centre. He can be contacted at [email protected]
Next Week: Explanation on diminishing Musharakah shall continue.